Deep Basin – Oil Price War and Its Implications - [Invest Like the Best, EP.160]

This week, I’ll be recording and immediately releasing a series of conversations on business and market reactions to the spread of coronavirus. The conversations will be on oil and gas, corporate credit, and the reaction within the venture capital community. Today’s conversation is with Matt Smith, Ian Singer, and Kobi Platt of Deep Basin Capital. We are investors in Deep Basin, and they were past guests on the podcast. We discuss the new price war in the oil markets and the impact it might have on equities and especially on U. S. oil producers. Please enjoy. This episode is brought to by Koyfin. For more episodes go to InvestorFieldGuide.com/podcast. Sign up for the book club, where you’ll get a full investor curriculum and then 3-4 suggestions every month at InvestorFieldGuide.com/bookclub. Follow Patrick on Twitter at @patrick_oshag Show Notes 1:59 – (First question) – An overview of the global oil market and demand 3:37 – Supply and demand shocks we’ve seen lately 6:22 – What happened this weekend with Russia and Saudi Arabia and why the outcome was so shocking 9:45 – The knock-on effects of this activity on equities 14:24 – Impact on US energy production 18:29 – What other industries will feel the effect of reduced production in the US 20:35 – Defining a price war and how victory is defined 27:53 – Saudi Arabia’s calculus in this energy fight. 31:11 – How does all of this change what factors they use to analyze companies 35:43 – What it actually looks like within the commodities markets to trade energy 40:01 – What uncertainty is most intriguing to each of them 43:00 – The long-term interest in investing in the energy sector Learn More For more episodes go to InvestorFieldGuide.com/podcast. Sign up for the book club, where you’ll get a full investor curriculum and then 3-4 suggestions every month at InvestorFieldGuide.com/bookclub Follow Patrick on Twitter at @patrick_oshag

Speaker names marked ? are inferred from speaking time and the show’s known hosts — they are not voice-verified.

• 0:00Patrick O'Shaughnessy?

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• 0:43Patrick O'Shaughnessy?

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• 1:08Patrick O'Shaughnessy?

  Hello and welcome, everyone. I'm Patrick O'Neal and this is Invest Like the Best. This show is an open-ended exploration of markets, ideas, methods, stories and of strategies that will help you better invest both your time and your money. You can learn more and stay up to date at investorfieldguide.com.

• 1:29Speaker 02

  Patrick O'Neal is the CEO of O'Neal Asset Management. All opinions expressed by Patrick and podcast guests are solely their own opinions and do not reflect the opinion of O'Neal Asset Management. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of O'Neal Asset Management may maintain positions in the securities discussed in this podcast.

• 1:54Patrick O'Shaughnessy?

  This week, I'll be recording and immediately releasing a series of conversations on business and market reactions to the spread of coronavirus. The conversations will be on oil and gas, corporate credit, and the reaction within the venture capital community. Today's conversation is with Matt Smith, Ian Singer, and Kobi Platt of Deep Basin Capital, a long-short energy specialist. We are investors in Deep Basin, and they were guests on the podcast last year. We discussed the new price war in the oil markets and the impact that it might have on equities, and especially on the US oil producers. We cover commodities markets, equities, and geopolitical considerations globally. Please enjoy.

• 2:31Patrick O'Shaughnessy?

  Gentlemen, we're going to talk about what the hell's going on in oil and gas markets over the weekend and the beginning of this week. It's been probably a historic, maybe the last 30 years' most significant big event in oil markets. I thought to begin, we could lay a very broad picture with Kobi, you describing, in the most basic terms, how much oil is produced in the world in terms measured in barrels, maybe. Pick apart the supply, where does it come from? And then pick apart the demand. What are the major sources of demand? And where does that come from? Because that will help us explain what happened with OPEC+ over the weekend.

• 3:01Speaker 03

  So just laying the framework for the global oil market, it's roughly 100 million barrel a day market. About 30 million barrels a day on the supply side come from OPEC. And then the other major producers are the US and Russia. The US actually surpassed Saudi Arabia and Russia last year, now is the largest producer of crude oil in the world. And in terms of talking about the global oil market and bucketing it at 100 million barrels a day, that's important to note that that's total liquid. So that includes things like biofuels, NGLs, things that aren't necessarily black crude. Then on the consumption side, that crude oil gets turned into...

• 3:45Speaker 03

  Products that are used in industry by various consumers. The main focus for the economy is gasoline use, but there's jet fuel. And then there's a host of fertilizer, different types of manufacturing processes that rely on hydrocarbons, both as a feedstock and as a process element for construction or manufacturing of things like plastics.

• 4:10Patrick O'Shaughnessy?

  So, so obviously, the price of oil is very much a function of supply and demand. Could you just at a high level, describe what kind of supply and demand shocks we've seen from the virus and from this increase in supply from OPEC? Just some, some, a general idea for what's happened in the last couple of weeks.

• 4:25Speaker 03

  On the consumption side, the non OECD, so China, India, Brazil have been some major consumers of oil demand growth over the last really decade or more. And China's been an incredibly important engine for that demand growth. So at the start of the year, consensus expectations in the market were for roughly a million barrels a day of, of demand growth. Most of that was expected to come from China and the non OECD. In the middle of January, we started to get the headlines about coronavirus. And the market went through the process of, of effectively assigning and trying to understand the magnitude of the demand shock.

• 5:09Speaker 03

  We could see very quickly that China started to slow refinery runs. So China imports crude oil and then runs about 14 million barrels a day of that crude through refiners and then exports the product into the global market. So when they shut down refinery runs, that immediately sort of started this backlog to build in the system. Of the roughly 14 million barrels a day of, of refining capacity and runs in China, early estimates and, and sort of the best we can gauge right now, they cut three to four million barrels a day of that capacity, almost immediately. And what that did was cause a surge in inventories because the oil was already on the water

• 5:53Speaker 03

  and it was already headed to China. And so the, the oil basically had to go somewhere. And when it wasn't going through the refiner, it, it showed up in inventory. The situation remains very fluid. And now, because the virus is spreading, it's frankly getting more difficult to assess from the demand side. So when it was isolated to China, it was fairly easy to tell what the demand impact was. Now that it's spread to Europe and the US, and really, the rest of the globe, because it's so decentralized, it's much more difficult to understand both the magnitude and the duration of the demand impact. We estimate that it's roughly 3 to 4 million barrels a day.

• 6:37Speaker 03

  So as you've gained some demand back from China, you're losing demand in places in other parts of the world. And so, right now, you know, at best we can gauge, that seems like a fairly even offset, sort of keeping that demand loss at the 3 to 4 million barrel a day level.

• 6:55Patrick O'Shaughnessy?

  Maybe describe what happened this weekend, what led up to it, sort of the major players, Russia, Saudi Arabia, maybe what the world expected and why this was such an unexpected outcome, maybe even for you guys.

• 7:08Speaker 03

  OPEC has provided the role of swing producer, shock absorber in the market for the past 40 years. And, most recently, starting in 2016, OPEC and some non-traditional members like Russia banded together to effectively try to provide a floor in prices for the oil market. Demand growth has actually been fairly robust up until last year. And it was really just a situation where the new technology and unconventional resource in the US was providing a huge new source of supply to the global market.

• 7:46Speaker 03

  So, OPEC came together in 2016 and effectively attempted to put a floor under prices and cut supply to the global market. Russia was on board with that, which was fairly historic at the time. That it's fairly rare for OPEC and non-OPEC members to come together. It has happened in the past, but it's rare. And they embarked on this rebalancing regime. Sort of fast forward to where we are today and trying to respond to this demand shock. OPEC convened last week and the expectation was they were going to try to cut supply again to try to offset some of the demand loss.

• 8:31Speaker 03

  I think when OPEC and non-OPEC came together in 2016, at the time, it was viewed as this was going to be a temporary solution to the market. That especially the non-OPEC participants weren't going to, never envisioned that they were going to need to cut for four years or longer to kind of bring about this rebalancing. And so, fast forward to last week, and it appears, based on reports, that Russia basically threw in the towel and said, "Look, we can't continue to subsidize the market the way we have and basically create a transfer payment to US shale producers.

• 9:13Speaker 03

  And given the magnitude of this demand shock, there's really nothing that we can do anyway." So, rather than cut production, and by the way, Russia didn't say, "We want to raise production." They just said, "We're happy to extend the current deal," which was re-solidified at an OPEC meeting in December last year, "but we're not really interested and nor do we think it'd be effective to try to cut even more here." That was a surprise. And the ministers left Vienna on Friday night. And the next big surprise was that Saudi effectively offered huge discounts on their

• 9:57Speaker 03

  crude oil, which is priced one month in advance for shipment or at least for auction to their buyers. And that was a clear signal to the market that Saudi was going to effectively engage in a price war. With all of non-OPEC, not just Russia, but Russia's obviously caught up in that.

• 10:17Patrick O'Shaughnessy?

  Matt and Ian, can you describe what you saw most immediately as the knock-on effects of this activity this past weekend in equities, obviously most specifically in oil and gas-related equities, but the entire market was down, you know, seven-plus percent on Monday alone. It wasn't just energy companies, it wasn't just banks. So from your perspective, focusing on those sectors but looking more broadly, describe what you saw and what you think the important impacts that this move this weekend will have on equities.

• 10:45Speaker 04

  The pieces of the puzzle started coming together, as Kobe described, several years ago when, you know, OPEC refrained from constraining the market supply in November 14. And at the time, a statement was made about letting countries produce to the capability of their resource. And November 14 was really, at the same time as US shale started to truly demonstrate its productive capacity and deliverability, it was at a time when capital efficiencies, meaning how much crude per unit of capital spent could be extracted. And of course, you know, the US shale patch had been, as we've discussed before, overcapitalized

• 11:27Speaker 04

  by a lot of debt and equity in the preceding eight or nine years. When OPEC laid out a lack of action in November 14, and then the US started to go through a period of stress, and then some moderate distress in the latter part of 15 and early 16, which quickly turned around and healed when investors injected about $30-plus billion of fresh equity capital into the shale patch in the first and second quarter of 16, and then as 16 went along, really renewed interest in the space with some fresh investor capital,

• 12:07Speaker 04

  all with the hope that OPEC would ultimately bail them out, which OPEC blinked in the fall of 16. And of course, they brought Russia in with them in this historic pact. And over the last couple of years, they've been trying to work out this, you know, transitory solution. But all the while, energy equities have been dealing with the gravity of a very clear picture that oil is fundamentally well-supplied. And all the while, as we've progressed up until even January of this year, when oil was well-supplied, when you take away

• 12:42Speaker 04

  Political frictions such as Venezuela, such as Libya, such as Iran. The picture was already a well-supplied, range-bound picture with increasing vol around geopolitical into January. And if you look at how oil traded between and how energy equities traded between the Soleimani killing in early January, the Iran retaliation for that, and then that period between that détente that started to occur after the Iran retaliation. And when coronavirus became very clear to the market about potential demand destruction, oil had already started to really fall, given the idea that it is well-supplied.

• 13:26Speaker 04

  At the time with and including political tensions and with the building very large amount of spare capacity. And so, you know, there is a, there's a kind of a long history of energy equities not working when there's abundant spare capacity, which is the case. And so there's been little to bring enthusiasm to the sector. And then when you start to think about the mounting concerns over a demand crisis on top of an oversupply situation, and then the market loses confidence in the cartel that controls a third of the global supply market, plus Russia. It's a cocktail that provided the market with unmitigated fear of holding securities levered to energy over the last couple of days.

• 14:11Speaker 04

  And I would describe the last, you know, 48 hours as quite fundamental. If you think about companies stratification by their leverage, by their survivability of a $20 fall in crude, but sloppy and, you know, many investors have been hurt, maybe, maybe permanently impaired by that. But on the other side of this, assuming that OPEC and Russia don't blink.

• 14:35Speaker 04

  As they did in the fall of 16, and assuming the US government does not meddle in terms of bailouts, there's the opportunity to actually have a much stronger, more consolidated industry that I think would usher in a period of investable, you know, more capital efficient, better scaled operatorship among US shale companies. And I'll defer to you on.

• 14:56Patrick O'Shaughnessy?

  Building on that idea, one of the, I think, principal reactions is what does this mean for US energy production and US shale, most specifically? I think if you asked the random market participant, they would, they would guess that shale producers require a decently higher price of oil to be going concerns, certainly relative to Saudi Arabia, maybe also Russia. So talk a bit about your initial reaction to what's going on in the shale patch and maybe build on what Matt said about the longer term viability of this so that it doesn't become a stranded asset class. I think that seems to be the principal fear that supply and demand are two problems. Investor appetite is a third problem and to say nothing of ESG consideration. So it seems like an incredible amount of headwind. You know, what do you see in this initial reaction?

• 15:39Speaker 05

  The cost structure of shale is starting to be pretty bifurcated where there are producers who have economies of scale in their operations and in their assets and have moved operating and capital cost structures to a place that actually can compete with greenfield projects globally. And then there's another class of shale that really can't. And that class of shale has been incrementally adding debt over the past two years while they've been buoyed by some reasonable prices, but still below where their, their marginal

• 16:20Speaker 05

  cost produces, but capital's been available. And so I think what we saw over the last really two days, and even before that, was the market starting to, to really sort people by where their marginal costs were. And I think what we're going to end up with on the other side, pending a reversal in OPEC plus policy or a zero interest loan.

• 16:44Speaker 05

  To distressed energy companies will be bankruptcies of those high cost producers and or such impairment to their liquidity profiles that they have no, they have no capacity to drill and they'll shrink in a magnitude of 10 to 20% a year. Whereas the strongest shale producers can move into a maintenance capital level or small growth level quickly and they'll be able to survive, you know, through the next two to three years, if that's what it takes for all underlying supply demand to fix itself. So the, you know, when we look at, at cuts that are likely

• 17:26Speaker 05

  coming and some have already been announced, Occidental Petroleum just cut their dividend 90% and shaved 25% off of their budget. Three or four other producers have already announced reductions in activity and capital for the year. We expect a lot more. It will take time for those to impact production in 2020 because wells that were drilled and completed over the last six months are what will contribute to the production for the next six months. So it will take something between six and 12 months for these activity cuts to hit volumes. We'll probably start to see a gradual decline in US volumes by the end of this year. And then we think that there could

• 18:11Speaker 05

  be a decline in the magnitude of 5 to 700,000 barrels a day by the end of 2021. But there are some resiliencies that can come. Service costs aren't static and E and Ps that do have some baseload activity are going to ask for price concessions to keep activity in the field and, and some of those things will, will help capital efficiency and it is ultimately better for a energy corporation to try to maintain its capacity level, even in a low price environment because it's still EBITDA. And when their EBITDA is falling from both prices and then also volumes,

• 18:52Speaker 05

  it's a further impairment to their capital structure. So they are incentivized to try to, to keep their production up as much as they can while preserving capital.

• 19:01Patrick O'Shaughnessy?

  What are the other important knock on effects that you think matter? You mentioned 25% sounds like capex budget cut from Occidental. I'm sure others will do something similar. Who are the recipients of that capex? Is it other companies just in the services space and energy? Are there other industrials? How are you guys thinking about how this might impact the broader market?

• 19:21Speaker 04

  Most of the capital that our upstream companies are spending move through energy services companies from the large cap integrated services companies like Schlumberger and Halliburton, as well as all of the small and mid cap pressure pumping, land drillers and other ancillary well site service companies. But it goes, that's kind of the easy answer. There are, if you think about the local operations and the communities that surround all of these well site operations, you have all of the services that support the people who are involved, the jobs involved in creating this great American industry. So there are actually substantial knock on effects of what has happened.

• 20:06Speaker 04

  And I would say it's difficult to measure other than you can see the economic benefit and measure the economic benefit of what the Renaissance has led to in terms of prosperity and lower energy prices for US consumers over the last 10 years.

• 20:21Speaker 05

  And I mentioned there are a group of shale companies that are going to have impaired capital structures and their loans and debt are held by banks that are going to feel the impact of potential bankruptcies, again, barring a historic intervention by the government. So there's a knock on effect to that as well. And I think during the Super Tuesday discussions, Houston was noted to be one of the fastest growing metropolitan areas and Houston is pretty tied to the energy industry. And you asked about service companies. Well, there's midstream companies too, pipelines that are going to have distressed tenants on their facilities and.

• 21:03Speaker 05

  Again, the knock on effect that goes through that is tough to quantify, but there.

• 21:08Patrick O'Shaughnessy?

  Kobe, I'm curious how you would describe this concept of a price war. A war implies people are fighting over some specific outcome. I'm curious how much you think this is all motivated by, say, Russia and others trying to hurt US shale producers versus motivated by their own internal interests, revenue or otherwise? And sort of what constitutes the end of a price war? What does victory mean in this context?

• 21:32Speaker 03

  I don't know that the answer is the same for all the different actors involved. I think what's created this opportunity in some ways is the accelerated demand drop that occurred because of the coronavirus. And I think the Russians probably saw an opening to recalibrate the market

• 21:59Speaker 03

  in the midst of a severe but temporary imbalance. I think Russia has been, and really the entire OPEC plus alliance has been sort of annoyed by the stubborn resilience of shale. And there's an opportunity or a window here to create so much price havoc that it forces a capital reckoning on the space. I don't know that the Saudis are in that camp. I think there's different priorities there. But rather than engage in a long protracted price war,

• 22:40Speaker 03

  I think the Russians saw an opportunity to do something fairly strategic and create enough short term pain to rebalance the market pretty quickly. I think the Russians have seen how US energy independence and abundance have given, particularly the Trump administration. Sort of free rein to really engage in a sanctions war globally. Without 13 million barrels a day of crude oil coming from the US, I don't think you get to sanction the Iranian regime into possible regime change.

• 23:22Speaker 03

  I don't think you get to eliminate a million barrels a day from Venezuela or sanction the Russians the way that they have. And so, and this is sort of getting at the point that the other guys just made, but the US is now a net exporter of petroleum, total petroleum, not crude oil, but when you include products and kind of everything in the hydrocarbon suite as in liquid form, the US is a net exporter. So, low oil prices don't mean what they used to mean. At the same time, US gasoline expenditures are only like 2% of disposable income. In 1980, it was 6%. So, the benefit of low oil prices for the consumer probably isn't,

• 24:06Speaker 03

  doesn't mean as much as it used to. And now you're talking about a sort of a structural drag or a headwind on the macroeconomic backdrop of the US. And so, if Russia gets to undermine both of those things and potentially even recapture some strategic influence in the global geopolitical landscape, now is a really interesting time for them to pursue this kind of strategy. I think Saudi has an entirely different set of priorities and frankly, has been very clear and credible about what they have wanted to do. And they've said all along, we're not going to cut unilaterally. We're not going to just carry the burden alone.

• 24:50Speaker 03

  And when Russia came to the meeting last week and dragged their feet and was clear that, you know, they weren't going to participate in incremental cuts. Saudi had no choice.

• 25:03Speaker 04

  You know, I think we saw a glimpse at the market for distressed companies that should not be capitalized with debt, who have, you know, high costs and should as assets be consolidation candidates or be shut down entirely. In 16 got, you know, were effectively saved by the late 16 OPEC deal. And, you know, we've talked in the past about systematic fundamental analysis, about taking bottom up well by well buildups of these businesses and rendering, you know, low variance pictures of what companies are capable of producing within their, the constraints of their balance sheets and covenants. And, and you can use various price decks to do that. And we've been obviously dynamically working with our models to try to, you know,

• 25:45Speaker 04

  understand what, what this means. And I, I think without, you know, sharing an explicit price forecast, I think what we've learned are a couple of things. One, US shale will be quite a bit more resilient in terms of the production output at the current mid 30s, low 30s price deck than the market probably, or OPEC, or Russia in particular, believed when it took these actions over the weekend. We need to stay here for three to six months, at least potentially to affect the change in very late 20 and 21. And so the market should not expect that these actions can be short-lived and have the outcome of tightening

• 26:27Speaker 04

  the market. That I think, again, it's very dynamic, the situation, but that the market probably believes. And then the second point would be, all of this gets muddied if the US decides to step in and bail out via TARP or other vehicle distressed energy companies and/or companies that cannot access capital. It'll have the inverse effect. And after

• 26:51Speaker 04

  You know, six to 12 to 18 months, you know, we will be in an even worse situation in terms of supply because it would be once again, somebody blinking and not allowing the markets to work and not allowing barrels to come out of the market at a low price.

• 27:05Patrick O'Shaughnessy?

  Would it be fair to just summarize kind of all that is we need price discovery, real price discovery in the oil markets to have a healthy global ecosystem and these various forms of blinking, whether that's backstopping through, you know, interest free loans or a renewed deal between OPEC plus, that all those that would effectively only prolong this same problem that we're digesting right now.

• 27:28Speaker 04

  That's right. But with the foundation being that this technology that's allowed us to produce as much as we have, almost 13 million barrels of liquids out of shale, we're not going to unlearn it. And so for any incremental, you know, five and $10 move in crude oil, the US has, you know, a significant capacity to produce incrementally. And so with that knowledge and as much spare capacity has been created by the various political ends being sought, as I mentioned Libya, Venezuela and Iran, the market should not expect that the crude price has, you know, significant unmitigated upside as in previous

• 28:11Speaker 04

  cycles because we know that crude is abundant. And so we're talking about what levels, what levels does a healthy market exist? And I think that's what we're, the market's trying to discover free and clear of any subsequent interference.

• 28:25Patrick O'Shaughnessy?

  Just to capture the motivations, you referenced the Saudis having quite a different set maybe of calculus than the Russian case that you laid out. Could you summarize kind of the key driving variables? I know, for example, that oil revenues are a huge percentage. I don't know what the percentage is, but sort of the market share of revenues in Saudi Arabia are disproportionately large in the oil space. Just walk through their calculus a little bit.

• 28:47Speaker 03

  There's a lot of uncertainty there and a lot of it has to do with the volatility within the, the political regime and the goals and visions of the economic transition that Saudi is trying to pursue. Obviously, they're deeply tied to the old oil world and it'll be very difficult for Saudi to completely ever divorce themselves from that.

• 29:19Speaker 03

  They have very ambitious, broad economic objectives and and social objectives that require a high oil price to smooth the transition. There's been a major political consolidation that's occurred in Saudi that continues to occur. There were there were two high ranking Saudi officials, family members, in fact, of the king and the and the crown prince who were detained on treason charges on Friday. And so power continues to be consolidated within Saudi. They have about $500 billion in reserves.

• 30:01Speaker 03

  They're probably going to run, you know, at the current oil price, they'll run a deficit of or they'll have to draw on those reserves by 30 to 40 billion dollars this year. So they have a pretty long runway to to sustain themselves in a low oil price environment. If this turns out to be not the targeted surgical strategic price war that that I think both sides or all sides believe is unfolding. So it's really sort of balancing the ambitions in moving off of a traditional hydrocarbon based economy to one of more diversification with a robust service sector.

• 30:43Speaker 03

  I think a big part of the IPO of Aramco was bringing Saudi into the fold of the of the global financial market and providing some transparency that a decade ago, five years ago, was unheard of. But at the same time, I think the regime struggles with with that transparency. And that was made obvious in a very painful way with the death of Khashoggi. So there are a lot of moving parts. I think I think the Russian motivations frankly are are more clear. And I think, given the political uncertainties and maybe even potentially the the the fragile nature of the Saudi regime,

• 31:28Speaker 03

  a high oil price is better than a low oil price. And they were prepared to cut supply by as much as

• 31:35Speaker 05

  800,000 to a million barrels a day in order to try to sustain something of a moderately high oil price.

• 31:44Patrick O'Shaughnessy?

  Ian, what's your take on the impact that some of the major quality and other factor exposures that you guys think about in the portfolio through all of this? It seems to us that, you guys have already mentioned it, there's been this sort of resorting or ranking of higher and lower quality balance sheets in the shale patch. And it certainly looks like higher quality, or at least very bad quality, are doing very poorly in this period of time. What other considerations are you looking at now? It doesn't have to just be quality, things like valuation, things like trend are fascinating in markets like this. What are you seeing inside of the energy space, in factor space?

• 32:17Speaker 05

  I think what's interesting about the factors that energy has sort of looked like the rest of the market, when you really break it apart, and growth has had a very strong year versus what you would define as traditional value. And growth in energy, we look at pretty strictly as debt adjusted cash flow growth per debt adjusted share. And even in the downturn, debt adjusted cash flow growth accrues to people that are judiciously using their balance sheet for high returning projects. And so when the market is falling apart, growth wins incrementally versus bad balance sheets by themselves.

• 32:56Speaker 05

  And so leverage has obviously had a very tough time all year and precipitously difficult time in the past two or three market days. And while growth inside of energy has not absolutely outperformed in terms of a relative performance versus the other factors, it's held up quite well. So I think that's been just sort of interesting to watch because energy is not really considered to be a growth industry, but inside of it, it performs in many ways that the rest of the market is performing. And fundamentally, it makes a lot of sense.

• 33:34Speaker 04

  The inverse of that, on the value side, without really going into great depth, because I know we're a little short on time, but price to book, which is one of the primary pieces of the value equation, price to sales is another, price to cash flow, price to earnings, or the inverse EDP earnings yield. We spent a lot of time internally talking about this, but book value of Energy companies should not be relied on, period. It's determined once a year, it's set at a price deck that's often

• 34:04Speaker 05

  ludicrous.

• 34:05Speaker 04

  Not realistic, it doesn't stress test the model at all. And so, you know, if you look back, for instance, you know, value just priced to book in energy the last 12 months, it's been a poor performing asset class. But you start to look at impairments or degradations of the book value. Most of those companies have materially written down their book value because the resource was not economic, because there were aggressive bookings of wells to be drilled after the five-year rule ended, when you start to really include proved undeveloped wells and reserves. Most of those have been written off because the companies can't sustain their current plans, let alone five-plus-year plans. And, you know, these impairments take book value and throw it out the door.

• 34:49Speaker 04

  So numerous companies that looked like they were 0.2, 0.4, 0.5 price to book are now zero price to book or negative price to book. And so we sort of think about value in numerous ways, net asset value, but not net asset value using some unrealistically high price deck, but what's, what's net asset value using a downside price deck? What's the margin of safety look like on NAV without heroic assumptions with, you know, heavy risking of what has to happen to achieve that? We think about net asset value on the current forward price curve. And of course, you know, we're running it Thursday, we run it last Friday, and you're running obviously a different price deck Monday and Tuesday. And oftentimes the answer doesn't change, like book value is impaired through, through time because it becomes fixed to the end of any given year.

• 35:35Speaker 04

  And so I, you know, I think we, we've steered clear of trying to use the market's traditional definition of value to look at it in our own perspective, you know, free cash flow yield, but not free cash flow yield this year because the company's not spending money and starving its assets because it doesn't have high return projects to pursue, but sustained free cash flow on a multi-year basis because the company's resource or its projects and toll bridges in the case of midstream support. Free cash and the return of capital to shareholders.

• 36:06Patrick O'Shaughnessy?

  Yeah, it's a really, really interesting nuanced take on value. And obviously, you're preaching to the choir on using book value just about anywhere. But in energy, it's especially interesting to hear. The last set of questions I have are kind of more on commodities markets. Something we haven't talked a whole lot about today, just like the actual trading of these underlying commodities. What they look like to you, who the major players are in this space, you know, whether that be speculators or traders and or, you know, airlines hedging. Cost of their input. Maybe you could describe a little bit of what goes on in those markets. Just because obviously, that's a key component of what's happening here as well.

• 36:41Speaker 03

  It's a great question, and I think just sort of going back to the initial topic of the size of the overall market, right? A hundred million barrel a day global market is massive. But the way price discovery works in commodities is that the market prices. The marginal molecule. So a 1% divergence between supply and demand. While it may be a rounding error to most people is the whole ballgame in commodities. That's why storage and that's why a swing supplier like OPEC is such an important participant in the market.

• 37:20Speaker 03

  Cause they absorb those imbalances when those marginal molecules are required by the market. When demand is strong, or when those marginal molecules need to find a home, when supply exceeds demand. The major actors in the commodity market are really physical arbitragers of value. So participants in the market who have physical supply. Or are physically short, like an airline, a refiner, who require the futures market for hedging.

• 38:00Speaker 03

  For the purposes of running their business, basically creating stability and muting some of the volatility. And the midstream, the way I think of midstream is is sort of the marketer that sits between the wellhead. And the consumer who is effectively providing logistical services in delivering the molecule through the system and to the to the end user. And so those actors are participating in the market every day to arbitrage molecules, in this case barrels, and find a home, whether it be in storage or a burner tip effectively for these molecules.

• 38:41Speaker 03

  What the market is attempting to negotiate or navigate at the moment is what the heck are we going to do with this onslaught of supply that is imminent? It's not here today, but it's it's it's coming. And the market is attempting to reprice to incentivize building of storage, which starts in the onshore market, that's the cheapest storage in the world, and then moves into the floating market. In in periods of extreme distress, so 2015, 2016, most recently, when supply exceeded

• 39:23Speaker 03

  demand by a significant level and you exhaust or the market works through the majority of the onshore storage, then tankers fill up with crude or product and literally just sit on the water and wait for the demand to catch up to absorb those barrels. So in that environment, which is kind of what we've seen this week, you you start to get really pronounced movements in the shape of the curve. And that shape of the curve of the futures curve, in in the case of crude oil, provides that incentive, that economic incentive to price for storage. And what we saw immediately yesterday is the market digested the information of the

• 40:07Speaker 03

  weekend very quickly and efficiently.

• 40:10Speaker 05

  Was the crude oil curves moving to price floating storage as early as, you know, overnight really on Sunday. And today and yesterday, there were, you know, tankers being booked just for that purpose. Again, not because of the surplus that's occurring right now, but ultimately sort of what's coming in the, in the next two or three months.

• 40:33Patrick O'Shaughnessy?

  You guys are all about the resolution of uncertainty, providing ultimate price action that rewards your positioning in the portfolio. I'm curious, just maybe one answer from each of you. What uncertainty, what set of uncertainties is most interesting to you in light of this recent change in energy markets? So another way of asking the question is, what are you watching most closely that you don't know the answer to that is going to impact where things go in the energy sector globally, in the commodity market globally? What are you watching most carefully?

• 41:03Speaker 05

  Before this afternoon, when an article came out that the United Sites might bail out shale companies with zero interest loans, which might gravitate to the high end of that, that list. It was what are the companies going to actually do in response to, to very severe but unknown duration price war? And the spectrum could be wait and do nothing until there's more information and the first quarter earnings aren't until May. And so, you know, they could just wait or they could do something much more drastic like Occidental did today, again, cutting its dividend 90% and reducing its capital budget by 25%.

• 41:45Speaker 05

  The majority of companies have yet to explain exactly what they're going to do. And there isn't 100% guaranteed good strategy because there's so many complexities and, and there's extreme path dependency for, for how this plays out and how information is gathered. So I'm really interested to see how, how corporate strategy changes in the midst of all of this.

• 42:11Speaker 04

  I'm with Ian on the regulator or government interference with the capital markets. I'd like to see how that plays out. Obviously, it really changed the course of things in 2008 and nine. And it could significantly cause a duration problem for the oversupply that could otherwise be fixed in a shorter period of time if, you know, without government interference. I'm actually on that in that same vein. I'm interested in seeing if they will let it play out this time. And they, they means OPEC, they means non-OPEC. If these market constituents who have taken strong positions the last week can withstand what's about to happen, which is a period of very low prices.

• 42:57Speaker 04

  There is a healthier supply and demand balance on the other side as we pass through the awful period of coronavirus and whatever that brings with demand. And we try to be agnostic to periods like this, periods of exuberance, periods of severe fear and distress. But I, as an American, I'm interested in letting the process, letting capitalism play out here because I actually think all parties will benefit on the other side. And I am skeptical if there's political and economic will among all of the parties involved in what started Friday and has happened into this week.

• 43:32Patrick O'Shaughnessy?

  One last question for you guys, which is investor appetite. So I mentioned earlier that that seems to be yet another challenge facing the space, even if there is this nice, maybe acutely painful in the short term, but healthier in the long term rebalancing, as you guys have described it, that there just isn't enough appetite from private equity investors, from public equity investors, from debt investors to provide the capital to this part of the economy just because the returns have been so bad and there are ESG pressures that, you know, seem to have been conjured out of nowhere very quickly in the last couple of years to divest or avoid. Companies in this sector. So last question is, you know, what do you make of the long-term real investor demand, debt and equity for energy?

• 44:16Speaker 05

  I think energy companies have had a hard time demonstrating what value is and what value creation is. And, and I think that not, not only have they had a hard time demonstrating, I don't think that they know exactly what investors want to see from it. And so, you know, over the last few years, I think energy companies have actually been given bad advice on what value creation means, and they've changed their strategy to gear towards what investors were telling them, but it wasn't even what investors wanted. And specifically, you know, the last two years have been a strategy shift from just production growth

• 44:57Speaker 05

  to free cash flow generation, sometimes in an underinvestment state, just to generate the free cash flow. And that's not really value creation. And so when you come into a place where the identity of an energy company and how they demonstrate value is, is already in question, they've pivoted to a strategy that investors wanted, but didn't necessarily make sense and wasn't rewarded. And then that moves into an environment like we're in today, where the price equation underlying all of this has been totally decimated. It is a very difficult situation. I think at the end of the day, oil and liquids hydrocarbon

• 45:38Speaker 05

  demand is not going away for a very, very long time. And the marginal cost to produce the world's demand, aside from what's happening right now, is higher than where we are at today. And so we do need companies that can efficiently and cleanly develop energy assets. And we want those companies to be leaders on the environmental side. And the state of Texas actually put out a very interesting report about, you know, the, the flaring of gas in Texas as an environmental concern. And in reality, Texas, the largest producer

• 46:19Speaker 05

  of oil in, in the United States, is flaring less gas per unit of barrel, per barrel of oil produced than basically any other

• 46:30Speaker 05

  Oil-producing country in the world. And so from an environmental perspective and something that I think ultimately investors should really think about is we want US companies producing energy because they do it much cleaner and more responsibly than than a lot of other countries. And at some point, that will be important to think about. And there will be structural tailwinds to the sector from a price perspective if we do let the duration angle play out. And hopefully, on the other side, the companies will have a much clearer sense of how they create value and they'll stick to that that strategy versus just trying to pivot to the flavor of the day.

• 47:12Speaker 04

  That was really well said, so I don't have that much to add. But I think the prevalence of moral hazard in the sector has upset folks for a decade or more, much like it has at any other time. It became systematically destructive. And moral hazard, it proliferates throughout the entire chain. And I would point to some things we focus on, which is, well, how do you how do you fix it? What could you do better? And for us, you know, we've talked about identifying winners and losers. And often winners are the most capital-efficient companies with responsible scaled operations, responsible, because if they don't have, if they don't do things well, like capture their gas, it's more expensive for them to operate.

• 47:54Speaker 04

  If they spill oil or have a water problem, you know, it's more expensive for them to conduct business. If they don't treat people well, there are liabilities. And if they don't think about returning capital to shareholders and corporate governance, it's not typically something that we would invest in anyway, because the economics don't make it a superior business. And vice versa, on the, you know, in terms of the weak companies, we also try to understand and exploit. And but this idea of moral hazard is something that, you know, I think goes all the way up through the chain. If you were to tie bankers and capital markets teams' compensation to the paper that they would have sold to investors in highly levered

• 48:41Speaker 04

  Energy businesses that with assets that didn't support the leverage, you know, some of this could have been avoided, some of the pain that has caused the industry harm could have been avoided, but that's typical of almost all industries that go through a period of technological renaissance, overcapitalization, maturity, and then the true winners and losers are found. And we're going through a difficult period for the capital markets in terms of understanding who those winners and losers are. And if, if the system works the way it should, those winners of which, you know, there are a clear couple of dozen in each of upstream, midstream, you know, half a dozen or so in services, those businesses will prevail.

• 49:24Speaker 04

  They'll consolidate the weaker peers and they happen to also be the most responsible and efficient organizations in the sector, just like has happened in the lifecycle of other sectors. And, and so it, you know, we actually think there is a, a beautiful period of investment in dispersion in the energy sector for a long time to come, and certainly opportunities in the commodity space, the way, you know, we're talking about the opportunity set.

• 49:48Patrick O'Shaughnessy?

  Well, guys, I really appreciate you doing this on such short notice. I'm doing a couple more of these this week. I was really looking forward to this one. A ton of nuance and interesting stuff here. So, so thanks so much for the time.

• 49:59Patrick O'Shaughnessy?

  Hey everyone, Patrick here again. To find more episodes of Invest Like the Best, go to investorfieldguide.com/podcast. If you're a book lover, you can also sign up for my book club at investorfieldguide.com/bookclub. After you sign up, you'll receive a full investor curriculum right away, and then three to four suggestions of new books every month. You can also follow me on Twitter, at Patrick underscore Oshag, O S H A G. If you enjoy the show, please leave a quick review for us on iTunes, which will help more people discover Invest Like the Best. Thanks so much for listening.