Jeremy and I have not invested in an oil & gas company for years. The reason can be traced to the very first stocks I bought when I started investing. Back then, in October 2010, I bought six US-listed stocks at one go, two of which were Atwood Oceanics and National Oilwell Varco (or NOV). Atwood was an owner of oil rigs while NOV supplied parts and equipment that kept oil rigs running.
I invested in them because I wanted to be diversified according to sectors. I thought that oil & gas was a sector that was worth investing in since the demand for oil would likely remain strong for a long time. My view on the demand for oil was right, but the investments still went awry. By the time I sold Atwood and NOV in September 2016 and June 2017, respectively, their stock prices were down by 77% and 31% from my initial investments.
It turned out that while global demand for oil did indeed grow from 2010 to 2016 – the consumption of oil increased from 86.5 million barrels per day to 94.2 million barrels – oil prices still fell significantly over the same period, from around US$80 per barrel to around US$50. I was not able to predict prices for oil and I had completely missed out on the important fact that these prices would have an outsized impact on the business fortunes of both Atwood and NOV.
In its fiscal year ended 30 September 2010 (FY2010), Atwood’s revenue and net income were US$650 million and US$257 million, respectively. By FY2016, Atwood’s revenue had increased to US$1.0 billion, but its net income barely budged, coming in at US$265 million. Importantly, its return on equity fell from 21% to 9% in that period while its balance sheet worsened dramatically. For perspective, Atwood’s net debt (total debt minus cash and equivalents) ballooned from US$49 million in FY2010 to US$1.1 billion in FY2016.
As for NOV, from 2010 to 2016, its revenue fell from US$12.2 billion to US$7.2 billion and its net income collapsed from US$1.7 billion to a loss of US$2.4 billion. This experience taught me to be wary of companies whose business results have strong links to commodity prices, since I had no ability to foretell their movements.
Fast forward to the launch of the investment fund that Jeremy and I run in July 2020, and I was clear that I still had no ability to divine oil prices – and neither did Jeremy. Said another way, we were fully aware that companies related to the oil & gas industry were beyond our circle of competence. Then 2022 rolled around and during the month of August, we came across a US-listed oil & gas company named Unit Corporation.
At the time, Unit had three segments that spanned the oil & gas industry’s value chain: Oil and Natural Gas; Mid-Stream, and Contract Drilling. In the Oil and Natural Gas segment, Unit owned oil and natural gas fields in the USA – most of which were in the Anadarko Basin in the Oklahoma region – and was producing these natural resources. The Mid-Stream segment consisted of Unit’s 50% ownership of Superior Pipeline Company, which gathers, processes, and treats natural gas, and owns more than 3,800 miles of gas pipelines (a private equity firm, Partners Group, controlled the other 50% stake). The last segment, Contract Drilling, is where Unit owned 21 available-for-use rigs for the drilling of oil and gas.
When we first heard of Unit in August 2022, it had a stock price of around US$60, a market capitalisation of just over US$560 million, and an enterprise value (market capitalisation minus net-cash) of around US$470 million (Unit’s net-cash was US$88 million back then). But the company’s intrinsic value could be a lot higher.
In January 2022, Unit launched a sales process for its entire Oil and Natural Gas segment, pegging the segment’s proven, developed, and producing reserves at a value of US$765 million. This US$765 million value came from the estimated future cash flows of the segment – based on oil prices we believe were around US$80 per barrel – discounted back to the present at 10% per year. Unit ended the sales process for the Oil and Natural Gas segment in June 2022 after selling only a small portion of its assets for US$45 million. Nonetheless, when we first knew Unit, the Oil and Natural Gas segment probably still had a value that was in the neighbourhood of the company’s estimation during the sales process, since oil prices were over US$80 per barrel in August 2022. Meanwhile, we also saw some estimates in the same month that it would cost at least US$400 million for someone to build the entire fleet of rigs that were in the Contract Drilling segment. As for the Mid-Stream segment, due to Superior Pipeline’s ownership structure and the cash flows it was producing, the value that accrued to Unit was not significant*.
So here’s what we saw in Unit in August 2022 after putting everything together: The value of the company’s Oil and Natural Gas and Contract-Drilling segments (around US$765 million and US$400 million, respectively) dwarfed its enterprise value of US$470 million.
But there was a catch. The estimated intrinsic values of Unit’s two important segments – Oil and Natural Gas, and Contract Drilling – were based on oil prices in the months leading up to August 2022. This led Jeremy and I to attempt to expand our circle of competence: We wanted to better understand the drivers for oil prices. There were other motivations. First, Warren Buffett was investing tens of billions of dollars in the shares of oil & gas companies such as Occidental Petroleum and Chevron in the first half of 2022. Second, we also came across articles and podcasts from oil & gas investors discussing the supply-and-demand dynamics in the oil market that could lead to sustained high prices for the energy commodity. So, we started digging into the history of oil prices and what influences it.
Here’s a brief history on major declines in the price of WTI Crude over the past four decades:
- 1980 – 1986: From around US$30 to US$10
- 1990 – 1994: From around US$40 to less than US$14
- 2008 – 2009: From around US$140 to around US$40
- 2014 – 2016: From around US$110 to less than US$33
- 2020: From around US$60 to -US$37
Since oil is a commodity, it would be logical to think that differences in the level of oil’s supply-and-demand would heavily affect its price movement – when demand is lower than supply, prices would crash, and vice versa. The UK-headquartered BP, one of the largest oil-producing companies in the world, has a dataset on historical oil production and consumption going back to 1965. BP’s data is plotted in Figure 1 below and it shows that from 1981 onwards, the demand for oil (consumption) was higher than the supply of oil (production) in every year. What this means is the price of oil has surprisingly experienced at least five major crashes over the past four decades despite its demand being higher than supply over the entire period.
Figure 1; Source: BP
We shared our unexpected findings with our network of investor friends, which included Vision Capital’s Eugene Ng. He was intrigued and noticed that the U.S. Energy Information Administration (EIA) maintained its own database for long-term global oil consumption and production. After obtaining similar results from EIA’s data compared to what we got from BP, Eugene asked the EIA how it was possible for oil consumption to outweigh production for decades. The EIA responded and Eugene kindly shared the answers with us. It turns out that there could be errors within EIA’s data. The possible sources of errors come from incomplete accounting of Transfers and Backflows in oil balances:
- Transfers include the direct and indirect conversion of coal and natural gas to petroleum.
- Backflows refer to double-counting of oil-streams in consumption. Backflows can happen if the data collection process does not properly account for recycled streams.
The EIA also gave an example of how a backflow could happen with the fuel additive, MTBE, or methyl tert-butyl ether (quote is lightly edited for clarity):
“The fuel additive MTBE is an useful example of both, as its most common feedstocks are methanol (usually from a non-petroleum fossil source) and Iso-Butylene whose feedstock likely comes from feed that has already been accounted for as butane (or iso-butane) consumption. MTBE adds a further complexity in that it is often exported as a chemical and thus not tracked in the petroleum trade balance.”
Thanks to the EIA, we realised that BP’s historical data on the demand and supply of oil might contain errors and how they could have happened. But despite knowing this, Jeremy and I still could not tell what the actual demand-and-supply dynamics of oil were during the five major price crashes that happened from the 1980s to today**. We tried expanding our circle of competence to creep into the oil & gas industry, but were stopped in our tracks. As a result, we decided to pass on investing in Unit.
I hope that my sharing of how Jeremy and I attempted to enlarge our circle of competence would provide any of you reading this ideas on how you can improve your own investing process.
*In April 2018, Unit sold a 50% stake in Superior Pipeline to entities controlled by Partners Group – that’s how Partners Group’s aforementioned 50% control came about. When we first studied Unit in August 2022, either Unit or Partners Group could initiate a process after April 2023 to liquidate Superior Pipeline or sell it to a third-party. If a liquidation or sale of Superior Pipeline were to happen, Partners Group would be entitled to an annualised return of 7% on its initial investment of US$300 million before Unit could receive any proceeds; as of 30 June 2022, a sum of US$354 million was required for Partners Group to achieve its return-goal. In the first half of 2022, the cash flow generated by Superior Pipeline was US$24 million, which meant that Unit’s Mid-stream segment was on track to generate around US$50 million in cash flow for the whole of 2022. We figured that a sale of Superior Pipeline in April 2023, with around US$50 million in 2022 cash flow, would probably fetch a total amount that was in the neighbourhood of the US$354 million mentioned earlier that Partners Group was entitled to. So if Superior Pipeline was sold, there would not be much proceeds left for Unit after Partners Group has its piece.
**If you’re reading this and happen to have insight on the actual historical levels of production and consumption of oil during the past crashes, we would deeply appreciate it if you could get in touch with us. Thanks in advance!
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.