The Sector Perfectly Primed For Asymmetry - Get In Now or Miss Out
Have you been considering investing in the oil market? Well Fergus Cullen thinks the time is now. Our 'unloved sectors' expert talks through the reasons why oil should be your next investment; including how to find companies that offer a good risk-reward and how to determine their opportunity based on the current numbers.
In a previous discussion, Fergus explained how to position yourself to “get lucky” by looking at the long-term chart of various companies that had crawled along the bottom and now are poised for a breakout.
"Trains are rapidly leaving the station across all the highly cyclical sectors. Uranium and natural gas being recent examples. In the chat on how to “Position Yourself to get Lucky” last I went over the chart pattern, I look for.
While investing in the trend breakout helps to de-risk the investment, building a position while it is still crawling along the bottom of the chart is how you get serious asymmetry. This begs the question of which sectors are still at the station? Tankers, offshore drillers and coal are some sectors I’ve already gone over.
Today I want to run through oil service stocks. Interestingly uranium has front-run the spot price while many areas of the oil sector are still trading at a significant discount to the current oil price. The reasons for this can probably be put down to investors buying into ESG and the green revolution projections that claim oil has peaked and will be steadily phased out from here.
If you’ve read my article on renewables then you’ll know I’m sceptical these projections will become reality. This delusion is our opportunity to continue picking up highly cyclical assets at cents on the dollar. These tough times have also transformed many of these companies. Oil demand isn’t going anywhere so finding ways to gain leverage to recovery is where I want to be positioned for the next few years. Those that don’t believe offshore will recover by default are implying majors won’t need access to 45% of their proven reserve. I’ll happily take the other side of that assumption." - Fergus Cullen
Looking specifically at the "unloved" oil service sector, he mentions that the market itself has not repriced these stocks yet and the historic lows are even lower than they were in the 90’s, which is stunning.
Using the example of 4 companies in particular:
- MMA Offshore (ASX: MRM)
- Tidewater (NYSE: TDW)
- Saipem (MTA: SPM)
- CGG (PA: CGG)
Fergus illustrates how to look for the upside potential by understanding and interpreting the data in order to evaluate a potential opportunity.
A Quick Overview of the Oil Industry
Taking a look at 4 stocks (Saipem, Tidewater, MMA Offshore, and CGG) from the period between 1995 and 2021, Saipem was up over 2,000% at one point, CGG were down 98% over this 25 year period, Tidewater was down 98% and MMA Offshore was down 88%.
These companies are all creeping along the bottom and the current sentiment is that the offshore space does not even need to exist; with the current oil reserves around the world and with plentiful shale reservoirs, offshore oil is looked upon to be an un-investable asset. This is where, Fergus says, the opportunity lies.
He is quick to point out that most people don't realize that the sector has shown some significant cost reductions over the years. Since 2014 when the price of oil fell off a cliff, the sector has made some significant changes and "cut to the bone" to survive.
Different segments of the oil industry, like subsea services, engineering, well-related services, rotating and processing equipment have had a minimum reduction of 30%, whereas capital costs of floating oil rigs have been cut by as much as 80%. What this means is that the whole sector has become incredibly efficient. In 2014 it cost USD$70 to pull a barrel of oil out of the ocean. Now the costs have come down to USD$30, which is even below the break-even for shale. These cost-cutting actions have not been priced in the market yet, and most investors don't yet realize the efficiency gains.
Who Will Survive is Key
The trick here is to determine which of these companies will survive.
When examining all the factors, Fergus points out that 45% of the big oil majors have got 45% of their reserves offshore, 20% in deepwater offshore, and 25% is in the closer water. People who hold the position that offshore drilling will not be required are essentially stating that 0% of the oil majors' reserves won't be required. Fergus says he takes the other side of that bet every day of the week, and here's why.
Looking at that thesis, take a look at MMA Offshore as the first company - which primarily does offshore support. The company itself deals in all the logistics of everything that goes to and from the oil and drill rigs.
With 25 offshore support vehicles, they operate the support and maintenance trucks of the offshore sector. But with all the trouble experienced by the offshore sector, this company has been pummelled since their peak in 2014. As a rough guide, equilibrium was 2.5os fees per rig and that got up to 3.6os at the peak in 2014; so at that point in time, there were too many of them.
When the oil crash happened, offshore drilling became fiscally unviable. MMA Offshore was forced to end contracts and laid off a lot of people. It went from USD$26 to USD$2 in 1.5 years. And since 2016, MMA has just been crawling and from 2020 going sideways. Interestingly enough, with the demolition of many of these companies during Covid, they maintained their price which means it found its floor in its stock price.
Currently balance sheets are average, they don't have much leverage with $92M in cash and $134M in debt and are still losing money. They are not near being profitable as they need to find a use for their specialized support vehicles. Currently trading at $92M Market Cap, MMA is cheap and leveraged to the offshore market improving - this is one of the things Fergus looks for.
Once the market wraps its head around shale's demise and demand bouncing back after Covid-19, it will have to reprice companies like these because investors will have to understand that 45-50% of the oil major reserves will have to be utilized and companies like MMA Offshore will become essential again.
There are some valid questions to ask, however, about the viability of the companies. The oil drillers find themselves much like the Uranium space, which has seen drastic cost-cutting and decreased financial impact and yet there are long-term overhead costs with the machinery waiting for the next cycle.
- Where do you find the money to do that in this unloved sector?
- How will you get the contracts in place? Who will lend these companies money without contracts in place.
- When does this industry get moving again?
- Which companies are not going to survive?
Tidewater Bankruptcy Story
In answering the above questions, Fergus references Tidewater and how they wrote off USD$1.6Bn worth of debt in May of 2017, and are currently cash flush. Tidewater has USD $149M vs $200 of debt so it's in a different situation than in 2016 when it went bust.
The positive is that due to all the prepackaged bankruptcies, Tidewater cancelled all unprofitable contracts. When they went bankrupt, the stock price went from USD$1,800 to $14 but the long term chart shows that throughout its history, until 2016 when it was over-leveraged, it did well.
One thing to keep in mind is that with capital-intensive offshore businesses, they require a lot of equipment, and use a lot of debt, and so you want to step in when some unnecessarily large salaries have been cleaned out.
The key is investing before the upswing.
Tidewater has 172 offshore support vehicles, which cost $3.5Bn But after the bankruptcy, they were able to depreciate those assets down to $900M: which represents 20% of that depreciated value.
So when you factor in the slow grind due to Covid, you're getting an entire fleet (10 years is average age and they have not even been used recently) and these vehicles last at least 30 years. So you're getting an entire fleet for 10% of depreciated book value: a real steal.
And because of the bankruptcy, the company has cancelled its debts; you can't create this company for that price. The replacement cost of the company is so much higher than its current value.
So, intriguingly, they actually have a deep moat, which has been created by the losses incurred by the previous shareholders.
So the key is to acquire all the assets at the bottom of the market and set yourself up for profits when the sector starts to recover. If you think cyclically, timing is everything.
High-grading is essentially taking the best raw materials first, so in the context of mining, high-grading is mining all your first-tier assets first, which shows strong cashflow.
It can also make a location or asset appear better than it is, because in reality you're going to need to mine in suboptimal spots eventually, which are far less economic.
In 2019, Tidewater had 217 offshore support vehicles. They disposed of 56, about a quarter of their fleet, and acquired 11 new ones. They now own 172 vehicles.
The problem is that the demand for those services are not there. So they have to cold stack the vehicles in a port. Of their current fleet of 172, 20% are stacked and only 66% are active. That's a drag on profitability because the utilization is so low. There's just no demand currently for their services.
Tidewater’s Balance Sheet: this demonstrates how they have benefited from the prepackaged bankruptcy. They went from USD$1.6Bn to $200M of debt and $150M cash. So investors inherit only $50M of debt, which is far better than the $1Bn of debt that they generated to acquire the fleet of offshore vehicles at a cost of $3.5Bn.
CGG is a geology-geophysics company. They do imaging and provide software for identifying oil at the seabed. They have all the data for people analysing how to find oil. The company stopped being in demand in 2016. The chart comes down from €200 to €1.20 and has traded sideways since 2016.
CGG is another example of a supporting industry for offshore that has had a terrible time.
Currently, CGG has a $188M market cap with $400M in cash. The company has $1.4BN in debt, and is losing money.
The markets are valuing it like that, but it has a solid floor. You can almost draw a ruler line across the support line. It refuses to go down further because people know there is inherent value there. When will their unique services be required again? That's the big question.
Many of these companies took on too much debt trying to be the biggest in their sector when times were good. And the management took on too many costs, when it would have been better to have been more prudent.
These are not terrible businesses. The key takeaway is that these are very cyclical businesses. And the opportunity as an investor would come from identifying a maximum pain point in a highly cyclical business - and buying at or near the lowest point before this industry starts to see higher demand.
Pay attention to when there's a big crash in the market. Cullen suggests using the percentage down as a gauge of how many strong hands are holding through it. When these big drops in the market happen, they don't even move. They might be actually up 1%, and it's largely irrelevant because the only people still holding these are a few late deep-value funds and a few wealthy investors that have ordered and forgotten about it. You've got no retail presence invested in some of these companies at all. There is very little institutional presence, Cullen suggests, because what fund manager is going to show this to their board?
That's where your real opportunity is: investing in companies that are so toxic and hated that when bad news can’t bring it down, and even the slightest positive news will send these things up, not by a few percent, but by 100s of percent.
These unloved stocks are similar to those in the Uranium industry. It doesn't take much for these stocks to start gapping up - and when they do - because they are so illiquid - you tend to see some quick upward moves.
Saipem, an Italian company, in the offshore sector, has a decent cash flow, and has paid down a lot of debt. It had $3M in debt a year ago and now it's at $1.2M. They have locked in new contracts with gas and renewables and are putting in wind turbines. They have a backlog of €25Bn and last year it was €8.5Bn and 90% wasn't oil. Take note that they have diversified away from being reliant on oil exclusively.
Saipem started off in 2016 with €8Bn of debt and they have managed to work it down to €1.2Bn at that moment. They've actually been a profitable company through some pretty harsh times. They also do construction projects and project engineering, but no one wants to touch the stock because of the connotation that it's an oil service company.
Saipem has kept the lights on with gas contracts, renewable contracts and construction projects, and paid down debt, which is an achievement.
But the truth is, the market hasn't reacted; no one cares, no one wants to buy stock, so it hasn't been repriced at all. There are too many people who feel that oil is never going to come back into mainstream use.
This is similar to the current environment in the coal markets. There is not a clear distinction in the public's mind between Metallurgical coal and Thermal coal - and therefore, even though there are companies creating cashflow, the stock price is still suppressed. Investors are only interested for a dividend gain, not capital appreciation.
In the oil sector, however, it is even more cyclical. When their services are required, their margins can go through the roof, as is typical when utilisation goes up.
Cullen sees a major difference with coal, namely, that once most people realize that shale is not going to plug the demand gap, and when demand for oil gets back to above 100M barrels a day, then there could be quite a panic and the entire industry could be see sharp upward movement.
The investment theory with oil tankers is the same theory as with offshore drillers. Start with the companies who are in the best position financially. Start with a small position and slowly scale into that position using dollar cost averaging.
Over the next year, Cullen says, pretty much all of his spare cash is going to be dollar-cost averaging into the offshore drillers and oil tanker stocks. This entire sector is crawling along the bottom but the use-case for oil seems inevitable.
Cullen says, "I can't foresee a world where they're not required again, so I might get 1 wrong and this whole thing might drag on another 2 years and I might lose the money on 1 of the more leveraged names, but I think we're close enough to the turning point that if start dollar-cost averaging, you'll have a very good outcome within a year or 2."
That asymmetry aspect is relevant in that if you cap your losses at 100%, and you pick up these absolutely despised assets, not much needs to go right for you to have a 3x, 4x, 5x, 10x pay off.
There are initial signs that the oil & gas markets are starting to show more confidence. But it's unclear when they will come out from behind the fog.
This is a good time to start dollar-cost averaging into some of these unloved sectors. If things take longer than expected before prices go up, you will have had time to accumulate more stock positions at lower prices. The offshore oil sector will come back. It's not a question of "if'' but of "when."
An impactful book on contrarian investing is “The Art of Contrary Thinking” written by Humphrey. B. Neil.
In the book, Neil goes into a plethora of studies from a lifetime of investing and the main concept that these studies backup is that when everyone thinks alike, then everyone will be wrong.
So the book goes through history showing this again and again. Big takeaway: when there is a strong herd consensus, it's usually completely wrong.
Howards Marks has some fantastic books on investing. His focus is market cycles. Marks has a knack for taking very complicated concepts and breaking them down into simpler parts. A great example is his 2 rules of investing:
"Rule number 1, most things prove to be cyclical. Rule number 2, when people forget rule number 1, there's money to be made."
And the oil sector is a very cyclical market. Oil will be in demand again.
The oil sector is unloved right now. But, investing is cyclical in nature. Particularly, with a commodity like oil, there will always be demand.
If your goal as an investor is to buy low and sell high, it may be prudent to look at picking up some stocks in the oil sector before the sector starts to get into higher demand.
This is a good opportunity for a dollar-cost averaging approach with a minimum 2+ year investment timeframe. The fundamentals show in many of these companies, decreased debt, depreciated assets, and a stock price that is undervalued by the market, and seems to have hit as low as it is going to go.
These factors can combine to be a shrewd investment for those who can stomach putting their money in unpopular investments and waiting for the oil cycle to start to come into favour with the markets again.