Musings on Oil

It hasn’t been a great year for oil stocks. The XLE is off 50% this year while the S&P 500 is close to record highs. COVID-19 has crushed transportation demand, which comprises the majority of oil consumption. The price war instigated by Saudi/Russia also made things a lot worse for producers.

Oil stocks have already had a rough decade. From the 2010-2014 period, oil prices ranged from $80-100. From 2015-2019, it averaged around $40-60. Oil companies, not surprisingly, made a lot more money in the first half the decade.

Hydraulic fracturing and horizontal drilling have helped access shale oil, increasing US production by a few million barrels a day. It helped the US achieve a greater degree of energy independence. But the increasing supply put additional pressure on oil prices.

The return on finding new oil remains low. For the past several years, it seemed like oil companies generated net income and paid dividends, but earned relatively little free cash flow.

On top of that, ESG mandates are encouraging oil companies to invest less in oil and more in sustainable technologies like wind and solar. This is particularly true in Europe. Emissions are the biggest downside to fossil fuels. They release a lot of CO2.

Finally, and potentially most devastating, the outlook for long-term demand has turned south. Just take a look at all the Teslas in any big city and you’ll get a glimpse of the future. BP has recently reported that oil demand will permanently decline from here. Peak oil? Yes, but due to demand, not supply. Other oil companies seem oblivious to the change.

Is it worth prospecting for investments here? There are net-nets among oil producers and services companies. Even the majors trade at or below tangible book value. I think the risk/reward on oil stocks is favorable.

Let’s first talk about oil’s fundamental advantages. First, it’s energy dense and relatively affordable. It is highly available with a global distribution infrastructure already in place. Oil is its own store of energy. It can be stored in tanks, in pipes, and even in tankers. It doesn’t require costly batteries for storage.

Oil is still highly strategic. Global trade depends on it. Militaries depend on it. The same is true for agriculture and air travel. There are a multitude of industrial and medical uses. There is currently no acceptable substitute for these applications.

But ultimately, it comes down to supply and demand.

On the supply side, capex levels are down. Rig counts are at record lows. Global capex for E&P companies will be in the $300-400 billion range this year. This is down from the $800-900 billion range earlier in the decade.

Negative prices earlier this year caused well shut-ins. Some of these won’t reopen. Those that do will resume production on their normal depletion curve. Shale wells typically have much higher depletion rates.

Overall, supply is down and capex is being cut. There is an extensive industry rationalization underway right now. That’s usually a good time to be buying any commodity.

The big question, of course, is demand. There are cyclical and secular factors at play. Roughly 50% of oil used is gasoline for cars. Another 8% or so is used for air travel. Vehicle miles are currently down by about 10% in the US. Air travel is down 60%.

Perhaps both will recover in the next couple years. But if air does not recover and people drive more, what will happen to oil demand? Both situations imply a fairly healthy recovery. I’m generally in the camp that things will return to normal.

And what about the long-term? Electric vehicles are the big threat. But oil has always had to contend with these threats. Vehicle emissions have been improving for decades, impacting oil demand. Vehicle emissions will continue to improve, and electric vehicles will accelerate that.

It will happen, but it will take time. There are 1.2 billion vehicles on the globe and 2.2 million electric vehicles were sold in 2019. But electric vehicle growth is accelerating, and small reductions in demand can have major impacts on price.

On the other hand, emerging market demand is still growing. Oil consumption per capita in the United States is ~900 gallons a year. This compares to ~150 gallons in China and ~50 in India.

Though the future is cloudy, it will take some time for long-term demand to be impacted. There is a reasonable case that oil demand will continue to rise for a while.

In the near-term, however, supply is down and demand could be coming back. If you believe that the post-COVID world could be anything like the the past, there could be a snap-back in oil prices. Investing in some of these oil net-nets could turn out to be a gusher.

US Banks and Margins

Banks have been troubled investments since 2007. The housing crisis and resulting aftermath destroyed the equity value for most banks. A few didn’t survive or were absorbed by others.

After the crisis, banks had new difficulties: increased capital requirements, limitations on business activities, accounting changes, and increased oversight.

Additionally, fintechs with better technology and customer acquisition capabilities have entered the space.

Stock performance has been weak. Many US banks trade at single digit earnings multiples, or even below tangible book value. Some banks could even be considered net-nets, depending on how generous you are on asset liquidity and debt levels.

Banks also currently have limits on their dividend payouts and are restricted from repurchasing shares. The Fed has reserved the right to evaluate this policy on a quarterly basis.

Finally, and perhaps most importantly, net interest margins (NIMs), at US banks have been on a 10+ year slide. Net Interest Margin is the spread of what the bank earns on its assets (i.e. loans) against its costs (i.e. deposits). This metric is the key driver which determines their profitability.

One theory for this reduction in NIM the past decade has been the decline in interest rates themselves. One of the bear cases on US banks is that NIMs will continue to decline as interest rates go lower, similar to what happened in Japan.

But is there a relationship between interest rates and NIM? In the below chart, we compare net interest margins for US banks compared to 10 year government rates since 1984.

Source: FRED

Interest rates have been declining throughout the entire 35 year period. The ten year government rates dropped by over 1000 basis points. Meanwhile the decline in US NIMs was about 70 basis points.

Not exactly a 1-1 move.

Source: FRED

In Japan, NIMs are indeed much lower. In the late 1990s, they averaged around 1.2% and are currently around 0.8%. We only have data through 2017, but NIMs dropped about 40 basis points since the mid-1990s. At the same time, 10 year interest rates dropped by 300 basis to go negative. Again, not a 1-1 move.

NIMs in Japan have always been lower than the US. This is similar to how returns on equity in Japan have just always been lower. Japan is a fundamentally different place in terms of business culture. For example, Japanese banks return far less capital via share repurchases.

From this analysis, it seems that NIMs have moved down about 10-15% of the move in the rates themselves. And while the absolute levels may vary between countries, there is no obvious reason why NIMs in the US should drop to Japanese levels.

All of this data occurred in periods of falling interest rates. At this point, you are probably wondering what happens to NIMs when interest rates rise?

Fortunately Wells Fargo has annual reports from all way back to 1969 posted on their website. Here is their NIM compared to the US 10 year:

Source: Wells Fargo annual reports, FRED

Just as before, there is little correlation between NIM and interest rates. Wells Fargo increased its net interest margin through the mid 1990s, before embarking the slow slide to today’s lower levels. From the early 1980s through the 1990s, its NIMs were increasing as rates were falling.

Overall, the correlation between government rates and bank NIMs is weak. If anything, the direction of NIM appears to be more correlated to economic activity.

So will NIMs in the US continue to go down? Possibly. There is increased competition from fintechs and regulatory oversight is not lessening. If they do continue their decline, the decline will take a long time.

Future stock returns of US banks will depend on your view of competition and the US economy longer-term. Given the way banks are currently priced, it seems like a decent bet to me.

Charlie Munger & Quality

As the legend goes, Charlie Munger was the one who convinced Warren Buffett to buy quality companies. Up until that point, Buffett has been managing his partnership by investing in cigar butts. By the early 1970s, Buffett had turned Berkshire around and had a high-class problem: too much money with too few opportunities.

In 1972, Buffett had the opportunity to buy See’s Candy for $30 million. See’s was an exceptional business. A candy business with untapped pricing power. Graham’s principles would never have allowed it. Buffett wrestled with it. Finally he was able to negotiate the price down to $25 million. Buffett paid a nosebleed ~12x after-tax earnings and 3x tangible book. The acquisition turned out to be a success.

Finally, Buffett saw the light and proclaimed, “IT’S FAR BETTER TO BUY A WONDERFUL COMPANY AT A FAIR PRICE THAN A FAIR COMPANY AT A WONDERFUL PRICE!” And the rest was history.

Since then, much has been said on returns on invested capital and returns on incremental invested capital. It turns out to be very important for future returns.

Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6% return—even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.

Charlie Munger

This, of course, is mathematically true. But investors, armed with this information and Microsoft Excel, have been justifying paying crazy prices for businesses they are certain will maintain high ROEs over time. And it will work if you’re right on the ROEs. While some investors will have the conviction to hold forever and get it right, it’s not easy. And most people can’t hold a stock for 2 years, let alone 20.

It’s also instructive to look at Charlie’s actual investments the past 30 years. Here’s the list:

  • Costco: High-quality business for which he paid 12-13x
  • Tenneco: Over-leveraged business bought at cyclical lows
  • Li Lu’s Hedge Fund (incl. BYD): Net-nets and cheap stocks in Asia
  • Posco: Low-cost steel business trading below tangible book
  • US Banks: Decent businesses bought below tangible book

Wonderful businesses at fair prices? Some of them are wonderful. But what constitutes a “fair” price? It’s certainly a lot lower than prices people currently pay for quality businesses.

My takeaway: Quality is great, but price matters too. A multiple of 12-13x might be their rule of thumb for a wonderful business.

But, in looking at Charlie, there doesn’t seem to be anything wrong with investing in a fair businesses at a wonderful price either.

New Rules: Net-Nets & Leases

Net-net investing has always been mostly foolproof. It still is. But the implementation of a new reporting standard in the past year has had a big under-the-hood impact on the calculation of what is a net-net. The changes raise some questions and provides opportunities for enterprising investors like us. We examine the implications below.

ASC 842 is a financial reporting standard that provides guidance on accounting for leases (IFRS 16 is the international version). The key update is that leases will now be recognized on the balance sheet as a liability instead of just expensed on the income statement. There is a corresponding “right-of-use” asset entry to offset the new liability. On the income statement, leases will be depreciated with an interest charge.

Effectively, these new reporting standards bring off-balance sheet liabilities onto the balance sheet. It treats leases more like debt. And since total liabilities are increased with no change to current assets, net-current-asset value is lowered.

Off-balance liabilities were always true liabilities, even if they were not reported. These obligations are especially real in a liquidation scenario. Many of us accounted for them in our analysis by factoring in the contractual obligations of the company listed in the 10-K.

Adding incremental liabilities to the balance sheet means that far fewer companies will qualify for net-net status. Take, for instance, Tuesday Morning’s latest 10-Q:

TUES 10-Q Snippet

As of June 30th, Tuesday Morning’s net-current-asset-value was $57 million. By December, the net-current-asset-value dropped to -$286 million and was no longer a net-net. Yikes. The red circles above show the difference. In the December quarter, operating lease liabilities increased to a total of $382 million compared to $0 two quarters ago. Bringing these liabilities onto the balance sheet completely changed the equation. Under this new accounting, it is not surprising they recently filed for bankruptcy.

Tuesday Morning had quite a bit more leverage than their June balance sheet indicated. IFRS 16 helps identify this. It levels the playing field accounting-wise for those who rent vs. buy property & equipment. It also helps shed light on leverage that an unscrupulous manager may have tried to hide off the the balance sheet.

One implication for us is that in making the financials more conservative several former net-nets may no longer qualify by traditional screening. It was already difficult to find net-nets, and now its even harder.

My general view is that the accounting change is a positive. I always do my own work on whether a lease liability is real or not. I generally include them. And the accountants have done the work for me.

But for certain going concerns, I think it’s important to be flexible. Many times, if sales decline, businesses will right-size their footprint by exiting leases over time. The leases were real but the liability was reduced over time. And in a true liquidation, it’s not clear the lessor is going to get everything they are contractually required to get. So in certain situations, that lease liability is overstated.

And because net-nets are harder to find, there may be companies that do not qualify today, but could have qualified under the old accounting methodology. I would happily consider these as potential investments if I felt the businesses would be going concerns and had limited other risks.

On the other hand, one potential downside implication is that by excluding the riskiest of the net-nets, you invalidate the prior studies which showed strong historical performance. For example, in March 2009, the share price of Tuesday Morning dropped to $0.53. About twelve months later the shares had increased more than 10x. If you held your nose and bought a broad basket of these net-nets, you did well. There were some bankruptcies, but also some spectacular winners. By ignoring the hidden liabilities, you effectively took much more risk and could have benefited from it. Would net-nets have performed as well historically under the new accounting methodology?

I don’t have studies to prove it, but my personal experience is yes. Most net-nets did well despite (or because of) the leverage on the balance sheet. And the few that went bankrupt were usually those with hidden off-balance sheet liabilities, or had some other issues associated with it. Net-nets did well across the board.

Overall, I view the changes as a huge positive. It makes net-net financials more conservative. There are fewer of them, but they are higher quality. And if some net-nets are a little harder to discover, I’m okay with that too.