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Crude Observations

1 Rant, 10 Rules

Well my peeps, here we are at the two year anniversary of lap-top closing day (officially March 13) and the unofficial two week anniversary (if you can call it that) of the criminal invasion of Ukraine by Vladimir Putin and I am wondering if and when we will ever be free of either. Not that I am in any way giving up on a resolution to either, I am nothing if not an optimist, I am just starting to wonder if we are so willing to accept one as being endemic, will our attention span last long enough for the people of Ukraine or will we, once the initial pain of higher prices is absorbed, get past the initial fervour and “just learn to live with it”.

 

It’s a troubling thought and not one we should discount in our world driven by soundbites, slogans, celebrity tiktoks and, obviously, corrosive partisanship and political showmanship.

 

Case in point, I know I have written about the Ukraine situation and oil prices for the last several weeks, but the last week has left me despairing that we will get it right on the energy front as the immediate needs are starting to get swept aside in a wave of politics and a need to reframe everything in the name of climate change and the energy transition.

 

And so we’re clear, the immediate needs are to address the soaring price of energy and how that trickles down to fuel prices and the prices of everyday goods in the form of inflation. This means the shortage of both oil and gas exports from Russia which have compounded the lack of investment in oil and gas in the last eight years just as we come out of the now endemic pandemic and a massive demand recovery.

 

Let me start off by saying that the initial policy responses relative to the energy trade by the Biden Administration, the Trudeau government and the European Union have been uniformly united and coherent. Commitment to setting rational embargoes on Russian energy and a mutual commitment ot reducing European reliance on Russian energy in the short and medium term.

 

Unfortunately, to use a NASCAR analogy, a great start has been wrecked by a 50 car pile up on the first turn.

 

It’s not that they aren’t well-intentioned, it’s just that the drivers appear, on an increasingly regular basis, to have no idea what they are doing.

 

Whether it’s the sheer hypocrisy of sending a US delegation to Venezuela (Venezuela!!!!) to offer up sanction relief and ask for more production or the chastising of the oil and gas industry to produce more while simultaneously threatening them with a windfall tax or laughing off high gas prices by suggesting people should just buy EVs (which by the way are largely on back order to 2023) or studying a coordinated LNG response for Europe but shelving it because it won’t result in emissions reduction, it feels like the Biden administration is in the midst of becoming a full on self-entitled, virtue-signalling, holier than thou mockery of itself. They just can’t get out of their own way. Send arms to Ukraine? Check. Crippling sanctions against a dictator? Got it. Solve an immediate term energy crisis with practical, actionable steps? Not a clue.

 

The tone deafness permeates the administration, because its leadership is populated with true believers and not pragmatists.

 

Don’t even get me started about the misinformation flowing as they try to deflect the rise of gas prices onto energy producers – it’s their fault because they won’t drill! New York financiers are to blame because they are greedy and want dividends. Oil and gas companies have 9000 leases! Best analogy I heard for those is that they are like the bundles of scratched lottery tickets you see in the dumpster behind the 7/11. You have 9000 because you hope 90 of them will hit, and it’s usually just a free play. Anyone in industry knows that the lease is just the first baby step in the alphabet soup of approvals required to actually think about maybe drilling an exploratory well, never mind rolling out rigs, crews, mud, sand, fracking equipment, more crews, gathering systems, pumping stations, tank farms, gas plants, flare stacks and pipelines required to get a “lease” into production.

 

It is inconceivable to the righteous mind that it is their own prevarications, mixed signals, counter intuitive messaging and bureaucratic roadblocks that might be holding up production.

 

Here in Canada, it’s no better. We have the second or third largest reserves of oil in the world. Let’s compare ourselves to the top 5. Unlike Venezuela we can afford to produce them. Unlike Saudi Arabia, we are ready to produce them. Unlike Iran, we aren’t under sanction for wanting to develop nuclear first strike capability against Israel. And unlike Russia, we aren’t the cause of this whole freaking disaster in the first place.

 

But listening to our government you wouldn’t know it. All you get is pious nonsense from Trudeau about supporting Europe with renewables and an environment minister who says it’s impractical to send oil and natural gas to Europe because our production is in the West and oriented for export in the wrong direction (true!), yet in the same breath says that we should and will be exploring ways to export our hydrogen riches to Europe. For the uninformed, let me point out that a) the technology and industry around hydrogen is in its infancy; b) any hydrogen project of consequence needs to be in Alberta because of our resource base; and c) to actually SHIP hydrogen to Europe we will have to build a pipeline to tidewater – either, say, along the ROW for the defunct Energy East oil project or a similar path as the Saguenay LNG project. Both of which of course would have helped Europe but are now long dead and buried.

 

There are two ways to address a supply crisis in energy: Produce more or use less.

 

That means incentivize short cycle tight oil production now. It means encourage people to consume less now. It means figuring out how to get more barrels out of Canada to the Gulf Coast now using all resources, like crude by rail. It means telling Europe that the US will send it the barrels it needs out if its Strategic Petroleum Reserve on a “lend-lease” style arrangement until the situation stabilizes. And maybe, with all these “leases”, permitted or not, maybe it means that the government that actually owns the land could drill themselves or joint venture with the oil companies to expedite regulatory approvals and put their money where their mouth is. How about them apples?

 

It also means publicly telling Saudi Arabia that it’s OK if they want to sit this one out, but we’ll remember this the next time you come knocking for weapons.

 

What it doesn’t mean is encouraging people to buy an out-of-stock and unaffordable EV in 2023 or laughing at them if they don’t have one already. Or slow-footing a solution for a continent because it doesn’t fit the political agenda of your slogan driven spending plan.

 

Then, and only then, can you get back into your forest for the trees obsession on the energy transition. Provided the electorate even allows you to stay in office.

 

OK, rant and COViD roundup over, let’s move on.

 

You would think that with oil prices trading between $100 and $130 that the opportunity to make bank off oil stocks has passed you by, but in some ways, you may be wrong.

 

Assuming we can drag prices down enough over the next six months and that we haven’t fiddle-farted our incompetent way into severe demand destruction and a global recession, there is always room to participate in what should be a robust run of good fortune for commodities.

 

So without further ado, I present to you:

 

The Rank Amateur’s Guide to Investing (and hopefully not losing your shirt) in Oil and Gas. (version 2)

 

Introduction

 

Hi, I’m that cranky Stormont dude. If you’ve made it this far, you are either a masochist or a regular subscriber. As a regular subscriber, you know I am good for the occasional nugget of wisdom regarding my favourite industry.

 

First off, by now you’ve been told oil and gas is a dying business, but bear with me. It’s time like these, where words like inflation, sectoral rotation, commodity boom, supply shortages, interest rate increases, deleveraging from growth and the like get thrown around that Texas tea becomes a lucrative investment thesis.

 

The sectoral shift was happening well before the current crisis moment. And now a whole new generation of investors is turning its eyes onto the oil and gas sector. You too can join the herd.

 

But be warned. Investing in oil and gas isn’t Bitcoin. It’s not pump and dumping soon to be bankrupt shell companies that don’t have viable businesses.

 

Oil & gas is, in fact, your grandfather’s business.

 

It’s definitely old school.

 

It’s not tech. It’s using technology to get nasty stuff out of the ground.

 

There’s no Twitter nonsense to follow. No Elon musk style CEO’s. There are very few fads. It’s a bunch of dudes poking holes in the ground and drilling tens of thousands of feet to crack rocks and hope oil or natural gas comes back in sufficient volume to pay the bills. It’s dusty, it’s muddy and it’s dirty.

 

It’s also super cool and fun.

 

That said, it isn’t simple. In oil and gas investing there are rules you need to pay attention to. Truisms to trading. And you may have to do some homework. And you will need to have patience. Lots of it.

 

Fortunately, I am here to help you out. I am going to unironically provide a guide for the times that will allow the most hip and uninitiated discount brokerage fumbler as well as the basement dwelling toxically masculine webstock warrior to successfully lose (or make!) money in energy investing.

 

And remember, do as a I say. Not as I do. It’s kind of the way it works in energy. Pick a stock, any stock. You’ll see.

 

Rule #1 – Do not day-trade energy stocks

 

Granted, they can have significant moves during the day, but these stocks don’t trade on momentum. Absent a news break, there isn’t a lot of intra-day movement. The direction for the day is usually obvious when the market opens with the price of the underlying commodity. Oil prices up, stock price up. Natural gas down, stock price down. And it doesn’t vary much off that, except when it’s opposite day. Be forewarned. The long-term trend and direction of oil and gas prices is going to be the catalyst for growth. This isn’t Tesla which can run up 6% in a day because Elon sends a tweet or Amazon that can gain 10% because they split their stock 20 for 1. No, this is a sector where stock prices can and have declined on monumentally positive news.

 

Rule #2 – Do not buy and hold

 

This is the flip side to the day-trading conundrum. Energy stocks do not lend themselves well to a traditional Buffett-style buy and hold strategy. It’s not “set it and forget it” like the Showtime Rotisserie machine. This is because oil and gas is a cyclical industry and the cycle will crush your spirit regularly, almost cyclically. Prices tend to move, trough to trough, on a seven-year cycle, although recent experience is shorter.

 

This means that if you buy an energy company at the bottom and forget about it, it could easily double or triple in value but by the time you look again it’ll be back to where you started. What a sector! I once did study of 30 oil and gas stocks over a seven-year time frame and found that the total return over that period if you’d held on was 0%. Genius! Okay, sure there are some big-cap names like Suncor and CNRL that should be part of any portfolio, but they all move with the underlying commodity.

 

The lesson? Pay attention. The time to get off the commodity train is always crystal clear with the benefit of hindsight but in the heat of the moment, it’s a white-knuckle ride. Watch for step changes in the commodity price. 1% or 2% doesn’t matter. 10% does. Don’t be afraid to cut and run.

 

Oh yeah, governments like to interfere. Don’t lose sight of the politics affecting the industry. Elon can get away with his BS because his cars are pretty and fit a political narrative, but if any oil and gas CEO emulated his BS, the entire industry would be under congressional investigation for price-fixing before the day was out.

 

Rule #3 – Fundamentals Matter

 

Unlike tech stocks that trade on multiples of fictional future revenue, what an energy company is doing today, in the real world, matters to its value. Some of these fundamentals include:

 

  • Reserve replacement

It used to be that this was one of the most important considerations to assess when buying a stock. Fossil fuels are a declining resource, so to maintain revenue and profitability you need to, logically, add at least as much reserves as are going down the pipe. Replacement it matters. Historically, the market has assigned a lot of value to companies that spent a lot in capex to develop new resources and the faster you grew the better. Now not so much. Now it’s all about stability in cash flow, paying down debt and dividends. Great. But you still need to maintain production to get that stability which means that the replacement of reserves still matters. Or put another way, if a company isn’t spending money on acquiring, developing and replacing production, that’s going to be a problem. Don’t buy businesses that don’t spend on maintaining their core business.

 

  • Finding costs

This is tied to reserve replacement. How much does it cost to replace production? This is all available information. Rule of thumb – companies that have high finding costs are less attractive than those that don’t, like oilsands.

 

  • Decline rates

How quickly is existing production declining? The faster it declines, the more money you have to spend to replace it and, all things being equal, the higher your finding costs. This makes the business less attractive. Who doesn’t have high decline rates? Oilsands producers. Who does? Light tight oil in Texas.

 

  • Breakeven cost

This is a useful metric. It shows what underlying commodity price is needed to generate positive cash flow. It’s also a deceiving metric because not every company calculates it the same. Is it before or after debt servicing and G&A costs? Does it include land acquisition and finding costs? Hedging? All legit questions. That said, a lower breakeven is better, because it leads to…

 

  • Cash flow

The ultimate prize. Cash flow. After all the moneys have been spent – land costs, finding, drilling, completing, CEO salaries, interest payments, scheduled principal repayments, G&A costs, royalties and tax – is the company in question able to generate cash flow to pay you (the equity holder) and its other capital providers (i.e. the bank) more than is legally required. This is called Free Cash Flow and the company that generates the most is the one that will win.

 

  • Use of funds

This one is new. Oil and gas companies are currently generating obscene amounts of cash. Historically, this cash was immediately plowed back into the ground because growth was rewarded. Now, not so much. Shareholders want their money back so look for companies that have capital discipline and pay down debt and pump out sizeable dividends, special or otherwise. Don’t buy into the hype of the share buy back, it’s a smoke and mirrors way of using your cash to enrich management and insider shareholders – and yes, I do believe that.

 

Rule #4 – Management Matters

This is critically important. Particularly in the midcap or more speculative space. Have they done it before? Have they created value for investors in the past? My general rule of thumb is that if the name behind the company rhymes with Rose or if they own a part of the Calgary Flames, then I’m in. In this business, successful founders are generally serially successful. Find them and follow them. Buy when they buy, sell when they sell.

 

Rule #5 – Natural gas will always disappoint

Look. When we talk about rules, this is the one that is guaranteed, until one day it won’t be.

Whether it’s pricing, weather, pipelines, LNG delays, AECO, NYMEX, industry upending shale discoveries and prolific over-drilling, methane regulations, associated gas from even more over-drilling, pure-play natural gas investing has been a zero-sum game since 2008. And every time you think it is going to turn around, you get whacked upside the head. Piece of advice? Be leery of producers and drop down the value chain. Buy the shippers and processors – companies that use the feedstock whose pricing never seems to be able to get out of its own way, that’s where the money is. Until it isn’t. Because gas will always disappoint.

 

Rule #6 – When in doubt, go big

Back in 2014, I had a broad portfolio of mid-size energy stocks that I had purchased on a buy and hold basis. By the time I looked again, I had a portfolio of juniors, micro-caps and tax-loss shellcos. A far better strategy is to go big. The big companies are big for a reason and, if you happen to ignore your investments for an extended period of time, say a week or two, you still have a passing chance of retaining some value and retiring before you turn 75.

 

Rule #7 – Diversification

Don’t go for a one trick pony unless you’re looking for a painted one. You can go up, mid or downstream. Oil, gas or both. Pipelines, crude, refined, petrochemical, heck you can even invest in companies that also dabble in wind and solar, it’s more common than you think. The key is don’t put all your eggs in one basket, especially if its natural gas. Depending on price, the company that refines will make money or the company the explores will make money. Sometimes both will, but rarely. The company that ships will always make money, just not as much. Nobody does all three. If the company says they are green, they are lying. Net zero is just 100 less 100 purchased from someone else who is -100. Integrated businesses are more stable than pure plays and won’t grow as fast. Gas will disappoint.

 

Rule #8 – It’s the Direction of the Price, not the level

Watching oil and gas prices can be traumatizing. They change by the minute and trade 24/7. You can lose your mind trying to track them and your investments at the same time. You need to make a decision. Either you slavishly follow prices up, down and around and slowly go insane or, you pick a good company that should benefit from a rising price environment (on top of what they already do) and follow the direction of prices. Don’t follow the gas price. It will always disappoint.

 

Rule #9 – Trust Murray

If someone at the company you are looking at is named Murray, it’s probably not a bad buy. This goes for Mullen Transportation and Murray Mullen, whose family has been doing this since the sector started in Alberta or Murray Edwards whose stewardship includes services, production and hockey. Come to think of it, you could do way worse than buying Mullen Transport, Ensign Energy Services and Canadian Natural Resources. And the Flames are doing well this year, even though I may have caught covid there. There are no Murray’s beholden to the natural gas business.

 

Rule #10 – Alberta is actually great place to invest

I know, I know. It’s poor form to be a homer and geographic concentration is a bad plan. But I’ve now gone through all my truisms/rules and objectively assessed them, Alberta comes out ahead of a lot of jurisdictions.

We have great producers. Some of the lowest costs for what we do in the industry. A favourable regulatory regime. Eventually even some pipelines. A diversified industry. At least two Murrays that I know of. Some of the largest producers in North America and some of the most entrepreneurial management teams. Outstanding fundamentals. Some green stuff. More natural gas than we know what to do with to keep our egos in check.

We are virtually the perfect destination.

What’s everyone waiting for? Send us your money.

Our gas will always disappoint.

 

And there you have it. If you made it this far. 10 Rules to a satisfying life as a broke oil and gas investor.

 

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