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).

Equities: cheap? 

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).

Why?

  • while exogenous temporary shocks like COVID are +- noise for long-term investors most of the time, these shocks tend to cause recessions late in the cycle:
    • Consumer / business confidence can only fall a lot if it is falling from a record high base level (e.g. not in March 2009)
    • Corporate debt built-up after a long cycle can cause domino effects from a short-term economic shock
      • the long-term indicators that correlate best with consecutive 10 year stock market returns, Shiller PE & Tobin’s Q compare the price of equities to measures of value for equities . (respectively: equity market cap vs cyclically adj. net earnings after interest costs and equity market cap/equity book value)
      • these indicators are far from perfect but have worked best in the past. Is today different?
        • blue chips balance sheets have deteriorated A LOT since ’09 : a lot of cheap debt has been added
          • Shiller PE, while at historically high levels, is oblivious to huge corporate debt loads when the interest cost of debt is ~0% as net earnings are ~unaffected
            • this is problematic for all P/E ratios, ~zero interest debt does not detract from earnings (i.e. debt is invisible), but the fact interest is ~0% does not mean the nominal debt balance is 0! the outstanding debt is still there and is highest in history
            • equities are residual interests in the business value after those historically high nominal debt balances  that cannot be ignored
        • valuation measures based on enterprise value (market cap + debt) such as EV/EBIT, EV/sales have never been higher than today (for the US)
  • when compared to the ’09-’15 period, it seems the buy the dip mentality is deeply ingrained in my proverbial neighbors
    • are stocks cheap when they cross the level they were at not so long ago before the recent feverish melt-up

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)

  • why do I own a US shale gas producer?
    • much lower decline rates (15-20 y reserve life),
    • both the commodity and equities are incredibly cheap (but most producers except COG carry high debt burdens)
    • US nat gas is the cheapest in the world right now, trading at 10$ per energy-equivalent oil barrel (nat gas prices are not uniform across continents due to relatively high costs of LNG transport vs oil tankers)
    • nat gas is the cleanest fossil fuel (30-50% lower CO2 per unit of energy vs resp. oil and coal, zero particulate matter & SOx & NOx)
    • most importantly, I believe the -95% punished shale gas stocks (and the incredibly cheap US nat gas price itself) are counter-cyclical in this weird junction in history.
      • In a recession, I expect “associated gas” from shale oil wells (cheap competition to pure play nat gas) to decline rapidly, which tightens US supply a lot, while demand for natural gas is not at all volatile (residential heating, electricity demand, chemical feedstock need does not change much in a recession).
      • I expect nat gas prices to rise in a global recession
  • but honestly, continuous technological progress makes time the enemy of shale investors in the long haul (the investment they make today is stranded tomorrow due to price deflation)
    • while investors should be willing to pay a lot for counter cyclical assets (I am) and shale gas E&P seems undervalued, time is not your friend

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:

  • Lundin Petroleum (family owned & great compounder in the space),  Talos, Kosmos Energy, Vermillion, Husky energy
  • IPCO –  spin-off from Lundin, high profit margin developed reserves,  valued at ~1/3 of P2 DCF value, opportunistic management buying new reserves with quick payback time, in absence of these deals, company buys back a lot of stock with steady cash flow (good VIC write-up) 

The crucial factor of course is capital allocation in the commodity space.

Any recommendations on good managements in this space are much appreciated!

TC