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Iron Capital Insights

  • Iron Capital Insights
  • April 24, 2020
  • Chuck Osborne

Texas Tea Revisited

It is hard to believe that 2008 was 12 years ago. Of course we remember it now for the financial crisis, but another highlight of 2008 was oil peaking at more than $160 per barrel. (Goldman Sachs said it was going to $240, and I repeat that every time any of our analysts quote a Goldman Sachs recommendation. But I digress…)

We featured the oil story in our second quarter 2008 “Quarterly Report” newsletter, Texas Tea. (It was also a highlight for me because I was able to reference “The Beverly Hillbillies.”) We later followed that up with more insight on investing in commodities like oil. I made the point, several times, that oil is not an investment. No commodity is investment-worthy. Benjamin Graham defined an investment as follows: “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return.” This safety of principal and adequate return are driven by the fact that investments have some intrinsic value. That value can be estimated by analysis of ongoing cash flows. Oil has no intrinsic value. Oil companies may have intrinsic value, as might an oil well, but oil itself does not.

One point I made repeatedly was that a barrel of oil is just a barrel of oil. If one were to bury it in his backyard and dig it up many years later, it is still just a barrel of oil. An oil company can grow or shrink, but either way it is dynamic. Stock in an oil company will not be the same years from now as many factors will influence that company’s success or lack thereof. Oil is just oil. When one eventually digs that barrel back up, he is just hoping it will sell for more than what he paid.

I believe our clients understood what I was saying; at least we stopped getting questions about adding oil to portfolios. Many market participants did not, as they loaded up on oil exchange-traded funds (ETFs). This past Monday, the oil they dug up from their backyard sold for roughly negative $40; in other words, they had to pay for someone to take it away. In the past twelve years, oil has dropped from an all-time high of more than $160 per barrel to Monday’s catastrophe. Oil is not an investment.

That did not stop Wall Street from creating a product that allowed investors to part with their money. This story is not just about oil, but also about the misuse of investment vehicles. Investors usually do not take delivery of actual oil; they purchase futures contracts. Futures allow commodity producers to lock in a future price. The best example is farmers: When farmers plant their fields in the spring they don’t know the price they will get in the fall. To protect themselves from prices falling they can enter into a contract to sell their produce at an agreed-upon price. If prices fall, they are protected; if they rise they may lose out, but it was good insurance. Likewise, oil well operators can do the same thing.

The existence of these contracts of course attracts the Wall Street gamblers. Speculators can buy these contracts as well, and hope that prices rise. Eventually, though, one has to deliver the commodity. Since speculators can’t actually do that, they are forced to sell the contracts before they come due. On Monday that was a big problem as no one wanted the actual oil and was therefore willing to pay for the contracts.

This spooked the rest of the market, but it shouldn’t have. This does not affect any company not in the oil business, except to the extent that oil is an input cost, and in that case it is a plus. The reaction made no sense, but so much in our world makes little sense today. The stock market recovery is still underway. The market always moves before the real world so hopefully the real recovery will begin soon. In the meantime, oil is still not an investment.

Warm regards,

Chuck Osborne, CFA
Managing Director