Taking More Exposure To Oil With NADL
March 30, 2015
Last Wednesday, right before the market closed, I initiated a small position in North Atlantic Drilling Ltd (NADL). I apologize that it has taken me so long to post about this purchase. Readers who have signed up for free email alerts got a notice the next morning informing them of my decision. As always, the full Value Focus Portfolio is at the bottom of this page.
Before I get into the reasons for this purchase, I wanted to give new readers a quick recap of where I am and how I got here. After starting a fairly successful investment management career, I became addicted to alcohol and lost everything. Some time later, I found myself surrendering to God's will for my life by going to a place called The Foundry. While there, I had no idea what I would do professionally once I left. However, I was pretty well convinced of one thing. My investment management career was long gone and never coming back. I saw no way for that to change.
Then another believer comes along and mentions the idea of doing an investment newsletter. I immediately was drawn to the idea because I really enjoy writing. I also thought doing a Christian investment newsletter would be a great way to share my faith and honor God with my work. My motives were far from selfless. In fact, they were pretty jacked up at times. But God's spirit showed me that, so I asked God to purify them. I asked him to write the story of Wisdom's Reward for me. I didn't even come up with that name, nor did I like it because I thought it would come across to people as though I were promoting my own "wisdom". But again, I'm not writing the story. Basically, the way I see it, I am an actor in a play being written and directed by him.
But because it's not always immediately clear what God would have me to do, I still bring my own views and experiences to the table. During my time working in investment management, I had come to a pretty firm conclusion that the only equity strategy that made sense for serious investors was to seek out companies with sustainable competitive advantages and long track records of increasing dividend payments. Then, I believed, investors should buy them only when they were being offered at an attractive value in the market. I still believe that is a very prudent and wise strategy. So, I started out writing about attractively valued stocks with a nice track record of increasing dividend payments.
After a series of unexpected events led me to the point of managing a family member's portfolio, I began sharing that portfolio with readers. Then, I believe strongly that God began leading me to step out of my comfort zone and begin taking greater risks. So, I did that. Up until now, it has not worked out the way that I would prefer. But God has been holding me by the hand and leading me the entire time. He continues to assure me that I can trust him. He continues to tell me to wait upon him. He assures me that he has a plan, and that his timing is perfect. So, I wait for him to provide results. But that doesn't mean I sit around doing nothing. I still have to work hard. I still have to stay as informed as possible. I still have to make decisions every weekday about whether to buy, sell, or hold, which stocks, and in what amounts.
In the case of oil stocks, I believe strongly that there is more pain to come. However, I recognize my own limitations. Also, like most human beings, I suffer from what Howard Marks calls FOMO risk. FOMO stands for "fear of missing out". Believe it or not, it's actually a real risk. Investment portfolios are typically set aside for some specific purpose. If you bury them in the ground (i.e. leave them in cash) or take very little risk, then your real risk becomes that you fail to generate adequate returns. When I think about the risk of being invested in oil and oil related companies at today's prices, it's a risk I'm comfortable taking. We may not be at the bottom for oil related stocks, but certainly we are on the low side for many of them.
Still, I also can look and see crude inventories continuing to build. I see risk that production will not drop for some time, and may in fact continue climbing. I tend to want to profit from my views. So, I'm torn between taking exposure to the oil space at what will almost certainly prove to be attractive prices (at least in many cases) versus waiting until it gets to a point where prices are so low that risk is almost completely gone (in terms of taking diversified equity exposure to the space). The problem is, there is no way to know for sure if prices will get that low. There's no way to know for sure if there is another leg down for crude prices. There's no way to know for sure if crude prices will linger at these low levels for an extended period.
Therefore, I have decided to start taking exposure as I find good opportunities. Right now, I see NADL as a good opportunity mainly due to its very depressed share price that came via indirect exposure to the price of oil, but also due to its status as a "special situation". The situation is special because NADL is being priced as though it has a very high risk of default. However, NADL's creditors recently received a guarantee on NADL's debt from its parent company Seadrill (SDRL). Further, SDRL already owned more than 70% of this company's equity. It seems pretty clear to me that SDRL doesn't plan to let the value of that equity drop to zero without putting up a fight.
Let me back up and say that the offshore drilling industry was suffering from oversupply before crude prices started dropping. Though, that wasn't necessarily true of harsh environment rigs, which are a very small and very specialized subset of the industry. Still, this is an industry that had plenty of problems before the crash in crude prices. There are also plenty of new rigs under construction. There are certainly no guarantees in this space. But, there is also a very large number of very old rigs still operating. It seems logical that a very large number of those rigs will be scrapped in the near future. But no one caves in without a fight, so the market could take a considerable amount of time to find balance.
Further compounding the problem, NADL has a lot of difficulty that is specific to its strategy. I would suggest reading the company's last three earnings call transcripts to get a good sense of what has been happening with the company. There is no need for me to rehash all of it here in detail, but I will try to give a quick synopsis. NADL operates harsh environment (think freezing cold North Atlantic and Arctic waters) rigs and drillships for large oil companies. If crude prices stay low for an extended period, E&P companies may stop exploring for oil in harsh environments, considering that the average cost of oil from those environments is very high. Lingering low crude prices would mean demand for NADL's rigs would dry up in the near future. Since they have major debt obligations, that presents a major problem for them. Last, but certainly not least, NADL had planned to do a lot of business with Russian oil company, Rosneft. They struck a deal prior to sanctions being imposed, which means that the deal would have been exempted from sanctions. However, the deal appears to be falling apart anyway with the drop in crude prices causing pretty much all Russian oil related entities some serious pain. So, in a lot of ways, this is almost as contrarian as coal. If someone were to ask me, where do things look the absolute worst right now? I, and most investors, would probably have to respond with coal, arctic oil exploration, and Russia as three of the top five. The offshore drilling industry might even make the top 5 itself. So, as always, there are good reasons that investors have run for the exits in a panic.
However, the future often surprises us. Further, the debt guarantee from SDRL gives me some comfort. SDRL has its own problems, to be sure. However, right now, they appear to be getting glowing support from their own creditors. That being said, the CFO of SDRL has noted that he expects it to take at least two years for the problems in the offshore drilling industry to be resolved. So, like most everything I do, an investment in NADL will probably require from me patience, self-control, and the ability to accept a high degree of uncertainty. Of course, as a Christian, faith, hope, and prayer are always the most important aspects of anything I do.
But I also use the ability and wisdom that God gives to me. That's why I have largely avoided shale E&P companies, or anything related to them. I am extremely skeptical of the long term viability of that industry (I am not alone: I highly recommend watching this presentation by Art Berman). There is a lot of hyperbole and nonsense that comes out of that industry, but very little in the way of profits. For a recent example, see here the comments of Gary Evans, CEO of Magnum Hunter Resources (MHR). This guy's company is laden with a huge debt burden, intensive capital requirements, and a very high cost of production. His company has literally never turned a profit. Yet here he is, being quoted in an article titled, How American Frackers Plan To Beat OPEC. He says, "OPEC is making a huge mistake. We made a lot of money with oil at $100, and we'll become more efficient and make a lot of money at $50."
I guess his statement was vague enough to keep him out of trouble with the SEC. He didn't really say what "we" "made" or "money" means to him. But it certainly wasn't his company making real money in the form of profits. Saudi Arabia is a competitor that has $700 billion in cash, no debt, the largest oil reserves in the world, and the lowest cost of production in the world. Yet this guy is going to "beat them". My BS meter goes off just about any time I read anything related to shale exploration and production.
Anyway, my skepticism of the shale boom is why I have tended to focus on other areas. For example, last summer when it seemed most investors were still super excited about shale E&P companies that were showing high production growth (in spite of zero or even negative profitability), I was starting to get interested in coal stocks (see note below). That's also why I'm more interested in offshore exploration than I am in anything related to shale exploration. I suppose time will tell whether that's a good stance or not.
I continue to look for good opportunities to take exposure to oil related companies. However, I don't see any need to rush in that regard. If something happens to send the price of oil spiking tomorrow, I can rest easy knowing I have some exposure. In fact, I'm currently in what I would call an emotional sweet spot. I'm at a point where I have some exposure and will be somewhat placated by that exposure if crude prices start soaring. But I'm also happy if they stay low for a while or continue falling, as I have plenty of room to add more exposure.
Best wishes to everyone in their investing!
P.S. I haven't initiated any buys or sells in COH today. This page is showing as "Pending Today's Transactions" due to a dividend reinvestment. Sharebuilder automatically reinvests dividends at zero commission, unless you remember to turn off that feature (I forgot in this case). Therefore, Sharebuilder is a decent brokerage for those who pursue dividend strategies. As I mentioned above, that's how I started out. Since I am no longer doing that, I may change brokerages at some point.
NOTE: I wanted to make a quick note here about contrarian and distressed trades. People often object to them by saying, "Well, if price goes to $1, it won't matter if you bought at $60 or $3. Either way, you still lost most of your investment." Or, they point out that if the stocks ultimately go to zero it doesn't matter at what price you purchased. That sounds like a logical objection. However, it ignores the risk-reward profile of such trades. Someone who bought, say Alpha Natural Resources (ANR) at $60 probably thought they were making an intelligent purchase. They thought the future for coal looked very bright. They totally missed the fact that commodities are always cyclical, that commodity production is always capital intensive, that this particular company had a lot of debt, and that every coal company in the world was rushing to increase production as fast as possible. That was a recipe for disaster. However, once the disaster already occurs, the risk reward tradeoff becomes more favorable. ANR is still a commodity producer operating in a cyclical, capital intensive industry in which no producer enjoys sustainable competitive advantages. The only difference now is that there is huge upside IF the cycle turns in the near future. One can potentially earn 10, 20, maybe even 30 times their original investment if the coal market turns quickly enough. That possibility never existed for investors who bought the exact same stock at $60. Yes, it can still go to zero and the results on this one specific trade would be the same for either investor. But, the investor who bought at $3 was fully aware of the nature of the trade, and probably diversified his exposure accordingly. The $60 investor obviously wasn't aware of the nature of his trade. His trade offered almost no chance for significant upside, but with all the downside. With such a strategy, it's almost certain that gains from the winners will not outweigh losses from the losers.