Why I Went to Cash & Why I’m Now Buying BerkShire Hathaway B Shares

A reminder: my blog serves as my own investment journal. Not as investment advise. You’re an adult. Dyodd.

If you follow me on twitter or Facebook, most of you will already know I’ve gone to cash, choosing to exit all trades. There are a few reasons why especially with the conviction that I had on the tanker trade.

Investing is About Probabilistic Wins

When I first invested in tankers, the thesis was simple. Underlying supply tightness would wind up ship charter rates, cash flows would grow, debt reduction would occur, multiple expansion might happen, and share prices would naturally follow.

All of the above happened with the exception of share prices. Shares appreciated materially for most tanker companies heading into December than dropped off a cliff as the consequences of covid attracted heavier shorting both via long tech / short commodites and from short traders who “foresaw” the coming rate plummets.

Of course, March Contango Madness (yet another symptom of underlying supply) tightness came around and promptly blasted tanker companies with cash. Just take a look at that cash generation.

And then the subsequent debt reduction.

This was generally the case across the board for most tanker companies in 2019 till 2020Q2. They had big earnings bonanzas, debt got reduced, companies got significantly derisked, intrinsic value should certainly have shot up as the useful lifespan of the company arguably increased when the risk of bankrupty correlatively decreased.

Yet share prices stayed muted. In fact, nothing much happened. Share prices bounced around a bunch and stayed below expectations. Here is where I thank my lucky stars. My early investment in tankers by portion of allocation was to severely overweight STNG at around $17-22 as I bought in batches. Later on, I added $TNK at close to $1.85-2 (pre-reverse split).

Then when I discovered Euronav, I made the simple decision to just lever up and buy a large amount. In fact, I was much more bullish on Euronav due to their VLCC heavy concentration, which was in fact the vessel class that was heavily in short supply. It was only my over weightage (with leverage) w Euronav that allowed me to stay above water in dividend gains. Shares appreciated about a dollar from where I bought in at $8.65 and bounced between there to $10.

All in, a year had passed since I started investing in Sept’19 to Sept’20 and as I looked at tankers, I felt disproportionately displeased.

Shorts had been wrong. Cashflow had been amazing. Debt had been reduced. Dividends had been paid and share prices kinda just languished. Euronav was the only one not down due to both yield and share buybacks.

Had any other company on the market announced heavy buybacks, great earnings recoveries, heavy yields, and a shareholder friendly management, we would have been seeing massive share price appreciations. In an era of companies like Nikola and Tesla, that’s not asking for a lot.

Yet nothing happened. I was both dismayed and irritated.

I could continue to hold, wait for the covid weight to be lifted off of oil’s back (which indirectly is a shipping problem) and therefore wait for share prices to appreciate, or I could get out whilst I was still up.

Invariably, this meant I had to take an educated guess on where covid would end up, how much that would affect oil demand, how badly shipping would be affected for the long term, and ultimately and most importantly, if the probability for shipping to still deliver outsized returns was still rather high.

My conclusion was “this is too difficult”. I could certainly stay vested, and watch it with an eagle eye, but with my upcoming planned surgeries, I think it’s best not to risk it.

There are just too many factors at play and anyone who had made predictions were laughing stocks. In fact, the only tanker company I am relatively certain will do well right NOW as of 2020 through 2021 was $DHT Holdings. Their long term charters reduced breakevens to $2800/day in 2020 and $11,400 / day in 2021.

None of the rest of the tanker management companies had the risk avoidance that DHT Holdings does and if I had to choose one company to put my money in still, I’d put it in DHT Holdings and just lever up for the dividend gains and call it a day.

But whining is for losers, and thankfully, I have no one to hold a gun to my head. So off we go.

Berkshire Hathaway B Shares Are Cheap

I’m a fan of developing new habits and routines. They compound your life’s expected value drastically over time.

Eg; I’ve lost approximately 6kg since I switched my routine to 4 eggs and hot cup of coffee in the mornings (milk, no sugar) over the past 3 months with little to extra exercise.

A simple but powerful habit when it comes to investing is to keep a checklist of high quality companies in a shortlist and revisit it whenever the VIX index (aka the fear index) spikes hard. Or whenever, you know, your phone starts ringing and people start saying the markets are “melting”.

Berkshire is one such company I’ve been very interested to buy into for quite some time. For reference, here is a quick article by Rod Maciver on passing Berkshire Hathaway at $97 per share in 1982 (the share today trades at $328, 804).

I’m not convinced me and Rod are standing at equivalent forks in paths but I am convinced right now that Berkshire as of today is rather cheap.

Here’s the quick but simple math as of the latest report: https://www.berkshirehathaway.com/qtrly/2ndqtr20.pdf

  1. Class A – 671,199 shares outstanding, current mkt price $328,804 ($220,692,915,996)
  2. Class B – 1,394,160,774 shares outstanding, current mkt price $218.94 ($305,237,559,859.56)
  3. Combined Class A&B Shares = $525.93B
  4. Current Equity Holdings: $207,454M
  5. Cash: $36,074M
  6. Short-term investments in U.S. Treasury Bills: $110,518M
  7. Sum of cash, short term investment in US treasury, equities: 354,046M, or about 354.046B
  8. Debt: 106,689M
  9. Minority interest: 3,758.0M

Numbers have quite closely matched Koyfin. Enterprise value from above is $486B. Operating cashflow was about $34B. Or about a 14x so-called “payback period”. It’s worth noting here enterprise value does not in fact account for the considerable amount of equities held on Berkshire’s balance sheet, which here totals $207B. If we strip that out from the enterprise value, we’re looking at $279.53B, which makes for about a 8x multiple.

This is a pretty astounding number considering the widespread overvaluations we’re seeing all around.

This is a list of companies termed “high quality” and it’s recent valuation ratios leaving out banks (companies were lifted from Base Hit Investing aka Saber Capital Database and augmented with some of my own additions, please note the quality of some of these companies are debatable and not set in stone). None of these trade at an implied discount as wide as Berkshire’s does right now.

Even with book value approximation, BRK trades at about 1.4x book value.

Is this reasonable when almost everything else trades at 2-50x multiples? I’d say the answer is generally a big fat no. If intrinsic value is an approximation, than I’d say right now BRK is severely undervalued.

For a company that’s virtually indestructible except by way of nuclear war and violent, ongoing, widespread political upheaval, fueled by negative cost of capital from insurance float and cheap debt, allocated by some of the top investing minds of the world, it seems ludicrous to me that it trades at such a steep discount even comparing it’s official 14 year payback period versus some other storied stocks currently selling on the market.

In other words, while I wouldn’t call Berkshire “dirt cheap”, I’d say it’s probably between “cheap to slightly under fair value”.

I’m not normally a “quality compounder” bro. That’s because most “quality” companies trade at higher multiples which demand intense execution perfection failing which it’s stock price takes a beating. Alteryx is but one example of what happens when performance is underwhelming. Given the significantly resistant nature of BRK’s businesses (which emphasize predictability), I would say that 90% of the volatility you can expect in their stock price will be caused by the fluctuations of the equities held on their balance sheet which will swing with the tides of the markets. This is acceptable to me.

Some other advantages as a retail investor:

  1. Berkshire’s reputation and cash pile gives it’s managers access to deals street investors do not. Dominion Energy pipeline deal was a good example. Buying into Berkshire here gives you indirect access to deals otherwise unavailable on the open market.
  2. It’s cashpile, access to negative cost capital (refer to 2002 letter for an explanation on float), is another compounding factor. It will be able to take significant action through upcoming down markets either rebuying its stock as Buffett has done or making other acquisitions. In this manner, the inverse is true. If you are a shareholder of Berkshire, you should actively wish and pray for a horrible down market.

Of course, some investors will also say that Buffett’s recent purchase of Barrick Gold and Japanese trading houses are a warning signal. I think this is perhaps, foolish in the extreme.

When you’re building a Death Star, it’s probably wise to not allow such a thing as a thermal exhaust port be your undoing. Given Berkshire’s immense equity holdings and large cash pile, acknowledging the risk of inflation or hyperinflation in the years to come and crushing the probability of tail events is the only sensible move – it’s the only thing that kills Berkshire other than widespread calamity and economic collapse. And even the latter is not so certain to kill Berkshire.

Imo, Berkshire is cheap, well run, has an inflection point at any dip in the markets, enjoy access to negative cost of capital or is able to lower its cost of capital, and is also run by the top investment managers the world has seen. I’d be insane to not be buying into $brk.a or $brk.b at current prices.

Managerial Risks – Present But Not Lethal

Yes. I know. I just waxed lyrical and here I am talking risks. The risks are real. Buffett is old. So is Charlie Munger. Managers and successors can and probably will at some point screw this show up – because at some point, every business will be run by an idiot and we can expect this to be the case for Berkshire if we extend probabilities out to an infinite time line.

What is the risk of this? I’ve debated and struggled with the concept of this as I tried to understand the eccentricities and personalities via interviews, news coverage, and market moves implied (Amazon and Snowflake purchase for example).

In the end, my thinking is to not imagine if Berkshire will succeed in the hands of the 4 managers (Ajit Jain, Todd Combs, Ted Weschler, Greg Abel), but rather if Berkshire will really be heavily impacted by one or even two failing managers.

The risk in my mind, is not an approximation, but I judge it to be small – present and dangerous, but unlikely to present catastrophic destruction of value.

A decentralized leadership makes it so that a critical failure at the top does not reverberate down to each corner of Berkshire. In this manner, and highlighted by the extreme out-performance of the Outsiders, who nearly all favored a decentralized approach, Berkshire seems to be in capable hands and a sound investment at this point in time.

Growth Risks – Acquisitions will determine future pacing

Small company, big moves. Big company, small moves. Out-performance of smaller market capitalized companies is a well-covered phenomenon.

Berkshire is not an exception to the rule.

Growth in earnings will depend on out performance in subsidiary businesses and equities it holds as well as acquisitions of other companies at sensible prices. If markets continue to be exceptionally expensive, we must depend on the management’s abilities to source deals that are sensible. This may not be possible upon the passing of Berkshire’s front line pair.

It’s main insurance businesses are also susceptible over time to changing industry dynamics. Against this, investors have no defense but a management team that has foresight, agility, and ability to act in time to turn the tides.

Further, upon the passing of Buffett and Munger, we have no defense against repeated poor acquisitions. We must therefore rely on managerial quality, and discipline.

If concepts such as network effects, switching costs, and pricing power are moats in a business, I would reason that exceptional managerial quality that can earn the praise and trust of Buffett is another. Unlike the past however, we must expect to keep a closer on Berkshire for managerial deterioration.

If I had to consider between a cheap shipping stock, and a cheap-fairly priced Berkshire, I’d call Berkshire any day.

Disclaimer: I am long Berkshire Hathaway B shares.

Update on DHT Holdings, Adding Epsilon Energy

My views on DHT Holdings have not changed. I want to re-iterate that I’m bullish on it. But to not update my readers would be pretty damned irresponsible so I’m going to do so here.

The basis of the update is this: DHT Holdings has a convertible debt to equity note out there floating with a conversion price of $5.347. The situation is simple.

If DHT decides to call the notes back and repay the debt, holders of the note get to convert notes to equity at $5.347 per share, which means that if the share price as of that date is above it, they profit from the difference in arbitrage. In sum, the full dilution is +16%.

This can and probably WILL create some short term downwards share price movement as (1) dilution (2) negative effects of reduced dividend per share takes place. The full article is on seekingalpha written by another author. The link is here. (https://seekingalpha.com/article/4356848-dht-convertible-notes-are-zero-cost-arbitrage-opportunity)

The notes are callable anytime between August 21, 2020, until the bond’s maturity on August 15, 2021. I expect DHT Holdings to try and address this asap starting Aug 21st, so I expect a conversion to be announced between Aug-Dec if any. Note that the conversion may not go through if there are no arbitrage opportunities – ie; the share price is at, or below $5.347.

My previous assumption was that DHT Holdings was trading so badly, no one would want to exercise that right. For them to think it would be profitable, they’d have to bake in a strong assumption that the resulting dilution would NOT drive prices to below $5.347 plus commissions. At 16% dilutions, that’s a hell of a margin of safety to bake in. At what level would they feel comfortable doing it? I know if it was me, it’d probably be around $8-$10. Then again, I’m no expert, and I don’t want to be caught w my pants around my ankles. Better to be safe than sorry.

Tldr; I will be adding short dated slightly otm put options to the portfolio covering the period from Aug2020 to year’s end.

Epsilon Energy

There are several main reasons why I like Epsilon Energy as of now.

  1. No debt
  2. Large cash balance of $15m, or approx 22% of market cap
  3. Cheap trailing ev/ebit of 5.635 (approx 6x).
  4. Low cost producer of natural gas, for which demand isn’t as heavily impacted as oil.
  5. Company just bought back 7.7% of total outstanding shares
  6. Management has skin in the game with with board and management owning 25% of the shares
  7. Gas macro is very unsurprisingly bullish given massive drop in gas rigs and production across the board as well as via associated shale production.
Range Resources slides

The focus is simple. The space is currently hated and generally experiencing negative share price momentum thanks to being lumped together with the oil sectors.

But common assumptions should always be examined. This is especially the case for natural gas – it does not suffer the same negative demand impact as oil, which is mainly a transportation fuel.

These are basic information pieces you can source from literally anywhere on the web. This is the demand side. So what’s the supply side? Let’s take a look at the futures as of now and see what it indicates.

Ownership Exhibit

per company presentation as of June 2020, here. (http://www.epsilonenergyltd.com/investor-center/news-and-presentations)

Hedges

Summary

I believe that the relative cheapness of the company, combined with sharebuybacks, thin liquidity, no debt, large insider ownership, and relatively low cost producer (as evidenced by being cash flow positive DESPITE low natural gas prices) indicate a compelling opportunity to be long Epsilon Energy.

Disclaimer: I hold no positions as of yet. This is not an inducement to invest.

Sizing Up On DHT Holdings

The past few weeks have been volatile and rather stimulating in tanker land.

For the uninitiatied, the tanker sector which trades on a correlated level to current time charter rates and expected forward time charter rates plus/minus a mix of oil demand flow.

As a result, bears have been largely rewarded for following a trade that has worked for the past ten years -> short tankers when oil demand is punished and short it harder when rates are low.

This hasn’t been helped by the fact that early investors who bought into the shipping mania seem to have nerves of glass with no holding power whatsoever. I imagine the volatility of the sector have given quite a few people whiplash.

There are several underlying themes I want to highlight today in the shipping sector few people have gotten their heads wrapped around.

1 – fixed long term charters have reduced breakeven cash levels for any company that got them early on. $DHT Holdings most of all.

2 – the above effect is reproduced in the sense that early, large profits raked in allows most tanker companies to have a high, yearly average rate which is profitable by far.

Image

Just look at the 2020 average rate and figure things out for yourself. I’ve already posted the prior cash breakeven estimates. If I’m right, we’re in for a hell of a bonanza year, short term share price movement or not.

My belief is as such; Not one analyst has been able to predict the average yearly highs or lows correctly.

Zero analysts have baked in the expected rates of time charters by pulling out a deep dive, evidence based look at the following contributing factors which include but are not limited to; manpower, geopolitics, oil policy changes, scrapping, storage demand flows.

Each of the factors I’ve highlighted above carry their own range of possible intrinsic outcomes, all of which are net positive for tankers in the long term if they do happen.

I hate referring to Buffett (now that I no longer have a marketing reason to do so), but he was right when he said this; “Forecasts tell you very little about the future and a lot about the forecaster“.

IMO, anyone trying to forecast rates need to have baked in a huge armada of information all of which branch off into various tangibles. I like to make analysis based on information now, and I like to make guesses based on what a very negative future looks like.

I think any god damned analyst worth his salt would put in the actual work to verify what happens in worst case scenarios and bake that into a trade plan to win.

Which brings me nicely to DHT Holdings.

Why Am I Adding to DHT Holdings in Size?

There are only two prevailing reasons why I’m adding DHT Holdings.

1 – The company owns a fleet of 27 Very Large Crude Carriers. (VLCCs)
2 – The company managed to lock in ten long term time charters. Leaving 17 of its remaining VLCCs on spot (no contract, demand/supply driven.)
3 – The ten time charters has as a result of its profitability and duration, reduced breakeven cash rates for the 17 spot ships as a whole to $2,800 per day for the remainder of 2020, and $11,400 per day for 2021. *Cash costs refers to OPEX, G&A, interest, debt amortization and maintenance capex.

By charter, I mean something like chartering a taxi. The taxi and the company has earnings visibility based on a contract. By spot, I mean something like a taxi/cab on the road. You pick up passengers and cargo whenever opportunities appear. There are more complications, but that’s about all you need to understand as a laymen.

This is DHT Holdings’ charter fixes, announced as of June 25th.

Further, for 2021, it’s spot ships are profitable at rates above $11,400 per day. That is yet another significantly low floor.

For current tanker rates:

Image

Even now, at the so called apparent bottom, vlcc rates of $21,000 per day imply $46,140,000 of free cash flows for $DHT Holdings ($18.2k x 17 shipsx 150 assumed remaining days). And we’re not even talking about the expected Q4 upwards bump in vlcc charter rates.

If I adjust for q4 to have an average of $30k average, we’re looking at $41m in free cash flows in q4 alone (not accounting for dividends, remember 60% of net income is distributed as dividends for shareholders). That’s a decent albeit not crazy number.

The real kicker here is 2021.

With breakeven levels of $11,400 the year throughout, let’s take a look at what various 2021 average rates would yield in terms of cashflow.

*I’m assuming 330/300 effective days to make room for error. You can apply your own range of assumptions. I’m not here to debate w you on the technicalities of average available days.


Some information to go alone w the above currently; DHT currently has an enterprise value of $1.49b. 2020 average rates stands as of now at $85,300/day for a VLCC.

We know from my prior post that VLCCs in general are headed for a bullish environment, with tonnage being tight and 27 VLCCs every year from the global fleet due for special surveys. If rates persist at $20,000 or lower, most of these older vessels will probably head to scrapping shipyards, effectively removing them from available storage. We also know, for reference, that the COSCO sanctions in Oct19 spiked vessel rates severely, reflecting the underlying tightness of the market. For reference again, there are about 700+ VLCCs, and about 100+ are due for special surveys through 2021.

What will rates look like?

Who cares?

As long as it’s above $2,800 for 2H2020 and above $11,400 for 2021, DHT Holdings has nothing but upside.

Best guess is its somewhere between $40k-$50k unless big time sanctions come around again.

If you’re looking for some dividends (DHT pays out 60% of its net income as dividends), and if you’re looking to size it up right, I think there’s not much of a safer play than $DHT. I’m mega bullish on it considering they have some of the lowest breakeven rates in the sector right now.

As for the rest of the shipping companies I own, I’m contented w the fact that they’re cash flow positive based on their yearly average. There’s really….not that much to talk about beyond that.

Disclosure: I am long shares with leverage. I own options covering my positions to cap maximum losses. I might sell covered calls against my position to generate free yield. DYODD.

Betting on a period of higher volatility.

Back in January and then in Feb, I begun calling for investors to look out for a recession. Present in both articles was a vix call trade idea, one I’ve rather shamelessly stolen from Mark Sebastian’s book, Trading Options for Edge. I’m no expert, so please go check out the nitty gritty details prior to executing the trade. I’m trusting you to be an adult about this.

To be exact, what I was fearing at the time was an economic downturn on the back of an already unstable economy. Valuations were running hot. People were actually saying something at 110x price to earnings was justifiable – because hey, it’s a growth stock, seemingly not attributing growth to be hinged on actual productivity and business transactions within an economy.

What turned out to be true instead was covid19 – the disease that quickly went international and locked down countries en masse. The VIX index spiked from 15 to 85 within a month.

Where I fucked up was two fold.

1 – I hadn’t managed my cash well, everything was in tankers.
2 – I delayed buying vix calls in Jan/Feb thinking I could instead build it in March through April.

What resulted was a massive lost in opportunity. It was a gigantic error, but that is spilled milk under the bridge.

I’m now again looking to buying VIX calls – within the coming week. I think now more than ever, we are entering a period of heightened instability. This instability can be attributed to any number of factors. I will go over them here in brief detail. You should go over them yourself via the web for detailed and more nuanced briefs.

1 – China/India’s fresh border conflicts.

I don’t think this will evolve into full out war. There are ongoing agreements for both sides to not use firearms during a clash. So what happens instead is..basically a melee gang fight. How much fighting does it take for one side to start using firearms versus another? How quickly will a situation evolve into all out war? Who are the parties involved if India/China conflict escalates? The answers are unclear. What IS clear is that IF conflicts evolve into greater levels of confrontation, the markets will not react kindly.

2 – Beijing currently has a 2nd covid virus cluster and has shut down a supermarket linked to the virus.

https://www.bbc.com/news/world-asia-china-53089137

150 cases have been confirmed as of now. Notably the market supplies 80% of Beijing’s vegetables and meats and apparently, is used by tens of thousands of people a day. If this is even HALF true, we’re in for round two in Beijing, China. I’m certain the government has learned from their first time and were already well prepared for their 2nd, but there’s really no harm protecting your downside.

3 – US riots/covid/unemployment/Presidential Re-election/Federal Reserve Printing

If you haven’t been hiding under a rock, you’ll know that the riots have intensified in certain areas of America. Add in covid19 cases, unemployment all time highs, and a presidential re-election, and you’ve got a pretty potent cocktail. What sets that off? I don’t know. But like a room full of nitroglycerin, when one box goes boom, there’s a chain reaction that’s not pretty. Massive protests/rallies means a higher chance of covid infections which feeds into more lockdowns. Violence and protests feeds into lockdown and unemployment. All of this is being fueled and kept afloat in the markets by unlimited printings. As of last known, apparently, the Federal Reserve is also fully capable of buying bonds.

What happens if the party stops? How does it come to a close? What happens when (not if) the Feds stop printing money?

These are complicated questions. But almost all of them will in some way mean heightened volatility.

I don’t know when, how, or what will trigger any of the above events to devolve into chaos worldwide. I just know that we’re at what it seems to be – always a hair trigger away from it.

I’m buying insurance via $VIX calls, and I’m acknowledging that this money might as well be marked as a total loss – and I’m okay with it. It’s a really small sum that only pays off rather big time IF shit goes down in a catastrophic way.

Another way to play this out is to initiate a collar trade. Long term vix has sat around 13-15, so you can say at 35, we have a ways down to go. Otoh, shit happens. All I know is, I’m going to try and protect myself. Have fun. Stay safe.

Northern Oil and Gas: A Perfect Storm

Business Overview

Northern Oil & Gas’s business model is simple – participate in owning the interests of the wells but let some one else operate it. Here are the listed benefits.

Naturally, this translates to operator risk – if someone incompetent or bankrupt operates your wells, you’re shit out of luck. Thankfully, that’s not the case here w most of their wells operating in the top 4 oil producer active counties.

Thesis

  1. Extensive Hedge Book + Flexible Capital Expenditures
  2. Debt has no significant maturities due
  3. Company has cut dividends and slashed capital expenditures
  4. Bought back debt at discounts
  5. Opportunities to buy great assets at distressed prices
  6. High insider ownership + Large insider buying

First, Valuation & Survival Analysis

  1. Enterprise Value -> Mkt Cap ($429.91m) + Preferred Stock ( + Debt ($1.047b) – cash ($8.5m) = $1.468b enterprise value.
  2. EV/Share-> $1.468b/497m = $2.95 per share
  3. EV/TTM Ebit -> 1.95

I’ll be the first to admit I’m not E&P valuation expert. I also acknowledge that Ebit isn’t exactly a fair number to be using when you’re looking at the cash flow from assets. But I’ve chosen to use that number simply because (a) NOG’s capex numbers are highly flexible and (b) to not account for that flexibility would be just as ludicrous. You can choose the number you want to work with but bear in mind that capex for 2020 was slashed to $200m by $NOG.

All that’s needed for these guys is to stop putting out intensive capex exceeding net income every year. Bahram Akradi (who recently bought a lot more shares) has also stressed, and I quote,

Q419’s transcript

As evidenced, they’ve dropped capex to $200M for 2020. This is rather indicative to me.

In addition, the company currently possesses $375-$400m of hedge book value. That is nearly entire market cap of the company.

And of course, if oil prices plunge further, leading to greater curtailment, that leads to greater hedge gains. On a fcf basis alone, $NOG will be reading as a stock with over 20% FCF Yield.

On a macro level, my personal stance is that oil is range bound. OPEC+ cannot keep oil prices high without US shale oil industry stepping in to curtail additional profits. between a range of $40-$60 is going to be the norm for quite awhile until demand finally stretches oil supply beyond breaking point for perhaps 1-2 quarters before excess supply coming online knocks prices back down.

This is why we want a low cost, high operating margin oil producer with low debt capable of making money in low price oil environments with excess strength to take on increased productions and make gains from temporary oil price increases.

Let’s dive into hedging.

Hedging provides solid value + Flexible Capex Allows Greater Maneuverability

When an oil producer drops capex, the indicative thought process is that even though short term cash flow improves (due to reduced capex), long term cash flow suffocates (since production -> revenue -> cash flow) is reduced as you have less oil to sell.

Whilst that is true of MOST natural resource plays, I don’t look at $NOG in a similar light. Remember, $NOG is entirely a non-operator model. They don’t control the production. They just hedge it.

$NOG has hedged 75% of production in 2020 and 50% in 2021 at extremely reasonable prices.

Here’s the fun part.

Image

In case you need help understanding what I’m getting at, I will make it clear.

1 – if NOG didn’t actually sell any oil for the remainder of 2020, they actually earn more money than they would if they DID sell oil since the hedges would become like market trades and become pure profits.

2 – these hedges naturally INCREASE in value as the price of oil decreases. Based on reports of increasing covid19 cases in US post-protests and riots, I’d bet on oil prices no recovering in the short term, which is perfect for $NOG.

3 – this cash value of hedges afford $NOG the ability to do two extremely cash generative things, 1st, buy back debt at huge discounts, 2nd, buy up assets at huge discounts. As of this writing, channel checks w owners of small energy producers who are also analysts in the field reveal that there is a sweeping wave of banking redeterminations reducing overall loans and adding pressure to the oil production companies. As of June 10th, $NOG also took the opportunity to swipe up some assets in the Williston Basin at rather decent prices (1.5 year payback period at June 5, 2020 strip prices). Company has also bought back debt on discounts previously. Reference conference calls and debt reduction releases.

4 – The extent and duration of the hedges extends till mid 2021, where I believe oil prices should bounce back above $50 due to a confluence of rising demand to pre-covid levels matching a period of low production due to reduced capex at current. This means that $NOG is set up for some seriously big cashflows at almost all points in time. If (a) oil stays low, they have sufficient hedges to last longer than everyone else. If oil (b) comes back up, but stays below target, they make some profits. If (c) oil comes roaring back up by 2021, they might lose some money on 50% of their oil swaps, but they’ll more than cover the bigger gains with the rest of their production. If (d) oil is not produced/sold, they absorb maximum profit from hedges and have effectively “increased” their reserves, though of course they’re paying for storage if they produced the oil.

Reference capex flexibility here.

https://seekingalpha.com/article/4331615-northern-oil-and-gass-nog-ceo-nick-ogrady-on-q4-2019-results-earnings-call-transcript

I also want to highlight that NOG has come pretty far if you look back into its history. Reference this particular bit; you can also reference the presentation made here.

Northern Oil and Gas Inc at UBS Global Oil and Gas Conference Transcript

Valuable insights can often be uncovered if you’re willing to not just look at the present state of the company but also take a look at its recent history and progress.

Yes. NOG has largely managed to do all they said they would do, but share counts also exploded upwards. Dilution was inevitable if they wanted to avoid huge amounts of debt. Why I feel that’s ok is simple because of their current operating size and increased asset base. They might have increased share counts massively, but their share prices are also anchored to oil. For those in the know, banks regularly determine the reserve value of a company based on recent pricings. If oil has gone up, your reserve value goes up, which increases your reserved base lending, which indirectly increases your NAV. Sure, its never great to dilute shareholders out, but that’s a risk you take when you invest in E&Ps. In any case, I don’t believe dilution is further necessary. Their recent acquisition was an all cash transaction w no shares issued. Further transactions would likely be the same, though I wouldn’t rule it out entirely. Just be mindful of it.

Risks: Dilution, Discounted Take Private Pricing, Oil Prices Rise Significantly Faster Than Expected

Dilution

Northern currently has preferred shares available for conversion to common shares that will increase the total float by 25% if all 5m preferred stock are exercised. I don’t think this is likely since the conversion effective share price is $2.29, implying a 129% increase for us from current share price levels. If that happens, I’m happy to sell prior to that. More likely than not though, is that if oil prices materially increase from here on out in the long term (2years), I believe $NOG’s share price will re-rate significantly higher such that the $2.29 ceiling will be breached without issue.

Hedge Fund Angelo Gordon Along With TRT owns approx 30% of shares.

Angelo Gordon recently bought up $NOG debt, and together with others, control nearly 60% of the company. I expect a take private bid to be a possibility at significant discounts from fair value of around $3-4 long term. Take private bids tend to be around 15-20% market premiums, so we can expect some gains there even if this happens. The worst thing to happen is that share prices fall lower than normal, stays there, and than they exploit the opportunity to take it private at lower than normal prices. Having said that, I think you can mitigate that risk by sizing up when share prices dip. I don’t anticipate a big dip since $NOG is well-insulated from lower oil prices and actually gain from it. But short-selling algos might short it since it “produces oil”. You never know.

Oil prices rise significantly faster than expected

$NOG’s hedge book value can quickly evaporate and turn into routing losses if oil prices rise significantly while their production remains curtailed under operators. I doubt this can happen, but you never know if a shitty situation can occur to throw a money wrench in your plans

Summary

In sum, I believe that their hedge book, their lack of bankruptcy risk, their current cash flow routes, their debt maturity profile, and their ability to lever capex to required amounts in the current covid19 storm represents a call option on higher, future oil prices. I further believe that the company is well positioned to monetize hedges when oil prices trend down further from 2nd wave of covid19 which is happening now, and to use that resulting cashflow to either reduce debt significantly ($1b) or buy up assets for cheap (recent williston basic acreage).

I would size this between 5-10% of my portfolio depending on your level of risk tolerance.

Catalysts

  1. Take private bid
  2. Huge free cash flows upon monetizing of hedges
  3. Oil price increases
  4. Massive debt reduction
  5. Sale of interests in oil wells

Disclosure: I am not long shares for $NOG but may take position within 72 hours of this article. DYODD. I am not responsible for your investment losses/gains.

Liquidity Services: Ridiculously cheap and at an inflection point. Giant insider buying.

Disclaimer: I hold no position in mentioned securities but plan to or will own positions within the next quarter as I expect short term share price weakness due to covid19.

  1. Department Of Defense contract overhang awarded since 2016 is completed as of Q2-2020.
  2. Market Cap as of last reported quarter standing at $197 million. As of last report, the company exited Q2, 2020 w no debt, and with $51.8 million of cash, putting EV at $145.2‬m.
  3. GovDeals, one segment of the business is capital light and growing. Cash generated from this segment alone was is worth the enterprise value of the business. Other segments, we get for free.
  4. Counter-Cyclical business proposition is at an inflection point. Net income exploded from $12m to $24m between 2006-2010 during the last cycle.
  5. CEO Angrick William bought approx $5 million worth of shares on the open market. For a comparison, his compensation for FY19 was approx $2.3 million all in including stock based compensation. He also already owned 3.7 million shares.
  6. Business shutdown via covid19 is net negative since LQDT moves physical goods, but current economic conditions should drive medium-long term out performance.
  7. Long common shares. Company needs to address high SG&A costs through its new merged marketplace.

Overview

Per its 10k, the business is in the reverse supply chain industry. The idea is simple.

Businesses throughout lifetimes will have significant discharges in terms of material goods.

Some of them will be looking to sell and recover expenditures where possible. Others will be looking to buy and reduce spending where possible.

Liquidity Services helps both sides and everything else in between including marketing, logistics, merchandising & channel optimization (reducing fats from a business), etc cetera. Fees are taken on a consignment (piece of the pie), profit sharing, or outright purchase transaction model (I buy from you, I sell to someone else).

Historically speaking, the company’s net income has been dog shit. Actually, calling it dog shit might be generous. Take a look for yourself.

Seeking Alpha

SG&A has been consistently and disgustingly high. A large part of this can be blamed on the 2016 Department of Defense contract which has recently been completed as of Q2 2020.

Read that line again.

“Company will bear all of the costs for the sorting, merchandising, and sale of the property”.

It’s a good thing this contract has been completed or I wouldn’t be bothered. I’m not a fan of any partnership where the variable cost is borne by just one party while the other side holds a fixed profit rate. The income statement above also shows this to be true. In fact, ever since 2016, net income has been negative. The good thing is, the DOD contract overhang is now gone.

Valuation: GOVDEALS Segment Worth the entire EV of LQDT at $145m. Investors get the rest of the business for free.

As of writing, the company’s enterprise value stands at $145.2m.

Note the high margins. Now if only mgmt could lower SG&A costs…

To understand why I would make the proclamation that the GovDeals segment alone is worth the enterprise value of the business, you have to understand how the segment operates.

Per LQDT’s 2019 Annual Report, govdeals is self-directed.

The GovDeals segment is an automated, consignment/commission based platform that requires no handling of inventory per their consignment model for sellers.

So, we have a segment of the business that’s throwing off $30M in gross profits alongside marginal overheads costs since no inventory is taken into account, AND, this segment is actually growing. (DOD contracts were under CAG segment, this is organic growth, numbers thus not inflated, also, as an aside, I’d like to see competitors try to muscle 13k government agencies versus LQDT’s existing relationship, and have 13k town hall meetings just to get to where LQDT is. If you don’t call that a moat, I don’t know what else you would call it).

So where do we stand in terms of GovDeals? At these prices, you’re paying approx $145.2 for a high margin, cap light, sticky, well-defended moat-like business with 18% growth thrown in, and a total addressable market size in the billions. (research from Brightpearl (2018) has found that more than half of all retailers (51%) claim their margins are being squeezed by returns, yet 69% are not deploying any technology solutions to help process them. The reverse supply chain addresses the redeployment and remarketing of surplus and salvage assets. These assets generally consist of retail customer returns, overstock products and end-of-life goods or capital assets from both the corporate and government sectors. The market is large, as indicated by an Appriss Retail report in 2018 that shows $369 billion, or 10% of total sales, of merchandise is returned on an annual basis. Estimates based on Bureau of Economic Analysis (BEA), U.S. Census, and World Bank reports, the global used equipment market is valued at approximately $350 billion.)

You get the rest for free. Here’s a look at segment growth since FY17.

Source

What’s a capital light, high profit margin throwing off $30m a year worth to you? Is 15x profits too much? 10x? 5x? Even at 2x, the business is still worth approx $60m. Assuming horrendous operating margins of 50%, and even taking growth potential and growth rates with a cubic meter of salt, paying $145m for this segment seems a no brainer. Assuming normative growth rates and normal operating margins, we’ll see profits from year 4.

All of this is not baking in the fact that this is a counter-cyclical business model about to experience a strong upward tick in business from a covid19 induced economic fall out.

Insider Buying

CEO Angrick William has been buying up a ton of shares (how I found this company in the first place).

He’s bought approx 963,828 shares for approx $5m (go do the precise math yourself). For comparison, his FY19 compensation was approx $2.3m, approx $380k of which was cash. I’ll let you do the math.

Upcoming Catalysts

The three things I’m going to be looking at are as such;

First, an upward inflection in business as covid19’s effects trickle through the economy. The last time this happened, LQDT’s revenue and net income skyrocketed over the next 4 years. Take a look at how supplemental operating data and net income ballooned. (note, dod contract here contributed 31.3%, 32.8% and 29.9% of total revenue for the fiscal years ended September 30, 2008, 2009 and 2010, respectively.)

Second, improving profitability, we need to keep an eye on LQDT’s ability to bring down SG&A costs. That’s the whole point of the consolidated marketplace.

Third, I want to see improved operating margins and free cash flow. The past few years have been a hurdle – unsurprising considering this is a counter-cyclical business model. But if the thesis is right, LQDT from here on out, should see increased q-o-q volume, net income, reduced operating expenses and reduced SG&A.

If the company can do these various aspects right, I suspect we will be able to see a significant re-rating of the stock. I don’t exactly have a rule of thumb, but this used to trade between $40-60. That’s a 10-bagger or so from where share prices are now.

Negatives

Like it or not, LQDT will pay the price for being a physical mover of goods even if its trying to get new a software slant and that is reflected in the . I anticipate near term share price weakness once q3 results are out and I will be using that to try and get a position established.

Also, a quick check on Glassdoor shows a mixed rating. I’m confident customers are happy – they wouldn’t be seeing growth if they weren’t. But the company culture can be improved.

Final Note

$LQDT is cheap, has multiple ways to win, has solved all of its prior problems, and is on the verge of a significant turnaround. It also has a massive tailwind in its favor with a rather significant defensible position – handling bureaucracy is a bitch. CEO and co-founder (who started the business nearly 20 years ago!) is buying large chunks even recently.

Disclosure: I am long $LQDT. I expect Q3 to have abysmal reported earnings due to riots and covid19 induced business shutdowns, and will be adding shares whenever possible. I may choose to hedge my position in case I’m wrong. DYODD.

When I take a swing, I tend to swing hard. Sometimes I’ll miss and look like a damned fool. But if every dollar I risk is for ten more dollars, I only have to win 2 out of every 10 times to double my money. Even if I’m only right once, I make back all of my money and learned a lot more for it. My style of investing might not be suitable for most people. Consider yourself warned.

On Tankers & Energy Producers

Investing at the point of maximum hate & pessimism

I have been bullish tankers since mid 2019. The road has not been a smooth one.

Due to covid19, oil going negative and then coming back up, as well as a plethora of extrapolated data indicating massive demand melt downs, oil tankers shares are in the doldrums.

I’ve taken the chance to expand rather massively on my initial holdings since December “highs”.

Why am I so bullish on the shipping space?

The shipping industry is one investors tend to avoid. A look at the long term share price charts of most shipping companies will tell you that they’ve been a terrible, long term, negative compounder of shareholder capital.

Management has shown a tendency to grow their fleets at all costs just as much as E&P companies in the United States has done the same in terms of trying to become the “top 5 producers”.

If that’s the case, why invest?

The answer is simple.

Supply and demand are now imbalanced, all things considered. Supply is massively constrained by lack of finance. And while demand has been hampered, as the covid effect passes (targeting 2020E), we should see demand normalize (w approx 10-15% range in accuracy) . IMO2020 contributes further to supply tightening.

Shipping turns on supply/demand of ships – all else being equal.

If there is insufficient supply of ships, shipping rates rise as refineries and global energy producers get desperate to secure transport. If there is a huge supply of ships, only extraordinary demand can cause rates to rapidly inflate. The rapidly aging fleet and the tidal wave of IMO2020 were 2 key factors that drove me to invest in shipping.

For those who are confused, allow me to sum up the thesis prior to contango and covid19 in 2020. This is a very rough timeline of events.

The Initial Thesis – Aging Fleet + IMO2020 = Reduced Supply

First. the age problem: Worldwide, tanker fleets built during the last bull run (200307,08) were rapidly approaching an age where charterers avoided chartering them to begin with. This is most true for product tankers ($STNG) than for crude (unrefined). It’s far harder to contaminate unrefined crude than it is to contaminate product (naptha, vegetable oils, etc cetera). Post 15 years of age, charteres tend to avoid booking you for shipping products (refined). That immediately poses a problem for product tanker owners. The secondary problem of an older ship is a special survey cost.

Post 15 years, a ship must undergo a special survey. In addition, it has to also undergo an intermediate survey cycle every 30 months at 17.5 years and at 22.5 years. Each survey can take weeks to finish, removing valuable time and earning days (just as a taxi in the mechanic’s workshop isn’t able to pick up passengers). The costs are also higher (refer diagram).

Think like a ship owner for a minute here. If you are to pay millions of dollars on an aging asset, the one thing for certain you want is to be able to make a multiple of that money back. This is simple business. You don’t want to throw away nearly $10m on an asset only to have it earn you $6M back. If that was the case, you would have been better off scrapping it. Rate visibility would be key here and in the volatile earnings world of tankers, it’s always better to be safe versus sorry.

Note that the charterers’ preferences still apply here, so even if you did choose to perform the surveys and try your luck, you’d still need to fall in line for lousier rates because of vessel age.

Also note, you can’t skip out on special surveys. Skipping means your ship doesn’t receive a classification, without which you have no insurance, and therefore, no customers.

2nd, IMO2020: In addition to a rapidly aging fleet, the International Maritime Organisation had set a simple rule to be followed in 2020 by all ships – no more burning of high sulfur fuel oil (unless you install a scrubber). Acceptable levels of sulfur in fuel oils was now set at 0.5%. That created a further problem.

As a ship owner, you had one of two choices. A) Burn Low Sulfur Fuel Oil (LSFO) which was more expensive. Or (b) install “scrubbers” which costed between $2.7-$5 million depending on whether you were a newly built ship or an older one.

As above with the surveys, the problem of whether you could earn your money back on the tankers you’re retrofitting remains a problem. If you couldn’t afford to install scrubbers, and if you had to burn more expensive low sulfur fuel oils, then your competitive advantage goes out the window. The best result here is yet again, to scrap the ship, take the cash, and move on with your life.

The bull situation summed up therefore was:

1 – historically net negative orderbook, aging fleet
2 – IMO2020 catalyst

Covid19 & Contango

This nicely brings us into 2020 and covid19, which took off in China around Nov-December and was noticeably worldwide by March. Almost immediately, oil prices started plunging as travel restrictions/lockdown/circuit breakers were put in place.

Contango” developed – a state whereby oil in the front months of the futures curve costed less than later months.

What this meant was that traders could short oil on the futures for the latter months and buy oil futures trading closer to the present to realize the profit.

Contango

All they had to to was figure out where to store the stuff in the meantime.

Land-based storage was apparently not a viable option, because contango quickly skyrocketed dirty tanker rates then clean.

More than 100 of the current 700+ tanker fleet are now officially in storage mode. Covid19 has also congested ports with reduced manpower, delaying another 100 tankers with demurrage fees racking up between 7-20 days.

rates of vlccs, normally used to store crude/unrefined oil.

You will notice if you look on the chart, two insane spikes for VLCCs. One in OCT19′, and one in the recent months.

Both are good clues as to the tightness of the supply of tankers, as well as supportive of the thesis that tankers were rapidly entering a bull market.

What happened in October was the COSCO sanctions imposed by the US for allegedly trading oil with Iran. Charterers quickly raced to replace all Cosco/subsidiary listed ships, which numbered about 47 versus the global fleet of VLCCs which numbered approximately 735 total Affected supply of ships at maximum was therefore approx 6%.

Removing 6% of total fleet supply sent rates from $40,000-$60,000 a day into $250,000-$300,000 a day for vlccs.

Here’s the juicy part.

Image

If removing 43 vlccs prompted such crazy rate spikes, what would the consistent removal of 27 vlccs do to rates over the next year till 2021?

Now combine that with a historically low order book.

Product Tankers (Refined)
Image
Dirty Tankers (Unrefined)

If you are possessed of common sense, no amount of fine data finagling will tell you that we are approaching a bear market for tankers.

That events such as this can rapidly effect such massive and volatile rate increases (which are still happening as of right now btw), explains the underlying under-supply and tightness of the tanker market.

Few participants seem to notice or care about this very salient supply/demand aspect. Most seem to regard it as a passing fad.

  1. There are investors today who are asking about oil demand putting downward pressure on tanker rates.
  2. There are investors who are short on tankers (thank you for the gift!), insisting to all who can hear them that rates are bound to hit rock bottom after 2 quarters of crazy earnings.

Some of these bears argue that a return to below operating expenditure daily rates is a “norm”.

I would like to remind readers that no industry can exist infinitely in a state where operating costs are higher than profits that can be derived for a long state of time (except, it appears for shale oil, which even now appears to be hurtling towards doom). That is why most shipyards went bankrupt and why most lenders cut off financing.

Balance will always be brought, and here, we see that happening. As of 19/5/2020, post contango extinction, rates are still excellent for tankers.

If a market glut of tankers leading to low supply is the norm and can be construed as a permanent thing, bears are either not using their heads or extrapolating too far into the future.

Few seem to have figured out that shipping companies, with massive operating leverage require just 6m-1year of earnings to earn their current market capitalization.

Latter presentations by $STNG Scorpio Tankers indicate a $55-60million move up or down in cashflows based on $1,000 up or down movement in rates.
Scorpio Tankers Head Trader, Lars Dencker Nielsen

For clarification, fleet wide break even for scorpio tankers is about $17,500.

Yes. That is nearly 10 times the break-even rate required for a ship. Also note, STNG owns approximately 42 LR2 vessels.

Let’s do a simple exercise.

Using very rough math, minus breakeven cash, let’s call it 20k, that’s $6,336,000 for a 40 day voyage. Even if only 5 ships get similar rates, that’s $31, 680,000 in profits over 40 days.

That’s 5 LR2s out of 42, and we’re just a little shy of $STNG’s entire Q1 net income.

Refer to the screenshot.

note difference in clean v dirty

Using very rough numbers**

  1. VlCC breakeven levels are approx $30,000/day.
  2. LR2 breakeven levels are approx $17,500/day.
  3. Suezmax breakeven levels are approx $21,100/day. (2019 est).
  4. MR breakeven levels are approx $15-$17,000/day. (yes, they’re bleeding as of now.)
for reference to tanker classifications, note difference in clean v dirty

Tabulate it, apply a discount, be conservative and factor in the above scrapping that’s due to happen as rates come down further.

They’ve already had a stellar q419, and my names have also reported stellar q12020 results. Hell, $TNK’s Q1 free cash flow generation was approx $81m. ($141m less $60m from sales of vessels. I’ve reduced since it’s non-recurring.). And $TNK’s market cap is $566.93m.

Given that $TNK’s fleet wide breakeven is also now reduced to about $10,500/day (ending 31 Mar 2021) as per earnings presentations (anything above goes to free cash flow), I find it hard to believe that the company will suffer any real existential crisis, leaving it perfectly positioned to capture significant upside as competitor vessels undergo aging and scrapping.

Just look at their debt repayment profile. Post 2020Q1 earnings, they’re standing at $368 million of liquidity. That’s enough cash to cover them in debt repayments till 2023 with no real operational difficulty.

Yet share prices are down, bears are dancing, and shorts are celebrating.

Shrug. I’m adding while the short pressure is piling up. I’m probably going to be adding well into q3 every month since I expect lower rates to exert greater downward pressures.

What I’ve described for $TNK materially applies to most tanker companies – they’re mostly derisked, have no real fear of bankruptcy, and while they’ll see a weak Q3 leading to increased scrapping (which we need to happen!), we’ll in general see year on year improved rates and therefore year on year improved cash flows and share prices.

I’ll let time sort out who’s right and wrong while I move on with my life.

To sum up for new tanker investors;

  1. pay attention to fleet age vs new fleet growth, we are at a point which have been somewhat delayed by covid19. enlarged fleet orderbook growth destroys any chances of sustained long term above average daily spot rates. I will personally go short if this happens and happily relinquish my tanker bull position.
  2. read up on imo2020 and the effects on shipping. Kuppy over at adventuresincapitalism has an excellent blog post here.
  3. there ARE scenarios for failure. if management teams now do ANYTHING but delever and reduce debt, sell. Leverage is well and good. But not reducing debt and buying more ships is a net negative. This is applicable to all tanker companies.
  4. Contango and COSCO sanctions are mere distractions. There will be others that will as the bears say, “temporarily spike up rates for shipping to lull dumb money“. If you pay attention to fleet demand/supply, the rest is noise. Note, this “noise” tends to push up earnings for us dramatically. The more the better. Just stay focused on s/d thesis.
  5. There ARE factors that can impact shipping supply/demand – a great depression for instance. You can mitigate risks by buying puts on your positions in tanker stocks. Naturally, this is insurance you have to pay to play in a sector which is volatile. I know traders who’re making 10-20% selling covered calls and shorting puts (to increase stakes) against their positions month on month. You know who you are. Great job, you. As for the rest, I suggest you get competent at doing the same. Options + common shares offer great rewards for holding onto positions which can be viewed as ludicrous. Also note IV now is higher than normal so options are more expensive to buy and more lucrative to sell.
  6. Shipping is going to be a volatile sector. We will see rates spike up, down, sideways. Share prices will do the same. Hell, I saw rates go up while share prices come down. This means you need to be prepared if you want to get in on the tankers sector. If you’re not, just don’t get involved at all.
  7. Keep in mind that on the demand side, I expect 2020Q3 to be horrid (I’m a born pessimist). What I’m looking for here is the scrapping activity of ships. I want the uneconomic players out of the game and I’ve been aching to see scrapping rates rise. But high 2019Q4 rates bailed them out then 2020Q1 contango bailed them out again. I’m not complaining since it’s led to record earnings, but I hope there are no more delays. Let the sword fall. This will come with some rate pains where daily rates look to touch or even go below opex rates for all but the best players. As I’ve noted above, the better positioned companies will be able to sustain this without much fanfare. Share prices will probably see some weaknesses and we can probably look to add here.

Time to Buy Energy Producers – Part II

I’m currently long Antero Resources, ticker $AR and will look to add Range Resources $RRC whenever possible. Both are gas producers.

Yes. I can hear it already.

  1. But producers have been a shitty investment for the past decade!!”
  1. “But management have done nothing but enrich themselves for the past decade, delivering zero results!”

Yes. I get it. Some investments over the past decade has done nothing but destroy capital. Why get on the train?

Because the inflection point is here and because maximum pain is finally forcing producers of natural gas to have some discipline.

If you haven’t noticed by now, I have a tendency to invest in sectors few want to play in. Energy producers, shipping, etc cetera are all areas people want to avoid. But such is the nature of extreme pessimism.

Kuppy, a guy I respect alot says that he’s made the most money when situations go from hopeless, to some sort of fucked.

I don’t exactly believe in that.

I believe that the turnaround, the inflection, that swap of beliefs from bear to bull, creates the necessary momentum for incredible gains. The difference here lies in the fundamental nature of people to both extrapolate good & bad scenarios many years forward. A bad year implies forward bankruptcy, a good year implies better highs in the future – or so we’d like to think.

You can come up with whatever name you want for it. The truth of the matter is that a turnaround is not just the best sort of story plot there is.

That sort of emotional power behind when a company goes from “oh obviously its going bankrupt” to “oh, wait, huh, erm, wow, maybe not?” is kinda extraordinary – and as such, the raise in share prices from a resulting set of beliefs are also extraordinary.

It is the hail Mary. The last second touchdown. The equalizing goal. The last ball through the hoop in the face of all the impossible odds which makes turnarounds ludicrously rewarding.

But!

There are risks entailed when you decide to invest in turnarounds.

Companies that can be classified as turnarounds most notably have larger than average, even toxic debt burdens (*see tankers above), are facing broad industry/sector/company specific headwinds (retail, office reits), and most have lost nearly 90% of their share prices over the past years and typically look as if they’re priced for bankruptcy.

Let’s get back to Antero Resources. Why long a natural gas producer and why now?

Simply put, 67% or nearly 2/3rd of US NGL productions comes from US oil/shale plays. Take a look at active rig numbers today versus a year ago.

Image
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You’re reading that right. Rig counts are at nearly 1/3rd of what it was a year ago. Across the board, massive cuts across most areas. If 2/3rd of ngl production is supplied by US Shale Oil, what happens when those supplies get cut off at the knees?

NGLs represents approx 30% of Antero Resources production and represented 27% of their 2019 revenue. Factor in reduced capex, maintenance mode production, flat production guidance, and you can roughly bake in where you think AR shares should trade. I’m thinking $5-6 depending on how high up NGL prices climb (since gas production is mostly hedged). $RRC is unhedged, so if anything, they should see big tie share price climbs in the event natgas climbs up sharply.

When will natural gas liquids/natural gas prices climb? I can’t say for sure. My suspicions are Q2/Q3 into 2021Q1-2.

I’ve leveraged the (paid) work of various other energy analysts. I will also add I am no energy expert – so take what I say with a grain of salt. Do your own work.

Disclaimer: I am long EURN, TNK, STNG, AR, RRC.

Time to Buy Energy Producers: Part I

  • Oil Demand Shock: Covid19 has impacted oil demand consumption by approximately 20 million barrels a day, dropping demand down to 80m barrels a day. Some postulate that total impacted demand could drop by 30 million barrels as the virus spreads.
  • Oil Supply Shock: On top of the supply shock, Saudi Arabia’s fallout with Russia to coordinate cuts has now resulted in increased production as opposed to the planned cuts. The Kingdom of Saudi Arabia now plans to boost production to 10.6 million barrels per day from May onwards.    
  • An increase in supply as well as a decrease in demand has walloped oil prices and subsequently, the share prices of oil producers. Many of them are now priced as if they’re going to go bankrupt in the next 2-3 years with an EV/EBITDA of 3 or less. Since oil is still a critical component of modern civilization, and since no clean alternative to oil has been found, I find it ludicrous to think that it is not worth owning oil producing assets at these prices provided they pass some safety checks.

Price per barrel of crude tumbled from $61.06 at the beginning of the year.

Naturally, the share prices of most oil producers quickly followed suit.

Since we are nowhere near the invention of a technology that can yet replace oil and the burning of fossil fuel, the selling off here seems quite absurd.

Whilst oil producers certainly haven’t been good investments given the shale patch’s intrusion and subsequent reduction of barrel prices; it would be a mistake to price most oil producers as if they’re going bankrupt in the next 2-3 years.

Yes. I agree, if $20 per barrel is the new normal, most oil producers will go bankrupt.

But is $20 per barrel really the new normal?

I doubt it.

In summary, here are the 3 major reasons I am long oil as of now, March 20th, 2020.

First, supply destruction via covid19 virus cannot last forever. In other words, mean reversion.

Covid19 is a transient disease that will take time to run its course. But when it does, humanity will be there again, demand for oil now hotter than ever.

Second, oil price wars cannot last forever either. They can run for sustained periods of time, but they cannot last inevitably. At some point, they too need to end. Saudi Arabia needs $80/barrel prices to balance its national budget. Russia needs $40.

Third, future oil supply will be severely impacted by current cuts in production. Oil fields in America are not easy to get back online once shut off.

Some oil extraction areas are just uneconomical to get back online once you close them, stripper wells (less than 15 barrels of oil production or oil equivalent a day) are an example. HFI Research estimates that in the USA alone, a lack of completing wells will lose an approximate 750k barrels per day.

Shale oil, which contributed 68% of US total oil production in 2019 has primarily rapid decline rates. Yes. The graph is right. Peak production for US Shale is about 1 month into production for most shale wells. As a comparison, most mature oil fields decline at 5-7% annually, allowing oil outputs to stay steady for a much longer duration.

Source: EIA

Fourth, as I write this, there is increasing pressure among oil producers to close production. This is particularly so for the places without neighboring access to ports and terminal hubs – landlocked, with no where to go, oil prices are negative in some places -> producers are paying people to take away their oil.

Oil producers are also cutting back on capital expenditures to develop oil fields and decrease production, all of which are bullish for longer term oil prices once covid19 is gone for good.

But there are complications in this tight tangled mess.

The following are factors I consider in the selection of an oil producer to own.

Cost of production à Not all oil producers are built equally. Saudi Arabia and its neighboring regions have extremely low breakeven cost per barrel compared to the rest of the world (price of oil necessary to balance national deficit aside). In an environment of $20 oil, the lowest cost producers win. We should aim to own only the best producers with the lowest cost incurred per barrel of oil.

Goldman Sachs has also published a report recently on this. Here is an excerpt.

And yet, all of this above are just the cream on the cake.

Yes. Shutting in production is bullish oil long term. It means that when demand inevitably comes roaring back, supply won’t be in time to meet it and we’ll see a short period of high oil prices.

But what is truly important is the current price of oil.

As of today (10th April), oil prices are still untenably low despite a recent emergency opec+ meeting committing to cut oil production.

My whole thesis is predicated on mean reversion – that oil prices can stay low for some time but won’t stay SO low forever. So if you believe that oil prices cannot naturally be held down so hard for so long, than the natural course of action is to long oil – or oil producers if you want the leveraged upside.

There are 3 major things I’m looking for in oil producers as of now.

Hedging –> Oil producers hedge their production most of the time. Either with protective swaps or with cashless collars meant to introducer a floor and ceiling price to the product they sell. This restricts profitability to a range but allows them sell production at prices which are (hopefully) cashflow positive. If we should own an oil producer, we should look to own the ones with a management team that has proven itself in hedging out production faithfully and reducing downside risk to their business. 

Debt –> Most oil producers have too much debt. The reason most oil producers are priced for bankruptcy is because most of these oil companies (especially in the US) are at high risks of financial distress. Most have debt burdens they cannot pay off without substantial equity dilutive actions or without getting further into debt – something that might not be possible given the current banking bearish views on energy. And who could blame them? The energy sector for the past decade has been a blackhole of capital spending and lack of shareholder returns for most oil producers. If we should own such a company, low debt/an ability to refinance debt, an ability to meet all debt obligations should be a priority. You can’t ride the upside in oil prices if you aren’t alive to do it.

Valuations –> I hate quoting Warren Buffett, but I think he said it best in two simple sentences. If you have to think too hard about it, you’re doing it wrong. And if it doesn’t hit you over the head with a baseball bat, don’t buy. Or at least that’s the gist of what I got. I’m looking for a valuation so insanely cheap, it looks positively stupid to not get in.

So how am I playing this bullish view?


Enter Tethys Oil.

“Tethys Oil is a Swedish oil company with focus on onshore areas with known oil discoveries. The company’s core area is the Sultanate of Oman, where it holds interests in Blocks 3&4, Block 49 and Block 56. Tethys Oil has net working interest 2P reserves of 26.1 mmbo and net working interest 2C Contingent Resources of 13.5 mmbo and had an average oil production of 12,832 barrels per day from Blocks 3&4 during 2019. The company’s shares are listed on Nasdaq Stockholm (TETY).”

Here’s the quick numbers rundown. All information derived from annual report.

Ticker$THYOF, TETY.ST
Share Price50.55SEK (Kroner, Swedish currency) / USD$5.05
Market CapUSD$192M / 1,924,973,456SEK
P/E Ratio4.46
Ev/Ebitda34,374,526shares x 50.20SEK = 1,725,601,205.2SEK, or, USD$171,070,201.93No debt+No minority interests -USD$75.6 in cash= USD$95,470,201.93 (enterprise value)   Divided by trailing 12 mths ebitda of USD$92.9M = Ev/Ebitda of 1.0276
Price to Cash Flow From Operations Per Share (USD)4.98USD (share price) : 2.64USD (per share) = 1.88
DebtThe Company has zero debt.  
Cost per barrel of oil (2020)2020 guidance of USD11.50 [average cost of production per barrel of oil in 2019 was $11.075]

From the annual report: “Tethys Oil’s (“the Company”) core area is onshore the Sultanate of Oman (“Oman”), where the Company holds a 30 percent non-operated interest in the exploration and production license for Blocks 3&4 (“Blocks 3&4”), a 20 percent non-operated interest in the exploration license for Block 56 (“Block 56”) and a 100 percent operated interest in the exploration license for Block 49 (“Block 49”). Tethys Oil also has non-operated interests onshore Lithuania via an associated company and in one license onshore France.”

Readers can ignore the licenses for block 56, 49, Lithuania and France for now. Those have not yet contributed significantly to the revenue of the company. Blocks 3&4 remain the core productive assets of the company and high levels of production in the range of 12,600 to 13,400 bopd (barrels of oil per day) are expected for 2020 (in comparison to 2019’s 12,832 bopd).

Block 49 is still under exploration, block 56 has not yet yielded results.

Let’s discount both blocks for now.

Focus on the cash flow of oil production from blocks 3&4.

2019-year end results were based on an average selling price per barrel, USD of $61.4.

Complicating the math, the licenses to explore and produce in the blocks of Oman are all held under EPSA (Exploration and Production Sharing Agreements). The agreement allows Tethys oil and operating partners to first recover operating expenses and capital expenditures from revenue. If you exceed 40% of revenue during a period, you can bring forward the unused balance.

The remaining 60% is split 80% Oman government, 20% Tethys and partners.

Sounds troublesome? I agree. It is.

What this basically amounts to is that a percentage of the oil sales price is recognizable as earnings to Tethys Oil while the company still bears operating expenses.

But let’s put that aside and look at the math.

I’ve modelled various oil sales prices of $30, $40, $50, $60, $70 to give us a clearer look at what kind of earnings, and hence what kind of valuations we can be expecting moving forward.

Using very rough numbers, we can approximate Tethys Oil to be free cash flow positive at $35 per barrel and above. Also, a notable point is that every $1 change in average per barrel price achieved results in approximately $919,800 of free cash flow. Note that this goes both ways.

Management Alignment à Magnus Nordin

Magnus Nordin has been the managing director since 2004. Since 2019 annual report is not out yet, I’ve used the company’s website displaying ownership structure.

What is significant to me is that even if we take 2018’s annual reported shares held count of 1,467,127 shares, that records Magnus Nordin’s stake in the company at an approximate USD$740,899.135. A third of a million. In comparison, Magnus Nordin’s compensation yearly was USD$47,040. That’s nearly 15 times his yearly compensation including long term incentive plans. So, I have ample room to believe that Magnus Nordin’s alignment is at least in the same direction as shareholders.

Management’s recent decision to axe dividends downwards while taking this chance to do mandatory share redemptions support my view that they are shareholder accretive, or at least, not working to enrich themselves vs the investors.

In Summary

  • Low cost of oil production provides Tethys oil with significant upside to higher realized oil sales prices
  • No debt allows Tethys Oil to lever up should they need to in an environment where interest rates are basically rock bottom.
  • Call option on future ability to find more oil production -> Company has 100% operating interests in Block 49 and 20% interests in Blocks 56. Block 49 is still pure exploration. Block 56 is undergoing testing of its drilled wells. In either case, I view their ownership in this areas as a free call option. Should significant discoveries be made, the company will be able to skyrocket total barrels produced over the future term and this should result in quite the gusher of cash. If nothing develops, we acquired the company at a cheap enough price that it doesn’t really matter. What we should watch out for is if management begins to start drilling recklessly. Much investment capital has been destroyed in this manner and is what makes energy a sector investors have learned to avoid as management teams put $1 into the ground to get $0.50 back out instead of the other way around. Having said that, I do not believe Magnus Nordin would willingly do this to himself. In 2018, his shares were worth nearly 20 times the value of his compensation (SEK80-100 vs the SEK50 now). He would likely want to see it back up there.
  • Management Alignment  à Magnus Nordin’s stake is 15x his yearly compensation.
  • Production & Reserves à Company has 1P (proven reserves) of 17,336 million barrels of oil left as of 2019. Given current run rates of oil production, the company has 4 more years of oil production left to go. Yet the company is priced at an EV/EBITDA of 1.0276, implying the company is not worth much more than a year of earnings. As we have reviewed, that is patently false.
  • Risks à Naturally, significant risks are present. Perhaps most salient, is that oil prices can suffer significantly in the extent of an extended virus/economic downturn

Disclaimer: I am not vested as of the writing of this article but will look to acquire a sizable allocation (for my portfolio) over the next 1-3 months.

Some further notes;

  • I am no oil expert. Information I’ve gathered has been from the web and further readings.
  • I get things wrong. I might get the future oil thesis of supply/demand imbalances wrong – don’t come crying to me if I’m wrong.
  • I am not a certified professional analyst. I’m a retail investor. I don’t run a hedge fund. I’m young (gf disagrees, body too for that matter), and I’m doing my best to get things right. But I do get things wrong too. If you catch something, just let me know. Even better. Do your own work.

All criticisms and questions welcome.