Dear Energy Investor,
In the fourth quarter, the
Energy/Natural Resources (ENR) portfolio returned +6.7%. For the year, Energy/Natural
Resources (ENR) portfolio returned +33.3%, outperforming the S&P500 Total
Return, which delivered +11.96%.
Taum Sauk holdings are making a
comeback: performance in 2016 was the best of any year since 2009. We believe
that the re-formation of the OPEC cartel in November 2016, along with the election
of Donald Trump, will bring to a close the worst period of low oil prices in 30-years.
When OPEC dissolved two years ago, oil
prices dropped 50% (70% at the nadir) and portfolio performance suffered
greatly. Over the long term, we believe that Taum Sauk will outperform. The
chart below shows the long-term track record of Taum Sauk (dark green) versus
an investment in the broader market (S&P 500, red) or passive energy (XLE,
light green). Looking at the chart, it’s
obvious that less reliance on the Fed and more on business helps Taum Sauk.
Cumulative Performance 1998-2016
Taum Sauk 677% (12.1% p.a.)[1];
XLE Total Return 344% (8.6% p.a.); S&P500 Total Return 156% (5.3% p.a.)
OPEC Re-formation (Possible Tailwind #1)
OPEC’s re-formation will remove
slightly less than 2% of global production from the market. The decision was a
long time coming, but it is welcome relief for many. Venezuela and Nigeria are
on the brink of collapse; Saudi Arabia is substantially poorer; redevelopment
of Iraq and Iran is slow. We estimate that producing at record levels for the
two years cost OPEC members half a billion dollars per day[2].
It seems that once per generation OPEC
members have to learn why they exist. External limits, like those imposed by a
cartel or government agency (e.g., Texas Railroad Commission), are critical to
stable prices because of the nature of oil resources. Oil is hard to find and expensive to develop
(high fixed cost) but cheap to operate (low variable cost).
We think OPEC will unify behind lower
production for a while. In a prior generation (1970s) OPEC restricted supply causing
high prices; then they regretted it, mostly because they lost market share, loosened
supply, caused 15-years of low prices, regained some market share but not as
much as they lost. Too much time had passed. High prices enabled new
competitors with new technology (3-d Seismic, directional drilling, offshore
and Arctic expertise).
The same thing happened this time. OPEC
allowed high prices for more than a decade.
They could have brought more production to market when oil was
$100/barrel, but they didn’t. Once again too much time passed and new
competitors (US independents) developed new technology (fracking). Even though
there have been over 100 bankruptcies in the oil and gas industry in the past
2-years, there are enough new competitors that have staying power, many of
which are in your portfolio, that OPEC will not regain their former market
share without bankrupting themselves. Although expensive and painful, fortunately
it only took 2-years to learn the lesson this time.
OPEC’s unity won’t last. As we
pointed out in a previous newsletter, cartels are inherently unstable. All
members are better off if they cooperate, but if everyone else cooperates, the
individual is better off if they cheat (a.k.a. Prisoner’s Dilemma). Cheating will
resume. Some members will produce more than they are allowed. Others will find
that their domestic supplies are limited, like Indonesia that joined OPEC in 1962,
dropped out in 2008, rejoined in 2015 and then dropped out again in 2016. Indonesia, like all OPEC members, wants
higher prices, but they are also a crude importer. It is nonsensical for them to limit their own
production in order to buy barrels they could have produced from someone else.
The US is in a similar situation. Domestic development has been restricted, not
by OPEC membership, but by lack of resources and tepid government policy. But now that the largest oil field in the
world has been identified in the US[3],
why would it limit domestic development in order to buy barrels from someone
else? Surely the United States is as
practical as Indonesia.
US Presidential Election (Tailwind #2)
Which brings us to the other phenomenon
that has developed since we last wrote: the election of Donald Trump and
Republican majorities in both the House and Senate. This last occurred in 1928.
We are as surprised as anyone else, although our middle daughter picked Trump
early in February and stuck with him despite the circus. The result is a dream come true for the
domestic oil and gas industry. President-elect Trump’s picks for key government
positions just couldn’t be any better:
Rex Tillerson, Secretary of State, former CEO of Exxon Mobil; Rick Perry,
Energy Secretary, former Governor of Texas; Scott Pruitt, Environmental
Protection Agency Administrator, former Oklahoma Attorney General.
We recently read Eye on the
Market Outlook 2017: True Believers by Michael Cembalest[4].
He organizes recent dynamics into a struggle between the forces of
globalization and modernization (central bankers, tech companies) and those who
are disenfranchised by these forces (inhabitants of industrial rust belts,
average citizens).
A couple of charts from his work really
caught our eye. First, the chart on the left shows that there has been a 50%
increase in the number of economically significant regulations passed during
the Obama administration compared to previous administrations. The sense of
growing red tape that we know from our work and hear about from our friends is
real. Carl Icahn, Special Advisor to the
President on Regulatory Reform, says there are “$1 trillion in new regulations
and over 750 billion hours of paperwork resulting from Obama regulatory.”
The chart on the right confirms that
people think that too many taxes and too much regulation are the worst problems
facing small businesses. We agree with Carl Icahn again when he says, “In my
view, it’s the potential change in the regulatory
agenda that may be affecting sentiment the most.”
Investment Themes
For these reasons, we believe that
the wind could be finally at our back. We are more optimistic about oil prices
and the potential for domestic development than ever. While we don’t know how
high oil prices will go (neither does anyone else), we do think there is
upside. The OPEC-led production cut is supposed to take effect this month. It
may already be having an impact. Stockpiles in the United States, which has the
most accurate inventory data, fell during the last week of December by
7,000,000 barrels.
We expect that the excess inventory
built in the last two years will work off during 2017. As shown in the chart
below, inventory levels remain elevated by about 20%. If OPEC extends the production cut beyond the
6-months that was agreed, the market will go from surplus to balance, and
possibly even to deficit. Demand is
inelastic, so as long as oil prices remain in familiar territory, we think
demand destruction is unlikely.
Ending
Stocks of Crude Oil 2014-2016[5]
Since the cut was announced in
September, prices have increased from $43/barrel to $53/barrel, yet the rig
count in the United States is 5% lower than it was at this time in 2016.
Producers hedged about half of their 2017 production at 2016 prices, so they
will be slower to restart suspended drilling programs than some may expect.
Although some basins, like the Permian, have seen rig counts increase; other
basins, like the Eagle Ford and Williston, have seen them decrease.[6]
We continue to own exploration and production companies focused in the Permian.
We entered oil field service names
during second quarter. We further
increased them during the fourth quarter.
All portfolios contain at least 30% oil field service. In some accounts with margin and option
capability we extended this to 50% during the fourth quarter.
There is a lot of well work to be
done. For example, with 658 rigs at
work, US production has fallen 10%, from a peak of 9.6 to 8.8 million barrels
per day. When production peaked, the US
had over 2000 rigs working. Just to
sustain current production, we estimate that the US needs over a thousand
horizontal rigs working. Even if the US makes up only a miniscule amount of the
OPEC production cut, there is a lot of work for service companies. Companies
that made concessions during the downturn are saying they will institute a 25%
price increase immediately when work resumes.
With a possible 40% upside in activity, 25% upside in pricing and share
prices still beaten down 75% from their 2014 highs, we think oil field service
is the best investment in our universe.
Nancy
January 9, 2017
Dallas, Texas 75205
646-296-6102
[1] Performance reported net of fees based on CIO track
record from 1998-2007: AllianceBernstein Long-only; 2008-2012 Taum Sauk World
Development Hedge Fund; 2012-2016 Taum Sauk Investments Managed Accounts
[2] In the April 2016 newsletter
we gave this example: OPEC essentially sold 33 barrels for $30 ($990) when they
could have sold 30 barrels for $50 ($1500) multiply by a million barrels a day,
which is $510,000,000 per day.
[3] In the September 2016 newsletter we wrote that the
Permian Basin has an estimated 160 billion barrels of oil equivalent to the
largest oilfield known: Ghawar, Saudi Arabia.
[5]
Energy Information Administration, http://tonto.eia.gov/dnav/pet/hist/LeafHandler.ashx?n=PET&s=WCRSTUS1&f=W, Web accessed Jan 5 2017.
[6] Baker Hughes North American Rotary Rig Count, http://phx.corporate-ir.net/phoenix.zhtml?c=79687&p=irol-rigcountsoverview, Web accessed Jan 5, 2017.
