Being Cheap In A Rich Market
So here’s the conundrum as you look to decide what to put in your holiday financial shopping cart in preparation for the big ‘20: we have a rip-roaring economy with strong jobs numbers and very low unemployment, we have a Fed that’s on hold until we get sustainable inflation over 2% (so far ephemeral), we have a thawing of global trade tensions that have arguably been the main drag on global growth and certain segments of the US economy – what’s not to like?
The problem is that the stock market anticipated this well in advance (you might have too if you’ve been reading Kaoboy Musings 😉) and has already priced in “rational exuberance.” With the market pricing in close to 20x forward earnings, stocks are not cheap, but I would argue that they’re not “irrationally exuberant” either as they were in the late 90’s. That said, with a year-to-date performance of around ~30%, the heady market makes the contrarian in me wonder whether even the Anti-Oracle I call the Bearded Hamster would be reversing his parting “get-out-of-the-market” call right about now (see Kaoboy Musings 16).
Again, the conundrum: if you believe, as I do, that the economy still has legs and may even be re-accelerating now with trade tensions on détente, what do you buy if you’re a cheap bastard like me and don’t want to pay market rates for forward earnings but don’t find sub-2% bank interest rates appealing?
What if I told you that there was a sub-sector of the market that has never been this historically cheap and that the “widgets” these companies make are “must-haves” for the global populace? What if I told you that the reason why this sector has been so battered over the last few years is because of a confluence of factors that have led to a temporary oversupply of these “widgets” but that these factors are now starting to align in the opposite direction and are likely to lead to a supply crunch of these “must-have” widgets? What if I told you that many of the companies in this space are now generating free cash flow even as they’ve significantly curtailed future “widget” production?
The New “Plastics”
If you haven’t figured out what this sector is yet (and haven’t read the last several Kaoboy Musings), I’m going to quote Mr. McGuire in The Graduate as he takes young Ben (Dustin Hoffman) aside and gives him career advice: “I just want to say one word to you. Just one word.” Nope, I’m not talking about “plastics” – I’m talking about “oil & gas.”
I attended an oil & gas conference in Houston this month and met with 14 companies, mega-cap down to small-cap, up and down the oil & gas food chain as well as many investors and analysts in this space – I was surprised that so many of us “endangered species” are still alive! Nevertheless, I have come back with some new micro and macro insights as well as more conviction in my thesis than ever before.
Let’s start with a chart that shows you in stark relief what oversupply in oil & gas has done to this sector relative to other sectors within the US stock market:
This chart shows 11 sub-sectors of the market as well as the S&P 500 (in white), normalized to the same starting point exactly 5 years ago. The top performing sector in green is large-cap tech. The massive underperformer in red is – you guessed it – oil & gas.
In past missives, I’ve outlined some of my bullish arguments already, so this time I’m going to start with the opposite, devil’s advocate, opinion as outlined in this article:
The article makes several key points:
- The US shale revolution of the last decade has given us a global surplus of oil & gas “widgets” that have not only cushioned the world against unprecedented geoplitical risks but have also led the US to become a net exporter of oil & gas and surpass Saudi Arabia in production.
- OPEC no longer has the market power it once did, and its cuts have only stoked shale competition.
- Even as shale growth is slowing, other non-OPEC sources of growth are “springing to life.”
- Demand for oil & gas is predicted to stall out by the end of the next decade due to EV adoption in an to forestall climate change.
- In an era where the words “oil & gas” have become politically incorrect, financial players are increasingly embracing ESG (Environmental/Social/Governance) investing standards and shunning this sector.
I’m going to address each of these points, one-by-one:
1. The US shale revolution has indeed decoupled oil, once a geopolitically semsitive commodity, from even extreme events like the attacks on Abqaiq in September. In the past, a shock event that takes 5.7 mm barrels/day off-line would’ve resulted in triple-digit prices; this time, we had a muted and brief spike that faded almost immediately after the Saudis assured the world that “everything was fine” and that full production would be restored within a month.
Several oil analysts I have met have called bullshit on the Saudi “everything is fine” narrative and think that they drew down more than 30 mm barrels from internal storage and that the recent voluntary Saudi “overcompliance” over and above the increased cuts is nothing more than a “face-saving” way to rebuild their reserves. Given the recent Aramco IPO, Saudi credibility as a reliable supplier of oil is paramount, and I buy into this thesis that the additional cuts weren’t a magnanimous “gift” to US shale (as the Saudis suggested) but a necessary action to replensih their own lost supply.
Despite what Saudi Arabia claims, many analysts believe that true spare capacity (short-cycle capacity that can readily be brought on within 3 months) in OPEC is less than 2 mm barrels/day, or roughly 2% of global daily demand. That is a razor-thin margin for error no matter how you slice it. The one big caveat in all of this is that Iran has about 1.8 mm barrels/day of capacity that is effectively shut-in due to the sanctions and isnot included in this estimate of spare capacity; if sanctions were lifted for whatever reason, the additional supply would negate much or all of the OPEC cuts.
2. The bigger issue of OPEC’s loss of influence and the US resurgence as a major world oil supplier rests entirely on the US “shale miracle” of this decade, which was enabled by a unique confluence of factors including:
- Plentiful domestic shale deposits
- Technological advances in horizontal drilling and hydraulic fracturing
- Abundant water supply (necessary for frac’ing)
- Economic and political framework of mineral rights that incentivizes drilling and exploration
- Plentiful access to cheap capital that enabled not just runaway drilling but also infrastructure buildout
- Abolition of the export ban that allowed US producers to access global markets
Not only do I believe that this alignment of factors is unique to the US and not replicable in other parts of the world that do have shale deposits but lack many of the other ingredients, I think several of the aforementioned factors are beginning to reverse here, namely:
- Most US basins outside of the Permian have already peaked, with “Tier 1” acreage already drilled out and “Tier 2” locations only half as productive according to some analysts. As a result, annual decline rates are ticking up from mid-30%’s to low-40%’s, which means that producers need to drill more just to keep production flat. To show how dangerously dependent the world is on the Permian Basin, this small slice of Texas accounts for 2/3 of US shale growth, and US shale represents about 2/3 of total non-OPEC growth going forward.
- Improvements to well productivity and drilling times are starting to plateau; in other words, technological improvements are likely to be incremental going forward as opposed to be revolutionary.
- Plentiful access to cheap capital has come to an end, given the value destruction in this sector over the last 5 years. Exploration & production companies are battling a two-front war, with capital markets demanding free cash flow and return of capital while their service providers are barely earning their cost of capital.
- The result is that most prognostications of US production growth are going to fall way short of expectations. Some of the folks I’ve spoken to think that US production growth for 2020 will be closer to 400-700k barrels/day vs. “consensus” expectations of 1-1.5 mm barrels/day of growth.
3. The point about non-OPEC growth “springing to life” is backward-looking. Outside of US shale growth and OPEC+, the last of the big projects are coming on-line now (including Brazil and Norway) from the 2010-2014 vintage of $100 oil-inspired wave of long-cycle capex (these projects have 5-7 year lead times), and this has already been priced into the market.
Looking at the chart above, you can really see why the last 5 years have been characterized by an era of oversupply. The supply from the projects put in place during the 2010-2014 era hit the market at the same time US shale production was going bonkers. Looking forward, no money has been spent on these long-cycle projects during this recent period of low oil prices, and that drought projected forward 5-7 years is about to hit us at the same time US shale production is rolling over – this is literally the opposite dynamic of the last 5 years. If I were a betting man (and I sure as hell am), I’d bet that the next 5 years look more like 2010-2014 than 2015-2019.
This article spells it out: https://oilprice.com/Geopolitics/International/The-Dark-Outlook-For-Non-OPEC-Oil.html
4. Global oil demand has been growing 1.25 mm barrels/day on an annual basis, consistently for the last 5 decades, and only 7 of the last 49 years since 1970 have seen negative blips in demand, according to Art Berman of Labyrinth Consulting Services (see Kaoboy Musings 15 where I included Art’s full deck). The notion that the “EV Revolution” is going to make this time different and cause forward demand growth to plateau or even decline presupposes the following:
- That EV adoption will continue based on economics alone. Evidence suggests the contrary as sales have slumped along with an end to subsidies: https://oilprice.com/Energy/Energy-General/Chinas-Electric-Vehicle-Bubble-Has-Popped.html
- That EV adoption will not encounter its own issues with respect to lithium and cobalt mining/disposal externalities. The whole focus on “ESG investing” seems disingenuous to me when it chooses to focus on one variable (carbon emissions) and disregard everything else. Witness: https://oilprice.com/Energy/Energy-General/The-Human-Cost-of-the-EV-Revolution.html
- On a current global base of 1.4 bn vehicles, EV sales of 2 mm in 2018 are inconsequential. Taking this number up 10x by 2030 (as some manufacturers have forecasted) will still only result in 60-90 mm total EV’s out of an even higher base of ICE (internal combustion engine) vehicles. If we then factor in the fact that 40% of annual car sales currently are SUVs which consume a lot more gasoline than cars, the number of EVs on the road just won’t matter at all to oil demand.
- The rapidly industrializing emerging economies of China and India are energy-starved and are far likelier to support urbanization initiatives that are viable with the current infrastructure as opposed to waiting for the EV revolution. The analogy of “going straight to wireless” in the realm of telecommunications just doesn’t hold up in this case.
- The whole ESG focus revolves around the debate around climate change and the focus on cutting carbon emissions. While I’m not going to get into a whole political debate about this topic here, I have been reading extensively on this topic and engaging with several experts in the field. In short, while there is no denying that the climate is indeed changing (and it has for the entire 4.5 bn years of Earth’s history), the science does not appear to support Anthrogenic (man-made) Global Warming (AGW). This is one of the most comprehensive papers I’ve come across that suggests that the focus on curbing CO2 emissions is tantamount to “barking up the wrong tree,” as Professor Giengengack, Chair Emeritus of UPenn’s Earth and Environmental Sciences said to me.
Here is the link to the paper: https://wryheat.files.wordpress.com/2019/04/climate-change-in-perspective-2019.pdf
As an investor and believer in free markets, I believe the capital markets tend to ferret out the most viable and economic solutions in the long term – capitalism culls out the weak in Darwinian fashion.
The following regression is from a site called https://wattsupwiththat.com and shows a very clear correlation of electricity costs with renewables adoption, i.e. the less you depend on hydrocarbons, the more expensive your electricity is. Note that Germany and Denmark, the poster-children of renewables adoption, have electricity costs that are 3x that of the US.
Bottom-line: I have very high conviction in this oil & gas thesis over the next several years, but this sector is not for the faint of heart. The two biggest risks are global recession and a removal of Iranian sanctions, neither of which I place high probability on.
There are many ways to play this thesis: through the commodity itself, through oil & gas weighted ETF’s like the XOP (exploration and production companies) or OIH (oil services), or through individual equities (which I would not recommend unless you do your own homework and are comfortable with idiosyncratic company risk). In the name of full disclosure, outside of my sizeable bets in GSE preferreds, individual oil & gas stocks comprise (by far) the biggest chunk of risk assets I have in the securities markets. I own FANG, VNOM, NOG, FLMN, ET on the public side and Birch Resources on the private side.
The Force Is With This One
Not only are the holidays upon us, Star Wars season is once again here as well. I officially submit my review of Star Wars, Episode IX: The Rise of Skywalker for your perusal.
As a long-time Star Wars fan, I had great hopes when Disney acquired Lucasfilm in 2012. Seeing what they did with the Marvel franchise, I naturally extrapolated similar success to what they might do with the Star Wars franchise, supercharged with the might and muscle of Disney behind it.
When the greatly anticipated Episode VII: The Force Awakens came out in 2015, while I was disappointed by the fact that the story arc resembled the original Episode IV: A New Hope very closely, I was still entertained because the director, J.J. Abrams, introduced some intriguiing new characters and plot elements that invited speculation (something the Star Wars fan community loves to do).
Along came Rogue One in 2016, the prequel to Episode IV: A New Hope. I loved this movie and was lucky enough to attend the red carpet premiere, replete with a full-scale X-Wing fighter on Hollywood Blvd -- the fanboy in me was in heaven! I remember thinking to myself that George Lucas made a huge mistake selling too cheaply and that Disney would usher in a new Star Wars Golden Age. So far so good!
Then came Episode VIII: The Last Jedi in 2017 – and my Star Wars dreams imploded faster than Death Star 2 over Endor. Inexplicably, the director Rian Johnson, systematically shut every plot door that J.J. Abrams opened in the The Force Awakens and simultaneously discarded every bit of fan-revered “canon” in one fell swoop. It’s as if he systematically hunted down and destroyed everything fans loved about Star Wars, a la “Order 66”! Honestly, forget about it being the worst Star Wars movie by far, it might’ve been one of the all-time worst movies I’ve ever seen in any genre, and Rian Johnson deservedly earrned his own entry in the Urban Dictionary as a result: https://www.urbandictionary.com/define.php?term=Rian%20Johnson. I could just picture George Lucas LOL’ing, knowing that forlorn fans like me would beg him to come back at any price – even with Jar Jar Binks in tow!
Meanwhile, as you can see below, the “official” critics gave it a 91% rating on Rotten Tomatoes – Jedi mind trick by Disney? Fans like me crushed it with a 43%, which I thought was generous (I would have rated it 1 out of 10).
So when a neighbor invited me to the “Friends & Family Pre-Showing” of Star Wars IX: The Rise of Skywalker at the El Capitan on December 16th, you can imagine my level of indifference. For the first time in the history of Star Wars films, I had seriously considered waiting for this one to hit Blu-Ray before seeing it, but since it was free, I figured “why not”?
Imagine my surprise when halfway through the movie, I’m not only not hating the characters any more, but I’m actually enjoying the movie! J.J. Abrams now has my undying respect as a Jedi Master for levitating this wreck out of the swamp – not only did he fix all of the issues that Rian Johnson created, he managed to do so in a way that almost allows you to think that some of the gaping plot holes in The Last Jedi were done on purpose. Almost. There were still a couple moments that made me cringe (watch it and you’ll know what I’m talking about), but not enough to keep me from seeing it a second time this weekend with my family. After Round 2, I actually liked it even more and would actually assign an 8 out of 10 for this one – I even rank it slightly ahead of Rogue One, and that’s saying a lot.
Note, however, how wrong again the “critic consensus” is. If you’ve been reading my Kaoboy Musings, you know how much I value contrarian thinking. Let this be no exception. Don’t trust the critics – go see The Rise of Skywalker. J.J. is a Jedi Master, and this is the finale you’ve been looking for!
May The Force Be With You, and Happy Holidays!
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Kaoboy Musings is a private distribution list/blog that I created to encourage dialogue regarding the economy & markets, geopolitics, investment ideas, and life in general. I have a passion for the markets and investing, and even though I no longer accept investor capital, I try to keep current on global events and opportunities and remain active in the markets. I’ve always found that writing my ideas down, sharing them with smart people, and encouraging two-way discourse and devil’s advocacy is often the best way to validate or invalidate a thesis and stay mentally flexible.
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