Saturday, May 5, 2018

Two management styles in the oil patch; what kind of investor are you?

Many investors are in it for a ‘quick buck’; others want to buy into a predictable business and have a long-term perspective. Now with the bull market in commodities started, you may ask yourself where you fall on this spectrum and what type of oil and gas companies you’d be inclined to invest in. If you are in it for the ‘quick buck’ you will anxiously look at each quarterly report; maybe even buy or sell shares on the speculation that this quarter will present a positive or negative earnings surprise. You want a company with ‘torque’, as Eric Nuttal, a popular oil and gas analyst calls it.  And you switch around from company to company at a rapid-fire rate, trying ‘to squeeze’ the maximum profit you can get. The long-term investor looks for steadier returns and a stock that may become a ‘core holding’ in the portfolio.
We discussed “Maximum Torque” in earlier blog posts, although we didn’t use that term.  It is basically ‘financial engineering’ where you use leverage (debt) to amplify your earnings and earnings growth -  in our case with increasing oil prices and gas prices. The other side of the equation is that leverage also will amplify your losses with falling prices. These are the type of companies where management tends to hype up the stock with aggressive growth forecasts and at the top of a boom they become so feverish in the pursuit of production growth that it becomes nearly obsessive. It is typical that this style of management only pays attention to inflating corporate ratios and often does not pay much attention to the underlying technical abilities and longevity of the company. They are only driven by rising stock prices and their management compensation in options which levers them even more to stock pricing than just common share holders. They are also aggressive in hiring staff so that they can drill even more wells regardless of how well their assets will produce over the long term; “We need maximum cashflow NOW”. The value of these stocks during a stock market boom shoot up like a rocket from the disastrous evaluation their shares received at the previous bottom of the market. That is “Torque”. 
But as they say, what goes up also must come done; and “torque” stocks will come down with a vengeance. As soon as oil (and/or gas) prices roll over or start to decline, the cashflow falls and these companies can no longer cover the interest on their debt. Just like hiring staff fast they would fire them fast; they no longer have money for drilling and they start to sell their often mismanaged assets for a song. Usually it is too late to pay attention to the technical management of these properties and the company crashes back to the low evaluations of the previous cycle; the company goes broke or is taken over for a song. Management has long ago cashed in their options and don’t care about the pain they caused to the staff; they don’t care about orphan wells they leave behind and neither do they care about environmental damage and safety which they so piously touted to their shareholders during the bull market. They made their stash; get a golden handshake while leaving with the cash.

The second style of management is trying to build a good long-lived business. Companies such as Canadian Natural or Vermillion or Suncor come to mind.  But they don’t have the ‘torque’ and torque investors would avoid owning these ‘stalwarts’.  Corporate ratios are important to these managers as well but so is the quality of the underlying business. The quality of their properties and the quality of how these properties are managed for the long run. This type of management cares about their staff which they want to build and improve over the long term; they truly care about their abandonment liabilities and the longevity of their assets. They do true reservoir management where they try to recover the maximum volumes of oil and gas for maximum profits over the long term. They are concerned about quarterly and annual performance but more in terms of ‘trends’ rather than just the most recent quarterly report. They are slow in hiring staff and they are reluctant to fire their staff because the quality of their staff is an asset in itself rather than that a staff member is just a number. They reward their investors with a lot less price volatility; they buy assets from others often during downturns for a song, and they rarely cut the dividends they usually pay. 

Those dividends are paid typically at moderate payout ratios not by increasing debt. They carefully manage their debt including their impact during the perpetual ‘next downturn’. These are the builders of long term projects such as SAGDs in heavy oil; offshore projects, etc.  They truly have a long-term business plan wherein oil prices may go up or down rather than building production to a few thousand barrels with the goal to be taken over. Management employed in these companies is turning over slowly and have been around for many years. You can recognize these companies already from the days they where juniors and how they managed their balance sheets.

So next time you invest in oil and gas, ask yourself what kind of investor you are and what your investment style will do to the environment; to the safety records of your companies and what it does to your staff at these companies.  It is easy to blame the ‘oil industry’; it is easy to blame evil management but really your investment choices influence what companies dominate the industry and ultimately society.

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