Why would anybody want to invest in independent oil and gas?

The current situation doesn’t make a lot of sense to me.  The management teams at these companies don’t give investors enough information to value the assets.  I think that investors would demand such information.  They should know the historical and projected decline curves of their company’s assets (for each basin the wells are in).  This is very basic information that investors need to perform their due diligence.

Another way of looking at it is to examine how a private market buyer would perform due diligence.  When an oil and gas company wants to sell its assets to private market buyers, it typically opens a data room.  I’m sure they provide a large volume of technical data far beyond decline curve data (e.g. reservoir models, data on porosity, pressure, 3-D seismic, etc. etc.).  Institutional investors and analysts simply don’t perform that level of due diligence.

The industry is a magnet for fraud

For the management teams, there are rewards for deceiving investors and virtually no consequences for doing so.  In situations like these, I expect fraud to be extremely high.  Most independent oil and gas companies inflate their reserves and make grand promises about the economics of their projects that have yet to deliver cash flow.  The industry has a very long list of companies that overpromise and underdeliver.

I think that the sector is very attractive from a short selling perspective.  I don’t think that the sector is interesting from a long perspective.  I don’t see the wisdom in investing in black boxes.  In my opinion, it is easier to find shorts in the sector than to find longs.

Similarities with mining

In both industries, there is a very high degree of uncertainty about the economics of the unextracted resource.  This allows promoters to overpromise without getting into trouble with the law.  Promoters, brokers, and investment banks are often involved in both industries.  The stock promotion dynamics are very similar.  It’s almost like they’re the same industry, even though the technology and the commodities are different.

Of course there are some small meaningful differences.  A mine in a developed nation normally takes 7-10 years from initial greenfield exploration to reach commercial production.  Oil and gas assets take a much shorter time to reach commercial production (typically a few years or less).

Because of this, oil and gas stock promotions tend not to last as long.  Eventually the oil and gas wells will come online (or don’t come into production on time) and investors will be disappointed.  I have a suspicion that oil and gas shorts are a little safer (though I’m not sure about this).  There are some oil and gas assets that legitimately take several years to reach commercial production (e.g. deposits that are stranded because the necessary infrastructure isn’t there, deepwater wells, oil sands mining, etc.).

Why would anybody want to invest in investment banks and insurers?

I would make very similar arguments about investment banks and insurers.  Many of them have derivatives that are incredibly difficult to value.  There are incentives for these companies to overstate the value of the derivatives book to generate “profits” in the short term.

Investors have no way of performing due diligence on a company’s derivatives book without knowing the details of hundreds or thousands of contracts.  I agree with Buffett in that “derivatives are weapons of mass destruction”.  Doug Dachille has an excellent presentation on Buffett’s love-hate relationship with derivatives that I’ve mentioned before on this blog.

Institutional investors

I don’t think that they really understand what they’re doing when they invest in oil and gas.  Hopefully I will be able to capitalize on the market inefficiencies that they sometimes create.  However, there is already a lot of  money shorting all of these same opportunities.  I need to be careful not to have too much exposure to crowded shorts.

*Disclosure:  I am still more long than short commodity stocks.  Almost all of my long position in commodity stocks is in Altius Minerals.

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2 thoughts on “Why would anybody want to invest in independent oil and gas?

  1. Pingback: How would a sociopath fleece investors in oil and gas? | Glenn Chan's Random Notes on Investing

  2. Pingback: Beating Wall Street in oil and gas | Glenn Chan's Random Notes on Investing

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