Shakes and Shares:
Shining Light on the Energy Market
“I drink your milkshake.
I drink it up!”
― Daniel Plainview, There Will Be Blood
The recent volatility in energy markets has investors feverish for a way to capitalize. Broadly speaking, the public market universe through about Labor Day of 2014 was short on great trends, ideas etc. While the S&P 500 finished 2014 up roughly 11%, unless you owned AAPL or the airlines, or were long at the right times, you likely under-performed. High yield spreads are also historically tight, so the search for yield/returns is in full force. As such, the tradeoff is to move out the liquidity spectrum and play in the private markets. While there is still wood to chop in that world (see my recent piece on Venture at Hedge Fund Intelligence) the search for a chance to capitalize on dislocations in more liquid, public markets is ongoing. There are a number of places where dislocations have and are likely to arise (see my recent piece on macro at Hedge Fund Intelligence) and energy touches all the major asset classes. Energy is a driving factor in sovereign policy decisions, it is a significant subsector in most equity indices, and the energy-related debt universe is one of the largest on the planet. Consequently, there are plenty of ways to try and play the market, it is just that not all of them are good, especially for non-specialists. The purpose of the below is to provide a frame for prudent energy investing in today’s market and to highlight some of the advantages and pitfalls of the different avenues of access.
[Hedge Fund Intelligence:
Venture Piece -
http://www.hedgefundintelligence.com/Article/3423054/Absolute-Return-HFI-Blogs-Archive/De-frothing-the-venture-capital-opportunity-set.html
Macro Piece -
http://www.hedgefundintelligence.com/Article/3397549/Macro-is-back.html]
A close friend and very successful energy investor once told me he thought there were about ten guys out there that were really good in the energy space. Such a small of a number of true experts seemed ridiculous to me given how many people have made fortunes in the energy business, but what he meant was that from an investor perspective, there are only a handful of people who truly understand all three major facets of energy investing: asset valuation, input cost dynamics (commodity price volatility), and financing. His argument was that there are a large number of people who have a good grasp of one or two of those facets and might do very well in the right environment, but few who can process and manage all three. Traditional commodity traders should have a good understanding of S&D dynamics, refining bottlenecks, et al and from there it is only a small leap to traditional equity valuation metrics. Equity investors might be very good at figuring out that a company is theoretically cheap to its asset value given some commodity price projection, but that is often contingent on a) a decent assessment of price movements, and b) the ability of the company to stay solvent over time. The facet that most investors miss is the financing component. Energy is one of the most capital intensive businesses on the planet and a company’s ability to continue to fund its operations is paramount to success.
With that as a backdrop, the appropriate frame for evaluation is simple. Let’s assume we have little ability to foresee a specific future price of oil. We are not insiders at OPEC but spend enough time in traffic to know that there is clearly a baseline for demand. We’ll have to settle for a range so a safe assumption might be that oil prices generically may remain between $35 and $75 USD/barrel. The probability that prices go and remain below that level seems low (although it’s one of the risks you’re taking) and whatever the chances are that they go higher is likely only relevant to your upside. With that assumption in place, can we find companies that have a proven track record of owning and operating good assets, have a low and/or manageable fixed cost basis, and are possessed of or have access to good funding options (good balance sheet, secured debt capacity, etc.)? The short answer is “yes,” those opportunities exist and for purposes of maximizing risk/reward, those opportunities are likely in the debt of good producers. Before we get to what that might look like though, it might be beneficial to highlight some of the pitfalls of the other avenues.
Servicers
During the shale boom, there were stories abound about the ancillary servicing business that grew rapidly as a result of the boom. Whether it be the company that makes containers for the safe storage of fracking fluid, the company that makes temporary roadway solutions for trucks, or the independent trucking companies themselves. When drilling, mining, business is expanding, the servicer benefits. However, when production wanes, so do servicer revenues. Additionally, servicers may have even more negative convexity to the broader market because they cannot "hedge" in the same way that producers can and for the most part, they all compete with one another because they are fungible, i.e. there is no real value add. In the oil market, with OPEC allowing for the supply glut, the hardest hit are likely to be the highest marginal cost producers which by and large are the oil sands and shale oil producers, i.e. oil producers in the US and Canada. Therefore, that doesn’t paint a rosy picture for domestic servicers especially.
http://www.himco.com/sites/himco/files/1287788311140.pdf, Christopher Paolino and Phillip Titolo, May 2014
Off-Shore Drillers
There is a lot of debate about offshore drilling. Love it or hate it, however, there is a lot of oil beneath the seabed and there are some companies that are pretty good at getting it. Proponents of the space right now point to the fact that you can buy securities at levels which translate to valuations of 6th and 7th generation vessels at far below replacement costs. This line of reasoning however doesn’t account for numerous other factors. First, the supply of rigs has increased due to a fair amount of spec building prior to the recent crash (thank you Fed for the low rates). Second, demand from the big majors has decreased as they’ve been frantically trying to cut supply chain costs. And the last factor is more macro that anything else, but interesting nonetheless. Namely, EM growth is slowing.
Transocean, for example, is one of the largest off-shore drilling companies in the world and generally a solid company, but roughly 30% of their revenue comes from Petrobas, the Brazilian state-run giant. Unfortunately, Petrobas is having all sorts of problems (and so is Brazil as a whole). Petrobas debt was recently downgraded to junk status by Moodys, making it the second largest “fallen angel” ever behind Lehman Brothers. As if that wasn’t bad enough, there is ongoing scandal within the Brazilian government alleging all sorts of bribes and corruption all the way up to President Dilma Rousseff. None of this is really all that shocking as a) Rousseff as the former Minister of Energy holds a board seat at Petrobas, and b) it is South America, where corruption seems to be the rule rather than the exception. As such, she is trying to distance herself from Petrobas and the scandal as much as possible. Consequently, Brazil recently withdrew backing from a proposed Petrobas bond issuance to avoid following the oil giant to junk status. So, hard times at both Petrobas and Brazil as a whole does not bode well for companies that rely heavily on their business. While this is a specific example, uncertainty about emerging markets in general (where a lot of offshore drilling happens) makes the sector a tough one to invest in for the time being.
Direct Commodity
- Liquid
Is oil a currency or a commodity? That is a good question and one maybe worth debating another time, but the answer may matter less than the question. Inherent in the question is the recognition that it is global and important to sovereigns but still has much of the supply and demand dynamics of a commodity. On top of that, some is controlled by sovereigns themselves or quasi-sovereign entities while global corporations control much of the rest. In the end, investing in oil directly (via futures, ETFs, et al.) is challenging. Even the experts have a very difficult time doing it consistently well as there are innumerate fundamental and macro factors to evaluate and term structures across the futures curve to navigate as well. It is liquid and can be volatile, so it’s alluring for investors to punt around. In very small size, a little punting is educational and potentially valuable, but “punting” is not really a winning strategy in the long term.
Direct Commodity
- Illiquid / Location Specific
As much as we might fantasize about “one day he was shooting at some food, and out from the ground came a bubbling crude. Oil that is, Texas tea…” it’s not a good investment strategy. Drilling for oil is great content for TV and movies because there is great potential for drama. It is famously boom and bust and do it all over again. There are success stories for sure and people from Texas seem to have an innate ability to stomach and thrive on that type of investing profile, but it doesn’t lend itself well to the objective investor. It’s an expert market, it’s illiquid, extremely capital intensive, and in many cases offers you little or no downside protection. Need I go on?
Equity
Whether current valuations for energy equities today are relatively cheap or relatively rich (you could make arguments for both) is really beside the point with energy equity investing today. In a normal market, using PE ratios, book value, free cash flow analysis, and debt-equity metrics are great ways to help determine value. However, none of those metrics really do much to determine the quality of a company’s financing. Below about $60/barrel, many of the loans made by banks to energy companies don’t work all that well and the banks tend to stop lending, ask for their existing loans back, etc. This can be very bad for even asset rich companies if they are cash poor. Given the aforementioned swings in flows and the capital intensive nature of the energy sector, this makes managing your business very difficult for execs and adds both volatility and uncertainty to equity prices. Furthermore, the correlation between oil prices and the equity of producers tends to be fairly dynamic, so if your belief is a bounce in oil prices back to a more “normal” level, equities may or may not react predictably. The below graph is a bit dated, but illustrates the point nicely. All in, you could be “right” about a lot of things and still not make money (which in the world of investing, means that you are wrong).
Source: http://static.seekingalpha.com/uploads/2008/7/22/saupload_correlation722.png
Debt
While I admit that my formative training as a “bond guy” makes me partial to the asset class, it is with good reason. First, bonds pay you an actual on-going risk premium (equities do to a small degree in the form of dividends, but the rest is theoretical until it is captured by a price movement). Said more simply, you’re getting paid every day while you wait for your trade to work, which means your risk/dollar invested is decreasing every day. Secondly, you hold a more senior position in the capital structure so in the event something goes south and there ends up being a workout in bankruptcy, a bondholder is in line before the equity holder to get paid (and find out what they’re assets really were worth). While that’s finance 101, it’s worth reminding yourself as you’re comparing investment opportunities. If “normal” market equity returns should be somewhere between 8-10% (which you’re less likely to get at today’s oil price, so a bounce in oil prices is inherent in that assumption to a degree) and/or you could get 8-10% to own senior debt in some of these companies (which you can right now), why wouldn’t you own the debt? Here is the basic framework for thinking about debt investing in the energy sector:
1) You look for companies that do not need a specific commodity price outcome to stay solvent, but can endure a wide variety of price outcomes ($40-$75).
2) You find the securities in the capital structure that are covered by NAV (DCF of what is economic based off of current commodity strip price) and can endure all the way down to $40.
3) These bonds should yield 8-15% right now so that even if oil does not rally or overshoot $40 for too long, you will get this yield.
4) In the event we get the price snap back that many people believe we will get in late 15 early 16, you should get convexity in the bull case and see mid teens to high twenties type total returns.
Many of the world’s major economies seem to be going in different directions. Europe is finally drinking the QE Koolaid, the US is on the verge of a QE exit, Brazil may become a disaster and there’s plenty in between. As such, energy markets along with other big macro vehicles are likely to remain volatile and potentially interesting for investors. But, as I’ve tried to highlight above, playing macro via the energy markets is not as easy as it may seem and a good micro lens is vitally important to success. It’s essential to think critically about all facets of energy investing, and specifically about funding. If one can gain a good understanding of the entire framework, there are ways to play the market that allow for mitigation of some commodity risk and that pay well while you wait for things to play out. Maybe then, you’ll get to drink your own milkshake.
