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Island Investing

Riffs, rants, and the upside of investing from way off Wall Street


Letter to Investors, September 2016

Below is my recent letter to investors in the Tarpon Folio, originally sent out on September 11th. You can view the original email here. And you can sign up to receive future letters here.

The Global Rebalancing is Here

Dear Investors,

The Tarpon Folio has returned 37.7% from January 1, 2016 through August 31, net of all fees. Over the same period the S&P 500 Index has returned 7.8%.

It has been a challenging time to be a value investor in the energy sector. The good news is that my being a stubborn fool seems to be working well for us. Thank you for sticking it out so far.

We continue to hold low cost-basis positions in sixteen energy companies that will benefit significantly as oil prices rebound.

Our companies operating in the Permian Basin of West Texas have continued to drive Tarpon’s outperformance. Our cost basis in Resolute Energy (REN) is $3.07 per share. Shares closed on August 31st at $16.91, representing a 451% gain. We have also seen a 594% return on our holdings of Clayton Williams Energy (CWEI), which we originally acquired for a weighted average price of $9.09 per share and which ended August at $63.11. Alas, neither position was a very large one for us in Tarpon originally, but we retain full positions in both companies today. All things being equal, both stocks should be ten-baggers for us at the peak of the oil cycle.

To be clear, we have owned a few duds during this oil cycle, too. The degree of difficulty when investing in small energy companies during the worst oil bear market in history has been considerably higher than I would normally choose to pursue…but, well, the potential gains have been that much higher, too. Fortunately, at this point, the difficult-and-duds have been jettisoned from the portfolio – some with extreme prejudice. But let’s just move along, shall we?

On The Permian

Analysts at Wood Mackenzie believe the Permian has larger recoverable oil and gas potential than the giant Ghawar field of Saudi Arabia. The Midland and Delaware basins of the Permian in particular “hold the largest number of undrilled, low-cost tight [unconventional] oil locations in the lower 48. No other region comes close.” Much of the capital in Tarpon is invested right there.

The geology of the Permian is unique. It consists of 3,000 to 5,000 feet of a dozen prospective oil zones, stacked right on top of each other. These “stacked pays” translate into dramatically lower costs to produce oil, making well managed Permian companies the most capital-efficient oil companies in North America. Over time, as technology continues to improve costs and extraction techniques, Permian players will steal market share from other higher-cost producers – both in the U.S. and abroad.

That said, we are value investors. We aren’t buying companies simply because they can spell Permian and plan to grow by constantly issuing new stock. The Street’s history of myopically rewarding growth above all else in the oil patch has created a number of extremely low valuations among the more disciplined of management teams. We are looking for the cheapest, safest exposure to the Permian we can find – run by management teams that emphasize internal economic returns over growth-at-any-cost – in order to maximize our own long-term returns.

The largest, most popular publicly traded Permian operators appear overvalued to me – in spite of the oil bust. In contrast, none of our Permian companies appear to get much respect at all from the Street right now, which I view as a good thing. But that’s a subject for another letter.

With reference to those two outperformers in Tarpon I mentioned earlier – two of Resolute Energy’s recent wells in the Upper Wolfcamp play in Reeves County, Texas, are now producing pre-tax, full cycle IRRs (internal rates of return) in excess of 100% at current oil prices. And that is just in two zones of what could be a dozen plays in the same stack. Clayton Williams Energy, historically a mediocre operator, nonetheless has 66,000 net acres of really good rock also in Reeves County, and is having operational discipline thrust upon them by a large private equity firm which has been buying up CWEI’s equity and debt. Recent transactions in the immediate area put CWEI’s landholdings well in excess of $100 per share.

On a look-through basis, an aggregated view of all Tarpon company holdings shows a clear, heavy and intentional portfolio weighting towards cheap, safe growth in oil production in the Permian. These companies should continue to be among the first to resume growth as oil prices rise – while either keeping their balance sheets stabilized and/or improving them.

We also continue to own companies operating in areas outside the Permian – including in Canada, the Bakken in North Dakota, and the Eagle Ford in Texas. I characterize these positions in Tarpon as low-to-no-current growth, but cash flow neutral. Despite a lack of growth of late, they own good-to-great rock that will drive attractive internal returns once their balance sheets are fully in order and as oil prices increase, at which point these companies can begin to grow intelligently – and at lower cost due to improved efficiencies, drilling processes and technology.

Our other companies outside the Permian should soon begin to appreciate significantly as well, assuming a sustained rebound in the price of oil is imminent. And I believe it is.

Stocks vs. Flows

I believe that there is a very high probability that the global oil market is currently balanced – meaning daily supply is meeting daily demand, right now in real-time. This pivotal development, however, is not being reflected in the price of a barrel of oil for a number of reasons.

The first is that the data that should confirm this balance is on a significant lag.

U.S. inventories and production data are delayed and revised for up to three months. Inventories in thirty-five other developed economies (“OECD” countries) are revised on a four to six month lag. OECD consumption data is published monthly, but global consumption figures are only published annually. Nobody has a good handle on monthly oil demand in small (“non-OECD”) countries – and that number could be meaningful at this point in the oil cycle.

Quick aside: a really interesting question right now is…never mind “balanced” – if the world was actually in a supply deficit right now, how would the market know?

Also, speculation in the “paper” markets could be temporarily masking fundamental shifts in the “physical” market by way of sheer volume. This one takes a little bit of explaining.

The “paper” oil market dominated by speculators dwarfs the “physical” oil market of actual oil producers. The volume of WTI (West Texas Intermediate) oil barrel contracts (1 contract = 1,000 barrels) is over 100x the volume of actual barrels of WTI oil that move through the Cushing, Oklahoma oil hub – and is more than 5x global supply. In other words, in the short-term, speculation can easily overwhelm longer-term fundamentals. Thus all these volatile short-term price swings.

To speculators, oil prices should be correlated most strongly to oil storage levels in the U.S. It’s “stocks” not “flows” that matter to the paper market – in other words, the level of inventories is of much greater interest than the supply/demand balance in the market. Speculators are incentivized to exploit arbitrage strategies (i.e. attempt to create risk-free profit) that right now seem to rely on importing low cost oil barrels in the U.S. – keeping oil inventories higher than might be expected – in order to then export it at significantly higher prices and profit.

Seasonal demand for oil in the U.S. is typically strongest in June, July and August – but the weekly headline numbers for inventory draws this summer, oddly, not only came in smaller than expected but culminated in a series of small increases in U.S. oil storage. This seemed all the more befuddling because oil was concurrently seeing very strong demand, and we saw multiple supply disruptions in the market this summer as well, from Canada to Nigeria.

So how in the world were oil supplies in the U.S. still building this summer?

Strong imports.

High oil imports in the U.S. – ostensibly driven by both speculators and refiners – painted a confusing picture in the paper market this summer. And those elevated levels of oil imports into the U.S. are obscuring more fundamental trends in the physical market, specifically in crude inventory withdrawal numbers.

Interestingly, the data seems clear that (a) a high percentage of oil imported into the U.S. this summer came from “floating storage” – ships that traders rent, fill with oil and temporarily park offshore in the pursuit of arbitrage – and that (b) those floating barrels are just about exhausted.

If you combine the drawdown in floating storage stocks this summer with reductions in oil inventories this summer in Saudi Arabia, Nigeria, Canada, Venezuela and Iran, you’ll come up with almost 80 million barrels of previously stored oil that is now gone outside the U.S. And that’s just from places that are easy to track.

So “stocks” or oil inventories are coming down throughout the world. “Flows” are slowing dramatically (see the footnote below). Once inventory stocks have reached an equilibrium point where global supply matches global demand, and oil no longer accumulates in storage, then the market price of oil will be less driven by the paper market’s obsession with near-term shifts in U.S. oil inventories, and global fundamentals in the physical market will resume their importance. And I believe that day is upon us.

The Rest of 2016

It is possible but unlikely that imports into the U.S. will continue to trend higher throughout September and October – a time when our refineries temporarily shut down to reconfigure for producing winter-blend fuels. And once fewer barrels are coming into the U.S. less than leaving, we will see oil inventory in the U.S. drawdown at a rate that will likely surprise many.

To reiterate – it is global fundamentals which drive crude oil prices in the long-term, not levels of oil storage in the U.S. The current persistent inventory surplus in the U.S., more recently due to the large scale movement of other people’s barrels into the U.S. to capture arbitrage and/or refining profit, is creating an impression of abundant global oil stocks while masking significant worldwide production declines.

The speculators’ obsession with the “stocks” view of high U.S. oil inventory levels is dominating the pricing of oil today. A fundamental view of changes in production “flows,” however, not only provides little analytical support for the speculator’s view – it eviscerates it by the end of 2016. As a result, I believe this will become obvious to both sides of the oil market in the next few months.

So while speculators, oil bears and shortsellers appear to be banking on increased storage builds in the U.S. during the refiners’ upcoming maintenance season, trading on simple seasonality may not work when re-balancing can occur in unpredictable ways, and especially now that U.S. producers can export oil.

If crude inventories in the U.S. could build this summer, then unwinding arbitrage trades on imported barrels this fall could completely flummox those who are ignoring the fundamentals. And that, too, would continue to be good for us.

In Summary

Based on my own tracking of global production “flows,” the world is currently in a deficit of approximately 1.2 million bopd – and headed lower – compared to a year ago. Demand, meanwhile, is up about 1 million bopd over the same period last year. All of which means that even if something miraculous happened – like that, say, Rhode Island suddenly starts producing 1 million barrels of oil per day – the world will still see a supply deficit of over 1 million bopd by the end of 2016.

The mainstream media and Wall Street continue to obsess about U.S. shale and OPEC. They are missing the bigger picture. Neither U.S. shale nor OPEC have any material additional capacity, and the 40 million barrels of oil per day previously coming to market from the rest of the world is in significant decline. The capex is simply not there to replace that declining production anytime soon. And the geopolitics of the Middle East continue to simmer on medium-high.

As a result, I continue to believe that the oil market is at serious risk of sleepwalking into a supply crunch in 2017.

When it comes to our own companies in Tarpon, I suspect the most near-term catalyst when it comes to further price appreciation is likely to be the current record high interest in shorting stocks across the sector. I believe the bears and shortsellers are dramatically overplaying their hand today. The primary question seems to be what exactly will convince them of that, too. I suspect that seeing significant drawdowns in U.S. oil storage during refiner shoulder season might finally do it.

Regardless, by mid-October, a more accurate global picture of supply and demand should become clearer to all – free of the noise caused by a massive shift of oil inventories into the U.S. this summer.

Signs of this are starting to emerge already, most notably in pricing curve signals like “fading Brent contango” – a narrowing discount between the price of Brent oil available for sale immediately and the Brent price six months out, which reduces the incentive to store oil. This signal in particular is probably the clearest indicator that the market is beginning to sense an end to the biggest oil bust of all time relatively soon. Another sign is apparent in a recent price hike by Saudi Arabia on oil shipped to the U.S. and Asia. The Saudi’s own oil inventories appear to have come down far enough, and they appear to not want their storage levels to fall any further while global demand is still very high.

Either way, it appears the tide is about to turn. Finally.

If I am right about the oil market being in balance already, then we will soon see oil prices begin to increase for an extended period of time.

If I am wrong, and the world is not currently balanced, or if for some other reason oil prices continue to wallow in spite of important fundamental trends, then the probability of that 2017 supply shock will increase materially. At some point it will become unavoidable. And though our gains might be deferred, they should still be significant.

In either case, our reaction will be the same. We will be patient and wait.

Please let me know if you have any questions.

Thank you.

– Cale


Much more relevant than market structure is market math. Other relevant facts from this summer supporting the conclusion the global oil market is currently in balance:

– By the end of June, Chinese oil production had decreased by 376,000 bopd compared to last year.

– In August, oil production in Colombia had fallen 102,000 bopd per day compared to a year earlier – an approximate 11% decline in a year, the biggest year over year (YOY) decline in its history.

– The hot mess that is Venezuela has seen its YOY production decline by at least 200,000 bopd.

– Nigeria’s YOY production is down at least 300,000 bopd.

– Mexico’s YOY production is down at least 100,000 bopd.

– In July, Russian production had fallen by 200,000 bopd – since just the first of this year.

– U.S. production is now down from the peak in April of 2015 by just under 1,000,000 bopd.

Each of the numbers above, without increased capex, will continue to fall into 2017. They appear largely unaccounted for in IEA projections. In addition, Brazil production is in decline; Petrobras now only has 10 rigs working offshore. The North Sea is in decline. Etcetera. I think you see the point:

Global production is falling significantly – all while inventories are being reduced by strong demand. That oil inventories in the U.S. have been too high for too long appears largely due to arbitrage and refiner incentives, both of which are (for oil bulls) problems that should soon take care of themselves.


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Read my original 82 page thesis on investing in select U.S. E&Ps (exploration and production companies) in the middle of the worst oil bust in modern history here.

Disclaimer: This post nor any of the material linked to herein in any way constitutes investment advice. Historical performance data above represents performance results as reported by the portfolio identified. Performance results are for illustration purposes only. Historical results are not indicative of future performance. Positive returns are not guaranteed. Individual results will vary depending on market conditions and timing of initial investment. Investing may cause capital loss. The S&P 500, used for comparison purposes, is significantly less volatile than the holdings of the funds listed. The performance data is net of all fees reflecting the deduction of advisory fees, brokerage commissions and any other client-paid expenses. The performance data includes the reinvestment of capital gains and dividends. The publication of this performance data is in no way a solicitation or offer to sell securities or investment advisory services.