What Can We Learn From the Energy Market?

Some observations from the recent performance of the energy sector

Author's Avatar
Jul 03, 2017
Article's Main Image

One of the most fascinating areas to watch for the past three years has been the behavior of energy stocks and how various investors have played the energy stocks.

Let’s go back three years to July 2014. Oil was selling at about $108 per barrel. By year end of 2014, the price of oil had fallen to $60 per barrel and less than $50 by January 2015. Then it ran up to $60 by mid-2015 and then collapsed to below $30 in January 2016, after which it made a big run to $50 by the end of 2016.

The energy sector was down 8% and 21.5% in 2014 and 2015 but up almost 24% in 2016. But that wasn’t the whole story. For instance, the behavior of integrated large-cap oil and gas companies behaved very differently from the small-cap oil service companies and offshore drillers. Many small-cap energy stocks went bankrupt, some fell 90% and then up 200% (still down 70%; that’s how math works).

What’s really interesting to me is how many value investors have been betting big on oil price recovery since late 2014. Some investors even had a large percentage of their portfolios allocated to energy stocks when the oil price was still above $100 per barrel.

More interesting is how many value investors were giving opinions on what the fair price of oil is and when the fair price should be realized and they all sound reasonable on the surface. For instance, when the oil price was above $100, most people were saying the sustained increase in demand (especially from China) and flat productions from some large oil production countries would make the oil price stay above $100 for a long time. When oil fell to $50, every oil bull was saying that’s not a sustainable level because the cost of production for the more expensive but still much needed oil exceeds $70 or $80 per barrel so the shakeout should be pretty short. The supply-and-demand dynamic will drive oil back to at least $70 soon.

Boy have some of the value investors suffered enormously from the energy stocks! First of all, the energy stock had a huge drag on performance. Second, they have to explain to the clients over and over again why oil should be $70 per barrel in the next 12 months. Third, after a big run in 2016, the agony started all over again in 2017. And last but not least, most of the predictions have turned out to be wrong, especially the ones about timing, and they still need to make more predictions and tell the clients they know what the future will hold even though the evidence suggests otherwise.

There are many lessons, all of which are not new, that can been learned from the recent energy stocks.

  1. I feel I have been using this Mark Twain quote quite frequently on this forum, but it’s really true and worth repeating: “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” There is nothing wrong in saying "I don’t know" and moving on to something that’s important and knowable. Too many factors affecting the energy market are unknowable (the politics, the true cost of extrapolation, etc.) and those who think they know should think twice.
  2. The great quote from Rudiger Dornbusch: “In economics things take longer to happen than you think they will and they happen faster than you thought they could.” And a great quote from Howard Marks (Trades, Portfolio): “Should happen is different from will happen. The most probable outcomes fail to happen all the time and even if they happen, they fail to happen on time.” Let’s combine them with a third timeless adage and we have a real lesson: “Sometimes being too early is indistinguishable from being wrong.” Very few investors expected the rapid decline of oil prices that started in the second half of 2014. And once oil has declined to $50, every oil bull claims that oil “should” get back to $70 within the next 12 months. And if you buy energy stocks in December 2014 and think oil prices will go back to $70 in 2015 and 2016, that’s not much different from being wrong.
  3. I don’t mean to rule out investing in the energy sector. There are many ways to invest in the energy sector but only few are prudent. Buying an E&P company that will go bankrupt if oil stays below $55 for a few years but will do great if oil sells more than $100 a barrel is very different from buying high quality energy stocks or bonds of companies that will survive even if the oil price drops to $30 and will do just fine if oil sells for $50 a barrel. Do you go with aggressiveness or with conservativeness?
  4. Understanding the business model is absolutely essential and I personally think the energy business is harder to understand than most investors think. Charlie Munger (Trades, Portfolio) has masterfully and succinctly put it this way: “The oil and gas business is very peculiar, the people who succeed in most other businesses are going way more physical volume than they did in the past. But a place like ExxonMobil (XOM, Financial), the physical volume goes by way of two-thirds; it’s just that the price of oil goes up faster than the physical volume goes down. That is a very peculiar way to make money. And it may well continue, but it’s confusing. We’re not used to it.”
  5. The intrinsic value of oil per barrel is far different from the marginal cost of producing a barrel of oil. And the intrinsic value of an oil-related company is quite difficult to evaluate. For you to determine the intrinsic value, you have to make all those assumptions on oil price during a different time period and each of the assumptions depend on multiple factors, which could then have a wide range of outcomes depending on another set of subfactors. So it’s almost contradictory to everything value investing is to calculate a tight range of intrinsic value of an oil and gas company. But I would also say that doesn’t mean you can’t find value in energy stocks. In certain instances you can still tell whether an energy stock is cheap – I don’t need to know if somebody is 280 pounds or 300 pounds to tell that one is overweight. But even in these instances, timing is crucial in terms of the IRR you will get from the investment and that’s hard to tell.
  6. Just because you have collected a huge amount of data doesn’t mean you should act as if you are right. In some cases the more data you have the more confident you are but I highly doubt this is the case with oil prices, especially in the short term and medium term. You can have a thousand charts and reports and, believe me, there are that many charts and reports on oil, but unfortunately oil price is still unpredictable. A lot of randomness is in play and randomness is, by definition, random.
  7. Expert opinions are useless at best and actually could be harmful. Let’s take a look at some experts’ projections of oil price in 2010 for the next seven years; you had to pay a lot of money for this specific service (IHS).

1122568701.jpg

First of all, the consultants were basically extrapolating, and nobody even imagined a complete change of direction in oil price for the next seven years.

Second, we know oil price is not linear but every consultant’s oil price is linear. Why? That’s the way human brains are wired.

Third, the consultants came up with projections with tons of data backing it up and yet they didn’t even come close.

Imagine that you pay tens of thousands of dollars for IHS’s service – since you paid a lot of money for the service, it must be accurate; otherwise your money is poorly spent. IHS went through all the trouble data and nicely put them together to back up a random projection – oil price. The commitment and consistency bias kicks in big time. You either believe that oil price can be predicted by paying a lot of money, which you did, or you face the reality that it can’t and there goes the money spent. Which one would you choose? I’d say this is not uncommon in the investment community these days.

How about the opinions of an energy legend then, say the “Oracle of Oil” T Boone Pickens? Well, in December of 2014, Pickens predicted that that Brent crude oil would be at $90 to $100 barrel in 12 to 18 months. That was off by quite a bit. What about his other projections? Well, in May 2015, he expected oil prices to recover to upward of $70 per barrel by the end of 2015 and approach $90 per barrel by the end of 2016, both of which are also off. And in 2016, he predicted that oil would be $70 by year end – another projection that turned out to be incorrect. But he also made some correct predictions. In 2007 he predicted that oil would rise to $100 a barrel, which it did by January 2008. And as recently as 2016, he predicted that oil would rebound to $50 to $60 a barrel, which was also right.

Should you have acted on Pickens’ predictions then? The point is, nobody can project the outcome of random events, even the experts who don’t want to admit.

Two important principles in value investing are the “circle of competency principle” and the “margin of safety principle.” Some value investors who invested in energy stocks may have deviated from them and suffered as a result. James Allen once said that “you either learn by wisdom and knowledge, or by suffering and woe, and you continue to suffer until you learn.” Success in valuing investing requires suffering but the most important thing is that we all learn something from the suffering.