My core investment philosophy is based on contrarianism. For a simple demonstration of this concept try going to your local horse races and placing the same size bet on the favourite horse in each race. If you participated in more than 10 races it is extremely likely you will end up with a net overall loss. It shows that a great horse doesn’t mean a great bet just like a great company doesn’t always equal a great investment - the odds become skewed by punters/investors who are eager to make money such that the payoff becomes less than the odds of winning. Investing is a little more complex in that the punting and race is continuous but regardless, my specific advantage and strategy is in bringing insight to locating underappreciated investments and buying them before they become widely recognised.
Reviled but Mispriced? Oil & Gas
Given my investment philosophy, there should be no surprise that I have spent considerable time studying the oil & gas industry which these days, rank among the most hated investment areas underperforming nearly all other sectors (even airlines!) over almost any timeframe. Using the XLE ETF as a representative, the price is back to the same level as in 2000 while YTD it is down -48% vs Nasdaq100 +33%: an astounding -61% underperformance! Meanwhile oil price currently ~$40/bbl is back to early 2000s levels.
The oil market has limited storage and only tolerates a narrow supply/demand imbalance (usually within a 1-2% annual range) before significant price moves. Forming a view on the balancing point between supply and demand is crucial to any investment.
Demand
It’s hard to add value on Demand side analysis given the virus unknowns in the short term and many changing variables longer term. Yet forecasting Demand is the primary fixation of the Market and a major reason for its negativity - extrapolating the current grim conditions well into the future. The magnitude of the current Demand collapse is unprecedented in history but I don’t believe ‘this time it’s different’ and I don’t believe we’ve reached peak oil consumption. While there is ongoing erosion of Demand in developed nations, this is nothing new. Low oil price encourages use and electric cars are still in their infancy in terms of production and infrastructure. Nothing I’ve seen suggests the virus caused a permanent impairment in Demand which as history shows, is inelastic and closely linked to economic activity.
Global oil consumption has been rising ~1.6% CAGR over the past decade and in 2019 it was 100.9m bpd. Demand today is driven by developing countries (non-OECD countries: ~53% of total consumption) while OECD countries’ demand peaked back in 2005
Energy demand is directly linked to economic activity. There were only 3 incidences of negative annual oil consumption in the last 30 years: 1993 -0.22%, 2008 -0.64%, 2009 -1.03%. The peak to trough fall from 2007 to 2009 was -1.4m bpd (from 87.1m to 85.7m) or -1.6%. This fully recovered in 2010 when oil consumption grew 3.5% yoy to 89.7m bpd
Oil consumption is expected to fall -8-9m bpd in 2020 to 91-92m bpd and estimated to recover by ~6m bpd in 2021 (still -3-4m bpd less vs 2019)
Future demand estimates vary. OPEC estimates peak by 2040 at ~109m bpd while BP’s most negative scenario estimates 2019 as the peak. Such speculation is typical during extreme price periods
My base expectations is for oil consumption to mean revert once the virus situation is stabilised and approach 2019 levels within 2-3yrs.
Supply
I believe most of the oil cycle insights can be found by understanding the Supply side whose behaviour seems typical of a cyclical commodity industry.
Up until mid-2014, the oil and gas supply side was a Roman style orgy of excess as industry captains emboldened by years of >$100 oil prices ploughed increasing amounts into growing their reserves and production (and bonuses). But a sudden steep drop in price from $110 to $50 within half a year led the industry to heavily slash capex in 2015 squeezing service providers and cutting investment in reserves. This pattern of behaviour can be seen repeated throughout history including the oil crisis of 1980s (supply shortages in the 70s led to elevated prices which then caused excess production build-up). This latest cycle should have ended in 2019 with the industry acknowledging years of under-investment and plans for a new multi-year capex upcycle starting 2020.
Instead the virus hit and the current 2020E capex is -29% (<$400bn) while production is expected to drop -6% (-6m bpd to 94m bpd). Since squeezing the oil service providers was done years ago, these capex cuts will come directly from cancelled projects and lower production. The 2020E capex brings the industry back to 2006 capex levels when global production was only ~83m bpd (-13% vs 2019 production) and despite global inflation from 2006 to 2019 equaling ~60% increase in prices. This capex does not look sufficient yet it reflects the economics of the current oil price. This situation isn't sustainable.
Majority of oil production are from conventional reserves (only low double digit is from unconventional/shale reserves) which require high initial capex and long lead time to develop. Once developed however, production is relatively low cost with stable output. In contrast shale reserves require lower capex and time to production (<1yr) but higher ongoing costs and fast depletion. Dependence on conventional reserves is the reason why there is a long lag between capex spend and production impact.
Most conventional reserves can cover their variable costs today but the deterioration becomes severe after a few years (typical E&P major’s reserve life ~10yrs and only a fraction of reserves are developed). CNOOC's cost structure (per BoE) illustrates this:
Replenishment/Development Costs ~$30/bbl: Finding $10, Conversion to Developed $13, Other Development $7
Production Costs ~$13/bbl: Remediation $0.5, Production $7, SG&A $2.5, Taxes $3
Total $43/bbl to maintain reserves and production. But only $13-20/bbl if no exploration and varying degrees of reserve development
The above is the cash cost estimate. Frequently companies will report "All-in Cost" which uses accounting Depletion, Depreciation & Amortisation instead of the many individual Fixed Cost items. This underestimates the true costs including exploration failure (expensed) and the current reserve development spending. E.g. CNOOC's "All-in Cost" is only ~$30/bbl.
The breakeven cost for new reserves must be considered to understand longer term oil market direction. The below charts from Rystad (top) and Market Realist show a similar story: only ~40% of global oil production sources have an average breakeven price <$40/bbl. And it is also estimated at $40/bbl oil only 55% of current global oil production is economic. The Supply side economics means the Demand outlook in 2yrs time is largely irrelevant – oil prices must rise and oilfield capex must increase or majority of production will end.
What about OPEC+Russia? This group represents ~50% of global production and were instrumental in balancing short term oil markets by cutting 10m bpd in 1H20 (20% of their capacity). Their continuing co-operation will be needed to balance markets in the short term until Demand recovers but the medium to long term Supply side economics situation remains the same.
Investments Actions
To be clear this isn't just a 'oil price will rise' thesis. The Market has sold down the entire sector well beyond reasonable levels - most E&P companies are trading at multi-decade lows (e.g. ExxonMobil is back to 2004 price) and the implied Price/Adj Reserve is well below replacement cost. The Market is so certain in its belief that fossil fuel industry will collapse and the new age has come (Tesla, clean energy) that the premium gap has become too crazy. Almost nobody looks at it from a existential point of view in the investment world and yet in the real world majority still drive gasoline cars and look forward to their next overseas holiday... The Market's short term goggles and fears are seriously mispricing the likely future cashflows from these assets.
My investments into this hated industry is divided into four primary areas:
Oil E&P: CNOOC, Lukoil, Exxon, Occidental and ENI
Gas E&P: Inpex and Woodside
Oil service providers: COSL and restructuring VAL
Related: CVR Energy
The E&P plays were decided via screening based on the:
Value: EV/bbl of adjusted Reserve (adjusting for Developed/Undeveloped, Oil/Gas)
History: normalised ROE, FCF generation, dividend payout
Operational: cash cost of replacement and production, reserve life
Debt: both a risk and upside enhancer
CNOOC and Lukoil were standouts in terms of their valuation, low cost operations, historical performance and low debt positions. In CNOOC's case, today one only pays ~$12/BoE of adjusted Reserves which is well below the $30/bbl cost to find and develop new reserves. CNOOC's shallow water China assets are among the lowest cost in the world and it has a valuable call option on future deep sea reserves (it has monopoly rights to all offshore China).
Occidental and Exxon isn’t as cheap but I added them for their low cost and quality assets, especially in US shale where they rank among the largest players. Occidental is heavily indebted ($47bn net debt and market cap only $9bn) with a cash replacement and production Cost/bbl I estimate to be in the mid $40s which makes it a geared play on the idea. I like Exxon for its non-apologetic attitude towards its operations and future – it knows it’s an oil company and doesn’t try to pretend to be otherwise. Also US E&P players tend to enjoy a premium so there is actually higher price reversion upside vs listed companies elsewhere. I bought ENI because it was cheap but its less of a ‘purpose driven’ position and could be replaced. These positions will be 'optimised' as facts change and I study other players.
The Gas E&Ps I’ve chosen are low cost producers with vast reserves, development options and low valuations. They are infrastructure like in nature in that their production and contracts are extremely long duration.
CVR Energy’s main operations is a set of quality regional refineries (low cost, high distillate yield). It has a moderate, manageable debt level and excellent capital management history (70% owned by Icahn since 2012 who maintained a great payout policy). Products demand will probably lead oil which may benefit crack spreads, also accounting wise, they book any oil price rise as inventory gains in the P&L which the market likes. CVR is small cap, illiquid and fallen -70% YTD; I think its trading at just 25-40% of fair value.
The upside calculation for these investments can be as simple as using their historical average share price when oil price was $50-60/bbl. For the E&P stocks, a more detailed calculation would be to use $50-60/bbl oil to calculate the P&L and putting a high single digit to low teens earnings multiple (depending on their own trading histories).
Final Words
To date these investments have been among the biggest detractors to my performance but I expected to be early and don’t mind looking foolish in the short term. Most of these companies are in deep value territory with mean reversion upside of >2x which means I just need my thesis to be right within the next 3yrs for a >20% CAGR payoff.
It’s interesting that many of the value/contrarian investment managers I respect with excellent long term track records have drastically under-performed in the current environment. I don't know how long it will last but I can feel mania building on the Street and concerns over a repeat of the dot.com bubble is always at the forefront of my mind. At worst I under-perform but I think at these price levels my risk of absolute loss is low.
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