When It Comes To Oil Prices, 'Nobody Knows Anything'

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Includes: AAL, APC, CVX, EOG
by: Jeremy Raper

Back in mid-November, when oil prices had fallen "just" 25% from ~$100/barrel to the still-palatable level of $83/barrel, Harold Hamm, the CEO of Continental Resources (NYSE:CLR) (one of the largest North American oil and natural gas companies, focused on North Dakotan shale plays), shocked the market by selling all his company's oil hedges -- effectively betting that the bottom for the oil market was in. "We feel like we're at the bottom rung here on prices and we'll see them recover pretty drastically, pretty quick," he mentioned on a conference call with analysts. Thenceforth, Continental would be going "naked" -- fully exposed to the whims of oil prices, up or down.

Oil currently trades at $43/barrel, so we know how that wager turned out (Continental stock is -30% since November). But the lesson here is not that Hamm made a bad bet that cost him; he has made plenty of bets in a colorful and varied career in the oil business, many more good ones than bad, and his personal wealth, while diminished, remains substantial (many billions). No, this anecdote interests me for different reasons. It highlights how little even supposed experts know about the forward outlook for commodity prices. Anyone who's anyone in the oil business will tell you that Harold Hamm "knows oil" -- his name is often mentioned in the same breath as the great speculator T. Boone Pickens, and among individuals he is perhaps most responsible for the shale boom and America's energy renaissance. Alas, the accumulated wisdom of five decades in the business and numerous boom/bust cycles provided no clarity into the depths of oil's current plunge.

That leads to the second takeaway from Hamm's mistakenly timed wager. The oil business, by its nature, is run by rank speculators, many of whom seem almost spiritually wedded to the gospel of oil (and by extension rising or at least firm prices). Most oil "lifers," indeed most all the whole industry (at least in the U.S.), were massively caught off guard by the sudden roiling of the markets after many years (post-2009) of robust prices even in the face of rapidly increasing production. The inability to recognize the coming crisis was partly economic (prices remained high for too long, in retrospect) and partly philosophical.

The U.S. shale revolution had been doubted by so many for so long that the early pioneers in the field -- men like Hamm and Aubrey McClendon, founder of Chesapeake Energy (NYSE:CHK) -- developed a fierce survivalism that no doubt helped sustain the notion of a "shale revolution" when it was in its infancy but clearly clouded their judgement when the market environment changed. To be so completely blindsided by a move in the markets -- and, indeed, to fight willfully against clear signals from the dominant market player, OPEC -- suggests to me, at least, a mostly emotional attachment to the U.S. shale revolution (a cursory examination of Hamm's rhetoric over the years confirms this conclusion).

The inability to forecast prices with degree of confidence is why I have always viewed commodity trading (and by extension investing in commodity-linked companies like oil stocks) as much more akin to gambling than value investing. If the cognoscenti like Harold Hamm have no clue, how can I, or anyone else, hope to have an edge in this game? Frankly, this doesn't even amount to speculation, where you accept the risk of losses in the belief that you are wagering from a positive expected value position, in my book. Hence, to apply William Goldman's famous quote about the vagaries of the movie business, when it comes to oil, nobody knows anything.

This is why, when people ask me what I am doing in oil, the answer is, "not much." I have tried to short a few busted, third-/fourth-quartile E&P names with huge leverage (as a bet on restructuring and equity going to zero), with some small success (I am short Afren (OTCPK:AFRNF), for example; see here). I have also tried to short some of the offshore drillers -- RIG, DO, HERO, VTG, etc. -- since industry capex cuts will obliterate both earnings and fleet values, but the timing and volatility of the underlying stocks makes it a tough racket (having been "chopped up" on a few small shorts, I have mostly moved on at this point).

Instead, the main way I have been playing lower oil is through a long position in the U.S. airlines stocks, particularly American Airlines Group (NASDAQ:AAL), which does not hedge fuel costs (~35% of opex) and so is a direct beneficiary of falling crude. However, this is more a bet on the airline industry, where consolidation and capacity discipline have created an extremely favorable operating environment, and where -- in AAL's case -- the integration of US Airways provides a long runway for de-costing the combined business. In other words, a low oil price is the cherry on top (admittedly, a potentially huge cherry), but not the main investment thesis. AAL stock still looks a value, to me, despite the massive move last year, at ~4.5x FY15E EV/EBITDA. If oil rips back, AAL will trade lower near term, but at current valuations I am still fairly comfortable the stock will outperform medium term.

My advice for any would-be bottom-fishers in the oil space would be to follow a similar route: Look for ancillary beneficiaries of lower U.S. oil prices (U.S. retail? Autos? Refiners?). Or, if you really want to speculate on a rebound in crude, stick with the low-leverage, more-diversified tier-one names (APC, EOG, CVX, etc.) and dabble in small size. Leave the speculation to the speculators, and let men like Hamm handle the margin calls.

Disclosure: Long AAL, short AFR (listed in London on the LSE).