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Re: Oil/Investing - Lessons From The Oil Patch / Will Atlas Shrug?
This is a retrospective on some of the lessons I've learned over my career in investing and hedging in the Oil & Gas space.
Investing in cyclical industries, especially Commodity Cyclicals, can be a very tricky business. You can get the Micro-fundamentals right but get killed by Macroeconomic Black Swans. Conversely, you can get the Macro direction right but still get blindsided by Micro issues at the Company/Regional level and/or unexpected Geopolitical developments.
This is not a post about past investment successes; rather, this is a retrospective on some of the mistakes I've seen committed and that I've committed myself over the last 20+ years investing and hedging this space. I will share anecdotes and lessons that I’ve learned from the School of Hard Knocks and hope these can help investors in the Oil Patch and to explain my reasoning for choosing the private equity route for expressing my long-term thesis.
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1997-1998: Asian Contagion
In 1997, fresh out of grad school, I took my first full-time job as an analyst in the hedge fund business at Canyon Partners, a credit-focused multi-strategy value investing hedge fund based in Los Angeles. My previous experience before business school was commodities trading at the J. Aron division of Goldman Sachs where I focused on commodity index arbitrage as well as taking speculative positions in 20+ commodity markets based mainly on top-down Macro/Technical Analyses and expressed through futures and options.
At Canyon, a shop focused mainly on bottom-up Micro/Fundamental Analyses, I was a fish out of water initially. While learning Fundamental credit/capital structure analysis, I sought to make myself useful by assisting in the hedging of the firm’s various existing positions via option structures. This is what led to my first foray into risk-managing an Oil Service Equity portfolio.
During the summer of 1997, Thailand/Malaysia/Indonesia all experienced a wave of currency devaluations. Oil started the year at a multi-year high of $27 and had traded off to around $22 by that summer. One of the senior analysts at Canyon at the time managed a portfolio of Oil Service Equities that looked very cheap by all measures of earnings and cashflows. Little did he or anyone else know that they would get much cheaper — like 75%-100% cheaper (yes, there were bankruptcies) — by the time the reverberations of the Asian Contagion rippled through the macroeconomy and crashed Oil into super-contango by the end of 1998.
Needless to say, these Oil Service Equities were smashed — and looked extremely cheap every step of the way down to oblivion.
The decision was made to hold the equities (unfortunately), but there were other ways to recoup losses. My solution at the time was to look outside the equity portfolio and go back to my commodity trading roots to find some kind of hedging opportunity. Spot WTI had already collapsed, so that was no use. However, the forward curve was in super-contango given the demand collapse as a result of the Asian Contagion denouement of Russian default and LTCM collapse. Noticing that one-year forward WTI traded at $17 still when spot was $10, I crafted a commodity-based hedge designed to roll down that super-contango and recoup some of those equity losses.
Cyclical stocks, especially Commodity Cyclicals, can have their Micro/Fundamentals swamped by adverse Macro developments. This is because they are price-takers by nature and have very little control over their Macro-determined top-lines. Therefore, Macro risk management must either take place internally at the company level or externally by the portfolio manager.
Commodity Cyclicals also often look cheapest near cyclical peaks because their earnings/cashflows are derived off of previously/currently high commodity prices — all lagging indicators. When the Macro turns unexpectedly, often these cheap stocks wind up getting a lot cheaper, which makes it psychologically difficult for portfolio managers to cut losses. This is the concept of a Value Trap — one of the most pernicious investing mistakes that I’ve both seen committed and committed myself (more on this later).
Look for out-of-the-box hedging opportunities. During that period, my vehicle of choice was 1-year at-the-money forward put spreads designed to roll down the super-contango that developed in Oil.
Butterfly Effects can take a long time to show up. It took 18 months between the initial wave of FX devaluations to metastacize into a full-blown contagion. Incidentally, this is why I am so concerned right now about the USD Wrecking Ball careening into China/CNY and feeding back into Oil. I wrote this piece last summer, detailing the events of 1997-1998 and comparing them to the present:
2014-2016: Macro Compounded By Micro / My Worst Investment Ever
For the next decade and a half, I gravitated to other sectors — both at Canyon and at my firm Akanthos (which I founded in 2002). It wasn’t until 2014 that I became involved in an Oil & Gas Equity — one that would be the worst loser of my career. That name was Sandridge Energy — the pre-bankruptcy Sandridge precursor to the Sandridge of today.
The original thesis was not a commodity-driven thesis at all. It was an event-driven thesis that bet that the largest shareholder, activist fund TPG-Axon, would succeed in getting the management team to make certain changes in its corporate governance as well as monetizing some of its noncore assets to unlock “hidden value.”
Meanwhile, Oil had been $100+ for years, and I had not focused on Macro commodity fundamentals for many years. After all, it was an event-driven bet, right?
Alas, as we would soon learn, the market doesn’t care about your investment thesis. We did not fully appreciate the magnitude of undisciplined production-driven growth of US Shale in the years leading up to the Oil Crash of 2014-2015, and when it happened, we committed the cardinal sin of adding to our position on weakness, falling into exactly the Value Trap mentality that clobbered my former colleague at Canyon in 1998.
Needless to say, the results were not pretty. At one point, we realized there was real solvency risk, but surely the assets were solid, right? Trying to distance ourselves from the encroaching flood threatening to swamp the Equity, we moved up the capital stack to the High-Yield Bonds — and compounded our error.
We would end up learning that Sandridge 1) had one of the worst/highest-cost geologic assets of US Shale — the Mississippi Lime, 2) the management team was one of the worst in terms of corporate governance and Capital Reallocation (more on this later). Not only had this management shrugged off TPG-Axon’s activist efforts, they wound up structuring egregious pay packages for themselves and swung for the fences to the detriment of bondholders — right up to the doorstep of bankruptcy. One month before missing its coupon payment, the management spent over $100 mm on a land purchase in the Niobrara Shale to shore up its Oil cut (because the Mississippi Lime is known for its high Gas cut) — this was a company buying then-untested acreage in an area with no infrastructure at a time when the company was running out of liquidity to even pay its coupons!
The company eventually filed for bankruptcy in 2016, and the “new” Sandridge that exists today was born out of the ashes of old bondholders from 2016.
Eventually, the port-reorganization Sandridge would attract the likes of Carl Icahn, who also waged an activist campaign against this same management team. Because my analyst and I were Sandridge “experts” by then, we flew to meet with Carl and his team in early 2018 to advise him. Eventually the old team did get ousted — but not before their golden parachutes cost the company tens of millions of dollars to Carl’s great chagrin!
Relative Value Between Post-Reorg Sandridge Equity & WTI, Late 2016-Present:
The most obvious one is: Ignore the Macro in a Commodity Cyclical at your own risk. We really screwed up by focusing myopically on the Micro and allowing ourselves to be complacent in the recency bias of $100 Oil. We further compounded our error by thinking the Oil selloff was overdone prematurely and adding to our position on the first sign of weakness.
A rising commodity tide floats all boats — even very poorly managed ones with terrible geology, but watch out when the tide goes out! We learned the hard way that the only Macro environment that can allow companies with terrible underlying assets to prosper is one of very high commodity prices. As the relative value chart shows, this type of company had explosive downside during the 2018-2020 Oil weakness but also explosive upside when Oil finally recovered. At the end of the day, however, you can’t change geology. Watch out below if the tide goes out again.
Sometimes the best hedge is just to get out. Some things are just not fixable. We thought we were risk-managing in this case by climbing up the capital stack and wound up getting hurt even more — especially when the same terrible management continued its last-ditch efforts to swing for the fences right before its missed coupon payment. This is a classic and egregious example of divergence of management interests that focus on maximizing Equity (a long Call Option on Firm Assets) versus caring about other stakeholders like Bondholders (who are effectively short a Put Option on Firm Assets). We should have just cut our losses in this name instead of continually fighting to recoup value in this name.
2018: A Year of Black Swans
I’m not going to focus on the COVID period, because that’s too obvious of an unhedgeable Black Swan. I actually think that 2018 represented one of the trickiest years of investing in the Oil Patch — mainly because of how constructive the Macro picture looked on this chart up until late Q3’18.
After our experience with Sandridge in 2014-2016, we really boned up on Oil fundamentals and became active distressed investors in the sector. In fact, it was during one of the many bankruptcies of 2016 that I decided to make an outsized bet on the bankruptcy restructuring of an upstream MLP named Breitburn Energy that led to my outsized private equity bet today as my vehicle of choice for betting on the long-term Oil thesis.
Back to 2018. As the lines indicate on the chart, up until Q3’18, the price of Oil had not only stabilized from the previously tumultuous period of 2014-2015 but had clearly broken out to the upside from the $40-$60 range that governed most of 2016-2017. Easy sailing, right?
Not so fast. Despite getting both company-level Micro fundamentals right and high-level Macro fundamentals correct, 2018 actually proved very difficult for public Oil & Gas equities primarily because of 2 Black Swans:
Black Swan 1: Basis Blowouts. The first was a Regional Black Swan of Basis Blowouts in Q3’18 related to offtake infrastructure bottlenecks out of West Texas. There was so much Oil being pumped out of the Permian Basin that there was not enough offtake capacity, which resulted in discounts of up to $10 to WTI prices! I remember poring over complex maps of pipelines throughout the country, wondering where the next bottleneck might show up. This was a very difficult Black Swan to identify and hedge, because it required not just company-level Micro analysis but a comprehensive understanding of regional pipeline dynamics.
Black Swan 2: The Trump Rug-Pull. Just as these Basis Blowouts began to ameliorate in Q4’18, a big Geopolitical Black Swan happened in November as Trump reversed his previously telegraphed decision to offer no waivers for Iranian Oil purchases as a result of pulling us out of JCPOA in May. Importantly, prior to this about-face, President Trump had convinced KSA to export additional Oil to compensate for sanctioned Iranian volumes. This bait-and-switch wound up flooding the market in Q4’18 (what Trump ultimately wanted), and you can see what happened to Oil prices in Q4’18.
Even if you get the big picture Macro and company-evel Micro right, you can still get blindsided by Regional and Geopolitical Black Swans! The Basis Blowouts we saw in the Midland/Permian Basin due to offtake bottlenecks and then the Trump Rug-Pull made this one of the most difficult periods I’ve experienced in the Oil Patch. The first risk was somewhat hedgeable through basis swaps (not that easy for folks without commodity expertise), but the second risk was a true Black Swan and impossible to hedge.
Duration-Match the Bet to the Thesis. Because of the volatility and difficulty of gaining any kind of edge in the Oil Patch, given the myriad company-level Micro, Regional Micro, Macro, and Geopolitical risks, the best way to avoid getting shaken out of a long-term Macro thesis is to Duration-Match the bet with the thesis and only trade in the short-term when you have the highest conviction.
Present Day Concerns
My last Substack details the evolution of my long-term Oil thesis, from the post-COVID period to the present:
Needless to say, I am extremely concerned about the short-term (6-12 months) setup for Oil.
Since my post, OPEC+ has cut a third time on June 4, and Oil prices have gone DOWN, not even lasting one day of pop.
I have been vociferous in predicting that OPEC+ would likely cut again after their first two premature cuts — just not so soon.
I don’t think KSA will continue to subsidize Russian free-riding, and there are already signs of fracture within OPEC+:
Now, I fear that OPEC+ is out of bullets just as the US Consumer is about to run out of gas (pun intended). The chart below, courtesy of Lakshmi Sreekumar of Capital One, shows how the US Consumer’s Excess Savings built over COVID is about to run out. Not only does this impact domestic Oil demand, it also represents the end export demand for China, which is why I’ve been harping on China’s necessary CNY Devaluation.
US Consumer Excess Savings (Or Lack Thereof):
And right on cue, China just missed BADLY on exports:
To me this corroborates that the Western Consumer is just about tapped out — and the Western Consumer is all that China has going for it.
Accordingly, I expect the CNY to continue to devalue, which will send a deflationary pulse for all goods — especially Procyclical Commodities like Oil that are USD-denominated.
And when that happens, my biggest concern for Oil is that OPEC+ might be out of bullets.
To use another Greek mythological reference, if Atlas the Titan is Saudi Arabia shouldering the burdens of OPEC+ Free-Riders (mainly Russia) in propping up Oil prices, WILL ATLAS SHRUG?
How I’m Implementing My Lessons From The Past
These are the ways I’m putting my own money where my mouth is and implementing my own learnings. I’m obviously not recommending that anyone follow my plan, because everyone’s risk profile and positioning is different.
Duration-Match Bet To Thesis To Avoid Shake-Out Risk
This is the most important thing that I’ve done, coming out of the 2015-2019 Oil Bear and what allowed me to stomach the gut-wrenching COVID period without panic. The way I am minimizing idiosyncratic Micro risks is by expressing my long-term bet through the post-reorganization private equity from the Breitburn Bankruptcy 2016. My fund along with a cadre of other funds that owned the senior unsecured bonds bought out the Permian Basin assets from the distressed corpus, infused the NewCo with capital, and hired a top-notch management team to harvest the asset. I’ve mentioned in many interviews and posts that this is a long-term position that I don’t intend to trade and is self-liquidating and duration-shortening, which eliminates Capital Reallocation Risk (remember my Sandridge example?). By Duration-Matching bet to thesis, I avoid getting shaken out by cyclical volatility and choose to trade in public markets only when I have extremely high conviction. I “Texas hedged” by going long Brent futures in early 2022 several times.
Encourage Internal Hedging
I respect the hell out of my management team and have daily dialogues with them about market and Macro fundamentals. Because my private equity position is very out-sized, I would never take on too much external hedging to avoid Duration Mismatch Risks (long illiquid private, short liquid public), but because I am 100% aligned with management, I have confidence in their hedging opportunism and that my views are taken into account as well.
Find Out-of-the-Box Hedges
At the margins, I try to find out-of-the-box solutions like I did in 1998. Then, it was a “Super-Contango Slide-Down” trade. Now, it is a CNY Devaluation trade, whose correlation to Oil I’ve explained many times. In particular, I view this trade as a combination “tail hedge” on 1. China slowdown, 2. Geopolitical escalation around Taiwan, 3. China Debt Bomb Black Swan, 4. CNY/Oil Doom Loop dynamics without the explicit worry of OPEC+ Cuts.
The bottom-line is that the Oil Patch is not a sector for the faint-of-heart, and the recency bias of the 2022 Bull Market can cloud one’s judgment as can be seen by the horrific YTD returns of even some of the savviest professional Oil traders.
I only trade actively in the public space (mainly via futures and ETFs) now when the stars line up to give me extremely high conviction. I don’t have that now, but that’s not to say I don’t have skin in the game, because I made the decision years ago to Duration-Match my bet via private equity which I own in large size.
Hopefully, these lessons from the School of Hard Knocks in the Oil Patch give you an idea of how tricky this sector can be. Getting the Macro right is difficult enough, but to get the Macro right along with all of the other aforementioned risks right as well takes a lot of work and vigilance. Counting barrels is not enough, because that kind of backward-looking myopia is exactly what got people run over so far this year.
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