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Oil: Opportunities Arising from Infrastructure Bottlenecks

“Allow yourself to stand back to see the obvious before stepping forward to look beyond” – Adrian McGinn

“The fact is, America needs energy and new energy infrastructure, and the Keystone XL pipeline will help us achieve that with good stewardship.” – John Henry Hoeven III, is an American politician serving as the senior United States Senator from North Dakota

“Is it in our national interest to overheat the planet? That’s the question Obama faces in deciding whether to approve Keystone XL, a 2,000-mile-long pipeline that will bring 500,000 barrels of tar-sand oil from Canada to oil refineries on the Gulf of Mexico.” – Jeff Goodell, American author and contributing editor to Rolling Stone magazine

“When a measure becomes a target, it ceases to be a good measure” – Goodhart’s Law

A concept that frequently occurs in the study of thermodynamics – the branch of physics concerned with heat and temperature and their relation to other forms of energy – is that of irreversible processes. An irreversible process is a process once initiated cannot return the system, within which it occurs, or its surroundings back to their original state without the expenditure of additional energy. For example, a car driven uphill does not give back the gasoline it burnt going uphill as it comes back down the hill. There are many factors that make processes irreversible – friction being the most common.

In the world of commerce when a supply- or demand-side shock occurs in a particular industry, it sets into motion a series of irreversible processes that have far reaching consequences not only within the industry which the shock occurs but for adjacent and related industries as well. The commodity complex, more so than most other industries, is typified by regular occurrences of supply- and demand-side shocks.

When a positive demand- or supply-side shock occurs for a certain commodity, the immediate impact is felt in the price of said commodity. As the price of said commodity re-rates, the net present values and prospective returns from investing in new production capacities for the commodity obviously improve. Once return prospects start to cross certain arbitrary thresholds – be it cost of capital, target internal rate of return, or a positive net present value – the investment case for the new production capacities strengthens. In response to the strengthening investment case a new capital formation cycle starts to take root and the amount of capital employed within the industry begins to increase, in turn impacting both supply-side dynamics within the industry and the demand-side dynamics within other supporting industries.

Conversely, when a negative demand- or supply-side shock occurs for a commodity, existing producers of the capacity start to feel the pain and suffer from declining earnings as the commodity’s price de-rates. A sharp enough decline in the commodity’s price can lead to marginal producers selling at prices well below their cash cost i.e. cost of production excluding depreciation and amortisation. At this point the capital employed within the industry begins to decline – this can occur in a number of ways including shuttering of supply, bankruptcies, suppliers changing payment terms, or lenders recalling or withholding loans.

The capital cycle set in motion by either demand- or supply-side shocks are difficult to reverse. Once capital starts entering an industry, it continues to flow in until the vast majority of the planned capacity additions are delivered, even if the pricing assumptions that underpinned the original decision making have changed for the worse. The continued flow of capital despite the adverse change in return expectations is due to what Daniel Kahneman and Amos Tversky call the ‘The Sunk Cost Fallacy’. The sunk cost fallacy is a mistake in reasoning in which decision making is tainted by the investment of capital, effort, or time that has already been made as opposed to being based upon the prospective costs and benefits. It usually takes a shock of epic proportions to alter such a behavioural bias, such as oil falling below US dollar thirty per barrel in 2016 forced OPEC to switch from a strategy of market share maximisation to that of production rationalisation.

In the scenario where capital starts fleeing from an industry even though the sunk cost fallacy may not necessarily drive decision making – unless of course the decision makers have emotionally invested themselves in the negative prospects for the industry – reversing the tide of capital outflows can still be extremely difficult even in the face of improving prospects. This is partly explained by the lingering remnants of the emotional, psychological, or financial trauma that decision makers may have suffered through when the industry went through the negative shock. It often takes a sustained recovery either in terms of length of time or magnitude of price for the trauma to give way to rational decision making.

The turns at which behaviour begins to adjust towards more rational decision making often provide the most profitable trading opportunities.

Investment Perspective

Investing in commodities or equities of commodity producers is not for the fainthearted. Even the most sound investment thesis can be derailed by any number of factors, be it geopolitics, innovation, tax or subsidy reform, cartel-like behaviour, or simply futures markets positioning. Particularly in times of high levels of uncertainty, extreme investor positioning either long or short, or after a sustained move higher or lower in the price of the commodity, investors can be exposed to very high levels of risk. It is at such times that investing in companies that form part of the commodity’s supply chain can be a superior expression of one’s view as opposed to taking a direct exposure in the commodity or its producers.

We think that given the sustained move higher in oil, that has clearly wrong footed many, extreme positioning on the long side in futures markets and impressive revival in US shale oil production, one may be able to better express a medium-term bullish view on oil prices by investing in companies that service the oil and gas industry. Specifically, we consider, at this stage, being long equities of companies with products and services targeted towards oil and gas pipeline infrastructure to represent a more balanced risk-reward trade than simply being long oil or a generic energy ETF.

Brent Crude Oil and WTI Midland Price Spread Brent WTI Midland Spread.png Source: Bloomberg

To quote Bloomberg from its article Crude in West Texas Is Cheapest in Three Years Versus Europe:

Oil traders with access to pipelines out of West Texas to export terminals along the Gulf Coast are raking it in from the rapid supply growth in the Permian Basin. The 800,000 barrel-a-day output surge in the past year has outpaced pipeline construction and filled existing lines, pushing prices of the region’s crude to almost $13 a barrel below international benchmark Brent crude, the biggest discount in three years. That’s about double the cost to ship the oil via pipeline and tanker from Texas to Europe, signaling U.S. exports are likely to increase.

The infrastructure bottlenecks pushing down WTI Midland prices relative to Brent Crude prices are the direct consequence of underinvestment in pipeline infrastructure. This underinvestment is the result of either (1) the expectation that oil prices would remain lower for longer or (2) that shale production would not recover even if oil prices recovered. We think the reason is more likely to the former as opposed to the latter.

Oil prices have recovered both in terms of the magnitude and the duration of the recovery to such a degree that investors and decision makers are beginning to overcome the trauma caused by the sharp decline in oil prices between 2014 and 2016. And only now are they starting to invest in pipelines and other oil and gas infrastructure to benefit from the recovery in both oil prices and shale production. Just as there was inertia in the change in investor attitudes towards oil and oil related investments, there is likely to be inertia – should there be a significant decline in oil prices from current levels – in stopping projects that have started and gone through the first or second rounds of investment.

Companies that manufacture components such as valves, flow management equipment, and industrial grade pumps, that are essential in the development of oil and gas pipeline infrastructure, we think, will be the primary beneficiaries of the recovery in oil and gas infrastructure investment. We also think companies specialising in providing engineering, procurement, construction, and maintenance services for the oil and gas services are also likely to benefit.

We are long Flowserve Corporation $FLS, SPX Flow $FLOW and Fluor Corporation $FLR.

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

Oil: Fighting the Myth

“This one will really take you back,” said the Great Winfield. “Sheldon’s Western Oil Shale has gone from three to thirty.”

“Sir!” said Sheldon the Kid. “The Western United States is sitting on a pool of oil five times as big as all the known reserves in the world – shale oil. Technology is coming along fast. When it comes, Equity Oil can earn seven hundred and fifty dollars a share. It’s selling at twenty-four dollars. The first commercial underground nuclear test is coming up. The possibilities are so big no one can comprehend them.”

“Shale oil! Shale oil!” said the Great Winfield. “Takes you way back, doesn’t it? I bet you can barely remember it.”

“The shale oil play,” I said dreaming. “My old MG TC. A blond girl, tan from the summer sun, in the Hamptons, beer on the beach, ‘Unchained Melody,’ the little bar in the Village…”

“See? See?” said the Great Winfield. “The flow of the seasons! Life begins again! It’s marvellous! It’s like having a son! My boys! My kids!”

The Great Winfield had made his point. Memory can get in the way of such a jolly market, that malaise that comes with the instantly gone, flickering feeling of déjà vu: We have all been here before.”

– Excerpt from The Money Game (1976) by Adam Smith (aka George Goodman)

Muscle Memory: Misnomer

Complicated skills that humans can overtime perform without much thought, almost automatically, such as riding a bike, playing the guitar, or knitting a sweater, are often thought of as being held in muscle memory. Think back to Karate Kid and Mr Miyagi’s ‘wax on, wax off’ training regime – popular culture fed us the idea of muscle memory and we gobbled it up.

While it is true that certain skills may require the strengthening of various muscle groups, the reality is that learning and retention of new skills occurs in the brain, not in muscles. The process of acquiring new skills causes changes to the structure of the brain. Magnetic resonance imaging (MRI) scans reveal that there is a visible increase in the number of the connections between the different areas of the brain that are required for the skill being acquired. This structural change alters the information the brain transmits to the muscles, thereby altering the movements produced by the muscles.

Ideas: Power

The ability to imagine a reality that neither exists today nor has existed in the past, to give birth to an idea, is one of the truly remarkable gifts endowed to humanity.

Ideas are the seeds of progress. It is ideas that enable large scale human cooperation that transcends self-interest, race, and borders.

Simple ideas: Highly contagious

Ideas are powerful. Simple ideas that are fully formed and easily understood are also highly contagious. Once a simple idea has taken hold, it is difficult, almost impossible, to eradicate.

Peak oil was a simple idea and it was easy to understand, making it both powerful and contagious. It was so contagious in fact that it bordered on belief; it was hardly ever questioned. And the parabolic rise in the price of oil during the last decade was taken by many as confirmation of that belief.

So when the price of oil crashed during the second half of 2014, the immediate reaction of the global investment community was not that peak oil was a myth but rather that OPEC (read: Saudi Arabia) had been greedy. That the cartel had artificially kept supply constrained to maximise its earnings and that the greed had comeback in the form of shale to bite the cartel in their proverbial behind.

The resilience of the peak oil concept is the very reason we think that oil prices recovered sharply during the first half of 2015 and that dedicated energy focused private equity funds were able to raise so much capital in a relatively short amount of time. As market participants witnessed the sharp drop-off in rigs across shale oilfields, it reminded them that cheap oil would eventually run out and higher prices would be needed to satisfy global oil demand – muscle memory or not, investors proceeded to bid up the price of oil.

Ideas that have taken hold in people’s minds are difficult to eradicate. And this is precisely the reason why an even sharper drop in the price of oil was needed to debunk peak oil as a myth. As oil prices tanked during the fourth quarter of 2015 and January 2016, a new idea took hold: the existence of shale placing a cap on the price of oil, i.e. if oil prices were to move above an arbitrary price, usually quoted to be between US dollar 65 to 80 per barrel, for a prolonged period of time, shale producers would ramp up production and flood the market with excess oil.

As oil prices recovered during 2017 so too did US oil production – US output has climbed by approximately 1.2 million barrels per day since January 2017. This surge in production is being seen by many as confirmation of both the responsiveness of shale oil producers and the existence of a cap on the price of oil. We beg to differ.

Investment Perspective

While the surge in US shale production has been impressive and may well continue for the remainder of 2018, we consider the supply and demand dynamics of oil to be decidedly in favour of steady or higher oil prices over the medium term:

The cyclical upturn in the global economy has supported oil demand, which grew by around 1.6 million barrels per day in 2017 and based on OPEC estimates is going to grow by a similar amount in 2018 and reach almost 100 million barrels per day.

Even though US shale oil production is increasing, it is not overwhelming the market. Suggesting that shale production is not exactly like a tap and that there may even be infrastructure related bottlenecks that constrain supply growth.

The anticipated phasing out of the combustion engine by electric powered vehicles, we think, will take far longer than oil bears expect. Beyond the intangible benefit – at least at an individual consumer level – of doing what is good for the environment, consumers receive very few, if any, tangible benefits in switching to electric vehicles. (We accept that there are some notable exceptions in countries where governments have incentivised electrical vehicle adoption through tax breaks, subsidies, etc.)

There simply are not enough electric vehicle charging stations across any automotive market of meaningful size. Any large scale roll out of electric vehicle charging stations would, in our opinion, have to be subsidised, directly or indirectly, by governments as any such roll out does not, at this stage, make commercial sense, even as an industry-wide joint effort.

China has been a strong proponent of electric vehicle adoption over the years.

China’s recent pollution crackdown, at face value, also appears to be a continuation of its policy of promoting electric vehicle adoption. The reality, however, is that the crackdown has placed immense pressure on China’s already limited natural gas supplies, fuelled discontent amongst its citizen and driven China to import record amounts of LNG.China simply cannot afford for the adoption rate of electrical vehicles to accelerate. We, therefore, think that China is likely to gradually phase out any remaining incentives for electric vehicle adoption as opposed introducing further incentives promoting adoption.

In addition to the above we do not think the market is fully pricing in the potential disruptions to supply from:

A collapse in Venezuelan crude production;

The increasing probability of the Trump Administration pushing through reinstatement of economic sanctions on Iran;

Sustained cooperation between Saudi Arabia and Russian in managing supply; and

Slashed exploration and production budgets across the non-state owned oil majors.

Positioning in futures markets remains stretched, making the price of oil susceptible to a sharp correction, especially if trade war rhetoric continues to ramp-up between the US and China. We would see any such correction as an opportunity to build a position in our most favoured oil plays.