Wednesday, November 9, 2011

Five Reasons Oil Prices Will Fall

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). 

SandRidge

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. 


Best Regards,

Kevin


Disclosure - Long FFH

5 comments:

  1. Kevin - there are so many flaws in your logic it makes me believe you were raised by a pack of retarded sheep dogs (yes, that is an ad hominem attack).

    "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."

    100% drilling success rate is hardly "fish in a barrel". You are wrong here.

    "Oil has had a tremendous run over the past decade and I doubt it will continue indefinitely."

    Way to back up your statement with facts Kevin. You are wrong here.

    "China cannot defy economic gravity."

    This doesn't fit the incoherent logic of your article. Or any logic. You are wrong here.

    "Commodity prices do not reflect reality."

    Where is your data Kevin? You are speaking in hyperbole and have exactly zero facts in your article supporting your opinions. You are wrong here.

    I suggest you actually look at the data - supply / demand data, marginal cost data, inventory data. Then you might one day be able to write a factually correct, coherent argument that is intellectually honest.

    Still waiting for the day you take this blog down based on your "wrongness".

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  2. Jon,

    Thanks for your comments, highly entertaining.

    Your 100% success rate comment demonstrates your ignorance. Thanks for putting it on display. Much appreciated.

    You have totally destroyed my arguments. What more can I say? Oh I know... You better look up the definition of libel before you comment here again.

    Regards,
    Kevin

    P.S. – If you think I’m so retarded why do you keep reading my blog?

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  3. Hi Kevin:

    I agree with certain aspects of this post and disagree with others. I agree that peak oil is a myth. I agree that we can't count on China.

    Perhaps, this is the one that I find the most difficult to swallow:

    "Commodity prices do not reflect reality."

    The reason is not that I disagree that commodities could be in a bubble--that could be the case, and recent rise in the oil price might see some pull back. Rather, I am bemused because it assumes that our current financial markets have anything at all to do with reality. You and I are in fundamental disagreement about fiat currency. Considering that fiat currency is a derivative and has no intrinsic value, it is curious that you could determine value of a commodity based on its nominal dollar value. This is what philosophers call reification. You are trying to determine the value of a concrete object (a commodity) on the basis of an abstraction (the value of the dollar).

    In this light, Jim Grant told the story of a letter to the editor of the Financial Times, in which the author said that he finally understands what Quantitative easing is, but now he isn't clear on what money is anymore.

    Commodities are real. Money is not. When the high/hyperinflation hits, I will be focussing on what is real, as fiat money will no longer represent anything of value. That is to say, my spam collection, my hoard of wine kits, and my unused toilet paper have intrinsic value, but the dollar, not so much. Commodity prices do not reflect reality, because money itself is not real. When this happens, it is better to have something that is real than a derivative of a symbol of the collective worth of an insolvent nation.

    Jon: I read Kevin's blog because I am an investor and I find it entertaining. I also found your comment worthwhile. I hope Kevin will continue to let you (and me) comment.

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  4. Hi Petros,

    I don't understand your statement, "fiat currency is a derivative and has no intrinsic value."

    1) What is fiat currency a derivative of? People like to throw around the word derivative but they don't have a clue what the word means. Derivatives are not evil either... they are a legal contract between two parties.

    2) Money does have an intrinsic value. Take it to any store and try it out. They will accept your piece of paper and will give you goods in return. IF it didn't have intrinsic value nobody would accept it. So to claim the dollar has no value is not reflected in reality.

    Money is simply the smallest, most easily transportable, and commonly accepted form of capital. It is the means of converting one form of capital into another form of capital. Money is just the most easily convertible and commonly accepted form of payment. In fact, legal tender laws require financial obligations to be paid in dollars.

    Every capital good (concrete object) is valued in currency (dollars) in order to more easily make economic decisions in the market place.

    Money is capital so long as it is accepted as a form of exchange. Everyone has to play the game. When that ends then I would agree with you it is not real. If however you believe our world is coming to an end and currencies are going to fail, you have much bigger problems on your hands.

    Perhaps you feel that "gold" is real. Gold is no more "real" than paper money. It has to be accepted for payments by everyone or it's really quite useless. You can't eat it, drink it, or wipe you butt with it (spam, wine, or toilet paper).

    Even if people abandoned fiat currency it wouldn't take long for a new one to be established. It would disrupt the payment system for a while but it wouldn't affect our productive capacity in the long run. You see we are not a wealthy nation because of money, stock exchanges, and banks. We are a wealth nation because we are the most physically productive in the world. Capitalism is simply an economic system rooted in Christianity and freedom that caused the west to flourish.

    I would recommend reading the book by Adam Smith, entitled An Inquiry into the Nature and Causes of the Wealth of Nations. It’s a Great book.

    Perhaps I will do some posting on what capitalism is and isn't in the near future.

    Best Regards,
    Kevin

    P.S. I will let anyone post here so long as they refrain attacking (and slandering) my character. When they do so they are really demonstrating their real character. Those individuals are immature and are poor critical thinkers. When they feel threatened, they resort to our innate natural tendency to fight (verbally or physically) or take flight (run away).

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  5. Kevin: Nice to see you are back from moose hunting. We share a preference for capitalism and moose hunting; on that we can agree.

    The reason why the dollar is a derivative is because it has no intrinsic value: it is printed on a special kind of paper with a special kind of ink, to be sure, but the market value of those elements is relatively small. The dollar has zero intrinsic value when it is created electronically, as most money nowadays isn't even printed, but is created as a line on the Federal Reserve's balance sheet (or other central banks for the other fiat currencies).

    The dollar therefore represents something else. Before, the dollar was a derivative for either gold or silver, the underlying asset which backed it. Today it still represents something more than its paper and ink, and that something makes its value not intrinsic but derivative.

    Of course gold has intrinsic value. Just because you are unaware or unconcerned about its many uses doesn't mean that it hasn't been and isn't still one of the most sought out metals for its own sake. Gold is also valuable as money, not as a derivative, because unlike the dollar, it has strong intrinsic value. I will just mention its value in ascetics: it can be used to make very valuable pieces of art, so valuable indeed, that you often need armed guards and safes to protect them from theft.

    What is the dollar of derivative of? The full faith and credit of the United States of America, as some have put it. But the United States is insolvent, and therefore the US dollar is only good to the degree that the United States does not debase it--but they have debased it, they are currently debasing it, and they will debase it further. Therefore, the dollar is a very dangerous asset to hold in that it is certainly going to lose value over time--indeed the inflation targets of both Federal Reserve and the Bank of Canada is 2%. Therefore, it is an asset class where those who issue it plan, nay hope for it to go down in value by 2%. That is the most certain loser in anyone's portfolio today.

    As the collapse of fiat currencies, the Austrians are wont to say that every paper currency in history has become worth nothing over time. Don't think that our current currencies are exceptions, as time will show that they too will become as worthless as the Zimbabwean 100,000,000,000,000 note.

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