So You Were Wondering About Oil

I’m often asked the question “what do I think about X (oil, Ukraine, China, interest rates etc…)” I can talk about oil all day long but it’s totally different if you are going to go out and invest you hard earned money. Below is my answer.

Question: I’d be really interested to know what you think about oil. There are some very beaten down names…. What’s the strategy here? Is this an opportunity for a long term buy and hold play, or is the consensus that there’s more carnage to come?

Answer: Hi Hank (may or may not be his real name to protect askers identity),

Thanks for reaching out. I follow the oil sector in a general sense but I’m not going to pretend that I’m an oil guru. I’m also not a fan of cyclical investments, such as commodities. You can make a lot of money in that sector but it’s just not my game. You only need to look at the last year or so to see how rock “n” roll prices can be. You can make money really fast and you can lose it even faster. Having said that, I always look for opportunities. Oil is probably the most important and strategic resource we have. Oil’s influence plays a central role in our everyday economy and lives. Regarding oil as an investment, I think I can answer that question in two parts. The first part is your own personal view on oil and the second part is the investment merit of the oil & gas companies.

Part One – View On Oil

It’s very difficult to determine the value of a barrel of oil, or any commodity such as gold because you don’t have a cash flow. At least with securities you have a framework for valuing things. For example, a bond is easy to value because it distributes a fixed cash coupon. An ounce of gold just sits there or on a finger. Oil at least has a functional value to society (In gold’s defence, if you watch reruns of Glenn Beck’s show it’s never worth enough). So how much is a barrel of oil worth? I have no idea. Non-income producing assets are worth what buyers will pay for them. For a while the cost of production was a reference for the lowest price possible for a commodity but now we are seeing producers below cost (including some gold producers). One of the main reasons why there are so many companies producing oil below cost or at break-even is because they have to service their debt. It’s pretty much the bank telling them to pump oil because the bank doesn’t care about the economics or fundamentals of oil. As a piece of advice, I would ignore talking heads’ price target on oil. It’s too easy to get sucked in by the fancy sophisticated analysis. The thing is if you listen enough there are so many contradictory targets. Before the oil crash Goldman Sachs was saying oil was going north of $150. Then they changed their mind to $48 a barrel after the crash. You hear so many different numbers being thrown around. What’s insane is that all these analysts have access to the same data bank as everybody else. Basically it’s all noise and those price targets go up and down like the tide. To answer a part of your question regarding if there is more carnage to come, well my answer is how long we will continue to see a decline in the price of oil is anyone’s guess. You really need to develop your own independent opinion with minimal advisory input.

My personal view on oil is that it’s bound to go up eventually. My opinion is not scientifically researched and I don’t have eye popping charts to show you. I also don’t subscribe to any conspiracy theories. My view on oil is simple and easy to defend. You could probably find the same view out of a 6th grader school notebook. In the short-term it’s impossible to know if the barrel of oil is going to $80 or $20. I heard intelligent cases for both side. If your idea of investing in oil is speculating on the price of oil in the next months or years, good luck. I can’t help with that and anybody pretending to is taking you for a ride. If your idea of investing is finding companies or assets trading below its perceived intrinsic value then I can steer you in the right direction.

My case for higher oil is a simple one. Now remember that it’s just an opinion. Demand worldwide should grow modestly over the next couple years. As a society, we still have a lot of work to do before we can switch to a reliable alternative energy source. Basically, what I’m saying is that we are not getting off our oil addiction anytime soon. I love clean energy and it’s definitely the way to go but I’m not giving up my pickup truck anytime soon for a bicycle (However I heard a company called Tesla is up to pretty amazing things with cars).

I do think that low prices is the cure low prices. The lower the price, the higher the oil consumption. (You can also make the case that higher prices is responsible for lower prices) On the supply side, producers just can’t keep operating at a loss forever. According to the IEA, supply will outstrip demand by 2m barrel per day (bpd) for the rest of 2015 and should equilibrate sometime in 2016. It sounds like a lot but it’s not. During Q2-2015, demand was at ~93.5m bpd and supply is at ~96m bpd but some analysts believe the demand side number will be revised upward with demand for gasoline stronger than expected. According to the Federal Highway Administration, the number of miles travelled on U.S roadways rose to the highest level ever in June. It’s easy to disrupt supply. War, geopolitics, a break down in the infrastructure, a problem at a refinery or with a pipeline, issue with transportations are just a fraction of the potential problems that could disrupt supply. Any problem with supply would therefore result in a rapid draw down of oil inventories. Plus you have millions of barrels that need to be replaced every year just because of depletion. Low prices also impact the economics of drilling, reducing additions to supply. What we are seeing right now is that producers are cutting production or leaving oil in the ground. So there’s a lot of pressure on supply. There’s obviously a lot more to oil than what I just mentioned. If you want to learn more about oil I suggest reading letters by Andrew Hall from Astenbeck Capital. That guy knows his stuff but keep in mind he’s a huge oil bull. A good resource is the IEA Oil Market Report. The U.S. Energy Information Administration also post weekly data on oil and energy.

Part Two – Investing in Oil

Just being bullish on oil shouldn’t be a reason alone to go all in and invest. Yes there are a lot of beaten up names out there and it looks very tempting to snap a couple shares here and there. The first thing I do is that I go right to the financial statements and start asking questions. Is the balance sheet strong enough for them to survive? Do they have enough cash to meet their debt obligations? In the crappiest environment, how long can they survive? What are the debt covenants? What’s their netback? How much capex do they need and how are they going to fund it? Any shareholder dilution? How long does it take to convert capital to cash flow? Do the math and invest for the maximum risked return.

Depending on how much time you have and knowledge you can poke at different part of the capital structure of a particular company. Distressed debt can be an interesting segment to look at. I would also look for companies that take advantage of the drop in oil price to review their cost structure. For some O&G companies, a drop in commodity prices can be a constructive county cyclical investment strategy which is designed to take advantage of lower activity level and lower service costs to deliver higher returns on invested capital. It’s an opportunity to lock-in suffering service providers at a lower cost. Basically low prices 1) helps weed out the strong ones from the weak ones and 2) and provide an opportunity for companies to plant the seeds of the future if oil prices turn bullish. If they can operate profitably in such a disastrous environment, the rest is upside.

While the upstream (exploration and extraction) side of part of the industry is in pain, the downstream industry which includes pipelines and trains that transport oil is making a killing in this low price environment. As an example, Phillips 66 (NYSE:PSX) and Valero Energy (NYSE:VLO) are pure refiners. As oil dropped, refiners and retailers are acquiring oil on the cheap which leads to margin expansion.

Integrated O&G companies definitely deserve to be looked at. These companies are involved in many aspects of the oil industry, such as upstream, midstream, and downstream. Companies like Exxon-Mobil (NYSE:XOM) and Suncor Energy (NYSE:SU) have their hands in exploration, refining, and retailing. With an integrated oil company, the business is not overly reliant on the price of oil. What they lose in the upstream part of the business, they make up in the downstream sector, so long as gasoline prices stay high.

You can also look at companies that have zero commodity exposure. Usually these companies have a fee based revenue, like pipelines. Kinder Morgan (NYSE:KMI) and TransCanada (NYSE:TRP) are among the companies that operate oil transportation infrastructure. These companies usually have exposure to volume, not price. What they charge is largely independent of oil prices and they are utility like.

Conclusion

If I can resume all of that, I have no clue what oil is worth and what is going to happen. I suggest you develop your own independent opinion. Take a long-term approach and ignore the noise. Wall-Street is not your buddy, pal, friend, or advisor. Basically don’t invest solely on what I just wrote or others. Don’t just snap up shares just because the sector is beaten up. Take a rational, analytical approach to all decisions. Always do the math and invest for the maximum risked return. Act like a crocodile, wait patiently for the right opportunities and take bold action when the time is right.

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