Happy New Year!
What a difference a year makes. In Q4’18, the market dropped 20% up until Christmas Eve, before recovering about 5%, bringing the Q4’18 loss to just under 15% and finishing the year with a ~6% loss and a lot of people calling for global recession. In Q4’19, the market rip accelerated into year-end, adding 10% to an already strong year to end with a whopping 29% gain on year – one of the best performances for the decade.
A couple key takeaways here: 1) a lot can change during the course of a year, so resist the urge to straight-line current trends and, 2) don’t always believe the consensus (which was climbing a wall of worry and calling for global recession)!
One of the biggest worries I always had as a fund manager at this time of year was performance anxiety. Not that performance anxiety, but worrying about either 1) how to make up a bad year, or 2) what to do for an encore after a good year. One year into managing my own capital as opposed to being a fiduciary for investor capital, I have to say that even though some old habits die hard, on this front at least, I am far less obsessive over an arbitrary demarcation point on the calendar. I don’t really care whether it’s quarter-end or year-end anymore – I just want my portfolio to grow over the long-term, and I’m much more at peace with resisting FOMO and being patient.
That all said, my goal is to constantly upgrade my portfolio and optimize for risk/reward – this is one of those old habits that die hard. What should one do now given the headiness of the markets (now trading close to 19x forward earnings) and the fact that the once-contrarian view (that we’re not going into recession, which I’ve been saying since Kaoboy Musings 3) is now becoming consensus?
Oil As A Safe Haven
As I alluded to in Kaoboy Musings 10, 15-17, I believe a relatively low-risk way of participating in a global economy that may now be reflating after the trade headwinds of yesteryear is to bet on the worst-performing sector of the last 5 years – the down-beaten oil & gas sector. Since 10/29/19 when I first opined about the opportunity in Kaoboy Musings 10, the sector as represented by the XOP ETF has gone up “only” 10%, although it first went down 10%. The nadir was reached on 12/3/19, and the XOP rallied 20% since, with some of the names I track up 35-40% in the last month!
For all of the reasons I listed in Kaoboy Musings 17, I still think it’s early days for this particular thesis – especially if I’m right about the global economy reflating after a protracted period of trade-negotiation inspired headwind.
I listed two primary risks to my oil thesis: 1) the risk of global recession, and 2) a removal of Iranian sanctions.
Risk #1 was greatly reduced with the Phase 1 deal with China – the naysayers say this deal didn’t accomplish much; my rebuttal: it didn’t have to accomplish much – it just had to stop getting in the way of an otherwise strong economy. There are signs that this reflation is already under way: https://www.bloomberg.com/news/articles/2019-12-27/china-s-economy-picked-up-in-december-early-indicators-show.
Risk #2 was a bigger wildcard in my opinion, because if the past is any guide, Trump’s market sensitivity has proven to be a great predictor of policy. Alas, I remember all too well how he sanctioned Iran in 2018, initially signaling “no possibility of waivers,” leveraged Saudi Arabia’s political weakness in the face of the Khashoggi murder to get them to open the spigots to make up for the inevitable loss of Iranian barrels, and then at the last minute granted waivers anyway – this is exactly what caused the oil collapse from $77 to $42 in December of 2018.
This year, with the attacks on Abqaiq in September pointing suspiciously to Iran, the U.S. chose not to escalate tensions in the Middle East by conspicuously not coming to Saudi’s aid to retaliate against Iran. After an initial spike to the mid-60’s, oil fell right back to $50 on the lack of escalation and on Saudi’s assurances that “everything was fine” and that production would be fully back on-line in a month. This always seemed suspicious to me, and we’ve since learned that Saudi Arabia did a masterful job of finessing the press on its reliability as a supplier due to its impending Aramco IPO but that it also decided to unilaterally “over-comply” to its already agreed-upon cuts at the OPEC meeting; as I wrote in my last musing, I think this is based on a very real need for Saudi to restock its storage that it used to shock-absorb the lost production from Abqaiq. This has created a dynamic of supply tightness that is only going to get exacerbated with the pickup in global demand from reflation, the rolling over of Permian production, the lack of major projects for the last 5+ years, etc.
To me, the only real source of spare capacity in the world is Iran, which has effectively been shut-in on 1.8 mm bbls/day of production due to the sanctions. With Trump knowing that Saudi is now “once bitten, twice shy” after the December 2018 head-fake and the fact that it is now on its own with respect to defending itself from attacks, I figured that the obvious lever for Trump to pull was to re-open negotiations with Iran and make a deal, hence my caveat.
The probability of lifting Iranian sanctions went to almost zero given the events of last week, culminating in today’s big headline about the surprise drone strike that took out Qassem Soleimani, Iran’s top general in the IRGC (Islamic Revolutionary Guard Corps). The escalation actually began on 12/27 when a U.S. civilian contractor was killed in Northern Iraq by Iranian-backed militia. On 12/29, the U.S. responded with airstrikes in Iraq and Syria against this same Kataib Hezbollah group. On 12/31, pro-Iranian protesters broke into the U.S. embassy in Baghdad, evoking memories of Benghazi. On the evening of 1/2, when U.S. intelligence found out that Soleimani himself was visiting Baghdad (possibly to incite further unrest), Trump gave the order to launch the drone strike that took out this target.
Although crude only closed up 3% today, note that it was already off the back of a steadily rising price due to the tightening supply/demand dynamic. Coincidentally, today’s closing price of $63.05 WTI is almost exactly the closing price of oil on the day of the Abqaiq strike on 9/16. See chart below:
This time, I think the market is under-appreciating the significance of this escalation, perhaps because of the post-Abqaiq correction. Unlike Abqaiq, where the U.S. chose a path of de-escalation, the Administration has now crossed the Rubicon with this attack by making it very clear that it would draw line at the loss of American life. What remains to be seen is how Iran will retaliate and how this situation will escalate. Suffice to say that the probability of Iranian barrels returning to the market just went way down – this time likely without a Saudi shock absorber.
Geopolitical instability has become an increasing source of concern for me, and I have been thinking about how to balance these risks against the otherwise bullish theme of global reflation. Aside from current headline-grabbing Iranian news, the world was beset by an unusually large amount of “protest pockets” in 2019. This article (https://www.voanews.com/americas/global-protests-2019-demonstrators-around-world-demand-reform) has an eye-opening chart:
Not surprisingly, many of these pockets of unrest stem from dissatisfaction with governmental corruption and crackdown on personal freedoms. Between a fully-priced stock market and escalating geopolitical tensions around the world, we are one major terrorism act away from a severe correction in many pro-cyclical sectors – especially tourism and travel-related. From an investment perspective, while it may be tempting to bail out of the market for these reasons, as Peter Lynch is famous for saying: “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” My solution? Invest in a sector that not only is attractive in and of itself (Kaoboy Musings 17 has a good summary of all the reasons) but is also potentially a direct beneficiary of the biggest pocket of geopolitical instability (the Middle East) -- I never thought I’d say it, but the oil sector could actually be a safe haven given recent developments.
Take Your Minerals Supplements
The quick, somewhat lazy, rebuttal to the bullish oil thesis is that high prices will provoke a very quick supply response from U.S. shale. The problem is that the spike in spot prices does not do a whole lot for the majority of shale players. Witness the chart below:
The charts show the increasing degree of backwardation in the oil market – similar to the concept of an “inverted yield curve” for interest rates. What this shows is a steady steepening of the inversion in the last several weeks. The orange line shows that despite spot prices reaching $63, forward prices one year out are around $55 and drop to almost $51 a little further out.
As an ex-commodities trader, I will tell you that current forward prices are not a good predictor of future spot prices and that I think this supply/demand tightness will persist for longer than most people think; I believe this will eventually pull the entire price curve up and eventually provoke a price response.
But in the short-term, that isn’t going to happen, because OPEC (which doesn’t hedge and sells its product at spot prices) benefits directly from high spot prices, and U.S. shale operators mostly hedge forward production by selling swaps out to 2021-2022. Many of the levered players beholden to covenants in reserve-based loan (RBL) facilities are required to hedge out a large chunk of their forward production even if it means selling at prices $8 below spot! Even the few players that don’t hedge still base their forward development capex plans largely based on the forward curve. Lastly, most equity analysts are valuing stocks in this sector based upon $55 price decks. Where do they get the $55? Look at the forward curve! But wait, didn’t I just say that current forwards are terrible predictors of future spot? Yup – despite that, basically everyone in the business – from operators to stock pickers – relies on the forward curve. This is also why I believe it is crucial to look beyond the forward prices and actually try to predict future spot based upon fundamentals.
In the meantime, I have been racking my brain, trying to figure out how to align my own incentives with those of OPEC. In other words, how do I pick securities that benefit most from spot prices that are high and going higher?
That is where “minerals” companies come in, and I will try to give a simple tutorial here.
In the U.S., landowners own the rights to the minerals produced from their properties, including hydrocarbons like oil and gas, and retain the rights to the royalties generated by the production of these minerals. Because landowners are often not in the business of exploration and production of oil and gas, they will sell off a large chunk of these mineral rights to developers who will bear the cost of exploration and production. The retained mineral rights still carry their pro-rata ownership of any royalties received from the production of the minerals (in our case, oil and gas) – without any burden of costs.
In recent years, a number of publicly traded entities have emerged that are “pure-play” minerals companies, where the managements have cobbled together “net royalty acres” that represent the implied pro-rata ownership of the mineral rights of these acres. Mineral rights owners may sell these rights for any number of liquidity-related reasons, and the successful minerals companies are able to amass concentrated net royalty acres in high-quality basins operated by high-quality developers. Because minerals companies don’t bear the costs and have no control over the development of the underlying acreage, all they can do is be smart in the acquisition price and selection of operators.
The value proposition to the investors of these publicly traded minerals companies is that they represent pure, unhedged plays on the royalties produced by the underlying net royalty acres owned by these companies. For my own purposes, this is almost a perfect fit for my desire to be “in the same boat” as OPEC and directly benefit from rising spot oil prices without having to worry about costs of production, leverage and capital structure, etc. Because these entities are like REITs in that they pass through 90+% of their free cash flow, they also avoid one of the biggest pitfalls in this sector – that of terrible capital re-allocation skills on the parts of management teams (a theme I wrote extensively about in Kaoboy Musings 16). In short, I believe that the current backwardated state of the oil market disproportionately benefits these minerals companies, which is why I have been buying them.
In the name of full disclosure, two publicly traded minerals companies I own currently are VNOM (Viper Energy Partners) which currently yields 7% and FLMN (Falcon Minerals Corporation) which currently yields 7.7%. I’m not going to delve deeper on the individual companies for now except to say that I believe both companies should be growing their distributions and should benefit directly from rising oil prices.
As always, caveat emptor. This sector has had many false starts in the past, and you have to do your own homework. This is just where I am currently perceiving good reward-to-risk potential in an otherwise fully-valued market – now vulnerable to geopolitical tensions.
I have been writing Kaoboy Musings for about 4 months now and am enjoying the conversations and devil’s advocacy that it spawns – for me, that is what makes it worthwhile. That said, I’ve had a vision for making it a more forum-like experience where folks can comment and opine around each thread, so I’ve spent the last several months learning WordPress and designing a website to house all my content. I have not yet fully locked down the site registration tech, so please bear with me. While it is definitely not ready for prime-time, I’m happy to announce that Kaoboy Musings now has a dedicated website:
Please check it out. There you will find all the “back issues” as well as a separate section that collates all of the content reviews I have done in past musings. At the bottom of each post, there is also a section where you can comment. I am hoping to foster an interactive community so that everyone benefits from the interaction – please don’t be shy and comment often! It’ll also help me test it out, as I continue to refine the site.
Thanks for reading, and best wishes for a Healthy, Happy, and Prosperous 2020!
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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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