In Feb 2020, I have added to AddCN (0.7%) @ 230 and 6% (Yixin) @ 1.69.
In addition, I have also opened a short position to BITA (-7%). I shorted BITA because of the unique characteristic where BITA’s downside in a case of deal failure is likely to be higher than Yixin. While the Yixin upside (20%) is substantially higher than BITA (~6%). So this creates an attractive situation where I can create a long/short value ratio of 10:3 (Yixin / BITA) to almost fully hedge out the downside risk of a deal failure
Sold ~20% of GAW position at GBP 61.3 because I have another opportunity in the game sector that I would like to deploy capital. Given the current market environment, I think the option value of keeping some cash is very high. So I sold some GAW to make room for the new idea while keeping a healthy cash level.
On another side note, Bill Gates published an article on Coronavirus (Link here) where he advised government around the world to assume that “Covid-19 has started behaving a lot like the once-in-a-century pathogen we’ve been worried about”. And then he went to outline measures to combat the virus and highlighted the importance of pre-emptive measures in the emerging markets. Bill is just an amazing human being.
I am put to shame as I have been preoccupied with the opportunity to profit from the market dislocations created by this virus and have not so far thought about how I can help with the pandemic. And frankly, there is probably little I can do anyway. Nonetheless, I am very grateful to people like Bill who are fighting the virus tirelessly. Without them, there would be no recovery and nothing to profit from. So for that, I am very grateful.
With that gratefulness in mind, I will resume my work to find the best opportunities to make money from!
This post will not be about the Corona shock itself. Rather forward looking & on knock-on effects.
Summary on the shock
I do believe this virus is in the sweet spot of characteristics between % mortality and other characteristics like incubation period to cause more simultaneous deaths (not anything like steady flow of traffic deaths) than ever before in absolute casualty cases. On the other hand, it is a mathematical certainty that consumer society will resume +- normal in a few months as the % of recovered population goes up and makes the viral reproduction multiple (R0) plummet. In simple terms: viral reproduction ability plummets as recovered population can’t infect others, nor can others infect recovered cases except for some exceptions (see most rudimentary math model in epidemics SIR model).
I personally haven’t deployed any cash/gold into stocks this week (though I do believe I should be almost always 90-100% invested in stocks as a stock picker).
At this point I’m inclined to buy the low debt names in sectors that were already cheap before this shock started.
High cash yields with bond-like robustness to a recession are key.
Energy is a good example.
Huge advances in shale technology were pitched by Wall Street as a reason to pour money in shale. Ironically, technological progress was the very enemy of shale investors (stocks are down ~90%) .
Not unlike Buffett’s Berkshire textile operations, technological advances lead competing producers to pour money and invest in new technologies simultaneously. A decision that seems rational when a consultant presents it in isolation (invest 1000$ in this machine that saves you 700$ annually per factory, payback time = 1.4 years) is not rational when every competitor is doing the same. The end result is more efficient production for all producers and hence price deflation. The only winners are consumers. This is why Buffett stopped investing in the ever-efficient textile business.
Back to shale.
A widely known consequence is that this amazing technological progress (machine learning is still improving fracking efficiency) has led the US shale producers to be the new global “swing producer” of oil. Shale acts as a ceiling on the oil price as the global supply cost curve has flattened. Technological efficiencies cause the absolute cost difference in developing a cheap Permian barrel and say more difficult Bakken barrel to tighten. India needs an extra barrel? Oil price barely needs to go up to drill more. No one talks about peak oil these days.
What is not widely understood right now – with energy equities at a multi-decade record low % of total market cap – is that the corollary is also true.
In stark contrast to conventional and deep water reserves, existing shale developments have very high annual decline rates (in the second year, 40% less oil flows vs the first year; in contrast to conventional decline rates which are in the single digit % p.a.).
Since 2015, the growth of shale production has been astonishing. Today, shale oil satisfies 7% of total global consumption (the latter is ~100m barrels per day).
In the biggest recession of our lifetime, oil demand declined only a few million barrels, (low single digit %), before it resumed its upward march:
Then why was the price move so abrupt in 2009? Existing developed production does not adjust much to lower prices as the cost to develop the field is already stranded.
The marginal cost of producing developed barrels that are already flowing is much lower than the all-in cost (incl. investment cost to develop) . In the past, oil prices had to fall towards the marginal cost of developed barrels to adjust production downward, as the geological decline rates of existing reserves were so low. In the past, price had to move a lot to balance supply with small changes in demand.
In the next recession, existing shale oil production will decline immediately by virtue of huge decline rates on existing production (i.e. mother earth). New shale development will grind to a screeching halt as the oil price moves down a little, below the all-in cost of development. By the way, Wall Street has already soured on shale producers as they have proven to be cash burning machines doomed by the Red Queen effect described above + a recession will completely halt the easy money flow for new development + we are seeing this already: the rig count is already down more than 20% (incl all types of development incl gulf of mexico).
In other words, my believe is that oil prices can’t move much down in the next recession as the cost curve thanks to technological progress has flattened, and the swing producer adjusts immediately to lower oil prices thanks to mother earth’s decline rate.
Conventional & deep water reserves are long-cycle. Today’s marginal producer is fast-cycle with huge decline rates, dampening oil price volatility for a given demand increase/decrease.
Oil equities have been punished indiscriminately last week, from a low valuation base.
What about ESG/political risk?
I do believe the risk reward of investing in E&P’s with cash flow generative conventional oil reserves in non-liberal democracies (South East Asia, Africa, Russia, perhaps US) is better.
However, climate activism tends to peak with the economy: in recessions there are more pressing issues for democratically elected politicians (job losses, ballooning deficits, bank runs etc.). Abolishing oil production (this causes more job losses, deteriorates export-import balance and deficits) is the last on the bucket list.
In short, I believe political risk will be fine in a recession.
And while society can legitimately choose to curb carbon emissions trough different mechanisms on the demand side, it is a fact that society would screech to a halt when oil production stops today. Stopping O&G production is the most efficient way to propel us back to the stone ages.
Personally, I find it distasteful to look down on investors that have risked real capital (indeed lost much in the last decade) in a sector that risks capital and livelihoods to produce the energy that society (still) needs (and takes) right now. Cheap energy has always been a fundamental driver to improving quality of life for the poorest.
What am I looking at?
I looked at US shale gas producers (AR: own a small position , Range Resources, COG, CNX: probably interesting here)
Right now I am looking at low cost (high margin) cash flow generative oil producers at single digit earning multiples
Even the lowest cost shale producers have low profit margins, making them speculative.
On to more conventional producers:
The crucial factor of course is capital allocation in the commodity space.
Any recommendations on good managements in this space are much appreciated!
How America’s most reckless billionaire created the fracking boom [Guardian] – Bethany McLean on the shale industry & Chesapeake (CHK) founder
“Landmen were always the stepchild of the industry,” he later told Rolling Stone. “Geologists and engineers were the important guys – but it dawned on me pretty early that all their fancy ideas aren’t worth very much if we don’t have a lease. If you’ve got the lease and I don’t, you win.” – McClendon, Chesapeake Energy founder
In my opinion, the US natural gas industry has become an interesting pond to fish in.
That other shale phenomenon, shale oil is actually the biggest risk factor for the price of US natural gas (i.e. cheapest fossil fuel globally, and cleaner than oil & coal). US Shale oil producers make their decisions based on the oil price. As a “side effect”, they also produce associated gas. This “free” natural gas competes with cheap shale gas producers in the US. Interestingly, the US natural gas price is becoming counter-cyclical via the worldwide oil price. As the oil price suffers from an important demand shock in a recession, and shale oil producers are swing producers of oil, this growing competition of “free” associated gas is turned off (hence local nat gas supply shrinks).
In other words, while US shale gas producers are amongst the cheapest fossil fuel producers in the world, most US shale oil producers are almost the opposite (the marginal producers that turn off if oil demand retreats). As “associated gas” production of oil producers is turned off, this is very positive for US natural gas producers.
As credit markets are already shutting for natural gas producers (have a look at breathtaking multi-year plummeting share prices of AR, RR, CNX), a recession will probably put a damper on shale gas drilling (i.e. capex) growth as well. Lastly, demand growth remains underpinned by being the cheapest fossil fuel in the world. Meanwhile, US natural gas equities are very cheap compared to their prospective maintenance cash flows (20-50% yields) and SEC PV-10 reserves. Both valuation measures give 0$ credit to the huge dormant assets convexity/optionality (no costs if US nat gas prices go down, but extra profits if nat gas starts rising). Of course these are commodity businesses with the usual disadvantages, except one! This idiosyncratic group of commodity businesses can’t be criticized as “cyclical” anymore. That is a game changer. More later.
“Simply put, low prices cure low prices as consumers are motivated to consume more and producers are compelled to produce less” – McClendon
Coming wave (next 1-2 yrs) of flagship fund raisings, chronologically:
Flagships will be additive to overall fundraising (last 3 yrs 90B of AUM raising without flagship wave, i.e. I believe only 1) and should be 30-40B USD in aggregate. Everything else equal, 120B AUM raising in 3 years is possible (bull case environment maybe).
The blog has been inactive for a while as the time hurdle to write down structured thoughts proves to be high.
From here we’ll post interesting notes, conference tidbits, thoughts in a more haphazard way under the post category “scribbles”.
We hope you’ll enjoy it.