How I came to invest in oilThis post was inspired by having read how Nukester came to be an oil investor. He brings a lot to the table and we are lucky to have him. I for one would like to see Nukester post more often.
Malx1 has immense knowledge on the oil industry and I look forward to reading anything he has to write on the subject, or any other subject for that matter.
Since this post was inspired by Nukester, I would like to describe how I came to be an oil investor.
I have been an investor for well over two decades and believe in doing very detailed research. This approach suits my personality and my love of business. It also allows me to value businesses more accurately and valuation is everything. If you overpay, it doesn’t end well.
Yes, this deep analysis approach is very time consuming. Time I have. I devote about 40 hours a week to this pursuit which involves a lot of reading and thinking and some calculation. There are two parts to valuation:
- Understanding the business, its competition, and the industry
- Estimating the future cash flows – in and out - and discounting them to the present using the risk free rate
I cannot value every company I study but I can tell you with certainty that if you don’t understand point number 1, you will not be able to value the company properly and this could lead to permanent loss of capital – something that makes me shudder.
How I came to invest in oil I had consciously made it a point never to invest in a commodity business. Too dependent on the price of the commodity. Boom and bust. Why even bother if you are not the low-cost producer. This is why I stayed away from oil and gas. After all, I had other businesses that I was invested in that had wonderful futures ahead of them and so why even bother with oil and gas (going forward I will simply use oil instead of oil and gas).
Then in April 2020, I heard on the business news that oil traded at a negative price. This negative price lasted only very briefly but it did get my attention. I looked at a number of oil company stock prices and they had been hit very hard – even harder when compared to their all- time high stock prices of a number of years ago.
This was interesting I thought. As you all know, I take the long view and I was already looking past COVID. Is there an opportunity here? Unfortunately I didn’t know the first thing about oil. All I knew is what I heard: “oil is evil, nobody is going to use this stuff in a few years, EV’s are going to be everywhere real soon and when that happens oil will go to $5 a barrel.”
Nonetheless I decided to study the oil industry – starting with zero knowledge of the sector. I read AIF’s and 10K’s, MD&A’s of as many companies as I could - probably around 50 companies. I read transcripts of conference calls. I read books and articles on how companies go about drilling, the techniques used and why, the life of a project, the quality of the wells etc. I read about shale – a lot about shale actually, and I studied data, a tremendous amount of data and I read papers on clean energy from university professors. I even read books on Rockefeller, Getty, T. Boone Pickens (the T stands for Thomas. If my first name was Thomas, I wouldn’t be using Boone :) ) and Irving just to see if I could get a historical perspective on oil.
I started my research at the end of April 2020 and by August 2020 I was getting close to being comfortable enough to invest. The problem was that I had no real cash available. You see I had done a lot of buying in March 2020 of stocks that I already owned (including making my single largest holding much larger – I kid you not in saying that it was trading at about $52 just before the pandemic and I was adding at prices between $16 and $18 – you need to be ready for these big rare opportunities) due to amazingly cheap prices, prices that I just could not resist and I had very little dry powder left. I had to sell something.
I don’t like selling but when something is a no-brainer, and I thought oil stocks were a no-brainer at that point, I will sell to raise cash. It’s all math. If I am better off selling, paying taxes, and still earn more over the next 10 years than by not selling, then I will sell.
So I sold two stocks that I had owned since 2012: Apple and Enghouse Systems. They were big holdings and so it gave me a lot of dry powder.
I felt that oil stocks, and 2 in particular: CPG and MEG, would be multi baggers and so a bit some of each but kept the vast amount of the cash for when I had completed my research.
Value versus Growth investing Now, this may shock you but I don’t consider myself a Value investor. I don’t consider myself a Growth investor either. I consider myself simply an investor and the reason is that growth is a component of value. If you buy something cheaply but it has no growth in it then time is your enemy and this is a bad investment.
Allow me to explain:
If you buy a stock that trades at 10X free cash flow and it earns $10/share it will trade at $100 (let us forget about multiple expansion and contraction from resulting interest rate changes)
If for the next 10 years it continues to earn $10/share then it will continue to trade at $100 (10X free cash flow).
Now if you can buy the stock at say $80 – which is 20% below where you expect it to trade - and it increases to $100 in 1 year, you make a nice 25% gain.
If however, it takes 5 years to get to $100 – you make a return of 4.6% compounded annually. So time is your enemy. Not only do you have to be right but you have to be right fast with this type of investment. I call this a bad business – one in which intrinsic value does not increase.
It is by far better to buy a business that has growth and is trading at a reasonable price. Time is your friend with this type of business as you not only get the spread between the undervalued price and its fair value but you also get the additional increase from the growing intrinsic value.
Back to oil Even though oil stocks would not increase their intrinsic values (later I would come to realize that yes their intrinsic values would most definitely increase) it made sense to sell AAPL and ENGH to buy into CPG and MEG due to the ridiculously low valuations.
These stocks were not only prices as though they were going out of business but the entire sector was prices as though it was going out of business – and this was and is absolutely not the case.
By the end of September I was confident enough in my understanding of the industry and put all of my excess cash into more CPG and MEG and added ARX and SU and have been adding all the way up to the present (although choosing my spots).
Canadian oil stocks used to trade at basically 9X EV/cash flow. I would be surprised if we ever see these levels again but nobody knows for sure.
I don’t see a reason why Canadian energy stocks can’t trade at 7X EV/cash flow, over time, as more investors come to realize what all of you oil guys already know. This will come in time.
Canadian energy sector The Canadian energy sector will essentially be debt free sometime around mid-2023. We will see more stock buybacks and this will increase the intrinsic value on a per share basis of these companies.
This is a recipe for outsized gains: deeply undervalued stock prices, increasing intrinsic values, and investors realizing oil will be needed to decades and decades.
Maybe the people that hate oil don’t want to hear it but it is the reality and we need to live in reality – especially investors.
My view on oil and oil stocks I continue to study the industry and I am always looking to shoot holes in my thinking but right now this is how I see it:
Impact of EV’s Yes there will be one but it will happen much slower than we think. Oil used for cars represents 27% of total oil. Not 100%.
There are still approximately 1.3 billion internal combustion engines to be displaced. This takes time. On top of that, the total number of cars keeps increasing. We have to factor that into our calculation.
Governments are/will put in laws to prevent purchasing non EV vehicles such as in 2035. However you still have to service existing internal combustion engine cars. The stats that I have seen as to how long you keep a car is anywhere from 7.3 years to 15 years – a big range. Even if you take 7.3 years and you buy in 2034 you will be using oil until the year 2041. More people than you think will fall into this category.
Let us not forget that a big build out of fueling stations will need to occur and that the fueling time has to be fast otherwise it will be a real mess. To get the number of fueling stations along with the speed we need will take time.
The future always happens more slowly than we expect.
Population growth 40% of oil demand is from population growth. 2 billion people will be added to this earth in the next 25 years and the bulk from countries that hardly use oil now.
Green energy It takes oil to transition to green. If you are all green and the sun stops shinning and the wind stops blowing – what happens? We saw what happened in Europe.
These are just a few items on the demand side (see one of my prior posts for more complete items)
But in my view the real issue will be on the supply side – lack of it that is. You can again refer that previous post but just for starters:
Shale is petering out. OPEC is running out of spare capacity and most OPEC nations can’t keep up with current quotas. No now large oil projects coming online. 2.2trillion under investment in oil since 2014. Past oil sites in Middle East worked too hard. Ask Malx1 what happens then. Oil companies not wanting to produce more as compensation no longer tied to production levels but to return of capital to investors. The list goes on and on.
So what happens then? Oil prices remain elevated. This lead to large free cash flows for the industry. This leads to massive stock buybacks (big dividends also of course). This leads to increasing intrinsic value on a per share basis. This leads to higher stock prices. This leads to investors exhibiting FOMO (fear of missing out) which leads to higher stock prices.
The bull run in oil stocks has a very long way to go.
It is my belief that we will see massive consolidation over time and so a lot of smaller players will be taken out.
This for another post.
P.S. If it wasn’t for studying oil I would not have thought about investing in GH.