Never Will I Ever Buy a Commodity Stock That’s Not a Low Cost Producer
Energy investors lost billions when oil crashed in late 2014, but those who bought in to well-managed low-cost players have, on the whole, seen a lot less pain than those who bought in to high-cost producers like Linn Energy and Breitburn Energy Partners.
It’s Never Will I Ever week on Industry Focus, and in today’s Energy episode, Motley Fool analyst Sean O’Reilly and contributor Jason Hall explain why they’ll never again invest in non low-cost commodity producers in the oil, steel, or any other commodity industry. Tune in to find out why the cost of production is so critical for commodities companies, some of the best low-cost producers in oil and steel, and more.
A full transcript follows the video.
This video was recorded on July 13, 2017.
Sean O’Reilly: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. Today is Thursday, July 13th, 2017, so we’re talking about energy and industrials. I’m joined today by phone all the way from Thousand Oaks, California by one of The Motley Fool’s exceptional contributing investors for the energy and materials space, Mr. Jason Hall. Good morning, Jason! How’s it going?
Jason Hall: Good morning, Sean. Things are fantastic. How are you?
O’Reilly: Very well. I have to congratulate you once again on your recently minted dad status.
Hall: Thank you very much. It’s been a lot of change, very little sleep, but well worth the experience so far, no doubt about that.
O’Reilly: I’m sure you’re going to crush this thing.
Hall: [laughs] I’m learning a lot about myself, and being humbled every day.
O’Reilly: That’s parenting 101 right there. Jason, many of our listeners may not have heard of you, but you’ve had a heck of a Foolish investing career. You analyze companies in the space, energy and industrials, you dip over to technology and consumer goods occasionally. You write about them for fool.com full time, you’ve met with industry bigwigs like T. Boone Pickens, Tesla co-founder Ian Wright, Clean Energy Fuels CEO Andrew Littlefair, and you interviewed them for The Fool, there’s videos up. There’s even a rumor that you were the left shark in the Superbowl in 2016, can you comment on that?
Hall: I’m not sure who started that rumor, but I’m approximately a foot taller than left shark. I’m going to have to shoot that one down.
O’Reilly: OK. In any case, I can’t thank you enough for calling in today. Thanks for your time.
Hall: Thanks for having me! I’m really excited to be on today.
O’Reilly: Jason, this week, I don’t know if you’ve heard, is Never Will I Ever week on Industry Focus. It’s where we dive into something that we will never do again with our investments, perhaps because we’ve been burned in the past, or maybe just philosophically it doesn’t jive with us. Our sector kind of lends itself pretty easily to this theme. I was immediately like, obviously, a commodity stock that isn’t a low-cost producer. Once I chose this theme, you were the obvious choice. I can’t count how many hours we’ve talked on Slack and stuff about the commodity space, the cost advantages and disadvantages of producers. You’ve taught me a lot over the last two years, so, again, thank you for calling in.
Hall: Absolutely. I think this also lends itself incredibly well because, especially when you’re talking about investing in commodities, something that Charlie Munger has talked about with Warren Buffett and with the success at Berkshire is, so much of their success is things that they’ve said no to. I think this is an industry and a segment of investing where the things that you say no to are going to guide 90% of your success.
O’Reilly: For sure. I’m going to suggest we do this in two sections. First, I want to talk about why owning a low-cost producer is so important in commodities. Maybe provide a few examples as cautionary tales. There are lots, way too many.
Hall: Especially over the last two years.
O’Reilly: Yeah. [laughs] Then, we should probably get into some true low-cost producers, exemplify why it’s really the only way to fly when it comes to commodities. Tons of examples, probably way too many than we could possibly cover in 20 or 30 minutes. But, I’m curious, what’s your favorite non-low-cost producer tale that did not end well?
Hall: It’s a personally painful one. If you go back to $100 oil in 2014, mid-2014 is when the slide started, and at that point, oil was still trading well over $100 a barrel.
O’Reilly: Thanksgiving Massacre.
Hall: Ugh, it was painful. I had actually purchased a small stake in both Breitburn Energy Partners and in Linn Energy.
O’Reilly: For our listeners who don’t know, both of those companies have not gone the way of chapter 11.
Hall: Right. There’s going to be a future for their assets, and that sort of thing. But in terms of us common investors, it was basically a complete loss. The short version is, both of those two partnerships, MLPs, an interesting structure that allows for big cash flows and dividends and that sort of thing. At $100 oil, it’s a great way to make money, to get dividends from oil producers. The problem is twofold. Neither of these two producers were exactly on the lower end of production costs, they were somewhere kind of in the middle, which is fine when oil is triple digits. The problem is, because they paid out so much of the cash flows in dividends and didn’t build any margin of safety, they were left swimming naked when the tide went out. The bottom line is, a lot of investors lost billions of dollars simply because these weren’t low-cost producers, and also, the way they managed their capital left them big-time exposed when the low-cost producers flexed their muscle and OPEC kept production high and drove prices down. And there you go, a cautionary tale right there. Two companies that were great when prices were high, but as soon as prices fell, they were devastated.
O’Reilly: I don’t think you could have picked a better answer, because it lends itself to so many offshoots. The first thing that pops into my mind is, one, I have to admit that I, too, had a Linn-Breitburn sad experience. But, they’re MLPs. Really, it’s basically the same deal as a REIT, a Real Estate Investment Trust kind of thing. They are granted tax advantages. They do not pay corporate federal income tax. If you go to Microsoft’s income statement or something, it’s like 35%, this is a chunk of change.
Hall: It’s a significant amount of cash flow efficiency that they gain.
O’Reilly: But there’s a rule. 90% of profits need to be paid out as dividends, which of course —
Hall: I don’t think that’s true for MLPs. I know REITs have to, but I don’t think MLPs have to.
O’Reilly: It’s not 100% the same. It’s a different sector. But it’s a weird thing called distributable cash flow, or cash from operations, or something.
Hall: There’s absolutely an expectation with MLPs. The whole benefit of the structure is being able to distribute cash, that’s the bottom line. It does not lend itself well to the producer side of the business, there’s no doubt about that. It sounds fantastic, but it hurts.
O’Reilly: It worked for a while, because you not only had an increasing share price, but you had this 10% dividend yield, and it was like, oh my gosh, this is awesome. But, the only way you expand, the only way you grow that dividend, the only way you grow that production of oil, if you’re one of these MLPs —
Hall: Leveraging the balance sheet.
O’Reilly: Yeah, issuing debt or equity, man. The share counts of all those guys went up every year. Debt went up. It requires capital to keep the party going.
O’Reilly: The other thing that I notice in retrospect, and I’d actually love to get your thoughts on this, you were talking about how these guys weren’t the low-cost producers, they’re at the middle of the range, or whatever. Their models, they weren’t traditional Harold Hamm type, “I’m going to find oil in this place that nobody’s found oil before.” They literally just issued debt or equity and then just bought assets from other companies.
Hall: Right, especially Breitburn, that was the interesting thing about their model.
O’Reilly: They would buy slightly older wells, basically, right?
Hall: Yeah. They were buying wells, they were buying traditional, they weren’t in the shale business at all, they’d buy traditional wells that were on the back end of their decline curve. They would use technology, some different injection technologies, to pump up production, but it just wasn’t particularly cheap. It’s not like shale, where innovation and drilling technology has helped. EOG Resources (NYSE:EOG) is an example, it’s one I know that you like that’s a super low-cost producer, great balance sheet. They’ve leveraged technology and done a better job of developing wells to drive costs out. Whereas, you have Breitburn, they’re buying wells that are already there, and it’s kind of the last puff off the cigar.
O’Reilly: Right. You mentioned EOG there. This was over a year-and-a-half ago now, but that was my first low-cost producer oil stock that I wrote about when I was learning about the space, this was when you and I started talking. But, EOG was kind of a happy accident, because EOG stands for Enron Oil and Gas. It was literally this castaway that Enron didn’t want because they were making so much money cooking the books — I mean trading. [laughs]
Hall: They were making it look like so much money.
O’Reilly: Right. They literally just cast away of all this land in West Texas down in the Eagle Ford shale play, it’s actually southern Texas that nobody wanted. They actually left and they got 632,000 acres of oil leases down in southern Texas that nobody wanted until shale technology was advanced, and then it was like, “Oh, wait a minute, we can make tons of money.” Their cost to production is like … I think their acquisition cost, their “acquisition cost,” we’ll talk about this later, was like $10. It’s insane. And it’s a happy accident, but it’s definitely not the Linn-Breitburn scenario.
Hall: No, not at all. They were one of the first innovators in the whole shale thing, and that Eagle Ford play, back when that was hot stuff. Now they’re a big player in the Permian, which is some of the cheapest shale oil in the world, and incredibly plentiful. And it’s not just production their production cost, that’s huge, it is a huge advantage to be on the low-end side of the cost scale. But it’s also management that has allocated capital well, and kept a solid balance sheet, right?
O’Reilly: For sure. You mentioned the management. EOG has a heck of a team. The thing I’ve noticed, because we did a bunch of prep for this show, the thing I’ve noticed with that in the last couple years is, a really good sign of a non low-cost producer in the commodity space is balance sheet gains.
Hall: Yeah, absolutely.
O’Reilly: You look at EOG or a Pioneer Natural Resources, their income statements are incredibly boring, to be honest with you. It’s like, nothing going on. [laughs]
Hall: Right. This is an industry that you want a boring balance sheet in.
O’Reilly: Amen. Do you have anything popping in your mind about, other than oil, any other commodity?
Hall: Yeah. I followed the steel industry relatively closely. It’s a little bit different than oil, but in a way, it’s not as different as it used to be, because one thing we haven’t mentioned with oil is that the true low-cost producer is still OPEC. You have Saudi Arabia with oil fields that are single digit cash production costs.
O’Reilly: The estimates I’ve seen, it’s like $8, it’s insane.
Hall: That’s the real gorilla. Even when you can produce $12-15, there’s still somebody who can produce it a lot cheaper. Again, oil is different because the international trading. However, steel, historically has been a pretty domestic industry just because of the cost of shipping and all that sort of thing. But even that’s changed over the past few years, where you have Chinese steel makers and Indian steel makers producing huge quantities of steel and then dumping it in the U.S. markets. There’s actually been a huge problem in the past few years of that industry, because it’s illegal dumping that’s being subsidized by the Chinese government, the Indian government, or whatever government that steel producer is. And that’s really hit steel prices in the U.S. when demand has been really high. And it certainly hurt the steel producers that haven’t been on the low end of the cost profile.
If you look at steel, low-cost producers, you have Steel Dynamics and Nucor, they’re generally the low-cost producers in the U.S. If you look at their returns compared to U.S. Steel and AK Steel, which are more on the high-end —
O’Reilly: Or lack thereof, when you’re talking about returns.
Hall: [laughs] Right, exactly. If you look at the returns over the past decade, for example, it’s remarkable. U.S. Steel’s stock is down some 90%. Since the bottom of the recession, early 2009, Steel Dynamics’ stock is up like 500%. So, incredibly different levels of returns. And what it boils down to is the way that they make the product. You have Steel Dynamics and Nucor that utilize these mini-mills which give them not just low production cost but also a lot of variability. And that’s huge when you’re in a cyclical industry where demand can really move a lot up and down between the peak of the demand cycle and the race to the bottom and the peak back up. The ability to scale down your production and bring your costs down is huge, absolutely huge. So, you have these other guys running these big blast furnaces, and they can make a ton of money when the industry is at its peak, but it’s only going to be at the peak for 10% of the time, and then they lose money for years trying to bring their production costs down. It’s kind of the same way. There’s technology, and they can manufacture products that have better margins and that sort of thing. But there’s only so much benefit you can get from that when your cost scale gets in the way. It’s exactly the same situation when you look at an industry like steel making, where you’re manufacturing a good, but still it’s a commodity cost, and demand for that commodity is still driving the price.
O’Reilly: Jason, we’ve been hating on the non low-cost producers in oil, steel, and structurally, philosophically, I think that probably applies to every other commodity producer. If our listeners want any more on this literally go to Warren Buffett name brands consumer advantage. It’s endless. The bottom line is, you don’t know the difference between somebody else’s oil, you know what I mean?
Hall: Right, exactly. It’s a true commodity.
O’Reilly: That being said, there are some awesome companies, awesome stocks, and awesome low-cost producers in the commodity world. Any popping into your head right off the bat before we dive into this report we found?
Hall: I mean, EOG and Pioneer are two. We’ve already mentioned that they do a tremendous job. They’re in the right place, they’re in the cheap plays, their management does a consistent job of adding assets in those cheap plays. They go about growing the smart way, and keep their balance sheets clean, so they really gain the most returns on equity and returns on invested capital, because of the fact that they are smart about how they leverage those cheap low-cost assets that they do have.
O’Reilly: Yeah, you look at a Pioneer, I can’t believe how bulletproof these guys have been. You mentioned the Thanksgiving Massacre, when OPEC refused to cut production, November 2014. That summer, Pioneer topped out at around $220-230 a share. And it’s come back a bit, but it’s still rocking at $160. You take a look at their cash flow statement, they’re actually expanding production right now, but 2015, they were $10 billion free cash flow positive. This is crazy.
Hall: I think it’s important to remind listeners, too, that oil is in the $40s now. It’s still well down. But early 2016, we were in the $20s. So, considering where we were at the bottom and where we are now, it’s remarkable that these companies have — here’s how strong their advantage is. They’ve been able to continue to perform well and they’ve grown production. That’s huge.
O’Reilly: Absolutely. I do need to correct myself really quick, I had the wrong window pulled up. They were cash flow breakeven in 2015. But, you look at the last 12 months, I have Capital IQ pulled up here for Pioneer Natural Resources, free cash flow break even in this world that we’re living in with $40-45 oil, it’s amazing that they’re able to do this.
Hall: Right. You could probably count on two hands the number of every producer in North America that’s doing that right now.
O’Reilly: Actually, funny you mention that because I have the list right here. For our listeners, you were good enough, Jason, to send over, Ernst & Young, the accountants, every year they put out this oil and gas reserves study report. They do it once a year, you can go to www.google.com and type in Ernst & Young U.S. oil and gas reserves study 2016 and get this for free, it’s a PDF. They break it all down. This list is basically a list of all the stocks that have held up these last two years. You have Anadarko, you have Apache, Breitburn is on there but that’s one of the bad ones. Do you think these guys just got lucky with where they bought the leases? What do you think the difference is here?
Hall: I think it’s two sides. To a certain extent, when it comes to the assets that they start with, there’s a little bit of luck there. But then they find something and they start adding to it, once they find out, “There’s a ton of oil here, let’s get it out cheap.” But where it’s not luck, and this is the big thing, is how the people that run these companies allocate capital. Let’s go back to the Linns and the Breitburns, where those companies have failed is, they gave all their money back to shareholders. Which is great, and you want companies that can do that. But, for a commodity company like an oil producer, to not retain capital, to buy those assets when you find them on the cheap and to have to use leverage, or to have to issue equity to do it, that’s a huge difference. So, it’s twofold (unclear 20:49), because they have the management that have been smart about how they’ve retained capital so that they can invest when they find those cheap assets to grow volumes. You see what I mean? It gets back to good management, it really does.
O’Reilly: Yeah. Ernst & Young lists basically every company in the sector, they have this proved reserve acquisition cost structure, and they do it on a per-barrel basis. Even Chevron right now, they have them listed at $24.58 per barrel. You have Approach at $9, Continental Resources at $42, that’s a fun one. But, EOG, $10. $10 a barrel. Blows the mind. Mr. Hall, you get the last word. Never will I ever buy a low-cost commodity producer. Any other disclaimers, reasons why you should break the rule, maybe?
Hall: I’m going to say, only if it’s a situation where it’s an incredibly strong balance sheet, and the management has a proven track record of operating well across different cycles of the industry. But I think in general, if you’re going to buy a company that’s in the commodity business, and you’re not buying something on the low end of the cost scale, you’re eventually going to get burned, because eventually prices are going to fall and the company is not going to do well.
O’Reilly: Got it. And one of the major red flags is balance sheet gains.
O’Reilly: Very good. Mr. Hall, we’re going to get you back to your family. Thank you again for calling in. I want to do this again soon.
Hall: Absolutely, I’ll be on anytime you’re willing to subject your listeners to my voice.
O’Reilly: You bet. I’ll talk to you soon, Jason.
Hall: Great. Cheers, thanks. Fool on, everybody!