Crude Observations

Rules for Oil and Gas Investing?

Over the past few months regular readers may have noticed that I have used this platform to allude to what may or may not be an emerging commodity super-cycle. Driven by gradual (or in the case of Texas, sudden) re-openings of the global economy as the vaccine rolls out and people get more comfortable being part of regular society once again, the theory is that demand for the building blocks of society will accelerate as restrictions come off.


I know many pundits and experts have modelled this as either a gradual recovery with modest growth or a short-term inflationary bump to be followed by a day of reckoning when the amount of money spent comes home to roost but I’m having a hard time buying into that moderation.


We are at the year 1 marker of Pandemic times (and this will be the last time I mention this) and people are tired. Tired of being home, tired of being told what to do. Tired of not being able to see family and friends, tired of the human toll and tired of the uncertainty. The vaccines, delivered miraculously in the nick of time, are going to allow this to unwind over the balance of 2021 and my sense is the pent-up demand is going to result in a period of economic growth and recovery that we may not actually be mentally or materially prepared for. As much as we appear to have overestimated the economic impacts on the downside, we are going to miss the scale of the recovery on the upside.


It’s this recovery that is going to drive the “super-cycle” as demand for anything from copper to lithium to agricultural products to lumber to steel is going to accelerate as consumer and industrial demand ramps up.


And smack in the middle of this sits everyone’s whipping boy, the fossil fuel. Or more specifically oil and natural gas and the companies that find them, extract them, ship them, process them and sell them.


An out of favour sector that was so down and out that many stocks were down by more than 75% from their already DOA 2019 levels and have languished since in a fever swamp of ESG, energy transition, EV ascendance, SPAC tech plays and Gamestop euphoria. Dead and buried. Done for. Pack it up and go home, nothing to see here, just a dying industry.


Well guess what.


They’re back.


And rallying. Just waiting for some daring investors to take the plunge.


But many investors find themselves in a quandry, because we (generically) have spent so much of the past year dunking in the energy sector that we don’t know how or when to invest in the energy sector anymore.


Which is kind of topical because a trending discussion this week has been about “international money and investors” shunning Alberta in general and the energy sector in particular. And I admit it, I see this in my daily life as someone raising capital for private businesses. And I bring it up ALL THE TIME because I am passionate about it, because, well, I live here.


But maybe, just maybe – hear me out. Maybe there is a knowledge gap that needs to addressed? I mean in addition to all the other issues, because let’s face it, the hurdles to capital raising in Alberta are large.


But to say that people “won’t” invest in Alberta is nonsense. There is always capital coming in, but sometimes a catalyst is needed and an onrushing commodity super-cycle pretty much has catalyst stamped on it.


The sectoral shift is already happening. It is evidenced in the recovery of trod-upon so-called “value” plays and the increasing volatility in the insanely over-valued and over-hyped tech world. It’s there in the run-up in the price of oil and natural gas – arguably ahead even of full demand recovery. Investment flows are changing.


And a whole new generation of investors, raised on Robin Hood trading platforms, bots, AI and algorithmic hedge fund annihilation is turning its eyes onto the oil and gas sector, of all things.


But, with that flow of capital comes issues. Investing in oil and gas isn’t Bitcoin. It’s not Redditt-driven price hyping or pump and dumping soon to be bankrupt shell companies that don’t have viable businesses.


Nope, this is an actual market for companies that have actual products, differentiated product lines and, what’s that called? Oh right, cash flow.


Thinking this through I ultimately decided I should do all these nutty investors a favour and give them the lay of the land as they chase this mysterious new market and see if they can profit from the hot-hot-hot energy part of the post-pandemic commodity party.


First off, oil & gas is, in fact, your grandfather’s business.


It’s old school.


It’s not tech for tech’s sake. It’s applied technology used to get nasty stuff safely out of the ground.


It’s not Elon Musk tweets and rockets blowing up. Nor is it Bitcoin and Twitter followers. It’s not a follow the herd and hope someone pumps your stock for you and it isn’t a day trading party. There aren’t investment-vehicle driven fads like SPACs to artificially deliver fake inflated value or IPOs that trade at 40% premiums a second after opening.


Nope. 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


Sure they can have significant moves during the day, but these stocks don’t trade on momentum. 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. 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.


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 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, you could easily see it double or triple and 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.


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. So 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 matter. 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.


  • 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.


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


I used to buy mid-size energy business on a buy and hold basis. This left me with a portfolio of juniors and micro-caps. 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.


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. Not sure I’d cheer for the Flames this year, but they appear to be plucky. There are no Murray’s beholden to the natural gas business.


Rule #10 – Alberta is actually great place to invest


I know, I know. I said that already. But I’ve now gone through all my truisms/rules and objectively assessed, 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.


Oh, and the volumes on some of our best plays are too small to day trade.


We are virtually the perfect destination.


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


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