Random Rambling on Oil

Academic economics textbooks  always preach on the law of supply and demand.

When demand falls, prices will drop and production level will fallaccordingly until equilibrium is met.With the recent oil supply glut and tumbling oil prices, one wouldreasonably expect a corresponding cut in oil companies' production.However, the truth could not have been further. The oil market did not correctin such a manner.
The recent quarterly results of shale oil producers show a y-o-y increasein oil production. How is this even possible in the face of declining oilprices?Firstly, shale oil producers had invested heavily during the shale boom inthe previous decade. The cash outlay had already been spent. A measly returnon investment is better than no return on investment. Secondly, theseinvestments were carried out using a huge burden of debt and other huge fixedcost. Production of oil at a low price would still at least enable them toservice their interest cost.
As an individual company, the action to increase oil production appearsrational and makes perfect sense. Collectively, as an industry, it seemsasinine. More oil production would certainly lead to oil prices spirallingdownwards, exacerbating the problem even further, with each producer soldering onto postpone bankruptcy by increasing output with the unintended consequence of dragging prices tounprofitable levels for everybody.As how the oil titan, John D. Rockefeller phrases it in his biography, "Eachproducer, while pursuing self-interest, generates collective misery. Everyman assumed to struggle hard to get all the business, even though in doingso, he brought upon himself and his competitors nothing but disaster."
On a side note, it is worthwhile to note that while John D. Rockefeller hadlived more than a century ago, his lessons on the oil industry are stillapplicable. Human nature does not change and the world very much still runs onoil.

Investment Mistakes(Thankfully by others)

Prabai's Mistake

Ok. Some might disagree that the outcome of Horsehead investment is still uncertain and should not be consider a mistake. However, falling from a price point of 9 bucks to 2 bucks would at least warrant a good re look. I will try to reverse engineer his investment idea at that point in time and what has changed.

Firstly, Prabai started out buying this coy as a net net during the 2008/10 period Nothing very wrong with that approach. Subsequently, the company move on to try and develop a new plant which will allow it to be the low cost producer, ( Steel coys paying them fee to provide them with waste product that can be use as valuable input for making Zinc). Buying Horsehead now while the plant is developing its moat is like getting in on the ground floor. (The numbers are not reflected in the financials). I can understand where is he coming from. Paying an attractive price with a huge potential upside.

What when wrong?

The plant failed to ramp up, encountering difficulties after difficulties, consuming loads of cash. With negative operating cashflow, the company is force to take on huge debt, taking on balance sheet risk and huge issuance of equity, diluting current shareholder interest. Adding on to it's woes, most of the debts are due in 2017, hence a potential liquidty crunch ahead if production still fails to ramp up by then,facing bankruptcy or another massive share issuance. Both does not bore well for the current shareholder. Lastly, falling zinc price is not going to help a Zinc producer very much. The movie is still currently being played out.

What can we learnt from this?

New plant production is never a dream fairytale, unlike the projection by managements, whose rosy production forecasts can only go one way, UP. Be wary when management says the problem is being resolved. Even when one problem seems to be resolved, another will surface to take it's place (There is never only one cockroach in the kitchen).

Secondly, beware of debt laden, high operating leverage companies operating in an economic sensitive industry. There is little room for errors.

Hence because of the above, there should be sufficient cashflow from other sources to cover the funding needs of the new plant. With a huge debt and negative cash flow, for Zinc, it seems to be a make or break situation.

Something to take note

One key point to take note when analysing a company annual report.

Do take note of companies that have large upfront cost (Such as marketing and advertisement costs) to acquire a customer and it’s expensed through the income statement, but then once you have that customer, it becomes a recurring stream of revenue.

It’s the idea of where the accounting doesn’t capture the value being created from locking in a long-term stream of service or parts business.

The concept is that the first several years are not going to look good on an income statement basis, but I’m locking in great cash flows for the next two decades. Great model, but the market hates it right now because the accounting earnings are bad, particularly if you’re in a ramp up or growth stage. However if you’re looking past that to the value creation, there can be huge opportunity.

there’s understanding the economics that are underneath it. You might have five years of high expense of acquiring those customers, and then you might have chunky amortization charges going to the income statement on the development costs and the customer acquisition costs for the next five years. At the same time, you’ve been locking in high NPV [net present value] customer contracts, but they’re not going to flow through the income statement

Joel Greenblatt Investment mistake.

Many good investors have always encouraged the use of an investment checklist to prevent or reduce investment mistakes made. The checklist can be compiled by analysing good investors past mistakes.(There are bounds to be mistakes).

I recently read a case study on Joel GreenBlatt most disastrous mistake written by J Allen Capital Management, the mistake on Key3Media was thoroughly analysed by them and it deserves a spot in all investor checklist. http://jallencapitalmanagement.com/posts/Joel-Greenblatt-Key3Media-Case-Study.html. From that article, we can see what leads him to buy the company and what was the eventual outcome.

Lessons of the story are high operating leverage,  economically sensitive industries and a material amount of debt.

Take note of companies that have a few customers that have high margins and make up the bulks of your revenue. This can result in high customer concentration risk.(Even worse, if those customers themselves are not doing too well).

                                                                                                                                                                                                                                                        

Beware of companies that are in economically sensitive industries that have experience a recent boom ( Technology industry in 2000, housing industry in 2006-2008 and the most recent boom can be seen in the oil industry). The underlying financials been analysed are overstated because of the recent boom. Reversion to the mean will occur eventually. In fact , this is one of the mistake made by Berkshire when investing in Cort Furniture during the technology boom.

Lastly, be wary of companies that scoop up high debts during the boom industry to fuel growth.

Well each factor alone can be quite dangerous but a combination of the above can be a recipe for losing a lot of money. During the boom, you could grow your profit without increasing your operating expenses, however during the downturn, your revenue and profits could vanish but your expenses remains unchanged.  As Joel Greenblatt mentioned, ”The tremendous operating leverage benefited from in good times was a double edge sword in bad times.” The revenue vanished will impact the net profit directly.

Buffet's Nuggets

The best businesses are those “you buy once” and then no longer need to invest further capital, Mr. Buffett says. That’s one reason real estate is a good investment in periods of higher inflation. A brand is a “wonderful thing” to own in inflationary periods, he says, referencing Berkshire-owned See’s. The value of the brand rises when inflation kicks in, he says.

Utilities and railroads, which of course are major Berkshire operations, require investments that rise in cost when inflation strikes. 

The best businesses are those “you buy once” and then no longer need to invest further capital, Mr. Buffett says. That’s one reason real estate is a good investment in periods of higher inflation. A brand is a “wonderful thing” to own in inflationary periods, he says, referencing Berkshire-owned See’s. The value of the brand rises when inflation kicks in, he says.

Utilities and railroads, which of course are major Berkshire operations, require investments that rise in cost when inflation strikes. 

Key takeaways from Jamie Dimon’s Shareholder letter 2014

The banking system is a lot less risky compared previously

·         Higher capital level compared previously for most of the banks.

·         Highly liquid assets held by the banks

·         Not many complex and exotic products around

·         Higher underwriting standards

·         Many standardized derivatives are moving to the clearing houses.

Future threats to the banking industry will include

·         Ambitious large Chinese banks which has the scale and the strategic reason to compete and yet do not need to live by the same US rules that apply to the large US banks.

·         Silicon Valley companies such as lending club who is able to connect lenders and borrowers quickly.

·         Competitors in the payments industry such as Paypal and Bitcoin.

·         Cyber Security Threat.

Key changes to the banking industry

Non-bank competitors have become bigger lenders in the marketplace.

There is far less liquidity in the marketplace because of regulatory requirement resulting in low inventories of securities.

In the event of a crisis, banks are reluctant to extend credit because it utilize precious capital and in addition to the low liquidity in the market, hence the market in general could lead to increase volatility.