[REPLAY] Deep Basin – Earning Alpha in Energy - [Invest Like the Best, EP.81]

My guest this week are Matt Smith and Ian singer of Deep Basin Capital, a hedge fund specializing in the energy sector. I first met Matt almost 10 years and, in that time, I’ve grown to respect him as much as any investor that I’ve ever met. Now having spent time with Ian, who specializes in oil and gas field exploration companies and the rest of the Deep Basin team, I have similar respect and admiration for all of them. Deep Basin does almost the exact opposite of what us quants do. In fact, their entire goal is to build a portfolio of mostly idiosyncratic or stock specific risk, the very thing us quants mostly remove from portfolios. Deep Basin positions the portfolio to make a series of carefully constructed bets, long and short, without taking market risk, style-factor risk, or even commodity risk. They use a hybrid fundamental and quantitative process which we explore in detail. This is definitely another good example of who we are all up against in public markets. What makes this story unique is that we are investors in Deep Basin’s management company and so have a clear interest in their ongoing success. Listeners know that I want to be as transparent as possible on this podcast so we event spend a little time telling the story about how it all came together a few years ago. I have learned a ton about investing from my countless hours with this team and hope that this conversation gives you a glimpse into what is happening at the cutting edge of investing in the world of hedge funds. Please enjoy my conversation with Deep Basin 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 Books Referenced Expectations Investing: Reading Stock Prices for Better Returns Show Notes 2:47 – (First Question) – Looking at the universe of the energy space that they are focusing on 7:48 – Breaking down the important components and their labels in this space 10:27 – What makes energy companies distinct from the broader market. 12:52 – How the isolate unique value creation 14:58 – Ian’s take on the upstream part of the business where he has spent a lot of time 18:35 – How does Deep Basin use data and what edge do they derive from it. 21:31 – What insight are they looking for from updated well data 23:59 – How do they use combine the business value that they measure with the market price that is being forecasted 24:40 – Expectations Investing: Reading Stock Prices for Better Returns 29:34 – How do they build an actual portfolio 31:51 – Their systematic approach to energy investing 37:53 – What are their thoughts about using leverage when making investments in the energy space 40:53 – A look at the changes to the hedge fund industry over the entirety of their careers 45:46 – Defining the culture of Deep Basin 49:15 – The story of how OSAM and the O’Shaughnessy’s came to be investors in the Deep Basin 54:13 – Kindest thing anyone has done for each of them 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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• 0:32Speaker 01

  This week, we are excited to re-release episode 81, Patrick's Conversation with Deep Basin Capital.

• 0:44Patrick 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.

• 1:04Speaker 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.

• 1:29Patrick O'Shaughnessy?

  My guests this week are Matt Smith and Ian Singer of Deep Basin Capital, a hedge fund specializing in the energy sector. I first met Matt almost 10 years ago, and in that time, I've grown to respect him as much as any investor that I've ever met. Now, having spent time with Ian, who specializes in oil and gas exploration companies and the rest of the Deep Basin team, I have similar respect and admiration for all of them. Deep Basin does almost the exact opposite of what us quants do. In fact, their entire goal is to build a portfolio of mostly idiosyncratic or stock-specific risk, the very thing us quants mostly remove from portfolios. Deep Basin positions the portfolio to make a series of carefully constructed bets, long and short, without taking market risk, style factor risk, or even commodity risk.

• 2:12Patrick O'Shaughnessy?

  They use a hybrid fundamental and quantitative process which we explore in detail. This is definitely another good example of who we are all up against in public markets. What makes this story unique is that we are investors in Deep Basin's management company, and so have a clear interest in their ongoing success. Listeners know that I want to be as transparent as possible on this podcast, so we even spend a little time telling the story about how it all came together a few years ago. I have learned a ton about investing from my countless hours with this team, and hope that this conversation gives you a glimpse into what is happening at the cutting edge of investing in the world of hedge funds. Please enjoy this conversation.

• 2:53Patrick O'Shaughnessy?

  So as you think about the energy space specifically, talk about the features of the universe that you're starting with, maybe define what that is, how many companies is it, and what makes that an interesting playground, if you will, for assessing long-short opportunities?

• 3:07Speaker 03

  If you think about, as an analyst, what you strive to do is find a place where you can add value, where you can do something that is repeatable, you can do something that is differentiated, and where you can find yourself more repeatedly on the right side of an investment than on the wrong side, and tilt the odds in your favor. Having spent some time in media and telecom, and then industrials and materials, and then for eight or nine years, energy, I've just found that not only was it a sector where I'm passionate about all of the intricacies of the business and the complexities of the global energy chain, but it happens to be a sector where the complexity scares people.

• 3:51Speaker 03

  And if you dig in and you construct a portfolio to remove some of that complexity... What's left over can be very long-term structural idiosyncratic investments on the long side and short investments in structurally advantaged businesses on the long side and structurally disadvantaged businesses. And you can do it, and we certainly try to here, in a way that's free and clear of oil and gas prices, free and clear of interest rates. And part of our education at SOTDA was building a high idiosyncratic risk portfolio. You know, I read the Buffett letter when it came out, and you know, I think he still spends some time on alpha and beta. And I would, I would say, I care a lot about the attribution, the

• 4:36Speaker 03

  nature of the returns that our process, that my process as an analyst generated. And in energy, like no other sector, I've been a part of, understanding these businesses at a very atomic level allows you to build informed views and very low variance models of what the future prospects for the business look like. And that allows us to have insights that we think are valuable and, and alpha generating. And the beta piece is the removal of all those things like oil, gas, interest rates, systematic risk. In many cases, we purposely try to get rid of style factor risk in the portfolio. And what's left are these repeatable, we think, asset-driven insights of these businesses. And unlike

• 5:20Speaker 03

  any other sector, we have 70 businesses that make the same product in upstream in the US, the liquid. Canada, you know, another 15. You can build a very elegant portfolio and really isolate specific nuances that you're trying to achieve in a portfolio. And we can stay in energy investments far longer than most investors can because we can take out lots of the bad things that can happen in the energy sector.

• 5:42Speaker 04

  For me, one of the, the interesting things about energy as an investment space is that everything is always changing all the time. And there's lots of places where that's true, but the assets change under these companies over the matter of, you know, three months, maybe six months. Technology changes every sector, and that's true in energy, unlike other sectors. A lot of the data that shows how and why those things are changing are available. And to the extent that you can stitch that data across a lot of different sources together

• 6:22Speaker 04

  into a coherent sort of analytical space, you can really get a deep understanding for how and why those assets are changing and what the prospects for each of your companies are. And just like any other sector where data work is being done, it's easy to draw lots of different conclusions from similar sets of data. And so part of what we do is paint that coherent picture across a lot of inputs and continually calibrate those inputs into what companies are talking about. And that calibration effort takes a lot of time, a lot of focus, a lot of systematic sort of pieces in place to capture all of those things.

• 7:05Speaker 04

  And the result is you continue to have a more informed, better dialed in version of what the company's prospects are. And that allows you to be on the right side of how those stocks move a lot more times than not. And the ability to integrate a lot of disciplines together to give a really robust picture of what each of those narratives are, but ultimately informed by what the ground level data pieces are painting is a unique thing to energy. And, you know, we've spent a lot of time putting all of those pieces together and throw

• 7:47Speaker 04

  in what the energy sector volatility looks like on top of that. And you have a pretty robust space for Alpha Generation.

• 7:54Patrick O'Shaughnessy?

  Well, one of the things that's fascinated me, just talking to Matt over many years, is like you said, the global complexity of this, especially where you've got one player that's incredibly opaque. You may not necessarily know what's happening in the region and has a huge impact on commodity prices, et cetera. At the risk of getting overly simplistic, but I just think it's useful since we're going to talk about how to attack a sector and construct a portfolio around a sector. Maybe we could. Just spend a few minutes on what the parts of the ecosystem are. So I don't want to take for granted that people know the key difference between upstream, midstream, downstream, service companies, et cetera. So I'll leave it to you to decide what those categories are. But maybe just a couple of minutes on like the taxonomy of the space, just so that if we use these terms later on in the conversation, we'll have sort of a record of what the map looks like.

• 8:39Speaker 03

  The chain really is dominated by, in terms of market capitalization, but also in terms of where the economic rent lies. Upstream oil and gas, the producers, they go out and explore for, acquire oil and gas resources in the ground. And they hire services companies like Schlumberger, Halliburton, et cetera, to exploit those. Service companies are, there are many service companies, and they've largely, a bit like D-Basin, become more focused on leveraging technology than traditional service companies that were just iron. And Schlumberger, in that regard, is certainly about as much of a technology leader as there is. From services, where you, they help you exploit the rock and produce oil and gas molecules. Midstream companies are next.

• 9:24Speaker 03

  The, you know, natural gas needs to flow through pipelines. Much of it has to flow through processing plants that separate the methane, which is the actual natural gas stream, from ethane, propane, butane, isobutane, all the natural gas liquids, many of which go into different processes like chemical raw materials or the refining process. And so there are multiple layers of separation with processing. And these gas molecules flow through pipelines into power plants, home heating needs, your stoves, you know, and they flow into industrial plants, et cetera. Oil can really move via truck, train, or pipeline. And once they get to the market, obviously, they're going to refineries.

• 10:05Speaker 03

  It's going on ships, tankers, it's being used for, ultimately converted into gasoline, distillate, jet fuel, asphalt, et cetera. So upstream services, midstream, downstream, which includes refining, chemicals, and all the way through to power plants where gas powers turbines and utilities, where, whether it's a local distribution company that delivers gas to you, or whether It's a utility that delivers electricity to you. All of it starts with really natural gas, coal, nuclear, et cetera.

• 10:33Patrick O'Shaughnessy?

  You mentioned you love tearing apart businesses, kind of the engineering idea, the stats background, technical background, et cetera. As you think about energy, the businesses themselves, what is unique or interesting about them? We've joked that it's like maybe structurally some of the worst businesses in the world. Maybe describe why that's the case and any other relevant features that make energy companies distinct from the broader market.

• 10:54Speaker 03

  All of the traditional investment principles I came up learning, you know, sustainable competitive advantage, five forces, the importance of management's ability to build a team and process and allocate capital to their resources to generate earnings, free cash flow, dividends, returns of capital, et cetera. If you look at the upstream business, and it's changing a little bit, but if you look at the upstream business largely, they're awful businesses. They are depleting assets, price takers. None of the USCNP's, for instance, set the prices for their products, period. And that will never change. They really control how they allocate capital to exploiting rock.

• 11:37Speaker 03

  They control the frequency or cadence at which they drill wells and turn wells into cash flow and ultimately recycle it in the ground. But these businesses are not ever going to be anything but depleting deep cyclicals. And they have to be treated as such, to be treated with great care. I think we could go on and on about why somebody would lend an upstream company the fifth turn of leverage on the underlying EBITDA when it's very hard to, when you move forward 10 years, cover the debt unless they go out and acquire or find new resource, which you currently can't underwrite when you lend them money 10 years. You know, there's an interesting conversation we had about the high yield markets for energy.

• 12:18Speaker 03

  But the important takeaway, though, is long only setting or credit setting or private equity setting, and we certainly have great respect for lots of smart investors in the space. But what we try to do specifically is in a high idiosyncratic risk or beta neutral portfolio, where you care about the oil risk and the natural gas risk that your portfolio exhibits. And in this case, we purposely try to make sure it's roughly zero. You can actually get rid of a lot of the bad stuff about these businesses. And what's left over are some very interesting value creation companies.

• 12:57Patrick O'Shaughnessy?

  Can you say more about that idea of isolating unique value creation post-neutralization of commodity risk? I'm just curious, like, what exactly you mean by that?

• 13:05Speaker 03

  I may overuse this, you know, we've been on the road a bit here recently, seen lots of companies, so not as of late. But if you think about modeling financial institutions, and as long as you have good command of their assets and liabilities, you can generally have a good understanding of their sensitivity to a given change in treasury curve to their cost of capital and understand how that impacts their earnings. And in the context of a portfolio, if you do that enough times with financial institutions, you can actually build a portfolio of financial institutions where you can really tweak your exposure to the treasury curve. Building a portfolio of energy businesses is very similar, particularly with upstream. And we're fairly upstream heavy with what we're doing so far.

• 13:48Speaker 03

  Each of these businesses has a fundamental sensitivity, which we call elasticity, like a convexity measure, to a given change in oil prices or natural gas prices. And that is to say, at $60 crude, EOG Resources generates a couple billion dollars of free cash flow. With that, it can reinvest in the ground and generate future wells that produce and grow production, and ultimately, they can return cash to shareholders. But that, there's a measurement, there's an objective measurement modeling exercise that you can do and understand the value and cash flow of these businesses at the strip using the prevailing oil and gas deck. You can sensitize that, which we do for every one of the business models, to understand exactly how value changes for a given change in crude oil or gas prices,

• 14:33Speaker 03

  similar to the idea of understanding of financial institution sensitivity to interest rates. And if you care enough to take the added step after you, you find investments that you like on the long side and investments that you like on the short side. With very little tweaking, you can actually achieve a portfolio where, you know, if there's a shock in oil or a shock in gas. You can be fairly agnostic to it. And that seems to be increasingly to us, a value-added way of isolating the company-specific investments that we're trying to make.

• 15:04Patrick O'Shaughnessy?

  Ian, I know you have spent a ton of time upstream specifically. I'd be curious for your take on that part of the ecosystem and sort of the levers that you think, one, most interest you, like, why are you fascinated by these businesses? And two, from an investment perspective, the sorts of things that you like to spend your time on. So as you mentioned, it's constantly changing, which is probably a good thing, right? Like, if you're in a competitive landscape, you want it to constantly change because then your skill can shine. So I'm curious how you think about it, the things that you think are most important to focus on. And as we think about alpha, alpha always requires that the broad market has got it wrong. So maybe structural ways or structural mistakes that markets tend to make specifically in that space.

• 15:46Speaker 04

  At a core level, what is interesting along the lines of assets are changing all the time and companies are changing the way they do things all the time. And I mentioned this before, we have information, well-leveled data across the United States and Canada and even other countries where we can look to see how those things are changing and more interestingly and more importantly, why they're changing. And so I spend an inordinate amount of time going through data to understand all those things and more or less rebuild all of the companies that we have in our investment universe from the well-level up.

• 16:28Speaker 04

  And, you know, whether it's a $200 million market cap company that has 100 locations or it's ExxonMobil, you know, that's the approach. And every company is interesting in that regard and how they're exploiting their resource and how they're developing, you know, their longer-term development programs beside that resource is really interesting. Something that markets have a bias on for really any sector is taking a base case and extrapolating that base case too far into the future. And we've found that is a commonly Repeated mistake in energy. And if you think about a depleting asset base, which you know, we talked about as part of why they're structurally not great businesses.

• 17:13Speaker 04

  The genesis of that is a decline curve for every single well. So the asset base is made up of a bunch of individual assets that are declining at some pace, which means that when you add all those things together, you have a large decline rate for every upstream oil and gas company that they are fighting by investing more capital into other declining assets. Base case is very, very important because your decline rate is your base case. And as wells change over time, not just at the beginning of their life, but forever, there are always times where people don't understand what the base of the company is.

• 17:56Speaker 04

  And you know, we spend a lot of time understanding those deep points where activities that companies have done years ago are affecting what their prospects are today. And you know, that's a, that takes dedication. It takes a lot of carefully controlled modeling so that you can isolate all of those things across all your companies all at the same time. And it's interesting work and it's nuanced work and the data sets are rich. And so for an analyst with a technical background, you know, it's a playground sort of every day to find something interesting to think about or talk about. And you know, with lots of companies with lots of assets, there's always sort of some new idea percolating to the top of the list.

• 18:39Patrick O'Shaughnessy?

  It's a great excuse to talk about data and the quantitative side of all of this and the importance of it. It's an extremely hot topic in all sorts of investment circles today. I think that almost every successful long-term asset manager is thinking about how to incorporate systematic tools, quantitative methods, data itself into their process to make it better. And energy is an especially interesting area for this particular idea. So maybe you could describe, we'll actually get into how you think about building a portfolio now and evaluating businesses with this, I'll call it man plus machine model. It's just a term that people People have kind of glommed on to, which is, you mentioned the legacy from Citadel of very systematic thinking, structured thinking around fundamental work.

• 19:21Patrick O'Shaughnessy?

  Now you've got this incredibly rich sets of data within energy, but from all over the place, from my perspective, extremely complicated and probably requiring some deep contextual knowledge to actually do anything with. One of the questions we get all the time is like, well, anyone could access this data, whether it's in a purely quantitative strategy or in a kind of hybrid like yours. How is, how are you going to have any edge in something that's just free for anyone to access, or even if it's not free and you need to pay for it, it's not overly expensive? How do you answer that question about the use of data and the edge that you derive from in the process?

• 19:54Speaker 03

  Going back to this concept of being students of our businesses and whatever sector it is you follow, the goal is to have an informed, low variance model of what exactly is transpiring in the operations and financial results of your businesses. And if you own, if you imagine owning a company completely, outright 100% of it, you know exactly what's going on in the business from day to day. You have a good sense of the prospects for the business looking forward. Hopefully it's in a business where you have more control over the product prices that you're selling and you have a competitive advantage. But in this case, energy, the sector happens to be a sector, again endowed with this incredible access to the data. The data represents access to the building blocks of our businesses.

• 20:39Speaker 03

  Ian mentioned, and certainly oil and gas wells are readily available, but because they're readily available, doesn't make them easy to wield. Having a pure data set, and the bigger the data set, obviously the harder it is to wield, but having a set of data in and of itself is not a solution, is not useful in investment process. You have to be able to distill the data down into its normalized component parts and be able to take that and turn it into a cohesive model for the business by wrapping financial statements around the data. Or put in simple terms, If these companies were factories, if they were manufacturing companies, understanding exactly how many widgets can be produced,

• 21:23Speaker 03

  the cost to produce widgets, the number of people required, the length of the manufacturing line, cost of distribution, et cetera, to get to the end market. In the case of energy, we have most of what we need to build very informed models. And it starts with this oil and gas well data.

• 21:37Patrick O'Shaughnessy?

  So what insight are you trying to glean as the well data gets updated? So I certainly understand, okay, these companies are predicated on successfully finding and extracting minerals from the ground. It's pretty straightforward and the uses are pretty straightforward. So what are you learning through those data updates? That's interesting and compelling. Are you building some sort of web of understanding of the viability of a certain set of acreages or regions? What is the insight that's different than just getting sort of an updated, you know, proven resources or updated asset value or something like that?

• 22:10Speaker 04

  It's sort of a lot of what you just described, but really when data are updated for all of the wells across all the US, we get a couple of things. One, we get a more current understanding of what the production of the company is, just the aggregation level of analysis. How much are they producing? And you know, there's some context and value that can be discerned from knowing what that level is. But more importantly, we can understand how different time periods of wells are changing. And if you understand how a resource base or the productivity of our resource base is changing over time, you start to uncover bits about the second derivative of the prospects of a company.

• 22:53Speaker 04

  And really, that's a really important thing because the second derivative is what makes deltas in cash flow for the business. If the well is going to cost the same but produce less, their cash flows will be lower, their economic return will be lower, the ultimate valuation will be lower. And conversely, if they spend the same and the well produces more than you expect. But then it also gives you insight into how a company is developing in their asset, you know, on a single acre or a unit of acres where a company is drilling, they don't just drill one. Well, they drill a number of wells in a defined system. How they drill those wells, at what depths, at what horizontal, lateral spacing informs

• 23:37Speaker 04

  how that productive system will produce hydrocarbons. And when you can evaluate how they've done that, the type of technology that they've used in the wells to actually get their production, and you can see what those changes in productivity are, you really start to paint a very rich picture of what is happening, why it's happening, and how to take those things to forecast what will happen in the future.

• 24:05Patrick O'Shaughnessy?

  So the second key component of this, we've really focused on your assessment of the value of the assets of an upstream business, or the value of a business, more generally speaking. The second key component here is market price. So the opportunity is going to be the gap between your assessment and the market's assessment. So we have price, but how do you take price and sort of back into what that means the market is estimating about the business as well, as about their assets, et cetera, so that you can gauge the width and maybe duration of that mismatch, of that gap between your expectations and the markets?

• 24:38Speaker 03

  You asked about Malverson, basically. One of my favorite investing books is by Michael Malverson called Expectations Investing. And to quickly summarize, he writes about using security prices to understand the embedded or price implied expectations. And if you, in any industry or any sector that I followed, if you build or care to build a strong model that captures the operating assets and financial performance of the company, you have the jumping off point for iterating to understand what the market must believe today at reasonable assumptions, holding all else constant, what the market must believe today about, for instance, production growth, or what the market must believe today if

• 25:19Speaker 03

  we know production growth, costs, and CapEx, what the market must believe about oil price embedded therein, or costs or capital expenditures, et cetera. And Malverson is helpful because that iterative process is required with this living, breathing set of companies. As these assets change, You're going to go mad if you don't try to slow it down and understand as things change, what it means for the change in the value of the business, but also what the market's understanding is. And you're constantly trying to recalibrate and find these big disconnects where the market doesn't see the assets quite how you see them yet. So we're entering an important topic, which is the idea of investing in energy businesses.

• 26:01Speaker 03

  Is it value? Is it growth? What's important? All the different factors. The problem with these businesses, mostly not the more structural technology companies like Schlumberger, but the problem with upstream companies is that the intrinsic value of the businesses falls when the commodities fall. There is no margin of safety when the commodities fall, which is what we've really seen play out over the last four or five years. So when you go through a valuation exercise and distill all of these well data and turn them into quarterly operating and financial models, when you're building a model for EOG, again, to carry that example forward, you're modeling the next 50 years by quarter. You're taking all of the known

• 26:42Speaker 03

  components of the assumptions, the well data, the cost, capital expenditures, et cetera, and you're turning it into a practical version of what you think the operating and financial results will be for that business. And if there's one endeavor that we have here, one pursuit, it's we try to do that with as low variance as possible. And what you get, and it is largely an objective exercise. And so that's a major, I think it's an important takeaway, which is that modeling an energy business, modeling an upstream company is largely an objective exercise, if you care to use the data available to you to do it. Oftentimes, people screw it up by injecting speculation on the commodities, but in reality,

• 27:24Speaker 03

  most of what you need to know is out there and available to you. So if you go through the, take the care to wrap financial statements around the data and you have a good picture of what the company's producing and generating for cash flow on the prevailing strip. Cutified strip. The strip prices are the forward commodity futures prices, where all the participants in the market are voting each day and they come up with a price for crude oil in both physical and financial terms. Same with natural gas. If you use that prevailing strip, which is frankly, if you owned 100% of one of these companies, it's where you would go out and hedge the cash flow of the business, which is why we use the strip. If you model a business in this way. The next 50 years by quarter, obviously, things can change and you can, there's a margin

• 28:04Speaker 03

  for error the farther you go out, but you can start to build an understanding of how differentiated, using objective assumptions, make your appraisal versus the current market price of the stock. And that's where it gets exciting for us is building an appraisal of net asset value that is where we find we're wildly different. Now, we don't just show up each day and buy cheap NAVs and sell expensive ones. The key is then finding where revisions to market expectations, when the revisions are so extreme that they will force the market around our point of view on the asset value.

• 28:43Speaker 04

  Just one thing to add, absolute price, absolute valuation is, as you can tell from Matt's description, it's pretty difficult in a, in a market that's as fluid as energy, where you know, there's geopolitical factors influencing price of the commodities, there's, you know, actual supply, demand factors and all sorts of other things. In a long, short approach, the ability to take valuation and use it in a little bit of a relative space is important. And being able to take the commodity component out of valuation via the way that we structure our portfolio is a key thing to do when we just want to isolate

• 29:26Speaker 04

  undervalued or overvalued operating performance. And when we look at, as Matt said, when we look at overvalued and undervalued companies based on how we appraise those assets, that's really what we're doing.

• 29:39Patrick O'Shaughnessy?

  Maybe talk about how you then are building an actual portfolio. We've talked about what it's neutral to, which is beta for the most part, commodities, interest rates, et cetera, fact, style factors. But how are you then actually taking your working knowledge, your company models, all the work you guys do constantly and relentlessly and turning it into an actual portfolio?

• 29:59Speaker 03

  If you can readily force rank these businesses each day in terms of the market's price versus your appraisal, it's the jumping off point for starting to think about portfolio construction. We tend to think a lot about quality.

• 30:15Speaker 03

  We tend to think a lot about the idea of longevity of a business. A lot of these businesses, again, because they're depleting, how many future wells they have to drill to generate returns that are as good or better than their current return on invested capital is an important feature of how we think about the sustainability of each of our businesses and their ability to grow and do so within the context of their balance sheet and covenants. If you think about the world, though, where you need to be mindful of the portfolio's sensitivity to crude natural gas and remove those, you can't just buy quality and short bad companies. You can't just buy good companies, short bad companies. And you certainly can't just buy management teams that you like and short bad management teams. What we try to do is balance out and be style agnostic

• 31:00Speaker 03

  and find truly disconnected, undervalued businesses on the long side and overvalued businesses on the short side. But where it could be in the realm of expensive companies, where, you know, something that may look expensive on near-term EBITDA is growing so quickly its cash flow stream that in three years, its multiple compresses substantially and it looks inexpensive. That juxtaposed with a company that looks incredibly low multiple today, but has no prospects to grow production and it's a depleting set of assets. So three years from now, its cash flow is less. There are multiple cases of this where what looks like a value proposition today in several years in the upstream business can actually look like a catastrophic destruction of value and vice versa.

• 31:45Speaker 03

  Oftentimes, expensive companies look more interesting from a multiple perspective than cheap companies because of this idea of longevity and sustainability.

• 31:55Patrick O'Shaughnessy?

  Let me ask you a clarifying question there. So one of the things that I've always fascinated with is understanding why the value factor, as an example, works. And when you dig into it, there's a lot of competing explanations for this. One is that they're riskier companies, so you're compensated for that risk structurally. One is a behavioral explanation. So people get overly pessimistic about the prospects of, say, a low PE stock. But ultimately, like, you're buying future fundamentals when you buy the stock today. And one of the interesting things about, say, buying low PE stocks is that fundamental Fundamentals tend to mean revert at the market level. So if you've got really bad recent trends, odds are that it'll be a little bit better than average in the future. And that's just a very broad generalization.

• 32:36Patrick O'Shaughnessy?

  But when you pair a low price paid today with the tendency of bad recent fundamentals, which is what value stocks tend to have to mean revert. It ends up being this great deal and you end up earning 4% annualized excess return over a really long sample, even when everyone knows about this. So it's, it's an open secret that value investing works. But what you said is quite a bit different than that, which is that in many cases, you might find companies, let's say it's a one that looks expensive on EBITDA today, but has much better prospects or the opposite of mean reverting fundamentals. So maybe you could unpack that a little bit more as to how you might go about identifying that kind of company relative to the more mean, like broad sample of mean reverting companies.

• 33:15Speaker 04

  The interesting thing about low multiple stocks and especially the upstream universe. You know, we talked a lot about assets can change all the time. There is an element of upstream oil and gas where companies sometimes have assets in a geological section that there is no promise to the upside. You know, the probability of the prospects of that resource improving have been statistically rendered to be very low. And so a low multiple stock that has underperformed because its assets don't working, don't necessarily have a fundamental reason for mean reversion because their prospects are not in a mean reverting type of area.

• 33:58Speaker 04

  It's not, you know, a consumer stock that is gaining and losing market share over time. It's a company with a physical asset that potentially doesn't work. And so as they continue to spend money on that asset and it renders sub economic results, its multiple will actually inflate over time. And, you know, you're sort of doing something that's counterproductive to what real value investing is. And so part of what we do is try to discern when a company with a low multiple is for a physically, geologically, structural reason, or if it's just the market doing something silly with a stock. And so, you know,

• 34:40Speaker 04

  We're not factor investors, but we're very aware of factors. We recognize that value can be an extremely positive tailwind to investing. But figuring out whether it's structural, that it's a value, quote unquote, value stock, or if it's just market perception is where we can come in and really add value with our analysis. And there is a, Matt was talking a little bit about portfolio construction and how it's not just about buying good companies and selling bad companies, but finding pockets of dispersion in all of those areas. A good company that has better prospects and a good company that has declining prospects, that's two highly valued companies

• 35:21Speaker 04

  that can be on different sides of a trade, or two low valued companies that have separate operating prospects can be on different sides of a trade and you're not making a factor bet. That is true alpha. And that is what our process and our whole systematic approach to this business is set up to do.

• 35:43Speaker 03

  We certainly appreciate some of the long-term tailwinds, like Ian described, that low multiple stocks have had. I think energy, in energy, there's a bit of a wrinkle. And that is, the price you're paying for a cash flow or earnings stream today has very little to do with the earnings possibilities for the business five years from now or 10 years from now. And when we stress this idea of building a 50-year model for each company, granted, the margin of potential outcomes is very wide. Understanding the prospects of EOG or Pioneer or Diamondback Energy or QEP Resources, which is quite topical, what their ability will be to reinvest their cash flow today to generate earnings next

• 36:27Speaker 03

  year, five years from now, 10 years from now, is of critical importance. The longevity of the assets relate back to the multiple you should be willing to pay on any metric for one of these businesses. And so it's hard about just thinking about pure low multiple PE or low multiple EBITDA investing is, you know, it's a moderately efficient market. You know, we can argue either side of that, but the market's trying to price and understand the EBITDA or cash flow growth of the earnings growth of these businesses all the time, the amount of capital they may need to fuel that growth. Looking at these businesses today, a low multiple business again may have limited business prospects. At a four times company, if they only have three years of wells to

• 37:10Speaker 03

  drill to generate returns, and then they have to go out and make an acquisition of more acreage, or of a company to backfill their depleting production, it doesn't matter if you're buying a low multiple company, because they're probably going to have to do an creative deal when the time comes. And so I think we, we try to think about the long-term earnings and cash flow potential of these businesses. We try to pay as low a multiple as we can for our longs today, and as high a multiple as we can for our shorts today. But each of the, each of the companies is so different in terms of their resource and rock, and their locations in those, and quality of those, and the prospects for those, that comparability is something you have to be very careful with of PEs,

• 37:55Speaker 03

  or of EBITDA, or of cash flow multiples.

• 37:57Patrick O'Shaughnessy?

  Let's talk a little bit about leverage at the portfolio level, not at the company level. So back to the way that traditionally speaking hedge fund portfolios should be constructed, which is neutral to a ton of stuff. So if you were unlevered, you would basically earn a return. That's the return spread between your longs and your shorts, hopefully, hopefully favorably in your direction. Obviously, it's very common then to apply leverage to that unlevered return stream of the difference between longs and shorts. How do you think about that exposure? How systematic is that thinking? How much does it change through time? What's like a rough range? This is a topic that we definitely haven't covered before, so I'd be interested to hear your perspective.

• 38:31Speaker 03

  I think there are two parts to this, and then Ian can add anything. But the first part is, the amount of gross leverage that you apply to your underlying equity AUM should be a function of the breadth of ideas and the conviction you have in those, in our case, in an idiosyncratic way. So the number of names, the more names, the more conviction, the more timeliness of the ideas, you know, ideally you Invest a portfolio today and tomorrow the market comes around to your point of view on every investment. That's obviously never how it happens. So think about it like a life insurance portfolio where you have duration matched longs with duration matched shorts, hopefully. Building a portfolio where you have lots of ideas is the first driver of how we think about leverage. The fewer ideas, if ideas are scarce, you know, we

• 39:16Speaker 03

  do not want to lever the returns of our investments on the underlying equity. The second layer, I would say, has been quite important recently as we've gotten into a less stable, higher risk, higher cost of capital regime, particularly Jan-, late January and February. How much you lever the portfolio, assuming you have a breadth of ideas, should be lower in times of extreme regime uncertainty, which we have every bit of that today.

• 39:46Speaker 04

  Yeah, there's sort of the two sides. There's a statistical approach, you know, a mathematical approach to risk and leverage, and there's a fundamental approach. And Matt talked a lot about the fundamentals, having a breadth of ideas, having conviction in them, having some, you know, fundamental stability in the broader, you know, macro landscape. And then alluded to the statistical side. We are always looking to provide a target risk. And from there, we can back into what the portfolio needs to do against our risk management calculations and leverage a lot of times, holding the fundamental pieces

• 40:27Speaker 04

  of this constant, falls out what that volatility target is. If you can highlight the dollars of volatility that you need to generate with your portfolio and then use a statistical risk management model to estimate what that portfolio volatility is.

• 40:45Speaker 03

  How would you assess the changes, like in your relative careers, in the kind of hedge fund industry? What are maybe the positive and negative changes that you've observed? Maybe Matt, you first, over the entirety of your career now? It feels like it's gotten harder every year. Using data in 2005, when I started professionally investing in the buy side, meant SEC Edgar website, you could go electronically pull financial statements and then you get on a plane to go see management teams. Now today, we still go spend a tremendous amount of time in the field with public and private companies to understand what's happening in the energy ecosystem. But the the major change that's allowed Deep Basin to exist has been this incredible programmatic access to these building blocks of our businesses via data.

• 41:27Speaker 03

  And certainly, you've seen statistics where the availability of data has grown exponentially and will continue to. We've seen that with energy data sets, with the data sets necessary. And frankly, it's why small operations, small, single person or two-person teams have a hard time wielding energy data in a way that's systematic. It takes a fair amount of team and process to do it. So the major change has been the availability of facts about our businesses to allow us to exist on this island.

• 42:03Speaker 04

  I think the the rule of 80/20 is sort of leaving, in some cases, in the investment universe. You have so many people that are specializing in sectors and going to pretty significant lengths to derive an edge that getting the last 20% right is the edge itself and the first 80% isn't really what.

• 42:29Speaker 03

  Just table stakes.

• 42:30Speaker 04

  It's not, yeah, exactly. And so I think from a positive side, when you work in the asset management field broadly, but particularly for hedge funds that are doing an extraordinary amount of work and trying to find some edge, you're working with a lot of really smart people and the number of smart people and their smartness seems to be increasing. And so, you know, from my seat, that's a good thing and it really makes you constantly fight complacency and it's a good driver. The negative side changes over the last, call it, five years. I don't know, maybe maybe the only thing I would say is that, you know, there's there's

• 43:13Speaker 04

  a lot of aggregation that's happening where independent fund managers are going to, you know, large platforms and platforms are great places. They're smart people, they've got great resources, they've, you know, they're built by really smart. Really thoughtful people, they have good returns. But it's changing the way that the market works in some cases and how liquidity profiles are transpiring and that's a advantage and a disadvantage in some ways. It creates a different profile of volatility. But in some ways, it's better for markets to have some fragmentation to them. And you know, that's a change that I think is not necessarily a great one.

• 43:52Speaker 03

  One very clear change is, is the role that passive flows are playing and you know, increasingly in driving securities prices. Some of it can be just paying very low fees for, in our case, the XLE, the S and P Energy Sector Spyder, or the O I H, the Services ETF. When there is material buying and selling of those indices, we see the correlations of the stocks contained therein as, you know, as picking up and driving and overwhelming really most of what's going on fundamentally in the short run. We've obviously spent a lot of time trying to build a portfolio that where we pay attention to our exposure to specific passive indices, et cetera, to try to mitigate that when it happens.

• 44:36Speaker 03

  But we frankly like that. In January specifically, there were tremendous reflationary forces that the market started to bet on and we're buying aggressively buying passive energy exposed indices. Now that's not worked out very well in the recent past in late January and February. But it caused tremendous distortions in the pricing of some of the securities embedded in those indices. And subsequently, these companies had to report earnings, provided forward-looking outlooks. And in many cases, you know, any benefit they saw from the passive index inflows was turned into, you know, serious downside stock price moves when, when the companies reported earnings, for instance, in February.

• 45:20Speaker 03

  So we, we try to use and surveil and understand what's going on in factors, what's going on in passive fund flows. And we try to Use those to our advantage when because they tend to cause distortions and mispricings today more than more than I can recall at any point in my career.

• 45:37Patrick O'Shaughnessy?

  So we'll close with a couple of questions on the firm. Culture is something that fascinates me. And then I've got a closing question that I ask everybody. We'll close with that. So maybe first a question on culture. So I think it's probably something that's it's it's a little bit fuzzy and very qualitative. If you're trying as an allocator, let's say, to assess the culture of an asset management business, but there's just no doubt that a strong culture is something that can help firms weather storms, can give them even a greater boost in good times. So as you think about being just, you know, a year or two years old with the basin, what are like the core cultural elements? Like if I went out and asked the rest of the team, if you had to describe the firm's culture in a couple of words, like what kind of words would they use?

• 46:17Speaker 04

  The first one that comes to mind is intellectual honesty and sort of honest holding of everybody to that standard. And, you know, the byproduct of having that be a real pillar of what we do is people aren't afraid to be wrong. There's no love lost or egos hurt when, you know, opinions change based on the presentation of new information. And, you know, so that type of environment really helps foster intellectual curiosity and removes the negatives of of emotion from what is an intellectual pursuit. And that's a great thing to have. And, you know, I think we have that in spades. And Matt can talk about some of the the personal attributes.

• 47:00Speaker 04

  But, you know, from my perspective, the fact that we've we've all worked together before and, you know, we have a aside from just being intellectually honest, you know, hungry professionals, we all strive to be good human beings. And that means holding yourself accountable and being honest and being, you know, forgiving and understanding. And I think everybody at this firm has all of those things that allows intellectual honesty to really be a core component of of our success.

• 47:31Speaker 03

  I would probably add just a couple of traits. One is, and this is is really informed by our past experiences that we reflected on, but we are obsessive about process adherence. You know, if there's one thing that really gets an energy portfolio down, it's when It would be if I were to decide to take a big swing at what OPEC is going to do in the spring or when Russia is going to give in on or take back or reneg on the cuts. Extreme process adherence, we have found, is the most important pillar of sustainably repeatable investments in this sector. There are certainly temptations to have commodity views. We talk about commodity views all the time.

• 48:15Speaker 03

  Now, we use it to get it out of the portfolio, but we see that temptation. Thankfully, it's now totally institutionalized, and it certainly was from the very beginning. But this obsession with process is something that happens daily. The second piece that I think is important is there's meaningful passion about the subject matter. I've been a student of investment cyclical companies since I started my career, and over a long period of time, it's really been focused on energy. And that may make me very narrow in my focus, but it's something that I've come to be very passionate about. Ian, Graham, Kobi, everyone has mostly devoted their careers to this discipline and this sector at this point.

• 48:57Speaker 03

  And for good or for bad, we love talking about digging in on trying to get it right and investing in these energy businesses in this idiosyncratic way.

• 49:07Patrick O'Shaughnessy?

  I find it incredibly important to be as transparent as humanly possible on this podcast. And so there's an important feature that we haven't talked about, which is that both our family and our business are direct investors in your business. And so I thought a fun way to handle that, rather than me just disclaiming it in the introduction or something like that, which I'll also do, is for you to maybe just tell from your side that story very quickly, because it's a neat story, one that's been incredibly interesting, an amazing way to learn for me and for our business as well. So maybe you could just end a few minutes on that as something fun, but also in the sake of transparency.

• 49:42Speaker 03

  From the beginning of my career through early 17 or even early 16, my long-term goal was always to build a sustainable investment firm where I can be a key determinant of the culture of this process adherence that I described and of the type of people who I'm surrounded by each day. And that is something that, in the case of Deep Basin, I wanted to capitalize like a technology company. When I left my prior firm in early 16 and sat out a year on a non-compete, I thought about who I wanted to be when I grew up and a critical piece was I wanted to surround myself by people who challenged me and make me feel stupid each day. And you

• 50:24Speaker 03

  know, I knew where to find some of them, but I was grateful to be introduced in early seventeen to Colby Platt and our team, Garrick and Travis and the members of our operating team. And in order to pursue and build the business that I really wanted to build, we had some options on some LP type seeds, traditional seeds. And we were thankful when we sat down and put our heads together with the O'Shaughnessys, with you and you and your dad, that you saw the vision that I had, that we had for the firm. And frankly, it needed to be capitalized like a technology business. And like no other seed that we evaluated, having a very

• 51:05Speaker 03

  long-term, permanent capital partner, that is like no seed that, you know, I saw when I started thinking about doing this. And certainly the fabric of the people we're in business with is important to me. And it was important when we started to build this, this team and culture. We believe in order to build a sustainable, you know, investment franchise, to invest in these businesses that we're so passionate about, we needed to build a team and process and sufficient motor on the business, which required a significant technology investment. That's why I describe it as effectively a capitalizing like a tech company. But we spent almost a year building a significant

• 51:45Speaker 03

  technology that allows us to, to today, you know, keep our eye on the horizon and have the headspace to take risk. And that, for that, we've been very grateful.

• 51:55Patrick O'Shaughnessy?

  I appreciate the story. I mean, obviously, I want to be transparent, given that, that we have a vested, vested interest in your success. And our view is that the future of this business is far more collaborative, maybe than it's been in the past. We're a loan-only business, so we're not directly competitive. But we found just tremendous value in being open to experimental and new ways of collaborating with other investors. You end up learning so much more than if you tried to just view everyone as a competitor. So it's been, it's been a remarkable experience. The, the last question that I ask everyone, so I'll ask, I'll ask each separately, is for the kindest thing that anyone's ever done for you.

• 52:31Speaker 04

  I'll go first. I think it was the second date that I went on with my now wife. And we decided to meet at Grand Central for oysters at the oyster bar there. And we were going through our meal and, you know, we had a few drinks and we're having a great time. And we went to leave and the waitress came up to us and said, you know, you guys are all good. And we said, what do you mean? We just had like two dozen oysters. Like we're, we're definitely not good. She says, no, there was a gentleman across the table from you that said he reminded you of him and his wife when they were young and he paid for your tab.

• 53:07Speaker 03

  You know, as I sit here today, my wife is pregnant with our third. And as I think about, you know, the 14 months or 13 months since we started to build Deep Basin, you know, the kindest thing by far that's ever been done for me is my wife enabling and encouraging me to pursue my dream, which has been building a team and process and culture where everyone can come and be passionate about this very, in many cases, people may think very myopic pursuit, which is systematic fundamental investing in these energy businesses in a repeatable way. My wife, I'm lucky, very simple things make her happy. She loves family. She loves to read. She loves to cook.

• 53:51Speaker 03

  And, uh, and I'm thankful that she has not only encouraged me to go out and do this, but she married me. And that I consider the kindest thing that anyone's ever done for me.

• 54:03Patrick O'Shaughnessy?

  Well, this has been really fun, as I knew it would be, an awesome, awesome deep dive into a very particular kind of investing. So thanks for your time, guys.

• 54:10Speaker 04

  Thank you.

• 54:11Speaker 03

  Thank you, Patrick.

• 54:14Speaker 05

  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. [Music]