Bristlemouth

A Value Investing Blog

Posted on 10 Apr 2017 by Alvise Peggion

Investing in an Oil Price Recovery

Investing in an Oil Price Recovery

 

The oil price’s stunning decline of the past four years from above US$100 per barrel to below US$50 has wreaked havoc across the oil industry globally, providing investors with a prospective place to look for cheap stocks. While internationally there were, and still are, plenty of them, we are not so lucky in Australia. The fortune of our local energy companies relies more on the price of gas than that of oil.

In the Australian stockmarket, it’s easier to gain exposure to a recovery in the oil price through oil services companies. As pointed out in the January monthly report, the Fund holds four stocks that should benefit indirectly from a higher oil price. These are Cardno (CDD), GR Engineering (GNG), LogiCamms (LCM) and Matrix Composites & Engineering (MCE). The Fund also owned shares in MMA Offshore (MRM). We sold them last year, adding to the existing investment in Matrix.

MMA owns a fleet of vessels that it charters to the offshore oil industry mainly in Western Australia. These vessels are used to tow and handle anchors for drill rigs, construction vessels and barges. They are also used to transport personnel and supplies to and from offshore oil platforms.

At the time of the Fund’s investment in early 2015, MMA had an enterprise value of $700m and $1.3bn of tangible assets mostly in the form of relatively new vessels with an expected life of at least 20 years. While a discount to these assets was warranted due to a chronic oversupply of such type of vessels, we thought that a nearly 50% discount was too big.

On the other hand, Matrix manufactures riser buoyancy systems – cylinders of plastic foam that help to keep the pipes connecting drilling vessels in position on the bottom of the sea. After the oil price collapsed, demand for new drilling ships, and consequently Matrix’s products, evaporated. The company’s order book shrunk from US$110m in December 2012 to US$22m in December 2016.

The Fund started buying Matrix shares in late 2015. The company then had an enterprise value of only $45m but tangible assets of more than $150m. The bulk of these were the result of years of investment, building the world’s largest and most efficient manufacturing facility of its kind. While the dollar value of this facility was, and still remains, tightly linked to the state of the oil market, we thought it represented a strategic asset that no competitor could justify nor afford to replicate.

Investing in an Oil Price Recovery

Doubling down on Matrix

While both Matrix and MMA stand to benefit significantly from a recovery in the oil price, the risk-return profile of the two investments has diverged meaningfully. While Matrix repaid all of its debt, MMA’s financial position deteriorated. The latter failed to sell enough vessels to reduce its debt burden, which at the end of 2016 stood at $400m, four times higher than its market capitalisation. So, Matrix’s ability to wait for an oil price recovery was enhanced, while MMA’s decreased notably. Importantly too, Matrix’s management can now focus on operating its business as efficiently as possible. MMA’s management doesn’t have this luxury, faced with ongoing negotiations with bankers while trying to run a business.

While we sold MMA shares at a significant loss, this could prove to be a good decision. MMA’s failure to sell its boats at a small fraction of the price it paid only a few years ago highlighted how greatly we underestimated the level of oversupply in that market. It might be hard for MMA to earn a decent return on its discounted assets even if the industry improves meaningfully. On the other hand, Matrix’s industry has become more attractive with one of its main competitors going broke and another one losing credibility with shipyards due to quality control issues. As the last player standing, Matrix should be able to earn good returns once the industry turns.

Despite these contrasting developments, the share price of both companies kept falling throughout most of 2016. So much so that we purchased additional shares in Matrix at a discount to even its current tangible asset backing of $0.44 per share. This price implied no value for its leading manufacturing facility. It could be a five year wait for a meaningful turnaround in Matrix’s business, but we expect it to be a worthwhile wait.

This blog post is an extract from our March 2017 quarterly report which will be released in the coming days. If you would like to be added to the distribution list, please sign up here.

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11 thoughts on “Investing in an Oil Price Recovery

  1. Thanks for that article. Your rationale as to the fund’s MCE exposure accords almost perfectly with my own, given i have held MCE directly outside of FOR since late 2016. I wasn’t aware of the favorable competitive dynamic (i.e. competitors going broke) – that’s an added bonus. I also suspect that, if MCE can get traction with the LGS devices, their margins on revenue will be higher as it’s a high spec product (and they disclose that they expect higher gross margin from LGS versus traditional buoyancy products). As to timeframe to maturity, i agree – this could be a 3-5 year wait, principally because basically all of MCE’s end client base is either in bankruptcy or very close to it – it’s going to be a few years before they’re ready to open their cheque books and reinvest in their floating rig fleets with some expensive new buoyancy systems.

    The MCE vs MRM example is a classic real-world representation of the problems of combining operating leverage with financial leverage. I prefer to simply never chase high operating leverage businesses as value situations if they come with high financial leverage, because the margin for error becomes very slim and the downside is, quite often, a near total capital loss (either due to hugely dilutive equity raise, or bankruptcy) if your assumptions are proved to be only slightly off.

    • I’d be cautious on the notion that competitors going bankrupt is automatically a positive thing. I’ve been following the offshore drilling industry for a few years looking for bargains. I have a short list of companies that I think will be “survivors” when the market levels out. However, I haven’t been comfortable enough to deploy significant amounts of capital here. Why? Won’t the survivors benefit when things improve? It was obvious that several of these highly levered companies (operating + financial, as you discussed) would go bankrupt. I asked myself, “Then what?”. The conclusion I came to was that these OSDs coming out of bankruptcy would actually be a greater threat to the “survivor” group because they can now bid on contracts unencumbered by the financial leverage they dubiously piled up before the downturn.

      And this is exactly how things are playing out. What the industry really needs is rationalization. This would involve liquidation of insolvent companies and scrapping of older rigs to rationalize supply. Instead, we’ve seen the recapitalization of poorly run companies. Equity holders get zero, lenders take a haircut, and management (often insiders) get 9.5% of the newly capitalized company. I’m all for incentivizing management, I just don’t understand why it’s the same management that ran the company aground in the first place.

      Anyway, all that rant to say that I think you are bang on in terms of where to look for value. I just want to caution you to think about the next steps after a bankruptcy because it’s rare for those competing assets to completely go away.

  2. There is school of thought, which says that shale oil changed the oil market permanently.

    Shale oil may respond to changes in demand very rapidly. It is 2- 3 months and not many years as with classical drilling. The technology is also quickly improving and apparently at the moment the break even point is between $60 and $70 per barrel and falling. There is also no shortage of capital willing to invest in shale oil.

    Moreover, shale oil technology has not yet been used much outside of US. Once it becomes more established and cheaper then we may see massive deployment worldwide.

    To me this means that we may no longer see the kind of price changes like in the 1990s from $10 to $77 per barrel within a few years. Shale oil may put a cap on price rises at about $60 per barrel.

    As always with commodities, this will put pressure on marginal producers and certainly stop their further investment. In oil market it is mostly the deep water oil that is the marginal producer.

    I would guess that this dynamics may play over the next 10 to 20 years. In this scenario Matrix et al. are a value trap.

    • Larry is right, but it is too late anyway. The northern half of the reef is already dead. If we are lucky five percent of the reef will be alive in twenty years. All this to keep alive a sunset industry in oil and coal.

  3. I presume Larry does not drive a car, or fly anywhere on holidays.

    OK, good, got that out of the way.

    Fossil fuels will be with us a a long time. The reef issues have little if anything to do with their use, and even if Forager or for that matter the whole of Australia got out of fossil fuels and somehow magically subsisted on unicorn farts, there would be no change in anything as the rest of the world is making as good as no change at all.

    In all those circumstances, Forager can and should invest wherever it sees fit. So called “ethical” mandates tend to be driven by activists and crisis-of-the-day, there are often unintended consequences. I have no support for these things at all. If thats what I wanted I would have invested through some other fund.

    • This is an old capitalist argument dating back to 1844, when it went something like “The (young) children should be forced to work in the mill as otherwise they will remain in conditions unfavourable to their development”
      It was true then and is true about climate change now, that doesn’t mean we should tolerate awful things happening.
      A countercyclical investment in O&G is how I am playing it, as the tight oil in the US is a ponzu scheme about to implode and I will recycle proceeds into renewables.
      Remember energy takedown is all aspects of our economy, personal transport only a fraction of that.
      Agriculture, industry, shipping.
      Long term though oil will get more expensive to find and renewables only cheaper so the writing is on the wall. Not sure that Tesla will succeed or if it does rapidly displace the vehicle fleet.
      The point is how soon and the answer is investors can make it happen not by divesting but investing.
      Or turn a blind eye as per the norm.

  4. Bill Gates has previously said and I am paraphrasing “humans overestimate the amount of change that occurs over 5 years but underestimate the amount of change that happens over 10 years.” I am hesitant to invest in fossil fuel related industries because I see the industry being far different in 10 years time and even 5 years we will see massive change.

    A thought experiment, how many barrels of oil are not used over the life of a car when an ICE car is exchanged for an electric car? There are countless releases of many car manufacturers who are releasing or developing compelling electric cars. I foresee eventually ICE cars will be a niche market much like vinyl records.

    Additionally, diesel generators are being swapped out for renewable generation + storage technology. Have a look at the many articles of islands ditching diesel gen sets and switching to batteries or pumped hydro. The amount of diesel litres these islands had to import and are now saving is astounding.

    You may argue that electric cars have failed before. The difference now is that we have companies like Tesla, all electric car companies, rather than ICE car companies developing an electric car on the side. Want to know the difference? Tesla does not have any of the legacy fossil fuel infrastructure, brand image or internal culture to contend with.

    Oil is a commodity which means it is subject to the most basic of economics, supply and demand. The largest area of demand, energy and transport is falling. Sure, oil will still be needed for fertilizers and plastics etc but far less than what is required now.

    You state in your article that it could take another 5 years to realize a return on your investment. By that time you may have been holding for close to 10 years. Not an investment I would personally make but that is the nature of investing – opinions differ!

  5. Late last year I was talking with an executive in the oil and gas industry and we were discussing the same issue about the devaluation of ships and mergers. His view was that the issue was far more complex.
    In particular;
    * Some global players are still operating unprofitably looking for growth and scale.
    *There are far too many ships for the amount of work over the foreseeable future. 35% of the fleet needs to be sent to scrap.
    * The offshore supply industry costs are way too high and they need to learn how to operate in a market where the price of oil is going to be +/- $60

  6. What’s the name of the comp that recently went broke?

    Thanks for the post and I am patiently awaiting the day when the fund trades at NAV!

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