A Framework For Investing In Oil & Gas Companies

I have avoided investing in oil and gas companies for years, knowing how closely their stock prices track oil prices, a variable I cannot predict. But I still have a framework for investing in these companies: Buy them really cheaply. This framework is inspired by the successes of investors Bill Browder and the late Charlie Munger.

In Browder’s excellent 2015 book Red Notice, which I had discussed previously in this blog, he shared his experiences investing in two Russian oil & gas companies, Sidanco and Gazprom. These are the instructive excerpts (emphases are mine):

“[On Sidanco] According to his data, Sidanco had six billion barrels of oil reserves. By multiplying the price of the 4 per cent block by twenty-five I got the price of the whole company: $915 million. I divided that by the number of barrels of oil in the ground, which told me that Sidanco was trading at $0.15 per barrel of oil reserves in the ground, which was crazy because at the time the market price for a barrel of oil was $20…

…I pulled out a piece of paper and drew two columns. I titled the first Sidanco and the second Lukoil, and wrote down every fact about each company that I could find in the magazine. When I was done, I looked over the accumulated information. There was practically no difference between the two companies. Little infrastructure had been developed since the fall of the Soviet Union, and they both had the same rusting oil derricks and used the same leaky pipelines, and they both had the same unproductive workers who were paid the same measly salaries. The only obvious difference between them was that Lukoil was well known and had lots of broker reports written about it, whereas Sidanco had none. When we compiled the information from these reports and compared them to the information on Lukoil from the magazine, they matched up perfectly. This led me to believe that the information on Sidanco was reliable too. 

This was a remarkable discovery. Everyone knew that Lukoil was a steal, since it controlled the same amount of oil and gas as British Petroleum but was ten times cheaper. Now here was Sidanco, sitting on a bit less oil than Lukoil, but not much, only it was six times cheaper than Lukoil. In other words, Sidanco was sixty times cheaper than BP! This was one of the most obvious investment ideas I had ever seen. My fund bought 1.2 per cent of the company starting at $4 per share, spending roughly $11 million. It was the largest single investment decision I had ever been involved with in my life…

…Finally, a little more than a year later, something did. On 14 October 1997, BP announced they were buying 10 per cent out of Vladimir Potanin’s 96 per cent block of Sidanco for a 600 per cent premium to the price we had paid a year earlier. It was a home run…

[On Gazprom] In terms of output and strategic significance, Gazprom was one of the world’s most important companies. Yet the entire market value of the company – $12 billion – was smaller than your average mid-size US oil and gas firm. In terms of hydrocarbon reserves, Gazprom was eight times the size of ExxonMobil and twelve times bigger than BP, the largest oil companies in the world – yet it traded at a 99.7 per cent discount to those companies per barrel of reserves…

…In a world where people fight tooth and nail to make 20 per cent, we’d just found something that might generate 1,000 per cent, or even 5,000 per cent. It was so obvious that the fund increased its investment in Gazprom right up to the 20 per cent limit, the largest percentage for a single stock that the fund allowed…

…By 2005, Gazprom was up a hundred times from the price at which the Hermitage Fund had purchased its first shares. Not 100 per cent – one hundred times.”

Coming to Munger’s investment, it involved a company called Belridge Oil. In the late 1970s, Munger invested in Belridge Oil at US$115 per share when its market capitalisation was US$110 million. At the time, the land Belridge Oil owned was sitting on 380 million barrels of oil reserves. The company’s market capitalisation meant that its oil reserves were valued at less than US$0.30 per barrel at a time when oil prices were around US$5 to US$6 per barrel. Around two years after Munger invested in Belridge Oil, the company was acquired by Shell for around US$3,700 per share, giving him a spectacular return of more than 3,000% in a short period of time.

To be clear, the Gazprom situation was hairy, and the successful outcome of Munger’s Belridge Oil investment came with a massive dollop of luck. Gazprom’s managers were stealing the company’s assets, and Browder had to rope in Russia’s government to intervene before the company’s stock price could surge. And after Munger invested in Belridge Oil, the price of oil increased to US$30 per barrel by 1980. But the core strategy in both cases was highly rational: Invest in oil & gas companies with oil reserves that are valued at massive discounts to prevailing oil prices.

I will continue to avoid investing in an oil & gas company if the investment thesis requires me to have a view on the future price of oil. But if I can find an oil & gas company with proven oil reserves that are valued at a tiny fraction of the prevailing price of oil, taking cues from Browder and Munger, I would be very interested as the huge discount removes the need for guesswork on oil prices.

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Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.  I currently have no vested interest in any company mentioned. Holdings are subject to change at any time.