Someone recently emailed me and asked the follow:
I juxtapose your thinking with the thinking of a blogger with a similarly named blog; when I read each of you, you each seem to be right to me but then this simply can't be so- at least about near term oil prices. Wondering how you see Fairfax purchase of SandRidge, and perhaps how I reconcile 2 variant blogs.
To eliminate any confusion I thought I would post my response here. My apologies for being so long.
If you look into recent history you will find I am not the same as the other blogger you are referring to. We have intensely debated in the past. That said I do regret picking a name similar to his blog as it is confusing. For the record, I never read his blog before starting mine and haven’t read it since. I read a few articles on another site and thought they were high on opinion and lacking in facts. He doesn’t have much to offer other than mainstream thinking. Original ideas are hard to come by and it is why I believe my blog has been so successful. I refuse to rehash the daily news.
When we debated PBG/PBN it became clear he doesn’t understand O&G and had never read the reserve report. He doesn’t understand how the reserve report is determined and doesn’t understand how an O&G company makes money. He believes that all an oil company has to do is buy a bunch of land and then start shooting fish in a barrel. I can assure you it is much, much harder than that.
Many of the companies he has recommended are very speculative and many have generated little to no real economic return. I don’t know what he’s saying now because he charges for his content. If history is any guide most of his ideas are small speculative O&G companies. Many don’t generate real returns but merely only turnover their cash flow and are at best asset plays. By asset plays, I mean you are essentially betting on the underlying commodity prices.
If that is “value investing” then he needs a new definition. It’s really speculation, be honest. You and the company have absolutely no control over the price of their products; you are a “price taker”. How do you make reasonable estimates about the future revenue and earnings? If we go to the other side of the spectrum, Coca-Cola is a company with huge “pricing power”. An increase in price doesn’t affect demand. Moreover, Coca-Cola increases the price of their products every year and sales continue to climb.
As for the price of oil, I am aware we disagree on where it is going. He is a believer in peak oil and I am not. What are the reasons that oil will go up further? I would like to know them. Is it just because it’s gone from $11/bbl to $100/bbl during the past decade?
If you have read my blog for any amount of time you will be aware that I am a firm believer in “reversion to the mean”. As Prem Watsa says, “Trees don’t grow to the sky.” Simple extrapolation of short-term trends will hurt you more in investing than anywhere else.
Five Reasons Oil Prices Will Fall
I have discussed my bearish position on oil for some time now, let me highlight five reasons.
1. Oil has had a tremendous run over the past decade and I doubt it will continue indefinitely. Reversion to the mean will happen. The reason for the run is mainly because of very accommodating fiscal policy both in the US and BRIC nations (Brazil, Russia, India & China). The Chinese stimulus has carried the commodity trade for the past two years.
2. China cannot defy economic gravity. Despite what the pundits say, real estate bubbles rarely have soft landings (Read Michael Lewis, When Irish Eyes are Crying). It is almost unbelievable that people still believe today that you can command control an economy. I mean look at the US. According to the Federal Reserve Chairman everything was great in 2006/2007. Then the crash comes and they say, “trust us” we are in control and can get us out of this mess. Let’s be honest it’s comical. Let me be blunt… You cannot command control an economy. This is the 21st century and we should have learned this lesson by now.
Reasons for the US Housing Bubble
To further explore how you cannot command control an economy, let me list my reasons for the US housing bubble (Let me know if you agree or disagree).
A) US government policy encourages home ownership and because they intervened in the “market”, people responded to the incentives. The creation of the GSEs (Fannie Mae, Freddie Mac), the tax deductibility of interest, and non recourse mortgages are all interventions that alter behavior in the housing market. Thus the housing market was no longer a “free” market.
B) The Federal Reserve dropped interest rates after the internet bubble and kept them too low for too long. Here the incentive was cheap money and it further encouraged home ownership and fueled the early speculation. This is another example of how intervention altered people’s decisions in the market. Thus we did not have a “free market” but a market full of incentives.
C) Finally, people believed in the sound premise that “real estate only goes up”, acted on the incentives, and then the price action took over. Finally in the late stages of all bubbles the focus is almost entirely on the price action. Once the price action took over, the bubble exploded and speculation become rampant. Stories about how your neighbor just flipped a house and doubled their money in one or two years become common.
Warren Buffett has said one of the most important things he learned from Ben Graham is that “you can get into more trouble with a sound premise than with an unsound premise.” If you understand what he's saying it so true.
Back to our Discussion
So China will not be able to defy economic gravity. They have some serious mal-investment in real estate. Because they consume 40-50% of the world’s commodities, once the game us up commodities will get hit hard. Back in 2008 the Chinese stimulus was something like 23% of their GDP. This resurrected oil and nearly every other commodity that fell hard back then.
3) Commodity prices do not reflect reality. Copper, although off its highs, is still selling for much more than the marginal cost of production. Copper is selling for $3.50/lb and it cost $1/lb to get it out of the ground. Have you looked at the returns the mining and metal companies making? I’m sure you have heard it said that profit margins are at record highs and are bound to fall to more normal levels. Well this is a sector that will have some significant margin contraction. If you look at commodity related equities, they have fallen much more than relative to the fall in commodity price. Why is this? Clearly the market (investors) are signaling a further fall in commodity prices. When commodity prices fall, oil will fall likewise.
4) I don't believe in "new era's. I also don’t want to take any unnecessary risks. If you step back and look at the price of oil you have to believe this is a “new era”. The market has numerous other opportunities so don’t box yourself into one sector.
5) On the flip side, what is the bull case? The bull case is we are running out of oil. While that may be true but isn’t it interesting US oil demand has fallen since 2005 (Click Here). High oil prices have also led to an onslaught of new technologies and energy sources. If you have a free market economy and someone has a need (in this case energy), someone will find a way to meet that need. Thousands of engineers are working on it everyday (Click Here for an Example).
I’ll keep this short. I looked very, very briefly at Sandridge. I'm not interested in owning an oil company and I didn’t see anything appealing so I took a pass. That said I believe Fairfax has invested because of two reasons. One is management and the second is hedging. I have heard Prem Watsa say that the speculation in commodities is out of hand and that he knows of only one company that hedges their prices. I took that statement to refer to Sandridge although I don’t know their hedging policy. If SandRidge has significant hedges that is smart and is likely the reason why he’s invested. Many companies won’t hedge. You want to know why? Because they are speculating that prices will go even higher. People never learn and never change. They constantly reach for risk & yield with little regard for the downside.
Prem understands this well and he never reaches for unnecessary risks or yield without adequate compensation. He wants to earn 20% on every investment that Fairfax makes. When he does that he leaves himself a large margin of safety.
Disclosure - Long FFH