Let's Talk About Oil
Good morning everyone.
Oil and gas continues to be one of the most volatile sectors to invest in.
Despite the volatility I continue to hold a meaningful amount of oil and gas names in my portfolio.
I think the sector is undervalue, underappreciated and will likely outperform over the next few years.
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Let’s Talk about Oil
I graduated college during the Great Recession. The was an impactful time in my life. Successful people I looked up and adored lost their jobs. Unemployed and out of work. Many homes lost their value. Single family homes went from $250,000 to $25,000. Foreclosure signs were everywhere. Demand for single wide trailer parks exploded.
Experiencing the Great Recession first hand as a young adult impacted the way I manage risk, personally and professionally. I was always drawn to having a strong sense of financial security — multiple income streams, no debt and a large cash reserve should the financial world implode on me that I could put to work to buy discounted assets on the cheap.
After college I started reading personal finance books to understand how to best manage finances. I was quickly drawn to the lessons of value investing by Ben Graham and David Dodd and fell in love with the methodology and process. Buy assets at a steep discount to intrinsic value. If you buy a basket of assets trading for 50% on the dollar, you will come out better than most speculators who claim to be investors.
I have written extensively about the importance of using a margin of safety with investing throughout multiple cycles. No matter where we are in the cycle, top or bottom, never deviate from buying assets at a steep discount from intrinsic value. Because when you deviate from these rules is when the gambling speculator takes the reigns.
I bring up the margin of safety methodology in-light of the recent downturn in energy equities. Energy stocks had a strong run over the past few years, but recently traded sharply down on concerns of a global recession. Investors believe that Fed rate hikes will lead to a recession which in turn will decrease the demand for oil, leading to a downturn in oil and gas prices.
Investing in commodity related names is a tough business. Any chimp analyst can figure out the business model of an E&P operator or miner. It’s relatively simple and once you understand the model you can apply that across the industry to figure out where the cost curve is and who controls the supply and demand. The tough part about investing in commodity related assets is forecasting what the price of a commodity will be in the future.
With commodities, investors tend to buy at the top and sell at the bottom. When commodity prices are at peak levels earning multiples look cheap. When commodity prices are at the bottom, earning multiples look expensive. Investors tend to get excited when they see a commodity producer trading at 1-2x free cash flow and disgusted when they see them trading at 50x free cash flow. Some of the best times to purchase a commodity producer is when it is trading at 50x free cash flow compared to 2x free cash flow as you are likely buying at the bottom and not the top.
That being said, buying coal equities two years ago when they were trading at 2x free cash flow turned small sums of money into handsome fortunes. Commodities are tough and predicting what the price of oil will be in 2024 is incredibly challenging. Predicting what the price of oil will be in 2030, an impossible feat.
To give myself a handicap when investing in commodity companies I gravitate towards these types of companies in order to protect my downside and invest with a margin of safety:
Clean capital structures: one class of stock, no preferred stock, limited warrants and minimal potential dilution.
Cash rich balance sheets: prefer net cash with limited to no debt. 2.0x debt to EBITDA can turn into 6.0x very quickly in a down cycle.
Low cost producers: I like owning commodity producers who can generate free cash flow in all business cycles, not just peak commodity cycles.
My goal is to limit my downside whenever I underwrite an asset. Commodity producers with a ton of debt and high costs perform the best during a bull market, but go bust during bear markets. If you think this up-cycle is different than the rest, think again. Eventually higher pricing will kill higher pricing as entrepreneurs see the profits they can make from one incremental well drilled.
Despite the fact that all cycles end, I do think the recent pullback in oil and gas prices is a bit extreme and we won’t be seeing sub $50/bbl anytime in the near future.
The oil and gas industry has essentially been in a recession since 2014. There has been minimal capex spent. Countless bankruptcies and restructurings. Investors have lost fortunes. Capital has literally been incinerated.
The green agenda push has been severe and dire to the industry. Majors are being forced by activists to become carbon neutral at some point in the future. The cost of capital has increased and lending on oil and gas exploration has gotten expensive, if not impossible. The Coronavirus Crisis accelerated the rollout of new strategies aimed at lowering carbon emissions and growing the renewable business.
Higher commodity prices will help oil and gas companies paydown debt and emerge stronger from the past eight year recession in the space. But capital spending on exploration and production is likely to remain muted as majors have committed to investing in renewables. As an example BP has committed to reduce its oil output by 40% or 1 million barrels per day by 2030. Shale producers have also promised investors they will be returning capital to investors who have not seen a return in 8 years.
Oil and gas companies don’t have many incentives to invest back into the oil and gas business. Politicians and activist green energy investors are pushing traditional oil and gas companies to invest in green and sell legacy oil assets. Banks are raising the cost of capital on fossil fuels, making borrowing hard and investing in the future tough. Investors in oil and gas companies are pushing for as return of capital as they have lost money for eight years.
The world is due for a multi-year commodity cycle and we are just at the beginning of this crux. If oil prices fall back down to $50/bbl, capex will further be pulled back and a rise in demand will lead yet again to higher energy prices as supply struggles to keep up. We need supply and it appears as if supply is just not coming online in this market where investors are asking for a return of capital rather a return to the heyday of growth in production. When an executive team’s bonuses are based on the amount of capital they returned versus deployed, you can bet your last dollar that an executive team will maximize their own self interest.
Despite my overall bullish tone on a multi-year commodity cycle, I continue to invest in low cost producers with ultra-clean balance sheets. The goal of any sophisticated investor is the minimize losses. If you protect your downside the upside will take care of itself. When you buy a high cost producer with debt, things turn south on you pretty quick.
If you follow the Telegram channel religiously, you probably know what oil and gas companies I like. My favorite one has a ton of cash on their balance sheet, they are returning capital and diversified into multiple segments. My other favorites are the drillers that are seeing day rates start to explode. The drillers have less clean balance sheets, but the torque in the earnings power can be quiet meaningful.
Want to learn more about my favorite oil and gas stocks? Become a Grit Alpha subscriber today, reply to the welcome email and I will get you the link to the Telegram where we can chat personally about my favorite stocks.