How Do You Catch a Falling knife? The simple answer is you don’t try. That doesn’t mean that many very smart, knowledgeable people with access to the best information about the danger of knives and Newton’s law of gravity don’t try, with the expected consequences. Yet, there could be some very good reasons to catch the knife:
According to Market Realist over $1 Trillion of upstream market capitalization has been erased due to falling prices. About $14 Trillion flowed into oil and gas exchange traded funds in the past 18 months. That does not include direct investment, primarily by the smartest of the smart, the hedge funds. The financial press is replete with disaster stories, most notably KKR’s worsening loss in Samson Resources Smason Resources. Yet some Wall Street analysts continue to be bullish on oil and gas. Others are betting we have hit bottoml. There are even those that confidently predict a rebound in 2016. .
Throughout 2015 hedge funds insisted the bottom has been hit. This thinking seems to be grounded in traditional contrarian theories that prices neither fall nor rise forever. Fair enough, and generally true, since asset pricing tends to revert to the mean, or the mean trend line.
But what is the mean and what is the trend line? A look at the S&P 500 for the past 80 years shows a steady rise with some oscillation around a fairly predictable trend. That is the anchoring paradigm for the mean reversion theory. But it does not always work, especially for a single asset class, and one that has had its fundamental economics hammered by a disruptive technology. A look at the microprocessor and hard drive businesses illustrates a relentless fall in the unit cost of processing or storing data.
The advice proffered and bets being made on the premise of a rebound in hydrocarbon prices don’t seem to take into account just how disruptive the technology is in oil and gas. It is more than horizontal drilling hydraulic and fracturing (HFHD). Those are actually old technologies that have been applied in new ways.
The refinements shale producers are making to the application of the technology is relentlessly driving down the breakeven cost of shale oil. Our research shows
that some producers are able to cover cash costs at prices as low as $12/Bbl and $1.25/MMBtu for gas. That does not allow for investment to sustain output, but the cost to maintain production is falling as well, in some cases as low as $5/Bbl. Further, the supporting innovations in drilling, completion and operation suggest this cost reduction is far from running its course. The practical limit of course is zero, but the vast size of just the US resource base suggests we will see prices of $20 before we see $50. And that recovery may take years, not months. Shale wells deplete very rapidly. That naturally takes supply off the market. But for an oil company to survive long term means there is pressure to sustain cash flow. That means sustaining production. One of the key gauges on the dashboard of oil company executives is the minimal capital expenditure level needed to sustain cash flow. Those betting on shale producers giving up and going to the ranch had best be prepared for a long wait.
Rising demand is the other anchoring point for the mean reversionists. The automobile market in the US and Europe may be at or close to the saturation point. How many more cars does one need and who will be driving them? The US work force is shrinking and more telecommuting is going on. Even a few toy cars and weekend sport-utes in the driveway, doesn’t have much potential to drive higher demand. The Millennial, Gen-X, Gen-Y and Homeland generations avoid the traffic hassles and seek greener transportation options than their parents and grand-parents. US auto sales are in reality replacements for vehicle retirements. The same could be said for Europe. It is true that US motorists are driving more miles (up 3.6% for the 12 months ended November 2015), but the increase is in discretionary miles, holidays, vacations, weekends. Younger generations are spending their money elsewhere and embracing ride sharing and Uber. The argument that the US will absorb the surplus is hard to buy.
China has already become the largest automobile market in the world and certainly has the growth potential to become even larger. With roughly seven times the US population, China’s annual unit sales could reach 70 million. With a geographic size roughly the same as the US, the potential for significant demand growth is certainly evident. However, useable roadways between cities and within towns will impact miles driven, as will the big unknown, consumer preferences. It is very likely that demand for fuels in China will grow. To bet that it will grow at a rate and of a magnitude to absorb current excess supply is the premise one has to rely on for rising oil and gas prices. Yet Exxon is predicting slower growth and a peak demand .
Other emerging markets will make contributions to demand as well, but their growth has been dampened by the overall sluggish global economy. Commodity based export economies are struggling. One of the key drivers of emerging market economies has been the development of free, fair and transparent markets. This trend will hopefully continue and lead to greater wealth which will translate into rising demand for mobility. But lest we get to rosy in our outlook, bear in mind that shale deposits are wide spread and vast. The technology being developed in the US will certainly find a home in South Africa, China, Australia, Argentina, parts of Europe and India.
On the other side, the conventional producers in Russia, the national oil companies especially Saudi Arabia, Kuwait, Iraq and Iran are doubling down and preparing for a long period of low oil and gas prices. In December, Saudi Arabia announced measures to reduce subsidies and government spending to align with reduced free cash flow. Russia and Iraq can’t afford to reduce production and Iran, after years of austerity, seems eager to increase revenues.
For some it is. In every economic dislocation, there are many losers, a few winners and a whole lot of chaos as the situation is sorted out. The fog of war seems an apt analogy since there is a lot of uncertainty, a lot at stake and a need for prudence and an imperative to be swift and decisive.
Certainly some assets will be developed. Many others will be deferred and some will simply be abandoned. Asset sales are a common feature of downturns in oil and gas. Some very successful companies were built or boosted by a timely asset purchase.
A few companies will be big winners, some will struggle to survive and a lot more will simply disappear in liquidation. What will differentiate the winners from all the rest? Some on Wall Street are assuming the big internationals will be safe havens and will pick up the pieces, going on to great success. Maybe.
But some are already struggling to figure out their strategy in the new normal. Others have made big bets on saturated or slow growing markets. Others still have pretty good strategies, but can’t seem to find a way to execute effectively. Size is certainly an advantage: strong balance sheets, cash flow, talent, viable assets and access to capital markets can be vital.
Some hedge funds have bet on highly focused strategies. “The riches are in the niches” is a very accurate aphorism. Companies that have identified very attractive plays with great economics and the resilience to withstand very low prices pitched the wizards of Wall Street and have raised significant capital. The results have been mixed.
A great strategy, poorly executed is a prescription for disappointment if not disaster. Investment analysis is an important skill, and assessing the strategy is crucial. But strategy can be overrated and the tendency of highly skilled people to become over confident is a common problem.
The track record of the investment professionals does not provide very reliable guidance in the world of oil and gas. Some have realized that specialized, industry specifi
c expertise is required. Hiring engineers and geologists seems to be a good answer. Some hedge funds have set up their own oil companies, fully staffed and equipped, engaging in even more detailed due diligence. It is an old tactic employed by the tax shelter shops in the ‘70s and ‘80s, without having made much of a difference. Those businesses raised and wasted enormous sums. Perhaps the new versions will perform better.
Yet all of the financial and technical skills and capital deployed in the North American upstream have, by and large, produced some pretty disappointing results. Fewer than 25% of these companies earned their cost of capital before prices collapsed. It seems
obvious that the solution is anything but obvious.
But the keys to success can be discerned. The goal is to identify the companies that have the greatest chance to survive, prosper and thrive. A parallel goal is to anticipate those that will return their cost of capital. And finally it would be a boon to surface the companies that will earn the greatest premium over their cost of capital. These are the companies least susceptible to falling commodity prices, the companies most likely to own the best assets, and the companies that will wring the most value from those assets. That is to say to avoid the falling knife.
One might think that the knife has to hit the floor before it is wise to venture into the upstream. But that is not the case. With all the flood of capital into the upstream over the last 10 years it is amazing to learn that there is value that has been overlooked by the hedge fund scouts and active fund managers. These are companies that are doing well even now, are well positioned for more stable pricing and will thrive on any kind of rising tide. Similarly, it is baffling that smart capital has over sold some asset classes that have little to no risk from falling prices, such as the mid-stream processors and transporters of crude oil and natural gas. Demand is still there and the need for infrastructure may be one of the growth opportunities in oil and gas.
For the most cautious, waiting for the knife to hit the floor is surely one way to avoid a bad experience. There will be some great bargains to be acquired once we see the limit of falling prices. My view is that we are not far from that point. As there is a practical limit to how low cash costs can fall. Now that we have seen the $20 handle, we are probably there. It may take months or even years for the shakeout to fully playout.
Bankruptcies will be numerous. Debt holders will own a lot of assets; many equity investors will take the medicine and move on. Sharks will be on the prowl, but they are as likely to be scavenging the asset pile as finding good feeding grounds. Sorting through those assets and assembling a sensible portfolio will be a challenge to be sure. Aside from putting a reasonable value on those assets, negotiating terms and commencing operations will be daunting tasks.
Oil and gas assets are not like financial instruments, they don’t carry a coupon or even a reliable dividend. To extract value requires a very different approach than most financial institutions can even conceive of, let alone implement. It will be very much like trying to put Humpty-Dumpty back together again.
What then makes sense? Catch the knife and likely get wounded? Let it fall and suffer the damage? Not great choices. But what if there was a way? Fortunately, there is. The key lies along the pathway taken by those few successful companies that have remained viable through this early phase of the lower for a long time price regime.
What distinguishes this elite group is a combination of factors, arranged in often unique, but singularly effective ways. Our research has demonstrated that these key factors are comprised of three dimensions:
Well and good, but what makes the combination effective is the way the three dimensions have been designed by each company and pulled into alignment. The specifics are documented in our series of case studies on the successful North American upstream companies. Starting with Cobalt International, continuing with Peyto Exploration and Development and soon to be followed with others, including Continental Resources, Occidental and Ultra Petroleum these are the elite enterprises that have the best chances to survive and thrive.
Investors seeking to build a sensible portfolio have some options.
From the founders, the boards of directors, the senior management team and every employee and contractor. All of them exercise leadership in their own realms of responsibility. Self-leadership, team leadership, and stakeholder leadership are all key elements.
Culture is a crucial element
Every organization has a culture. It may not be the best or even desired culture, but it forms from the values, priorities, habits, interactions and efforts of the people. Good leadership gets a healthy culture.
Talents, skills and knowledge, the intellectual capital of a successful enterprise.
Some of it is intellectual property actually owned by the enterprise. Most of it goes home at night, hopefully to come back in the morning. A successful enterprise invests to develop talents, refine skills and impart new knowledge to its team. But there is little that can be done to preserve and sustain that investment.
…and incubators of the investment in people. These are habits of thought and drivers of behavior. Building and reinforcing positive attitudes is a hallmark of the elite. They do it in many ways, some formal and systematic. Some practical, pragmatic and common sense methods but the best are those that are built upon empathy. We’re not talking about touch-feely coddling approaches. What works is empowering the higher motives of the team. The drive to succeed, to accomplish, to own the outcome, and become a part of something bigger have been critical to successful teams from the Roman Legions to NCAA champions.
Values and motivators are the surest way to instill winning attitudes. What is important is to recognize that we all have different motivators that are the outgrowth of our values. Some are driven by an individual need to succeed. Others view money as life’s scorecard. All of us have some degree of the key values but there are typically two or three that dominate. Knowing these values and how to motivate the individual is something unique to the elite enterprise.
The Team is the central business unit of the upstream company. Behavior is a key element of team work. How we like to communicate and be communicated with, our preferences for interaction, our need for stability or our desire to explore all contribute to effective teams. But it is important for team members to understand each other and interact in a positive constructive way. The tools to understand behavior are well developed, effective and reliable. The elite upstream companies build effective teams. Some are surely better than others, and even the best have room to improve.
Business Processes in the upstream are varied, but fall under several larger processes:
The methods and means by which each of the specific processes is undertaken, determines how well the strategy is executed. Even a cursory review illustrates how different these processes are. Integrating and aligning them is the key to ensuring they support the strategy, some other agenda or nothing at all. Seamless integration of these processes is mission critical if effective execution is to be achieved.
The falling knife metaphor puts into perspective that we are entering a new normal. How long low prices persist will determine who will survive. However, one thing is certain the survivors will be adept at more than technology, they will build winning organizations. The real question is; Who will take up the challenge and when?