Iron Capital Insights

  • Iron Capital Insights
  • December 12, 2014
  • Chuck Osborne

How Low Can it Go?

I am getting a lot of questions about the price of oil these days. Mainly people want to know how low we think it can go. Of course, the investing world seems to have a very short memory; it was only a few years ago when people were asking how high it could fly. The answer to those two questions is the same: I have no idea, and neither does anyone else.

The bigger issue here is why in the world is anyone who is not in the oil business, buying and or selling oil? Why would anyone invest directly in a commodity? The problem with investing in oil is that it is just oil. It produces no cash flow, it is not dynamic; it is simply oil. Just a few years ago I noted that if you buy a barrel of oil and bury it in your backyard, then dig it up twenty years later, it is still just a barrel of oil. You are just hoping someone will pay more for it. That does not make for a very good investment.

Few listened. Investing in commodities has been a big fad over the last several years. It is hard to find a “model portfolio” being pushed by any Wall Street firm that does not have at least a five percent allocation to commodities. Institutional investors have bent over backwards to get so-called hard assets, i.e. commodities, into their portfolios. The extent to which this was successful is demonstrated by what has happened.

OPEC reported earlier this week that they expect the demand for oil, from those planning to actually use it, to drop by 200,000 barrels a day. That sounds like a lot, but the world’s daily consumption of oil is approximately 90,000,000 barrels. That 200,000 barrel drop is less than one quarter of one percent. In other words, the demand for oil has not materially changed.

It is true that the western hemisphere’s energy boom has increased the supply of oil, but that has occurred over many years, not since July 2014. So, demand has not changed and supply has not changed, yet the price of oil dropped 40 percent? This tells us that the actual price of oil is being set by commodity speculators (and there is no such thing as a commodity investor), not by the actual supply and demand for oil.

As we discussed when the price of oil was going in the other direction, investing in oil-related companies is another matter. Stock in a company is much different than a commodity, even if that company’s business is related to a commodity. Companies are dynamic; they change. Twenty years ago Amazon was a hot dot-com book seller, while Sears and Kmart were big blue chip retailers. Today Amazon is a blue chip “old tech” retailer of everything and many believe that Sears, which has since purchased Kmart, will cease to exist as a retailer within a few years.

But how does one know which companies are worthy of investment? One knows by exercising prudence, selecting companies from the bottom-up – meaning he invests in a company because of the growth and financial strength of the company, not because he thinks he knows what the price of their products will be next week. The drop in oil prices has shown this. In the short term all energy-related companies have been hurt in the stock market as speculators are either panicking or taking advantage of other people’s panic. Some of those companies are getting what they deserve and others are babies being thrown out with the bath water.

Seadrill is an offshore drilling company whose stock price has gone from $41.29 per share to $11.56 per share. This company was extremely aggressive in expanding and has done so primarily from borrowing money. Investors who look from the bottom-up see a company that is very risky because of its debt level. Sure enough, they have had to cease their dividend payments, and if oil stays down they may have to restructure the company in bankruptcy.

Helmrich and Payne is another driller, mostly on land in this case. They have managed their growth in a more balanced way. They have a strategic advantage in fracking technology, which lowers cost, and they have a strong balance sheet. Their net income per rig is still correlated to oil prices, but in 2009 when oil’s price was where it is today they made $1.4 million in net income per rig. This year they make $1.9 million in net income per rig and they have 135 more rigs than they did in 2009. Even if per-rig net income goes back to 2009 levels that is still solid growth over that time period. They have a strong balance sheet with a debt level that would be manageable in the worst of scenarios. This company has  been strong and if anything will likely benefit from the increased demand from oil – which is what happens when prices fall – and the increased market share as more aggressive competitors are unable to whether the storm.

I have often spoken about prudent investors avoiding loss. The loss of which I speak is the permanent loss of capital. Those who invested directly in oil have likely just experienced such a loss; so too have top-down investors who invested in highly leveraged companies. Prudent investors, while not immune to short-term nonsense, will nonetheless come out even stronger in the end. The carefully selected companies are strong enough not only to maintain in any environment, but also to gain market share as less prudently managed competitors meet their fates.

There is much to be learned here. The companies I highlighted are for educational purposes; these are not specific recommendations. It is the big picture one needs to see here. Prudent investing is done from the ground-up. It is absolute return-oriented and it is risk averse. This drop in oil prices is a good example of why those three things are so important to long-term success.

Chuck Osborne, CFA
Managing Director