False Profits: A Prodigal Value Investor Returns from the Oil Patch

Summary

  • There are two ways to create value in the upstream business: find and produce extremely low cost-of-supply resources; and, integrate along a value chain in order to sell at relatively higher prices.
  • Of these two options, rational integration is far more scalable and repeatable.
  • Data of historical free cash flows overwhelmingly supports the notion that integration is the strategy most conducive to value creation.
  • However, omens of an oil and gas upstream and midstream investment bubble have not been conducive to identifying investment opportunities.

I watched There Will Be Blood a few years back, right after oil prices tanked in late 2014. A scene stood out in my brain, though I never really figured out why until now.

2007_there_will_be_blood_001Source: Critical Analysis: There Will be Blood (Paul Thomas Anderson, 2007). The Film Emporium Blog. 9 October 2010

It goes like this:

Our protagonist, Daniel Plainview is “hunting quail” — a cover for prospecting for oil — on private property with his adopted son HW. HW runs off to retrieve a downed quail and returns to his father with a tarry black substance covering the bottom of his shoes. They soon realize that they have found their “pay sand”.

Then, as they both gaze over the horizon, we learn about Daniel’s vision; one which foresaw the crux of petroleum economics through the century and beyond.

so-so. if there’s anything here…we take it to the sea — we can go into town and see a map – but what we do — we take a pipeline from here to Port Hueneme or Santa Paula and we make a deal with Union Oil — this is what we do and we don’t need the railroads and the shipping costs anymore, you see? …and then we’re making money. we make the real money that we should be making and we’re not throwing it away — otherwise it’s just mud.

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Looking for Value in the Oil Patch? Try the Value Chain.

Summary

  • It is difficult to locate value within the conventional notion of the petroleum industry, especially in the upstream.
  • A holistic approach to the much broader petrochemical and petroproduct value chains suggests that most of the economic value in the petrochemical industry is created and realized downstream.
  • Vertically integrated value chain players are able to source cheap inputs and produce value-added products with intangible values.
  • A simple case study of 10 publicly traded companies which occupy the “sweet spot” of the petroleum value chain corroborates the intuition regarding economic value realization.
  • The value chain analysis framework can be applied to any situation in which raw materials are liberated from commodity market forces.

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Right-Headed Investors Should Avoid Upstream MLPs

Summary

  • Over the last seven years, the majority of upstream MLPs have been unable to cover their investment and distribution costs through operating cash flows.
  • Upstream MLPs seems to be indicative of the broader upstream oil and gas industry with respect to investing and distribution/dividend coverage.
  • While some of the upstream majors appear to be fairly priced, high-quality independents tend to be over-capitalized, while under-capitalized firms tend to be of lower quality.
  • The majority of economic value in the oil and gas industry is realized further downstream.
  • Investors who insist on exposure to upstream oil and gas assets are likely better served by focusing on high-quality integrated majors.

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The Ten Pillars of Quality Investing or: How I Learned to Stop Dumpster Diving for Undervalued Stocks

After recently having completed testing on a general method of discounted cash flow (DCF) analysis for estimating a broad basket of stocks’ intrinsic values, I became more concerned with “quality”. While DCFs remain the foundation of any sound business valuation, I discovered they are highly sensitive to the assumptions and data used. Slightly changing a minute detail can drastically influence the result causing an attractive investment to all of sudden seem not so attractive and vice versa. While relative valuation methods were a natural alternative (Wall Street’s preferred choice, in fact) to circumvent the sensitivity issues, I was inclined to believe that an ability to define robust ‘quality factors’ would complement the ideological purity of the discounted cash flow approach much better. The purpose of this discussion is to demonstrate that a good company can indeed also be a good investment.
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Yeah, man, that pretty much sums it up

I have had several people already say to me that I am giving away too much information about how to profit in the market. If they mean that I have not been concise enough, duly noted. I must work on expressing myself more clearly.

If, on the other hand, they mean that I am giving away too much intellectual property without payment, then my response is that I have said nothing new. If sharing out the truth made it any less potent, then no one acting on publicly held information could conceivably earn returns above the amount of assumed risk. This is not true for the following reasons:
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I Bought Apple Today

I finally broke down and bought a share of Apple today. It closed near where it opened; down 5.48% today after the unveiling of iPhone 5C and 5S.

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Analyzing RenTec’s Top Holdings using SEC Form 13-F Filings (Precis)

In this post, I present a case that alpha can be gleaned from publicly available SEC Form 13-F data. Traditionally, pundits looked at commonalities in institutional top-holdings by dollar amount. Research suggests that these aggregated top holdings among many institutions can be indicative of their “best ideas” (1). That may be all good and well, but common sense indicates that the best leads should come from a good institution’s top holdings per unit of capacity. For my institution, I use RenTec because:
a.) they are quantitative and therefore it may be easier to find commonalities in their holdings; and,
b.) they have consistently delivered exceptional returns.
I believe that their “best ideas” should be those positions in which the position size is largest relative to capacity because a moderately-sized holding for a small float stock is much more indicative of expected risk-reward than a relatively much larger position in a relatively much larger float stock. Additionally, focusing on a single institution (rather than many) allows us to ask the all-important “why” by determining if there are any commonalities in their top holdings. Understanding the “why” might us allow us to move beyond “piggybacking” off of quarterly 13-F data, and understand what drives the decisions of the best in the industry. I argue that if we can deconstruct some of the decision-making criteria, we can use this for finding our own unique source of alpha.

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Grading the Gurus

FORWARD REMARKS
I used to think of myself as contrarian, but after completing my most recent research project, “Grading the Gurus” (which I presented at the last MBIIM) , I now realize that I only appear to be a contrarian. I’ll spare you the discourse on how I came to that for now, but I’ll make sure to include it in my closing remarks.

For those who were unable to join us last Sunday, I thought I would summarize the presentation and the following discussion. Without further ado…

INTRODUCTION TO ‘THE PROBLEM’
Like my previous post says, “I have often wondered if it makes any sense to pay attention to investing gurus.” And there certainly are a lot of them. Most of which seem to promise you that they’ve found the “secret” to easy money, whether that be a method of valuing companies or assessing the market’s future direction. However, evidence suggests otherwise as it has been proven that 85% of mutual funds have underperformed “dumb” index funds over the last 40 years. This means that all those fancy folks that went to fancy schools and wear fancy neckties are not as smart as “passive” investors. Therein lies the problem…

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The Usual Suspects: A Preview of Sunday’s Investing Presentation

I am going to give a brief talk this Sunday as part of the brand new Meetup Group, Monterey Intelligent Investors. The details are as follow:

Sunday, August 4, 2013
10:00 AM to Cafe Lumiere
365 Calle Principal, Monterey, CA

Grading the Gurus
I have often wondered if it makes any sense to pay attention to investing gurus. I’m talking about the greats; the legends; the Warren Buffets; The Benjamin Grahams; those with real followings, real track records, and, most importantly, real philosophies. In brief, I want to ask questions and query data in such a way that will help people place the “usual suspects” into one of three groups:

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S&P 500 Historical Valuation

Dr. Robert Shiller is a leading authority on behavioral finance, a field that attempts to get at the heart of market economics. What’s at this heart? People, naturally. What’s the point? I argue that it behooves traders and investors alike to retain some degree of insulation from the general population’s view on value, and instead rely on a more rational definition of value. Schiller’s cyclically-adjusted Price-to-Earnings (CAPE) and Price-to-Earning-to-Growth (CAPEG) ratios are indeed very simple, rational, and hold a great degree of predictive power.

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