One of the great ironies during the decade of ZIRP/NIRP and QE, is that while it created plenty of asset price inflation, it created minimal consumer price inflation. I suspect this is because free money brought forward all sorts of unprofitable new supply, creating oversupply in most industries and crushing end-market pricing.
Look at shipping for instance, excluding some brief spikes, you’ve had all these vessels losing a few thousand a day because of oversupply. In a normal market, owners would be forced to liquidate assets as leverage ratios increased and debt covenants were violated. Instead, during the most recent decade, operators kept losing money and banks ignored it because interest rates were so low that it didn’t matter—they could just add the accrued interest to principal and overall principal levels would barely budge. Even more amazingly, these same owners were able to go out and borrow additional money to order more new-builds; to be delivered in an over-saturated market. No wonder shipping rates collapsed and have stayed down.
A similar thing happened in shale oil. These wells aren’t profitable using full-cycle economics with WTI anywhere near current prices, but that didn’t stop these companies from being able to raise hundreds of billions to go drill wells that were net destructive of capital. As you could imagine, this increase in oil supply led to lower realized oil prices.
The same trends happened in all sorts of other sectors from office buildings to high-end luxury apartments, from fast casual restaurants to retailers, from iron ore mines to frack sand. You get the point, cheap credit led to too much supply and it crushed the prices of the inputs that ultimately lead into consumer price inflation. Nothing shows this better than the fact that oil bottomed at roughly the same time that 10-year yields bottomed in 2016.
Now, these trends are going in reverse. Interest rates are going up and new supply is abating. As an investor, I want to be invested in sectors where they will not be adding much new supply—especially if I can buy existing supply at a fraction of what it cost to build it a few years back. This is because as new supply abates, existing supply will begin to have pricing power and become more profitable.
With that in mind, over the summer, I built up a large position in offshore drilling supply equipment providers. My view was that I was buying steel at 20 to 30 cents on the dollar—prices that would clearly disincentivize new construction. More importantly, as oil prices increased, this equipment would go back to work. All summer long, I spent my time listening to conference calls and reading industry publications. At the time, it was clear that tenders for equipment were accelerating and that 2019 would be the first year of recovery after a 5-year downturn. Then, oil declined by 35% and my thesis died with the price of oil. In selecting investments, I always worried that oil prices could decline, so I purchased companies like Tidewater (TDW – USA) with no net debt or companies like Ensco (ESV – USA) and Noble (NE – USA) with well termed out debt. I wanted long-term call options on an industry recovery. Unfortunately, this oil price decline has postponed the offshore recovery for a year or possibly longer. My thesis is still alive, but I’m clearly wrong on the timing.
Fortunately, I bought these stocks cheaply, just as their recovery started. Even more fortuitously plenty of other stocks have declined recently—companies where the underlying trends are unusually bullish, like natural gas producers. I complain a lot about my taxes, but at least I get to write off losses when I can. These losses are valuable—especially given how good this year has been for the home team. With that in mind, over the past two weeks, I have sold all of my offshore equipment suppliers (with the exception of my TDW warrants) and transferred the capital into natural gas producers. Incidentally, over the past two months, these natural gas producers are down even more than the offshore supply equipment companies I sold—despite the fact that natural gas may have just started a multi-year recovery. If a bunch of energy funds are going to liquidate and sell their natural gas producers, I might as well take advantage of that and capture the tax losses along the way. I can’t complain about that.
While it has been frustrating to see some pretty large gains turn into small losses in the offshore sector; that is the nature of investing. Then again, with natural gas potentially about to lift off, I much prefer exposure there. Remember, with natural gas producers, you are buying drilling locations, infrastructure and existing wells at a fraction of what it cost to acquire and drill them. More importantly, you are getting current supply with exposure to near-term pricing increases. Just as importantly, as capital dries up, they will begin to drill fewer oil shale wells. Thus far during 2018, there has been roughly a 10 Bcf increase in overall supply but approximately 5.5 Bcf of it has come from byproduct gas associated with shale oil. What do you think happens when that byproduct production slows or declines with less drilling? Remember, shale wells decline at 60-80% a year. Given the rapid increase in demand, this should lead to a re-pricing of natural gas.
Finally, the natural gas producers in my basket are just silly cheap. What do you think happens when gas settles out in the mid $3’s and netbacks per mcf double? What if netbacks triple?
Disclosure: Funds that I manage are long TDW Warrants, AR, GPOR, RRC, SD