Seeking Alpha
Hedge fund manager, arbitrage, contrarian, long/short equity
Profile| Send Message|
( followers)  

Editor's note: Originally published on June 20, 2014

by Brad Thomas and Chris Tell

Our friend and colleague Harris Kupperman recently wrote an article about Kashagan and the massive delays being enjoyed by this particular project. The problem is that Kashagan is a poster child for the sector as a whole. This isn't an anomaly.

Let me copy a few key paragraphs from his article:

Ever since oil prices bottomed in 2002, people have wanted to believe that new supply would reduce prices. Over the past decade, they've talked about increased Iraqi and Libyan oil; there has been the promise of tar sands and Brazilian pre-salts and now they're talking about shale oil. Yet, despite all of this talk, world oil production has plateaued for years.

The simple truth is that much of the world's easy oil has now been exploited. The world isn't running out of oil any time soon, but we will need much higher prices to bring new supply online.

The oil industry is not dissimilar to large-scale infrastructure, something I will never invest in for all the reasons I laid out here.

Further evidence of just how easily things go wrong in this industry landed in my inbox a few weeks ago from a friend who is a technology expert working on an oil and gas deal.

Chris,

I'm working on an oil/gas field project these days. That industry has an amazing amount of waste - recently a series of shale oil wells were dug with pipe measured (manually) by a tape measure with 3″ of the length project off - no one noticed. So all of these pieces of the well pipe were 3 inches short and thus the assemblies for 11 different wells came up short. In all cases, bits didn't make the end so all the wells had to be filled with concrete and started over.

A $100 tape measure cost $100M in damage, with almost a month in delays, pulling bits back out of the wells, concreting them, starting over, etc.

YIKES! Laugh, or cry, this sort of situation, while anecdotal, shows us the immense numbers involved, and when something goes wrong, it costs a HUGE amount of capital. The reality is that the industry has failed to bring on increased supply, and while in the short term fundamentals don't matter a jot in a central banker-liquidity driven world, in the long term, they ALWAYS matter.

Harris goes on to discuss the fundamentals…

Just look at how complex the problems related to these mega-projects are-mistakes in engineering can cost tens of millions and delay billions in cash flow. With oil at $100 a barrel, prices just aren't high enough to justify the investment in many of these projects. At the same time, investors are learning that shale oil wells have higher decline curves than expected, which substantially reduces the economics on many of these projects.

Over the past few months, I've heard some very smart people speculate that oil prices will decline as new supply comes online-mainly related to shale oil. This just isn't the case. If prices decline, it won't be on the supply side-it will be demand related.

The oil bull market started over a decade ago and is a trend that you can bet on for decades into the future. Every time a Kashagan gets deferred by two years, it will force producers to re-assess their oil price assumptions for investment, and possibly choose not to make the investment. Don't let people convince you that oil prices are going lower, they aren't-they're likely going much higher. If someone wants proof of this, have them do a bit of reading about the decade-long fiasco named Kashagan.

Even without Iraq descending into a civil war, the fundamentals for oil going higher are hard to ignore. Brad Thomas and I have made a habit of catching up on the markets on a weekly basis, and so it was with interest that when I rang him up this week and said something along the lines of "what's the topic this week?", he immediately responded… oil.

Brad's rationale is driven from his trading strategy, which is "finding deep value situations with an asymmetric payoff". Brad mentioned how so many times over the decades of trading the markets, he's been down 50% or more on a trade with years to run to expiry and has ultimately made out like a gangster with a bad rap song and millions of Twitter followers.

Specifically, Brad looks for low volatility coupled with very favorable fundamentals, and in his alert to subscribers this week, he just bought a large oil company with 2 years to expiration. I've excerpted a small portion of his rationale…

All the recent talk about crude moving higher due to problems in Iraq/Ukraine is very misleading. For the last three years something has been brewing with crude. Its trading range has been narrowing and it appears to be set to break to the upside. Considering that crude has essentially gone nowhere for some 4 years, the upside is likely to surprise most, perhaps to a magnitude that will rival what happened in early 2008!

Take a look at crude - seems this sucker is about to blast into the stratosphere! We can see the base being built over the last 3 years. These formations typically break either up or down, and given the fundamentals discussed, I don't want to be short.

(click to enlarge)

Brad then goes further to explain what makes for the asymmetry in the trade…

Few, if any, are expecting a dramatic move higher in the price of crude. I say this because volatility on long term call options on the big oilers is being sold at record low levels, and materially lower than it was being sold in 2007 prior to the price of crude doubling in some 12 months. If it was expected that crude would move materially higher over the coming months, then volatility certainly wouldn't be sold at such low levels.

Both Harris and Brad are two of the most knowledgeable traders I know, and both believe we should be looking at this sector right now. I'd love to know your thoughts.

Source: Is Crude Setting Up For Something Big?