Category Archives: Energy

why commodities companies overinvest, turning boom to bust

November 21, 2013 By in economics, Energy, Industry Analysis, Mining, semiconductor manufacturing, Strategy, Technology Tags: , , , , , , , , , Leave a comment

This is a continuation of my post from yesterday.

It may be that, as Chris Hackett suggests in a comment to yesterday’s post, that everyone has his head in the sand, not only commodities company CEOs and boards.  Maybe it’s some deep-seated psychological need to have the good times continue, or maybe a denial of the finitude of man, or…  Yes, commodities companies aren’t the only ones who extrapolate chiefly from the recent past in forecasting the future.  Nevertheless, I can think of three reasons why commodities companies feel most comfortable reinvesting cyclical cash windfalls back into new capacity in their primary business–even though that action itself inevitably triggers a cyclical downturn.

1.. It may be the best they can do.

Looking back at yesterday’s post, I think I was a little unfair in saying that there firms never think of diversifying.  During the first oil crisis in the early 1970s, all the big oils did diversify.  Gulf Oil bought the Barnum and Bailey circus (great job, Gulf; no wonder you got taken over); Mobil bought Montgomery Ward and Container Corp of America (both disasters); Exxon started a venture capital arm, which produced nothing of note.

Peter Lynch, of Fidelity fame, called this kind of move “diworsification.”  Ugly word, but an accurate observation.  Look at HPQ or Microsoft as other serial diworsifiers.

Of course, this is not really the best a company can do, either.  The firm could pay a special dividend to shareholders, but this sensible action rarely occurs to CEOs.  Reinvesting in a business they has some expertise in always seems to be the safest bet.

2.  Holding on to cash may be personally risky to a CEO, for two reasons:

–a cash hoard may make the company a takeover target.  Great for shareholders, not so much for the ego of a person who’s a demi-god to employees, but just a broken down old guy (albeit a rich one) if he loses his position.

–a sensible strategy would be to amass cash with the intention of buying assets on the cheap from semi-bankrupt competitors a couple of years after the cycle turns.  Suppose the cycle lasts longer than the CEO expects, however.  His profits are less than competitors; his company’s stock underperforms.  Maybe he’s ousted before he can act and his successor reaps the glory of making canny acquisitions.

Arguably you have more job security by staying with the herd.

3.  I can believe that adding capacity at or near the top of the cycle can make a perverse kind of sense under three (or maybe four) conditions.  They are the assumptions that:

–all attempts to diversify into other businesses will end in disaster,

–the company’s industry is in secular expansion, so that new capacity will be very valuable in the next upcycle,

–the company will be the first to add significant capacity, and will therefore have a year or two of supernormal profits from the new plant.   That will ease the pain of the downturn and put the firm in a stronger market position in the next upturn.

–(the, maybe, fourth)  even if a firm can’t be alone as the first to add new capacity, it should expand anyway.  This extra industry capacity will at least foil rivals’ plans to cash in big with their expansions.  Yes, the downturn will come earlier than otherwise, but the present market structure will be preserved.  A bit Machiavellian, and maybe giving undue credit to guys who think buying the circus is a great idea.  But it’s possible.

My bottom line:  long-cycle commodities, epitomized by base metals mining, are a true boom and bust industry.  As such, they’re a value investor’s dream come true.  For the rest of us, if we want to play we have to be in the uncomfortable position of buying when the stocks are very beaten down and it seems all hope is lost.  If you’re not accustomed to thinking this way, picking the right point to buy will be very difficult.  In any event, that point is not today.

the decline phase of the base metals cycle–where we are now

November 20, 2013 By in Energy, Industry Analysis, Mining Tags: , , , , , , 1 Comment

I started my career as a securities analyst as a generalist.  I covered companies in the oil and gas, utilities, and electronics industries as I learned the trade.  After I’d been working for a few months, our oil analyst was headhunted away and–poof!–I was the new oil analyst.  That reoriented my progress for several years much more toward natural resource companies.

One of the more peculiar ones I encountered as I expanded my coverage was Moore McCormack.  A conglomerate, Moore McCormack was originally a shipping firm but had expanded into iron ore and coal mining, cement, and oil and gas drilling.

On the theory that most things happen for a reason–no matter how hard it may be to see the rationale from the outside–I asked the CFO how the company had evolved in such a singular way (I was thinking “into such a ragbag of sub-scale commodities businesses” but phrased my question differently).  He told me that Moore McCormack deliberately specialized in holding long-lived assets that required large amounts of up-front capital investment and where the firm was essentially a price taker.  In other words, it specialized in commodity mining and shipping.

Why do this?  …because, he said (incorrectly, as it turned out), the key to success in these business lines was how the capital investment is financed.  And Moore McCormack was an expert in financing.

The company dissolved during the Second Oil Crisis of 1978 and the ensuing recession.  It couldn’t survive the sharp shrinkage of cash flow in all of its business lines caused by the ending of an almost decade-long commodities boom and the economic downturn that accompanied/intensified it.

How did this happen?

The base metals industry–shipping, too–is extremely cyclical.  But each cycle lasts a decade or so, much longer than an ordinary business cycle.  A boom begins when garden-variety economic growth expands to the point where demand for metals exceeds available supply.  Fabricators need more copper for construction or  iron ore for steel car bodies than existing mines can handle.  Or, say, the developed world is using more petroleum than the existing fleet of tankers can carry.

Because it may take five years to open a new mine, or a similar span of time to get a new cargo ship from the yards (a year+ to build, a four-year waiting list), the only way a user can get the commodity inputs he needs is to bid them away from everyone else.  So prices go through the roof.

But commodity producers in general, and base metals firms and shippers in particular, are like lemmings.  Everyone is making money hand over fist; everyone plows the cash into expanding capacity like there’s no tomorrow.  No one puts much cash away for a rainy day; no one diversifies sensibly.

Then–several years, maybe half a decade, into the boom–the first new capacity begins to enter the market.  Prices begin to flatten.  Then a cascade of new output comes online–much more than anyone can possibly use.  Commodity producers frantically put as much of their expansion on hold as they can.  But it’s too late.  Prices sag.  Cash flow shrinks drastically.  And the industry waits for world demand to grow big enough to create demand for all the new capacity there is.  The bust lasts maybe another five years.  And then the cycle begins again.

For base metals, we’re in the decline phase now.  I don’t have any idea how long the current period of weakness will last.  But I don’t think the turnaround is any time soon.

To me, the interesting question is why managements of companies in long-cycle industries exhibit the same imprudent behavior cycle after cycle.  Don’t they know their own industries?  Don’t they remember what happened last time around?  If they do, they somehow convince themselves that this time will be different.

More on this tomorrow.

A side note:  Moore McCormack thought it was diversified, even though it recognized that all its divisions had the same economic characteristics.  Sort of like thinking a balanced meal consists of several different flavors of ice cream.

thinking about big integrated oils

May 28, 2013 By in Capital-intensive firms, Current Market Thoughts, economics, Energy, Industry Analysis, Recent Market Action, Strategy Tags: , , , , , , , , , Leave a comment

hedge funds attacking Big Oil?

Over the weekend I read a blog post (which I can no longer find) in the Financial Times pointing out that activist investors are getting set to attack the large integrated oils.

Why?  

They persist in investing in massive long-term, risky, low-return oil exploration and development projects.  It’s what they do.  In the view of the hedge funds, this makes no sense.  The oils would be better off finding better things to do with their cash flow, returning it to shareholders if nothing else.

I doubt that this will happen   ..not that hedge funds may not try to change oil company investing plans, but I don’t think they’ll be successful.

Big Oil is important in developed countries because the companies spend a ton of money securing access to petroleum.  Nations are heavily dependent on oil to fuel industry.  The oil firms get huge tax breaks for finding and developing oil deposits because these nations are heavily dependent on oil to fuel commerce and for heating.  This is especially true in the US, which is unique among richer nations in not responding to the oil shocks of the 1970s by taxing oil to control consumption.  We do this to support our globally non-competitive, but politically powerful, auto industry (most of which went bankrupt in the Great Recession anyway).

Given the strategic importance of oil,

why are the returns to oil exploration low?

A generation ago, they weren’t.  Drilling took place mainly in the developed world, often on parcels leased to the driller by the government.    The landowner got an initial payment plus a modest percentage of any finds.  Projects that made good economic sense when oil sold for $7 a barrel are bonanzas today.  Big Oil got most of that.

In contrast, major exploratory drilling today is done in emerging economies, where the big untapped pools of oil are.  But ever since the first nationalizations of drilling projects in the Middle East in the 1970s showed how one-sidedly favorable production agreements were to the oil majors, terms have been tilted much more heavily toward the host nations.  Today’s production agreements provide little more than a specified return on capital to the oil explorer.  Price hike windfalls go to the host, not the big oil.

In the face of less favorable economics,

why continue to drill?

Three reasons:

–it’s still profitable

–it’s what the oils do best.  The last round of oil company diversifications, admittedly a long time  ago, were unmitigated disasters, and

–the home countries of the major oils need a steady supply of oil to keep industry humming and citizens warm in winter.

It’s this third reason that I don’t think activists see.   

At some point, shale oil may change the situation.  Even so, I figure it would be politically unacceptable for any big integrated to dismantle, or even substantially curtail, its exploration and development efforts.  The worry would be that in times of shot supply, oil would go solely to project developers.  In fact, Asian countries are concerned about this possibility that they’ve designated their big oils as “national champions,” whose job is to secure oils supplies for the home country.  Profits are secondary.

I don’t think Washington, or London, or Paris would allow its oil exploration firms to drop out of the race, even if short-term economic returns to the companies and their shareholders might be better if they did so.

 

 

lower oil prices: stock market implications

June 29, 2012 By in economics, Energy, Industry Analysis, Recent Market Action, Refining, Stock ideas Tags: , , , , , Leave a comment

falling crude oil prices

It late February, the West Texas Intermediate oil price was $110 a barrel.  Now it’s $80.

North Sea Brent crude, which is much easier to refine and therefore sells at a premium, was at $120 four months ago.  Now it’s at $92.

That’s a price drop of around 25%, even though June is seasonally stronger period for demand than late winter.

That’s good news for consumers, especially in the US.

Here’s why.

a thumbnail sketch of the oil market

Petroleum is a peculiar commodity, for several reasons:

–huge size.   The world uses around 80 million barrels daily.  At the current $80 each, that’s $6.4 billion a day in value, or $2.3 trillion a year.

–disproportionately large consumption by the US.  The US makes up about 4.5% of the world’s population–but uses over 20% of the global oil output.  How so?  It’s partly because the US is a rich country.  But it’s mostly, in my view, the result of long-standing (and misguided) policy in Washington to subsidize an inefficient domestic auto industry.  (We’re the only industrialized country without an effective energy policy, and we’ve been like this for forty years–but that’s a topic for another day).

–supply is very inflexible.  Most pools of oil are buried under great pressure deep beneath the earth.  Draining these reservoirs without drilling a gazillion wells in each is a complex process that involves starting–and keeping for years and years–a steady flow of crude from all parts of the field toward the surface.  In almost all cases, stopping, or even trying to slow down, the flow can be disastrous.

As a result, when demand slows, as it is now, the only way producers can sell their surplus output is to lower the price–sometimes by a lot.

implications of falling prices

There are two major ones for stocks:

1.  Most oil (and natural gas) companies make the bulk of their money from developing oilfields and selling the output.  Lower prices translate directly into lower profits.  There may be different shades of bad, depending on whether the producers own the oilfields outright or have production-sharing agreements with third parties.  But it’s not good.

The one exception is companies that whose business is completely “downstream, ” that is, who refine and sell petroleum products, especially gasoline.  They’re buyers of crude oil, so their margins may expand as prices fall.  Ultimately, though, competition forces them to pass on almost all their lower costs to customers.

2.  Falling oil prices are a boon for consumers, particularly in the US.  Sustained over a year, a $30 per barrel reduction in the oil price means an extra $1,700 in spendable income for the typical US household.  That’s the equivalent of a 6%-7% pay raise.

think modest

That’s not enough for the Porsche or the Tiffany tiara you’ve been eyeing.  And the extra income won’t be particularly noticeable to the affluent.  But it will be an important boost, I think, to the everyday buying of ordinary Americans.  So Wal-Mart and Disney (I own DIS) should benefit.  Generally speaking, average citizens should continue to feel better about their economic circumstances, even as the economy shifts into a lower gear (is there one?) and job growth slows.  So retailers who sell low-ticket items should have the wind at their backs.

question from a reader: the merger of Alpha Natural Resources and Massey Energy

September 26, 2011 By in Current Market Thoughts, Energy, Industry Analysis, Private equity, Stock ideas, Uncategorized Tags: , , , , , , , , , , , Leave a comment

the question
24.149.88.16

I listened to a debate recently on the merits of small commodity companies
acquiring larger ones. The company in question was Alpha Natural Resources purchasing much larger Massie Coal.
Can a smaller commodity company like ANR actually make the investment finacially feasible when they bought a company that was already foundering?
I enjoy your blog greatly!

my thoughts

At the outset, you should be clear that, although I’ve done extensive research in natural resources over the years, I don’t know much about the coal industry. So personally I don’t know enough to want to buy ANR stock.  But I can see several issues a buyer might want to explore.

background

ANR, which has private equity roots, was formed in 2002 to buy assets from Pittston Coal and has since growth by acquisition.  Its largest purchase to date is Massey Coal, a 2000 spinoff from Fluor.  It bought Massey in June 2011 for about $1 billion in cash plus just over 100 million shares of ANR stock, worth $5 billion+ at that time.

By revenues, both are roughly equal in size.  Mine output seems to be similar as well, with 5/6 thermal coal for power generation and 1/6 higher-value coking coal for blast furnace steel making.

Massey is the owner of the Upper Big Branch Mine in West Virgina, which experienced the worst domestic coal mining disaster of the past forty years on April 5, 2010.  A methane gas explosion there killed 29 miners.

Since the Massey takeover, ANR shares have lost about 60% of their value.  Part of this is due to general selloff of commodity stocks on worries about economic slowdown, part to former Massey shareholders cashing in their profits, part to ANR’s announcement in September that sales volumes will be lower than expected.

merger issues

My experience is that there are two types of risk in a merger like this:

–Are Massey’s safety problems confined to this one mine, or has that company been cutting corners to increase profits of other mines as well?  Certainly, industry gossip may provide clues.  But until ANR actually analyzes the Massey properties one by one in detail, it won’t know for sure.  Aside from the human issue, the question is whether ANR will have to make substantial capital investment to get the Massey mines functioning properly.  In other words, are the Massey properties actually less profitable than they appear to outsiders?

–Does ANR have the management depth to run an enterprise twice its former size.  It may be able to rely on the former Massey management.  But suppose they just refuse to do what ANR wants?  Sounds silly, but culture clash is a significant risk.  The risk going in is much higher when there’s evidence of badly-run operations.

In addition, is the ANR management composed of deeply knowledgeable and experienced coal miners?  …or is it basically a financial company doing a “rollup,” that can make generic efficiency improvements but entrusts the actual operation of the business to others?  I don’t know.

–One positive thing.  The combination was done mostly for stock.  So increased financial leverage isn’t a risk.

specific questions

A quick look at Value Line shows that ANR achieves only about half the operating margin of the VL coal industry.  Why?

My guess is that coking coal may be as much as a third of ANR’s profits, although only about 1/6 of volumes shipped.  At least some of that goes to China.  If so, have recent profits been inflated by flooding and transport problems in Australia?  How long will that advantage last?