Construct Your Oil Portfolio: The Trend Following Version

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Includes: ATHOF, BP, CRC, CVX, DNR, GPRK, MCF, MEGEF, NOG, OIL, OXY, PBR, QEP, RDS.A, RDS.B, REN, ROSE, SN, TOT, UWTI, XOM
by: Laurentian Research

Summary

This is Part 1 of a three-piece series aiming to take a long, hard look at how to go about building an oil stock portfolio that fits your personality.

Before building an oil portfolio, know yourself first. It's important to find out whether your temperament fits trend following or value investing.

Trend followers tend to invest differently from value investors, generally and in the oil patch.

In this article, I also recapitulated how a trend follower can waltz through an industry cycle, in hope of capturing the highest rate of return.

If you know that you are vulnerable to prediction errors, and … accept that most “risk measures” are flawed, then your strategy is to be as hyperconservative and hyperaggressive as you can be instead of being mildly aggressive or conservative." - Nassim Nicholas Taleb

The energy sector is in the midst of a massive upswing. A combination of strong global oil demand and muted OPEC production has driven the supply and demand to a balance after a three-year turmoil (see here). Crude oil prices (OIL) have reached the highest levels unseen in a long while and seem to be continuing their ascent, spurred by geopolitical unrest around the world (Fig. 1).

Fig. 1. Stock chart of WTI price. Source.

Having survived a long period of depression, the oil companies are now leaner and more efficient, much more so than in the days of giddy oil prices. This, of course, sets the stage for the profitable years to come.

Therefore, it appears to be high time to think about allocating funds to the oilpatch. To that end, one may ask such a pertinent question:

  • In what way should we construct a portfolio of oil names that offer the maximum expectant rate of return at an acceptable level of risk?

Below, I present the approach we at The Natural Resources Hob (TNRH) use to go about such a daunting task. For your reference, by following such an approach the TNRH model portfolio returned 49.6% on an annualized basis in 2017 (see here).

First order business: Self-examination

It is supremely important to first ask a personal question about oneself:

  • What type of investor are you, a trend follower by nature or a value investor by personality?

The trend followers

As human nature dictates, the vast majority of investors are momentum chasers who attempt to ride the coattails of a prevailing uptrend, in hope of pocketing a nice profit E by buying at X and selling at [X + E].

Trend following can be an enormously profitable strategy, especially when the investor turns out to be right in identifying a trend, making an early entry and pulling off a timely exit. A successful operation like that involves an element of market timing, which lends this investment approach a speculative flavor.

A trend follower typically asks: do I see a trend, is the trend continuing, what's my rate of return if I ride the trend? Many trend followers take cues from research on the fundamental factors, but for them, the primary lure of an investment idea often winds up to be a rising price. A pop in the price of a stock will pique the interest of these investors and stir up an urge to follow on.

It is critical for a trend follower to realize that his investment idea is just another hypothesis yet to be proven up and that, by the time an idea is clearly working, it probably has already become too crowded a trade to warrant an entry.

Unfortunately, many trend followers favor their idea to be agreed upon over to be debated against; some may even get irritated when their idea is being challenged. An emotional reaction as such, I think, does not necessarily mean their idea is irrefutable or they think they cannot be wrong. Rather, they probably know that further deliberation on the idea will lead to a weakened conviction and that a weakened conviction will invalidate their trade.

For example, I have heard so many times of an argument that goes like this: this stock will produce a rate of return as high as RW when the oil price reaches W by the end of the year, therefore it is a good investment and worth buying. What is missing in the argument is a consideration of

  • the probability pW of oil price reaching W by the end of the year and
  • the rate of return R-W when the oil price fails to reach W.

The composite expectant rate of return of the idea will actually come to:

  • RW X pW + R-W X (1-pW).

As a matter of fact, that the oil price will reach W is in itself a hypothesis, the testing of which is unfinished until the next big crash. To build an investment thesis around an assumed scenario without considering the alternatives is the same thing as believing that idea is more attractive than it actually is, both tantamount to walking into a minefield blindfolded.

When it comes to forecasting the oil price, if he really had a direct line to God, he might as well buy a call option on margin or back up the truck going long VelocityShares 3x Long Crude Oil (UWTI). The truth is nobody can consistently forecast the oil price correctly; even the most pretentious fellows will admit to this. More critically, even if one happens to have "correctly" predicted the continuation of an uptrend, the unexpected reversal down the road may give him a start and take all the profit away, as so many have learned the hard way that the market has its way of humbling the market participants.

The main risks faced by a trend follower are (1) to fail to make an early entry, thus missing the fattest profit in the inchoate stage of the oil upswing; (2) to fail to make a timely exit such that a surprising crash erodes much of the gain. Numerous trend followers lose their proverbial shirt by forgetting they are engaged in market timing. The bane of the game of market timing is that one can feel he is an investing genius as long as the bull market continues; sooner or later an unexpected market reversal will sneak up and humble him.

Therefore, a trend follower with the intention of participating in the oil upswing should realize:

  • First, he is actually participating in a speculation that the oil price will continue to rise. He should not allow himself to be fooled into believing in his own invincibility, even if he is paying attention to minute details in all the research reports.
  • Second, he needs to have a pre-conceived exit plan and resolutely executed it at the first sign of trouble. His greatest risk is an exit done too late. He should not permit the bull market to aggrandize his trader' ego.

The value investors

Fewer investors than is believed actually practice value investing, even though a plethora of empirical evidence proves the effectiveness of the approach.

A value investor, on the one hand, attempts to determine the intrinsic value V of a business behind the stock, on the other hand, uses the thus-derived intrinsic value as a yardstick to guide his entry and exit.

  • Specifically, if the stock price p is lower than the intrinsic value by a sufficiently large margin of safety [V-p] or, in percentage, [V-p]/V, then he purchases the stock, knowing that he is being protected by the cushion provided by that margin of safety.
  • Inversely, if the stock price p has gotten too much ahead of the intrinsic value V, then it's time to exit, regardless of the rosy extrapolation of the uptrend toward the infinity.

Value investors often have to ignore what the price action, as contained in the recent uptrend, is telling him. This is described as acting contrarian against the group think, the consensus of the crowd, or the herd mentality. One needs to, in Warren Buffett's words, "Be fearful when others are greedy and greedy when others are fearful." This is easier said than done because it requires a lot of mental fortitude to actually pull it off. As Ralph Waldo Emerson quipped,

It is easy in the world to live after the world’s opinion; it is easy in solitude to live after our own; but the great man is he who in the midst of the crowd keeps with perfect sweetness the independence of solitude.”

A successful value investor needs mental independence, rational thinking, detachment from the herd instinct, and a cool-headed reading of crowd emotions to buttress his conviction in pursuing an investment idea (Fig. 2).

Fig. 2. The four primary human faculties, i.e., the instinctual, emotional, social, and cognitive, and the six main capabilities, i.e., 1, self-control; 2, curiosity; 3, charisma; 4, empathy; 5, self-knowledge; 6, social awareness. Source: the author.

Benjamin Graham, the father of value investing, said,

The true investor scarcely ever is forced to sell his shares, and at all other times he is free to disregard the current price quotation. He need pay attention to it and act upon it only to the extent that it suits his book, and no more. Thus the investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage. That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other persons’ mistakes of judgment.”

The greatest risk a value investor faces is to have unknowingly arrived at a wrong valuation of the prospect. In order to mitigate such a risk, he resorts to the adherence to the principle of margin of safety. Many modern value investors require the presence of near-term catalysts; some of them use technical analysis to monitor the shifting market sentiment so as to pinpoint the optimal entry and exit points.

A master practitioner of value investing has the luxury of enjoying a peace of mind, knowing that, in the long run, the advantageous economics of the chosen business will ensure an adequate rate of return for him. He is spared from the stressful chores of closely monitoring the daily price action of his holdings. Only in such a state of mental tranquility can he focus on picking up signals instead of noises, looking at the long term in place of the transient, and seeing the big picture rather than the nitty-gritty.

Trend following in oil stocks

In a series of articles entitled "The Great Oil Upswing: How To Get The Most Bang For The Buck," I outlined how a trend follower may navigate through the cyclical upswing of oil. These articles can be accessed here:

My first proposition presented in the articles is that the currently unfolding oil upswing involves four phases as follows (Fig. 3):

  • Phase I is defined as from the operating expenses of the low-cost oil producing assets (P0) to the average breakeven of all producing oilfields (P1).
  • Phase II is when the oil industry trudges along in a holding pattern until a new supply-demand balance is achieved, which probably ended sometime in late 2017.
  • Phase III lasts from the point of the surplus oil is exhausted (T2, P2) to that of the rising demand is finally met by expanded production (T3, P3), which is probably where we are today.
  • Phase IV starts at the supply-demand balance (T3, P3) and ends on the edge of the next oil crash (T4, P4).

Fig. 3. The four phases of the Great Oil Upswing in terms of oil price, P, and time, T. Source.

My second proposition therein is that a trend follower can adjust his holdings in terms of the cost structure and growth potential of the assets held by the oil companies, in hope of getting the most bang for the buck (Fig. 4).

  • In pre-Phase I, he can park the capital on the supermajors, including Exxon Mobil (XOM), Chevron (CVX), Shell (RDS.A) (RDS.B), BP (BP), and Total (TOT), which with their low-cost, low-growth assets and vertical integration tend to be resilient in a descending market.
  • In Phase I, he may switch to the high-cost, low-growth asset holders, such as enhanced oil recovery - EOR - specialists Occidental (OXY), California Resources Corporation (CRC), and Denbury (DNR), the second to third-tier unconventional asset holders, like Sanchez Energy Corporation (SN), or deepwater pure play Petrobras (PBR), which typically deliver explosive gains in a short span of time as they come out of a potential bankruptcy under the burden of heavy debt.
  • In Phase II, he can choose to stay on the sidelines to conserve cash or invest in the low-cost, high-growth names, such as GeoPark (GPRK), Resolute Energy (REN), or Rosehill (ROSE), which may outperform in defiance of the times of uncertainty.
  • In Phase III, he may load up on the high-cost, high-growth asset holders, such as Bakken pure play Northern Oil & Gas (NOG), Contango Oil & Gas (MCF), QEP Resources (QEP) which, though trying to build a presence in lower-cost Permian Basin, have a lot of higher-cost drilling locations and PUDs in Eagleford, East Texas, Louisiana and elsewhere, and oilsands developers, e.g. Meg Energy Corp. (OTCPK:MEGEF) and Athabasca Oil Corp. (OTCPK:ATHOF). In a supply-deficient environment, the seemingly endless growth potential of these companies becomes especially appealing to investors.
  • In Phase IV, he may start to sell, in order of decreasing costs, his holdings to the starry-eyed new entrants who think the feast in the oilpatch will go on forever.

Fig. 4. Buckets of oil assets by production growth potential and cost structure. Source.

It is inevitable that the oil trend followers will be off in pinpointing the exact inflection points, thus losing some torque here and there, which tend to cut into his overall investment performance.

For someone whose mantra is to be on top of the trend and whose positions are consequently in a rapid shift, the focus of portfolio management is directed toward component diversification and cash position adjustment.

Investor takeaways

The rising oil prices are piquing the interest of investors as of late. However, investing in the oilpatch can be more complicated than simply chasing the oil prices. Therefore, a special deliberation is warranted.

Just as in investing in any other industries, an investor needs to align the investing strategy with his personality. A trend follower differs from a value investor in due-diligence questions asked, investment approaches taken, types of stock invested, and main risks faced.

A trend follower can adjust his holdings as the oil upswing unfolds so as to get the most bang for the buck. He needs to pay particular attention to the cost structure and growth potential of the assets held by the oil companies.

Stay tuned for the next piece on income investing in the oil patch followed by the final piece on oil investing in pursuit of capital appreciation.

Disclosure: I am/we are long THE TNRH MODEL PORTFOLIOS.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: For a full disclosure, please find: https://seekingalpha.com/instablog/41325066-laurentian-research/5105418-disclosure-pertains-postings-laurentian-research

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