Robert Rodriguez likes to buy stocks at their lows. When there are not enough stocks hitting new lows, he closes his fund and piles up cash. Does that hurt his performance, in short term it may. But over the last 20 years his $2.1 billion FPA Capital Fund has averaged an annual total return of more than 16.9%, net of sales charge, handily beating all the benchmarks by wide margins.
Key Attributes for Success
- Focus on market leadership or niche companies that are in industries that are perceived to be out of favor and unloved — a bottom-up strategy.
- Select companies that have strong balance sheets — typically with total debt to total capital of less than 40%.
- They must be at a significant valuation discount to the market and its historical valuation parameters.
- Acquire them at modest premiums to book value and at less than 1x revenues.
- They should be on or close to being on the new low list.
- Have a long-term investment time frame — typically three to five years.
Where did he find values in the market these days? Energy stocks! Although he has only 59% of the fund invested in stocks, more than1/3 of that is in energy stocks. Does he always like energy stocks? No. At one time he has less than 3% of the fund invested in energy stocks. This article summarizes his recent commentaries about energy stocks so that we value followers can learn something from it.
Experiences With Energy Stocks in 1979, Reduced Exposure From Over 40% to 3%
Robert Rodriguez: We remain very optimistic toward the outlook for energy prices. Before discussing why, I would like to take you back many years into an earlier part of my career. It was 1979, the Iran/Iraq war was taking place and oil was approaching $40 per barrel. There were many “experts” who were calling for $100-per-barrel oil within ten years. I had the good fortune to participate in a high-level corporate meeting at a former employer, where the longterm outlook for energy prices was discussed. At the conclusion of that meeting, the firm’s senior energy analyst concluded that oil would likely be at $80 in ten years. I asked a simple question as to what might be the effects of this forecast on our life, property and casualty, and consumer finance operations, should he be correct. At the end of this discussion, it was estimated that nearly 90% of the company’s operations would probably be bankrupt before we even reached the ten-year mark. My associate and I walked out of that meeting and began selling our energy holdings the following day since, if our company experienced this bankruptcy scenario, this outcome would have serious negative implications for the economy. Over the next two years, we reduced our investment exposure from over 40% to nearly 3%, just before I left the company. I revisit this period because, during this discussion, supporting documentation was presented that indicated oil production would not peak for at least another 25 to 50 years. I never forgot that chart.
After Almost 20 Years, Robert Rodriguez Revisited Energy Stocks and Bought First Energy Stock Since 1981
Robert Rodriguez: In 1997, I began pondering how the long-term outlook for oil consumption and oil prices may have changed since that fateful meeting nearly 18 years earlier. One would think that, after all this time, energy companies and investors should have a better understanding of the situation. It appears that this was generally not the case, since oil prices and share prices were low and heading lower. In thinking about this, I began to realize that, fundamentally, nothing had really changed, in that no major new fields had been discovered and that consumption had continued to grow. At the beginning of 1998, my associate, Dennis Bryan and I, began a search for an energy analyst. We were very fortunate to have found and hired Rikard Ekstrand. He joined us at the beginning of 1999 and our first energy investment entered the portfolio two months later. This was my first investment in energy since 1981. The point in reviewing this is that we consider energy to be a strategic investment area for us. We expect it to be a large percentage of your Fund for many, many years to come and, therefore, we tend to look through the short-term price variations of our holdings. If share prices rise too rapidly, we may trim a portion of our holdings, but if they decline, we will add to them, aggressively.
Why We Are So Positive About Energy Stocks
Robert Rodriguez: Why are we so positive? Despite the price runup in energy stocks during the past five years, this sector represents barely 10% of the S&P 500. This is up from a low of approximately 5%, but it is down from the 1979 peak of over 30%. Notice that the energy sector topped out at a level that was very close to where the technology sector peaked in 2000. Though it has been a strong performer these past five years, its significance, as a percentage of the major averages, is still substantially less than other periods when a sector has become “the” sector to own. For example, the financial-services sector currently represents over 22% of the S&P 500. After nearly 25 years of interest-rate declines and the explosion in financial derivatives and questionable lending practices, we prefer to be invested in energy rather than in financial services.
Oil Prices in the Past Century, Would Cost $100 in Ten Years
Robert Rodriguez: When I entered the investment industry in 1971, worldwide oil consumption was approximately 45 million barrels per day versus 84 million today. The last major oil fields to be discovered were in 1968 at Prudhoe Bay, Alaska and the Shaybah offshore field in Saudi Arabia. We are on the verge of doubling consumption and yet, there have been no other major fields discovered. In the case of the Shaybah field, production began in 1998, so this has helped Saudi Arabia to maintain its daily production. After nearly forty years of searching, with the most advanced technology available and no major fields to show for it, does this not raise a question as to the likelihood of a continuation of low-cost energy prices? Between 1933 and 1970, the price per barrel of oil increased at approximately a 10% compound growth rate, from 10 cents to $3.39. With huge oil discoveries in the 1930s, 40s and 60s, oil prices were low and controlled by the U.S. For many of these years, the price was maintained between $1 and $2 per barrel. With the peak in U.S. oil production in 1970, the world entered a new era. Between 1970 and 2006, oil prices have grown at about an 8.6% annual rate. Much of this rise has occurred in short time periods. As demand grew into the available supply, oil prices began to escalate. For the entire 73-year period, oil prices have grown at approximately a 9.3% annual rate. Given that there have been no major oil discoveries since the late 1960s, this raises the question of what might the rate of growth be in oil prices going forward. If we are to be conservative, possibly a 5% growth rate might be appropriate. This would be a little more than half the rate of growth for the last 73 years. If this were to occur, a barrel of oil would cost approximately $100 in ten years. For consumers not to experience an increase in their energy spending as a percentage of total spending, either their incomes have to grow in line with energy prices or they will have to reduce their energy use. Either way, this could affect the nature and growth of the economy considerably.
We believe that we have passed the point where oil prices can be sustained at a low level for any lengthy period. As an example, Rikard Ekstrand and I were in a finals presentation to a prospective client in September 2004. At that time Rikard and I played a game where we each guessed as to what oil prices would be in five years. We both picked $50 or more independently. The prospective client was impressed; however, the more important issue was how did our guess compare to what the market was expecting? When we checked the future’s market price for September 2009, it was at $36. What this example demonstrates is that the energy markets had not yet fully realized that world oil prices were in the process of fundamentally changing. As it turned out, the market was wrong by 100% (oil prices recently peaked at $78) while we were wrong by “only” 50%. In our opinion, we still believe the financial and commodity markets are continuing to play catch-up.
We Believe That Oil Prices Are Likely to Be Sustained at Higher Prices
Robert Rodriguez: Oil prices have recently declined from the recent high to $58. Is this the beginning of a major decline? Have prices overshot and have we, as investors, become part of the consensus crowd? In our opinion, NO! We believe that “investment” managers are as short-term as always. They worry that the economy might slowdown or be on the verge of recession and, therefore, oil prices will decline. This may not occur but it is more likely the terrorism oil risk premium is starting to decline. We do not know, nor do we care. We believe that oil prices are likely to be sustained at prices higher than what the consensus may be currently anticipating. In the final analysis, it will be the interplay between demand and supply that determines the outcome.
World Oil Production May Have Reached Its Peak
Robert Rodriguez: In the case of supply, within the next five years, three countries may reach a peak in oil production: Mexico , China and Russia . Several analysts estimated that Mexican oil production would likely peak around 3.4 million barrels per day and that this event would occur in 2004. Mexico ’s largest oilfield, Cantarell, appears to have peaked and if this is the case, so has Mexican oil production, since six of every ten barrels produced by Mexico comes from this one field. Earlier this year, a 3% decline rate was forecast for Cantarell’s production. This has proved incorrect since it is now estimated that the decline rate is 8%. Obviously, this is likely to be of some concern to Mexico . Should this forecast of peak oil production for these three countries be correct, an additional 35% of non-OPEC oil production will have peaked, and together with the 41% from eleven major countries and others that have experienced a peak in production rates, 76% of non-OPEC oil production might have peaked by 2012. If this occurs, it will give the middle-eastern countries even more clout in the setting of oil prices. This is not a pleasant thought.
As for the possibility of Saudi Arabia and OPEC riding to the rescue, there is a major debate occurring within energy circles as to whether they will be able meet rising oil demand. Saudi Arabia says that they will have no problem meeting incremental oil demand for years to come. They estimate that they have over 250 billion barrels of reserves. This estimate has not changed since 1988, despite their producing over 3 billion barrels per year for nearly twenty years. Saudi Aramco, the Saudi state oil company, has acknowledged that its gross depletion rate is now approaching eight percent. If true, Saudi Arabia needs to bring on 800,000 barrels per day of new oil production each year to offset declines in existing fields. Several OPEC nations appear to have already peaked in their production capabilities. We wonder whether the margin of safety is as great as what Saudi Arabia would have us believe. The last independent audit of their reserves was done nearly thirty years ago and at that time, their reserves were estimated to be 110 billion barrels. It does raise a question.
The Primary Reasons We Have Focused Our Investment on Oil Drilling Companies
Robert Rodriguez: It is impossible to know when a peak is reached until several years afterward. For example, depletion of the U.S. oil reserves was first signaled by the drop in yield to exploration in 1940, as measured by barrels per foot drilled. But with enhanced technology, oil production kept growing for another 30 years despite a deceleration in yields. But then the inevitable happened, production peaked in 1970, and it has declined ever since. Interestingly, 80% of the oil produced today flows from fields discovered before 1970, according to 13D Research, Inc. Even more alarming, the world industry is now producing approximately three times the volume of crude it is finding each year. In other words, at current levels of drilling for oil, we are using up and not replacing 67% of our oil consumption or about 55 million barrels per day. This last point is one of the primary reasons we have focused our investment on oil drilling companies because current levels of drilling will not sustain current production. Exploration and thereby drilling for oil must increase to keep production levels from declining over time.
The Change in Supply and Demand
Robert Rodriguez: Oil depletion is accelerating, as evidenced by existing field production declines. According to 13D Research, Inc., ExxonMobil estimated a few years ago that by 2015, because of depletion of existing fields and growth in demand, the petroleum industry needs to add 100 million barrels per day of production. This is about four times the current level of production being added. If correct, this should be a boom for the oil drilling industry. Even if we see little growth from current production levels, exploration activity will still need to increase substantially just to keep production constant. The leverage potential in the oil drilling business we’re invested in is very large. As demand for drilling rigs strengthens from already elevated levels, rig day-rates will likely rise and the incremental change will flow straight to the bottom line, with the growth in profits far above the growth in sales.
On the demand side, we are witnessing a major change, with the increasing demands from China and India . As of 2005, China ’s annual per capita consumption was estimated to be 1.8 barrels per person while India was at 0.9. By comparison, U.S. per capita consumption was 25.6 barrels. U.S. consumption has continued to increase despite the rise in oil prices. Even with the recent rise in gas prices above $3 per gallon, demand only flattened. In our opinion, for over thirty years, the U.S. has not had an energy policy, other than one of cheap oil. For example, the United Kingdom and Japan consume no more oil today than they did in 1973. After the North Sea oil fields were discovered, the UK continued a policy of high gasoline taxes so as to discourage consumption. Japan began an aggressive policy of diversifying away from its heavy dependence upon oil to one that included nuclear energy. It appears that it will likely take considerably higher oil prices to constrain U.S. oil demand.
The Energy Sector Will Remain a Strategic Investment Area for Us
As you can see, we have given this considerable thought and believe that energy will be a growing issue over the next several years; therefore, the energy sector will remain a strategic investment area for us, as it has been for several years. Should energy prices decline more than we expect and the share prices of several companies that we are monitoring decline appropriately, you will see us expand our energy holdings by a substantial degree. It would be remiss of me not to pay special acknowledgement to the book “Twilight in the Desert” by Matthew R. Simmons. This reinforced already strongly held opinions by both Rik and me.
Current Energy Holdings
On Rowan Companies, Inc (RDC)
Robert Rodriguez: We added to our Rowan Companies holding because we believe the offshore-drilling business environment is extremely attractive currently, and we expect this trend to continue for a very long time. The company has no net debt while selling at less than 10x this year’s earnings. With a shortage of jack-up rigs internationally along with a balance between demand and supply in the Gulf of Mexico , offshore drilling day rates are extremely attractive for Rowan.
On Patterson- UTI Energy (PTEN)
Robert Rodriguez: Patterson- UTI Energy (PTEN), one of the two largest U.S. land drillers, declined over 25% for this reporting period and nearly 16% in the third quarter, in response to weaker natural gas prices. We repurchased all of the stock previously sold and we are now increasing our exposure. Investors are fearful that land-drilling day rates will decline because exploration and development companies will begin to defer some of their drilling activities. At our recent purchase price, PTEN could experience a 50% decline in earnings and we would still be paying barely 10x earnings. The company has no short- or long-term debt and is currently repurchasing stock.
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