Sunday, May 13, 2018

How my split personality invests in commodities

That commodity investing is a cyclical game is an understatement. The cycles are relatively easy to understand, but more difficult is the integration of corporate finances and technical execution.  Being a petroleum geologist this is emotional for me and there is a polarized relationship with  management, technological soundness and the stock market. Being an investor as well as a geologist, makes me better see all sides. When I listen to financial podcasts on this topic, mostly presented from the investor point of view, I learn a lot.  Everyone knows resources are very cyclical. Not a single cycle though, resources are behaving like composite cycles: demand and supply is at the top; industry business cycle is next; then a technological cycle; a political cycle and a stock market cycle.  Remember physics and wave theory?  Well these cycles are not in phase; they interact, they resonate and sometimes they counter-act (dampen) each other.  This is what makes each commodity cycle unique and not only in size, i.e. amplitude.

Demand and Supply Cycle

This cycle is relatively simple until you dive into the details and until you sift through the noise of all those market prognosticators each with more, or with less true expertise. Ask yourself when listening to them: Is this another copycat or is this an original thinker. How many cycles has the prognosticator actuality ‘lived through’ – not as an oblivious child but with his/her eyes wide open?  Is this gal making a living by shorting or by being long in the market. The shorts want to push prices down and the others are typically more bullish. Rarely is a prognosticator truly objective.

The supply and demand cycle is the biggie because it determines prices and interacts directly or on a delayed basis (lag time) with most of the other cycles. Exception maybe the political cycle. All those forecasters have typically very questionable and vague input parameters.  For example, OPEC countries like Saudi Arabia lie about what they have in oil reserves; about what is in storage and about their political needs.  Even the E.I.A (Energy Information Administration – U.S. Gov) and the I.E.A. (international Energy Agency – represents consuming countries) driven by hidden agendas,  biases or limitations when publishing their numbers.  What does the U.S. storage numbers include?  This is truly frightening and the uncertainties implied in its definition shows how tentative these storage numbers really are. E.I.A. does not even take pipeline capacity into account thus it overestimates for example the production from the Permian Basin.
But even brokerages like Goldman Sachs or Raymond James put out their forecasts with their own twist(s). I do too, when attempting to figure out what the supply and demand situation is. Of course not, I am truly objective and the most accurate prognosticator in the whole-wide world; except on those days that I am not. ๐Ÿ˜Š  But with the supply-demand cyclicality the clichรฉ goes: High prices are the antidote to shortages and low prices will fix the oversupply.  I will never forget the story of the ghost oil tankers floating on this planet’s oceans filled with close to 400 million barrels until the day that oil prices turned around and nobody could find this ghost fleet. Demand and supply stories like these are common.  Or the Uranium supply story with an ever-changing angle such as the ‘used’ uranium market which recycles uranium or the supply of weaponized uranium.  Everyone has a supply scenario, many chewed over or plagiarized numerous times.   Now with $70 oil a reality, prognosticators think $100 per barrel oil is possible.  Is that straight-line extrapolation? For now, let’s say I may agree with the $100 dollar idea.

Industry business Cycle

Managements allocate funds during the hydrocarbon business cycle, It responds to the supply cycle; it also responds to investor enthusiasms which often is based on how other sectors are doing and where they get most bang for the buck. Typically capital spending goes down first but today it is likely to rocket upward. Then there is management self interest: options and skin in the game.  Options motivate managers to hype the stock and to increase leverage on the balance sheet, all to drive share prices through the roof and along with it their options.  As stock market lackeys, these managers tend to think like shareholders short term or at least they do not seem to think beyond the current commodity cycle. There are also managements that have a lot of their own money on the line; i.e. skin in the game through their share equity holdings. Some are builders of true long term businesses but many are here as well are in it for the short term.
Management are keepers of the corporate ratios not necessarily efficient exploiters of technological and financially sound businesses.  It is often in conflict with the technical staff and the social interest holders – often called ‘stake holders’.  Management is often not aligned with the ‘owners’ of the companies, i.e. the shareholders. Sometimes they are in cahoots with creditors and ‘screw’ the ownership. There truly are a myriad of angles.  Many managers are more people’s persons than technical – they think they are technical but often do not understand that side of the business very well.  They are attracted to the glamour.  The technical guys, like me, we are the rock and engineering geeks and we are more interested in doing what is right for the property than what is right for business. Managements bloom during the boom and, once they get the taste of ‘power’ they keep on starting-up new ventures during each down turn, especially after their previous ones bit the dust.  Some make it, but many are destroyers of other people’s capital.  Look for managers who build up assets during down turns with a longer term view.  They buy cheap and try to sell high. Often they cash in by selling to the large operators.  I used to work at Canadian Natural Resources.  They are cash conscious and have a reputation of being hardnosed.  They look longer term and they have a mission statement that is sometimes followed. It is admirable and here paraphrased as: “We do things right, for a profit and with fun”.   That is in my books the closest alignment between shareholders, management and staff that I have seen in industry. 

Technological Cycle

As said, technical staff are the geeks. The other staff is typically longer lived in the corporate structure and with less pressure – the ‘bean counters’. ‘The others’ are the administrative part of the business. The technical staff is well paid during booms but are the first to get fired during busts. The work pressure is enormous – that is why the pay is so high. But this industry eats its technical staff and then spits it out during the down turns. Industry complains about lack of ‘skilled workers’ but really it is the high pressure working environment and the being axed at the first sight of trouble that makes many of these careers short lived. The lifers, like me, are used to the ups and downs; we love the technical puzzles; we love the money during good times.  During the ‘good times’ we really have a dream job as long as deadlines are met and management implements our technology dreams. Greenhorns joining the industry during the ‘good times’ think that this dream-life is the norm. Then we hit the cliffs and things turn nasty at a rapid pace. So many are eaten alive; chewed up and spat out on the street with a broken career and a repossessed BMW.
When oil prices turn up so does the hope of the technical staff. But it will often take a while until there is new project money. The industry right now is licking its wounds and experiences profits earned with maximum margins at this early stage of the cycle (long before the stock investors return).  Surviving staff is abused working far past the end of a normal working day – some work until 8 pm at night; many others wait on the side lines – sometimes for several years to get back in. There is a lot of passion for the oil and gas game. Once you survived the boom-bust grinder you have a much more business-like if not jaded view of the industry. But solving nature’s riddles; production issues hidden deep below where the eye can see that has an incredible attraction and it is the one thing we all dream of doing.  Typically, after a year of better or good oil and gas prices we are back at our game and the pain is forgotten. Until next time…

Stock market cycle

Most investors are there to make big profits and quickly.  They don’t care about a company’s longevity and the fate of its workers.  As long as they make money from production or asset growth. They dream of doubling their holdings or better, as happened so many times during previous cycles. And if management doesn’t ‘perform’ then they fire them or more likely, the investor quickly switches to another company.
Oil & gas is capital intensive with relatively little staff. The industry is essential for our economy. Despite the deluded, we will have this industry for many more decades. For me, this is one of the worst and longest down turns since 1982. If fact, 1982 to 1994 felt like a continuous flux of ups and downs; the prices were lowest in 1986 but the pain was most intense in 1982. 2000 to 2007 were the golden years; we recovered after 2009 but the depressed gas prices always weighed on the industry. For me, the lay-offs started in 2014 and peaked in 2016. Unemployment amongst petroleum geologist and engineers may be still close to 60%. But with turning oil prices and the return of investment capital this may look very different in a year from now.  My previous employer counted 60plus geoscience related staff in 2012 and we were down to 4 in 2016 and the last four, of which I was one, are now gone replaced by a few pieces of ‘fresh meat’.  Soon stock prices will pick up and investors will once again throw unlimited money at us. (We will get our revenge ๐Ÿ˜Š).

Political Cycle/Social license

Alberta knows the good and the bad. Unfortunately, it seems our politicians don’t and switching after 40 years of conservative politics to the NDP couldn’t have been more poorly timed.  For years now we have been beleaguered by misleading and oversimplified statements (lies) of the environmental activists. We suffered from social license and political correctness.  If you think that the technical knowledge of management about how to run an oil and gas asset properly is bad, then just wait until you hear the political nonsense or the hysteria of the activists and the cries from the Canadian public in general.
This may sound arrogant but oil and gas is extremely complex with many technical disciplines involved ranging from geology to reservoir engineering to drilling and completion engineering – not to mention finance, marketing or investor and public communication. It involves real estate, land deals, production hedging, asset allocation and pipelines to name a few. The process to get a hydrocarbon molecule from the reservoir pore to a pump or in a plastic grocery bag is extremely elaborate and complex. I have just a faint understanding of it all. Just imagine what a consumer or a 20-year environmentally aware student must think. I know young activist, you are about to leave school and thus you must know everything there is to know… except, at 65 years I still learn everyday.  Your luck and apparent confidence is because, as they say, you don’t even know what you do not know. I, on the other hand have probably forgotten more than you know and even I don’t know what there is more to know.  You know what? I think by now you get my drift. ๐Ÿ˜Š  The industry is trying to educate how complex matters are. If we can’t simulate a ‘simple reservoir’ accurately then what is the chance that a 25-year old’s PHD thesis with a climate change simulation truly can predict something as complex as climate?  But of course, they are certain of themselves while us old technical geeks are too deeply involved to be able to explain it all to a polarized public opinion.
To me, CO2 is a building block of life not a poison. We should try to reduce our emissions especially those truly harmful. But dreams of cars emitting water vapor and running on hydrogen are pipedreams and even then, H2O vapor is ‘worse’ than CO2 as a green house gas.  Water, as you may have heard, being another building block of live.  Yes, the oil industry does not only comprise saints and I am glad that someone is keeping an eye on us and hopefully on all other industries as well. Let’s start with the concept that hydrogen and electricity are NOT energy. They are carriers of energy!  Energy is converted into electricity or hydrogen.  You may dream that a couple of wind storms and sun light collected on a minimal portion of this planet’s surface can power all of our transportation and manufacturing and housing and computers in offices and cell phones and…  Not likely, especially since oil demand by it self increases nearly by 1.5million barrels every year!
We are now caught in the political cycle. An industry that is not that well versed in public communications. We ought to be good at it but, as said, we never set out to be politicians, we are just a group of geeks not much different than silicon valley – yes we work a lot with computers!  And those same investors greeding out on Amazon and the rest of FAANG are also investing in our geek-hood from time to time. You think Elon Musk is such a great communicator? Many of your pension funds invest in us at the lows of the downturn hoping just like retail investors to make a quick buck while you tie a big block of cement around our legs and tie our hands behind our backs. Yes, I am one of those investors as well – maybe a bit more aware about this industry and a bit more aware of the reactionary, illogical attitudes of the current B.C. government and the hypocrisy of the Trudeau Liberals for whom we are a much easier target than, say, vote rich Ontario’s automobile industry or Quebec’s Bombardier. Probably this political cycle will pass as it did for the lumber industry or Canada’s banks.  Yes the political cycle is also affecting the resource industry and its duration is a lot less predictable than that of the other cycles. But opinions are changing now over 60 percent of BC'ers are in favor of the pipelines and want the NDP government to shut up. In Ontario the people realize the corruption of 'green energy' and the super high energy prices that not only makes their life expensive but also make them lose their competitive edge. Maybe this cycle is also turning in oil (and other) industry's favor.

How to invest?

Right now, according to my somewhat contrarian views it seems we are in a sweet spot.  If you have listened to past advice, you may own now some oil and gas. We cannot really time investing in this ‘cycle’ so we’re putting in small amounts of money over time, thus building up to a full position.  A diversified stock portfolio holds at least 20 stocks, my portfolio holds typically more. Starting off we invest a tiny fraction up to 1 percent of stock portfolio value and a maximum of 20 stocks or no more than 5% in an individual stock.  Five percent of a portfolio may be a substantial chunk of change, although a lot less than the oil and gas waiting of the TSX. But then, is the TSX really that well diversified?  Currently, my total holdings in oil and gas are 5% and as such, I am severely underweight. There is still lots of time, most investors are not very enthusiastic on the sector. So potential for lots of profit. I have found my favorite oil and gas companies and now with proof that the recovery is in place and not far from truly picking up, I will add.

First, to ensure against Canada’s poor business climate including the pipeline issues, I will invest in the U.S.  A large multinational comes to mind. I also invest a bit in the U.S. petroleum industry using an ETF such as XLE. I am not that familiar with the U.S. based oil industry.  With my oil and gas dependent Calgary Real Estate and ownership of my petroleum consulting company, I will benefit plenty. I probably don’t go over 10% in my portfolio for oil and gas. I will allocate it towards the companies I already own; most towards the best current performers.  I am greedy, and it will take all my discipline not to buy more in an extremely cheap Canadian oil and gas sector.
But don’t aim at one style of company, especially not the ones handicapped by political issues (unless you think this will pass soon).  You can invest in light oil producers in Central Alberta or in Saskatchewan.  Don’t go after the ‘sexy stuff’ rather invest in companies with good balance sheets, proven profitability and good pipeline access  I think this bull market will last another 3 to 5 years, so there is plenty of time – don’t be afraid of ‘missing out’,

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