Hunting: An Oil Net-Net

When scrounging around for cigar butts, it is rare to find one that is covered by Wall Street. Hunting PLC, a supplier to the oil & gas industry, is one of these companies. Despite the research coverage, Hunting still trades below net working capital. Such is the revulsion to oil stocks today.

Hunting is headquartered in London, but has operations primarily in the US. It has a 100+ year history in industries such as shipping and transportation, and still has significant equity ownership by the Hunting family. Its primary focus today is making products for the upstream oil & gas industry. The majority of Hunting’s revenues are derived from US shale, though they also sell into offshore and subsea markets. Hunting’s exposure to shale has made it ground zero for the current oil downturn.

Hunting makes a variety of products such as premium pipes and perforating guns. They have a good reputation in the market, but essentially, they are levered to drilling & completing oil wells. Given the depletion curve in typical shale wells, shale requires a lot of drilling. And Hunting has benefited from this activity the past decade.

At this point, US rig counts and frac spreads are at very low levels. They are only slightly above the multi-decade lows hit earlier this year.

Will shale come back to a reasonable level? That’s the key question for Hunting. It depends on oil prices, as shale is the marginal producer. I have a constructive view on oil as discussed previously (Musings on Oil). I also believe that shale drilling has a future, in the US and abroad, though probably at lower levels than in the past.

The last cyclical low for the oil industry was 2015-2016. During that period, Hunting posted significant operating losses and took impairments on inventory and goodwill.

The 2020 cycle low is even lower. Hunting has already taken another round of impairments and write-offs. But they posted a trading update with “underlying” EBITDA results that were breakeven. This is a significant improvement from the 2016 level. They made the tough decisions on their business early and are not bleeding cash. Should EBITDA results stay breakeven, they should preserve their net current asset value and survive a long time.

Hunting holds a fair amount of inventory and should generate a significant amount of cash as the business contracts. In this way, the business is counter cyclical. Working capital will unwind as revenues decline.

Management seems capable and properly incentivized. They will continue to do tuck-in acquisitions. And most likely, they will stay focused on upstream oil and gas.

One potential risk for Hunting is actually the family ownership. They still own stock but aren’t really involved in the company other than being reliant on a dividend. In 2016, they raised a decent amount of equity to fund a dividend (at a price 3x higher than today). The quote from the annual letter was that the canceling of the dividend “caused grief to some of our loyal shareholders.” I’m assuming the descendants of Charles Hunting don’t see the same investment merit in the business as he did.

Given the strength of the balance sheet today, the funding of the dividend should not be an issue. But going forward, the family will more likely to be focused on receiving a dividend rather than more accretive uses for their cash. This may not be optimal for capital allocation.

I don’t know when shale drilling will recover. But if the environment reverts to some reasonable historical level (say 500 rigs in the US), Hunting should be solidly profitable and trade at a low multiple to its earnings.

For what it’s worth, Goldman Sachs thinks Hunting is worth about double the current price and rates it a “Buy.” Might be worth swimming with the vampire squid on this one.

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.