Trump’s “Delta” / Jobs & OPEC Friday / The Oil & Gas Opportunity / The GSE “Piggy Bank” and the Government “Mob” / Hamster Tracks

Kaoboy Musings 16 – 12/6/2019

Trump’s “Delta”

Here we go again.  On 12/2/19, Trump indicated that a trade deal might have to wait until “after the elections,” sending the markets swooning a ghastly 2% (gasp) from an all-time high on 11/27/19 before recovering the entire move by the end of the week after “new” signs of progress yet again.  That the market isn’t completely inured to these about-faces by now is beyond me.

In options lingo, we have a term called “delta,” which denotes an option’s sensitivity to the underlying stock price (mathematically, the delta is equivalent to the first derivative of the option price function with respect to stock price).  A call option with a delta of 1 indicates that the option will move 1-for-1 with the underlying stock and is thus very sensitive to stock prices; a call option with a low delta, say 0.3, will only move $0.30 for every $1 of stock move and is considered relatively insensitive to stocks.

If President Trump were an option, he’d have a delta of 1.  Enough said.

Jobs & OPEC Friday

Friday, 12/5/19, was quite eventful.  Despite our high-delta President’s penchant for calming the market after any kind of swoon, the U.S. economy at least appears to have real underlying strength and does not need require the jawboning.

In Friday’s unemployment report for November, the U.S. economy crushed expectations, adding 266k jobs in November versus expectations of 180k.  Although the resolution of GM’s strike accounted for 46k of these “adds,” recall the 128k surprise last month vs. 85k expectations during the strike.  Indeed, in this Friday’s report, there were also upward revisions of 41k for the previous two months.  It actually seems like the U.S. economy is reaccelerating, despite the lack of a trade deal.  I have contended for months that folks shouldn’t put too much credence in the unprecedented length of the expansion but should instead focus on the relative lack of intensity of expansion over the last decade; for this reason, I continue to believe that the U.S. economy can continue to surprise people in its virility – especially if we get a trade deal.

Next, OPEC+ concluded its 2-day summit and managed to surprise the world with an unexpected additional cut of 500k barrels/day from its 1.2 mm barrels/day cut level established back in 2018.  This is a big deal.  The oil markets have been remarkably complacent even after the attacks at Abqaiq earlier this year, mainly because of the elevated inventories in the system, much of which has been contributed by runaway U.S. shale production (more on this later).  This being Abdulaziz bin Salman’s first OPEC meeting as Saudi Oil Minister, the world did not know what to expect.  Abdulaziz has now shown his cards, in my opinion, by throwing full support to his brother Crown Price Mohammed bin Salman (MbS) in a bid to remove the oil glut and “juice” the recently IPO’d Saudi Aramco.

Although crude only rallied a little over 1% on the “surprise cut,” it had already bounced 4.5% from the 12/2 “no trade deal until after elections” global market swoon.  Nevertheless, I think oil is poised to grind higher over the next year.  The forward curve of oil (similar concept to yield curve) is now massively inverted (we call this “backwardation” in the commodity markets).  This chart shows how the level of backwardation has been steadily increasing over the last several months, showing an increasing wariness of supply tightness:

This brings me to my growing conviction in opportunity in oil & gas that I began to write about in the last several Musings:

The Oil & Gas Opportunity

This is an amazing chart:

The white line shows a chart of WTI crude, the green shows Henry Hub Natural Gas, and the purple shows the XOP (Oil & Gas Equity ETF) over the last 5 years, normalized to the same starting point to show how each asset class has performed relative to one another.  The devastating underperformance of the oil & gas equities relative to the commodities is stark.

Here are my takeaways:

• While the U.S. has benefited from the “energy independence” from the Middle East that the shale revolution has brought, it has largely been an era of “profitless prosperity” for the U.S. oil & gas industry.

• Despite the industry’s promises of being able to prosper above $50/bbl (you can’t see it in this chart due to the normalization, but WTI crude has been consistently above $50 since the beginning of 2017, except for a brief stint in December of 2018), the lack of free cash flow to date has all but destroyed investors’ confidence that shale producers can ever inflect to free cash flow. 

• The massive underperformance of the underlying equities (purple) to the commodities (white and green) indicate a growing disenchantment with the sector – arguably reaching crescendo extremes at this point, with the entire U.S. oil & gas space accounting for less than 4% of the S&P and worth hundreds of billions less than Saudi Aramco’s $1.7 trllion alone! 

• Note that this massive underperformance of the XOP actually understates the underperformance of the sector since this ETF only contains the largest, best-capitalized names in the space.  I follow a basket of “post-reorganized” small-caps in this space (companies that have already been through the Chapter 11 wringer once), and of the 22 or so names that I began following a couple years ago, the median ytd performance for 2019 is -54%, excluding the 5-6 names that have been complete wipeouts a second time around, going to the “Chapter 22” (2nd consecutive bankruptcy) route. 

• I believe that investor disenchantment is warranted from the standpoint of companies showing terrible capital re-allocation skills.  This is the crux of the problem, in my opinion, for a public E&P company – what do you do with the cash flows from producing wells that are supposedly highly profitable from a well-specific perspective?  For public companies with stories to tell and empires to build, managements have typically diverted this cash flow into new projects and new acreage in sometimes unproven regions with questionable geology and economics.  So even if individual wells show 50% IRR’s, what good is it if the company continues to burn cash in aggregate?  This is why so many public E&P companies are trading below the present value of their reserves (“PV10” in industry parlance) – public markets are ascribing continued value destruction.

• This brings to mind an interesting “arbitrage” opportunity that ideally requires activist, private equity – buy up some of these sub-scale operators trading at significant discounts to proved/developed/producing (“PDP”) reserve value, sell off the proved/undeveloped (“PUD”) reserves, and run the companies off like liquidating trusts.  In my mind, this is the only way to ensure convergence to reserve value and eliminate poor capital re-allocation as a risk. 

• The public market alternative is to invest in low-cost operators who have a combination of good capital discipline, strong balance sheets, good inventory depth, and shareholder-friendly initiatives.

• What is different now than years past is that company managements are finally “finding religion” and finally listening to shareholders in terms showing capital discipline; in many cases, lack of liquidity is forcing this discipline upon producers. 

  • One aspect of capital discipline is restraining growth.  Rig counts have fallen to multi-year lows as a result (although the counter argument is that increased drilling efficiency have countered much of this effect):

• The other aspect of capital discipline is returning excess cash flow to shareholders either through buybacks or dividends. Naturally, only larger players with scale can afford to do this, and this is where I’m investing in the public space.

To summarize, the confluence of several factors is making me very excited about this space:

• The Darwinian culling of the U.S. shale industry has forced consolidation and capital discipline amongst smaller players.

• Big players are beginning to inflect towards free cash flow and the return of cash flow to shareholders.

• The supply side of the equation is getting tighter:

Non-OPEC production growth (of which the largest component is U.S. shale) is starting to roll over.

iOPEC+ (the “+” denotes Russia) has shown remarkable discipline and not only rolled over its previous 1.2 mm barrel/day cuts but surprised the market with an additional 500k barrels/day in cuts.

• The demand side of the equation has shown remarkably steady growth (see my notes from Kaoboy Musings 15) and may even accelerate with a lessening of trade tensions.

• From a valuation and sentiment standpoint, we are at a nadir.  That said, this sector has been a “widow-maker” for many, and I caution would-be investors to do their homework and have a longer-term horizon (3-5 years) in order to weather the inevitable bumps.  For those not looking to have idiosyncratic stock risks, ETF’s like the XOP and OIH can be good sector substitutes. 

Full disclosure: I am heavily invested in this space and currently own FANG, VNOM and ET, although I frequently do relative-value swaps with other names in the sector.  My largest position, however, is in a private equity called Birch Permian.

The GSE "Piggy Bank" and the Government “Mob”

Outside of the oil & gas opportunity, my other favorite opportunity, as many of you know, are the GSE preferreds, which I continue to believe have 150%-200% upside from current levels over the next 12-18 months.  I have written extensively on this topic and would be happy to share my past Musings with anyone interested.

In Kaoboy Musings 13.5, I gave some soundbites from Judge Sweeney’s hearing in the Court of Federal Claims, where multiple classes of plaintiffs have sued the government and FHFA for a “Constitutional takings” of private property when it put the GSE’s into conservatorship in 2008 (some are suing over this event) and then again when the Treasury/FHFA enacted the Net Worth Sweep in 2012 (some are suing over this event). 

I’ve now had time to go through almost 300 pages of transcripts from that day in court and want to include some choice words the Judge had for the government:

• “how does the Government justify never allowing Freddie and Fannie to pay off money it received and eventually being able to stand on its own feet, which it could have done, and then let its board decide whether or not to pay a dividend to the shareholders. It seems from the beginning when you have FHFA coming -- and Treasury coming to the board of directors of the enterprises and saying you either agree to the conservatorship or you’re out, it seems as though there was a death grip placed on the enterprises by Treasury and FHFA”

• “they were never allowed to repay -- the enterprises were never able to repay that which they borrowed. And so they were never allowed to stand on their own two feet again as much as an entity can stand on two feet.”

• “There was this siphoning of every dollar of profit.”

• “I’m very concerned that Treasury approaches the board of directors of the enterprises and says, you either agree to the conservatorship or you’re out. That’s -- that sounds like undue influence, if not a death grip.”

• “It’s as though it was somebody --they were used as like a piggy bank that they could – or it was this funding stream. And I’m a taxpayer so, I mean, it’s great that the Government can generate tax revenues, that’s fine. But it should be fair and equitable”

• “a reasonable plaintiff or investor, knowing that an infusion of capital was required and the Government was going to provide that infusion of capital and that the company -- in this case the enterprises -- would have the opportunity to repay the loan and then regain its footing and then eventually to be able to pay dividend, that’s what one would expect. One would not expect in the United States of America that the Government would step in with an infusion of capital and not then not allow -- and the dividends were going to flow to the taxpayers to repay the taxpayers, one would not expect that all profits would be directly flowing into the U.S. Treasury and that the company would never be able to repay that which it borrowed, get back on its feet, and resume normal operations and pay dividends again.”

At one point the DOJ lawyer characterized preferred investors as holders of “lottery tickets” hoping for a windfall, to which Sweeney replied:

• “I appreciate your lottery ticket analogy, but the Plaintiffs owned stock, which is far more certain than a lottery ticket. A lottery ticket, you may have one in a billion or 100 billion chance of winning. Stock is something that -- it’s a certificate of ownership, you’re invested in that company and, God willing, you get a return. For preferred stock, they certainly were enjoying a return year after year after year. I think there was always a dividend paid except for maybe one of the enterprises in 1985, something like that. So, there was a fairly consistent return which is much better than lottery ticket, at least any of the lotteries that I know of.”

And finally, perhaps with Martin Scorcese’s The Irishman fresh on her mind, Sweeney says on pages 275-277:

• “I hate to say it, I’m not -- this is going to sound so flip, and I don’t mean for it to, but this is like the mob. And it’s not, of course, but, I mean, you have all the money is being turned over to the Treasury.”

• “But, you know, what kind of – how are they saving -- it’s almost as though the companies or the enterprises have become shells, and they’re able -- and they’re supposed to continue on in their work, but they will never make a profit because everything’s being diverted to Treasury.”

Hamster Tracks

Lastly, I want to pay homage to a long-time market pundit whom I’ve affectionately named “The Bearded Hamster.”  The Hamster was a frequent market prognosticator on CNBC; after several decades of doing this, he finally decided to call it quits last week. 

Predicting the future is damn hard to do with any sort of consistency, but what I found remarkable about the Hamster’s calls, however, was how consistently wrong he was – there is signal value in any kind of consistency, even if points you 180 degrees in the opposite direction!  In fact, long before I started writing Kaoboy Musings, I thought I would one day create a blog with a dedicated section called “Hamster Tracks” to spot what the Hamster was doing and then make the opposite recommendation. 

Tongue-in-cheekiness aside, I suspect that his consistency in making terrible calls stemmed from two primary mistakes.  First, his worldview was largely informed by “trend-following,” which generally places you among the consensus.  Now I’m not saying the consensus is always wrong.  In the financial markets, powerful long-term trends do occur and can make patient investors a lot of money.  The problem, however, is that in the short-term, being in the consensus can often mean that you’re the “Johnny-come-lately” left holding the bag when short-term winds change direction.  This leads me to the Hamster’s second big mistake: being too short-term on his calls and getting scared out of his thesis at precisely the wrong time, exposing himself to severe whipsaws, both financial and emotional.  One of the biggest impediments to investment success is one’s own emotions, and not doing proper due diligence and/or not giving a thesis enough time to play out will make it easy for Mr. Market to shake you out at the worst imaginable time.  Alas, the Hamster allowed this to happen all too frequently.

I try very hard not to be Hamster-like by 1) trying to gauge the “consensus view” embedded in the market and then deciding whether or not to join that consensus; more often than not, I tend to take the other side, because contrarian bets usually have better reward-to-risk ratios, just like betting on the underdog usually gets better odds; 2) trying to be patient and not let the short-term schizophrenia of the markets scare me out of a solid thesis; truth be told, I’ve often been “too patient” and overstayed my welcome in certain situations, so this is always a work-in-process for me. 

So I am genuinely bummed that the Hamster has called it quits, because I am losing a valuable signal going forward.  He did, however, offer one last nugget of wisdom last week: he advocated getting out of the market and going mostly into cash ◊ I guess this bull market may yet have some legs! 😊

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About

Kaoboy Musings is a private distribution list/blog that I created to encourage dialogue regarding the economy & markets, geopolitics, investment ideas, and life in general. I have a passion for the markets and investing, and even though I no longer accept investor capital, I try to keep current on global events and opportunities and remain active in the markets.  I’ve always found that writing my ideas down, sharing them with smart people, and encouraging two-way discourse and devil’s advocacy is often the best way to validate or invalidate a thesis and stay mentally flexible.

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