I’ve been an oil bear since last year, which has worked out quite well so far. It may be a good time to summarise my case. I should have written about it earlier, as it’s starting to become mainstream!

Demand and supply

On the demand and supply front, the big shock is increased from US shale. This is well known, but it seems to have taken some time to make an impact. Besides, many US exploration ventures are funded by a lot of debt, so not flexible as they could be — they’ll keep pumping as long as operational cost are break even. Exploration and setup costs are sunk costs, and leveraged structure prevent waiting for better times. Rapid technological improvements in extraction add to the price pressure.

Shale also applies to natural gas, which has seen it’s own supply boom, likely taking market share for some oil applications (NG vehicles?). For electricity, renewables have been getting from insignificant to a minor player, which is also more competition.

On the demand side, it seems merely steady, or facing downward pressures (“China”, austerity). With all that no surprise the price has to come down.

Besides known reserves are vast on a human lifetime scale. If we keep facing static or slowly increasing demand, speculative exploration could be totally suspended for thirty years or more, and the world would be unlikely to run out. This is a challenge to new exploration, which is merely adding to the glut.

Politics

On the politics side cartel agreement seems harder to obtain than in past cycle bottoms. US producers and OPEC agreeing seems very improbable. Even the recent partial deal between Russia and Saudi Arabia — keeping production at the current relatively high level — might be difficult to maintain as producing more to compensate for lower revenue per barrel will be a temptation difficult to resist.

Climate change policies may work out in reducing demand (at least some).

Cycle timing

Commodity cycles — over-investing when prices are high and under investing when they are low — tend to be quite long (5-10 years) as it requires project planning to flow through to reality on the ground and there’s lot of inertia around.

There are several signs of not being at the bottom, like high volatility, media interest, bullishness of traditional oil sector investors although this may be turning.

A strong contango (higher prices on contracts for future deliveries) is a sign of probably excessive hope, and keeps supporting production at above-spot prices — until it doesn’t.

The money shot

Not making any precise forecast, but let’s say that WTI is probably going to stay in a range $20-$35 until at least the end of 2017, with perhaps short lived escapades on both sides of the range.

Back to the trading floor

This post is really just an excuse to make a portfolio update less boring: in addition to selling BP and Total, as previously discussed, I’ve sold Petrofac. Although they seem well equipped to survive a downturn, the market will probably ignore that for a long while (the name of the company may be a curse). I’ve added more Amec Foster Wheeler, which is a more diversified (and further diversifiable) engineer at a distressed price (hence being underweight in the portfolio).

This is despite not being supposed to do significant sector bets in the Obliquity portfolios, but I make an exception in order to minimising regret: I’d be pissed if I’m right on oil while owning sector losers. It’ll be easier to accept missing a sector rebound (if possibly costly).

On the trading front, I’m short contango and long crude carriers (the speculators will need storage, while the carriers’ share prices have been moving down with oil) via options.

Monetary policy’s impact is made relevant by sticky prices. The stickier nominal salaries and fixed prices for products and services are, the greater the impact of changes in nominal money quantity.

Thing is, prices are getting less and less sticky.

Long gone is the time where the price of flights was printed in a paper catalogue updated once a year. Dynamically priced flight can include changes in fuel cost, or demand and supply pressures, every few minutes, and people got used to it. You have a ballpark idea of what a flight cost, but known that the exact price will only be known at the time of booking.

Anyone who buys tech gadgets and shops around using internet comparison engines will end up paying the producer country price, as lean distributors with little stock and tight margins pass through currency impact, and this model dominates — sticky price competitors are structurally more expensive because they need¬† to add a buffer to both hedge currency risk, and to prevent adverse selection (people buying from them only when the exchange rate has moved favourably since the last sticky price was set). Even supermarkets now have dynamic price labels that can be updated in seconds.

What’s left of sticky prices? Wages and property are perhaps the main markets where stickiness still applies, though this too is challenged by short term rental contracts and short term employment (be it old school or gig-economy style), or variable compensation (bonus or commission based long term employment) where the net wage becomes decoupled from the notional sticky base salary. This is still a strong force, but for how long? I suspect the writing is on the wall: prices will get less and less sticky.

A possible danger for monetary policy is that backward-looking simulations use datasets from olden times, when prices were stickier than they are today, and thus unless a gradual decrease of stickiness is embedded in the model, will make increasing false predictions. More generally, monetary policy may become less and less important as nominal effects reduce, as changes to nominal quantities get absorbed by reality faster. Another reason to give fiscal policy a greater role in macro-economic management.

I used to think, like most value and fundamental investors, that market timing is difficult or impossible. I’m starting to come back on this and considering having a market timing component to my portfolio. It’s too risky to do on the market as a whole — moving one’s entire portfolio between stocks and cash or bonds — because this is undiversifiable (a portfolio dominated by whole-market timing has effectively 1 holding), but there may be opportunities for risk controlled allocations to sector or company specific cycles.

As a starting point I’m building a check list for spotting sectoral cycles. It’s a work in progress but here it is:

Bubble Bull/bear trap Bottoming
Dominant discourse “Paradigm shift” “This is a bubble!”, “This is the opportunity of a lifetime!” “Nobody ever made money investing in this!”
Volatility/volumes High/mid Mid/high Low
(Social) media interest High High Low
Closed-funds discount Premium Small/no discount Discount
Themed ETFs and retail products Launching Closing down

Why isn’t everybody doing it?

Most of these factors are reasonably easy to spot. But it’s that easy, why isn’t everybody doing it? A couple of possibilities:

  • The idea here is to capture sentiment, so it’s subject to errors if there are fundamental change that can kill an industry or are real paradigm shifts involved.
  • Knowing broadly where you are in the sentiment cycle seems straightforward, though imprecise and unlikely to find exact tops or bottom. Waiting for the cycle to turn may take longer than most investors’ attention span. Capturing a bottom or shorting a top may require more patience than most people have.
  • Intermediaries will have a hard time selling market-timing products as most clients behave like the herd (by definition).

Prospective guesses

Bubble Bull trap Bear trap Bottoming
Biotech, Internet retail, Unicorns Small caps, Equities Oil, Energy Metals mining, Airlines, Tankers/Shipping

Now the question is: is this confirmation bias? The Obliquity Portfolios have grown slight under/overweight in most of these themes — before I quite realised I was trading boom and bust cycles. I’ve also opened a little long tankers option basket a few days ago.

The current models used to fund digital media are not very satisfactory.

Old Newspaper likes firewalls, with content behind a monthly subscription. Like in the good old dead tree times. While those with a conservative ageing demographic can sometimes get a sizeable subscriber base, it does not seem to be the future when it’s so easy to move elsewhere in a world of plenty of free content. Attention seekers and new entrants will always be happy to produce free content when the cost of publishing itself is so close to zero.

Digital Natives like the advertising funded model, free to access at the expense of privacy, degraded user experience and an incentive to produce “Social Media leaders’ 25 ways to produce Click Bait headlines” content.

I hereby propose a new model: charge for comments. There are lot of trolls in the world who have a lot of rage, seem very motivated, and produce a lot of low quality and oft duplicated content that would be nice to see less of.

Several models can be envisaged:

  • Charge per comment: each post is charged a small fixed amount.
  • Deposit system: the user pays a fixed amount, once, that gives a right to a number of daily comments. The amount, or some of it, is forfeited if one or more posts are moderated away. Users who do not post objectionable content can get their deposit refunded when they decide to stop posting – for them posting remains close to free.
  • Attention auction: for popular articles with many comments, you could auction the most visible places in the comment page. Surely some people would pay a penny to lift their pearl of wisdom to comment page 1. This can be combined with the deposit idea.

This should help deal with spam as well as trolls incidentally. Payment in digital currency can preserve anonymity if so desired.

Finest English toiletries

Today adding Creightons to London Stamps. I was mostly sold from this video presentation. It seems a neat little business for an outright silly price. In addition to passing my check list, it’s very illiquid which I like — I’m happy to wait for normalisation and can survive getting stuck if not. There’s some insider control, which I don’t usually like, but it seems spread between several people who seem benign. I don’t quite understand the market but it does not seem rocket science either, happy to bet on the management here.

There’s very little else to say about it, possibly a good thing.

Diesel fumes

I didn’t buy it at the best time — it was quite fashionable at the time — but I like cyclical generator and chillers rental business Aggreko in Obliquity London, so I’ve put it back up to full mid-cap weight. The portfolio is possibly diversified enough, so consolidating or selling positions that have become underweight seems appropriate at the moment.

Despite having a notional check list for small caps, I’ve not been very careful with checking it formally. It’s also a good time for a review as my small cap investment style is maturing.

Picture of earthquake survival checklist

Earthquake survival checklist (credit: David Pursehouse on Flickr)

Owner business

As a replacement for the vague “useful business”, I’ll now try to answer the question: “would I like to own, and possibly run, this business as a private company?” However preposterous for a pint-size armchair investor, the idea is that it’s a business I must be interested in and understand enough, and would be happy to be stuck in (swapping CEO roles or even a majority stake in a private business is considerably illiquid compared to flipping listed stocks). This should eliminate a whole class of scams, and encompass classic criteria like “do not invest in things you don’t understand” or “invest like a businessman”. Besides, if one likes a business it’s much easier to weather price weakness, as one can emotionally compensate for (potential) financial failure with satisfaction from higher purpose (within reason).

Takeover potential

I’ve realised that since starting the portfolio many of my small cap exits are companies being taken over by larger groups. This is a pretty nice way to manage small cap exits: no transaction costs, usually a price premium, and no decision to take. And it makes a good sanity check new investment, as a company must be in some shape to be worth taking over.

The wallet test

As a simplified version of the executive character test, I have to ask myself “would I lend my wallet to the CEO for safekeeping?”, trying to guess that from hints in CEO interviews, reading reporting narratives between the lines, or interviews by trusted third-parties. (Idea first seen on the Value and Opportunity blog.)

Access to bank lending

This is about finding out whether a conservative banker would lend to the candidate business. This implies a solid balance sheet and somewhat predictable cash flow. It can be inferred from regulatory reporting on credit lines or covenant updates, or guessed from the balance sheet and business model.

Minimum (expected) profitability

Is this business making at least £1 million (or equivalent) profits annually, or, for recovery situations, can it be expected to reach that within the next 3 years? This takes out things that are too small to be listed, or too far away from break-even. Most story stocks (notoriously disastrous as a class) should drop out here.

The pass rate should be at least 4 out of 5.

In the spirit of the obliquity principle there’s no price or valuation test (other than that implied in the takeover test). Looking at the price too closely is probably counter-productive — I’d expect buying blind based on the above checklist should already give appreciable outperformance compared to small caps as a whole. And in any case I can’t help doing it, which is not incompatible with passing the check list, which is just a minimum standard.

A review of the existing Obliquity London Stamps portfolio holdings is now due.

Hubris

Here is a belated report on (breaking my rule on writing before trading here) for the sale of Tungsten in London Stamps.

Tungsten is an invoicing network that processes supplier invoices for blue chip companies. The processing network is barely break-even and the business model was to make money on value added services, notably invoice discounting (factoring). It’s a fair idea, and goes well with the theme of banking disintermediation which I think will be relevant for some years to come. The problem here was that the approach was full of hubris, which fell flat so far.

The company has now re-framed its ambitions and management: same business model, less hubris. Perhaps not the time to sell, but it’s still materially loss making, and the market hostile. Break even is probably at least two years away, with probably a fundraising or two in the pipeline, so more one for the watchlist, to revisit in 2017, maybe. The market will forget having been burnt, but in the next few years the memory will probably cap the upside. Basically I think it’s highly likely to get cheaper before it gets better, and that some years away.

I probably shouldn’t have invested in hubris, though my rationale was that they only needed to achieve 20% of what they promised to justify their valuation.

But hubris is costly. For instance, reading between the lines of the latest update one guesses they structured the deal with their financing partner so that it paid off above high volume thresholds, so modest but real factoring volume produces zero income…

Gadgets

The proceeds were reinvested in Toumaz, doubling down an existing position back to median weight. I’m still confident the new health products have a chance of success. Liking the product range, I’m happy to give it a chance longer term.

Losing the bulk

Interbulk, the dry bulk business will soon leave the portfolio as the company is being taken over. This was a bet on their market turning from cyclical lows. The company was heavily indebted but with cash flow just enough to fund the cost, and backed by large logistics company who are the controlling shareholders who could support it through bad times, it did not seem too likely to go bankrupt.

Obviously someone else will get the full upside (if any), but as a 30% profit above cost, and a large premium on the recent share price, I can’t complain. The risk the controlling shareholders would not be nice to the minority was also a potential issue.

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