The oily rag

For my sins, I work in the Oil (and Gas) sector, and there’s been a few tweets back-and-forth about what I thought of the sector.

My first admission is that I’m probably not the best person to ask. I would be embarassed to call myself an expert in the sector, or claim to have any special insights that would give me an edge in investing in the sector. Having said that, a few points might be of interest to you.

I work in oil "services", providing consultancy to the big oil players in the North Sea. We have foreign clients, too; Norway and places like Dubai being amongst the largest. Not much in America, believe it or not, although we do have a lot of contact with their North Sea operations.

Oil services tends to be somewhat feast or famine, and is dependent on how flush with cash the big boys are feeling. Some of our services are might be what you would call "bread and butter" – stuff that the likes of BP would need on a regular basis whatever the oil price. Surprisingly, though, these services are still dependent on the price of oil. The majors cut things to the bone when oil prices are weak, with a tendency to play catch-up when prices are high. I’ve observed that we are definitely in a buoyant phase. A project that one of our consultants is looking at is a review of the health and safety at a client platform. From some of the things I’ve been hearing, "not before time" seems to sum things up nicely.

I think that, as an "insider" of the industry, I would say a few things:

  • my knowledge of the sector I would rate as reasonably poor, and that there’s no special edge that I feel I have
  • if you want to know if the oil sector is doing well, look at the oil price, and look at company margins – duhh- yes, it really is that obvious – as regards as to "what happens next", your guess is as good as mine
  • I think that services is somewhat of a lagging sector anyway – it tells you what is happening and what has happened, not what happens next. it is, of course, the "what happens next" that is the critical part of investing

Personally, I no longer have any resource stocks. I’m basing this on a contrarian stance, rather than inside knowledge. This boils down to a number of considerations:

  • the operating margins are absurdly high. Sharelock Holmes reports an operating margin of 44% for BLT (BHP Billiton) – that’s monopolistic-type profits, not the margins you’d expect from a simple dirt-shifter.
  • mining and oil comprise about 30% of the market cap of the Footsie – surely a red flag given the cyclical nature of the business
  • prevalence of discussion of miners on the bulletin boards. Everyone’s discussing miners.
  • lots of financing being raised by miners to get projects off the ground – I’m talking about the junior miners here
  • lots of fairly recent flotations of miners – with at least one going straight into the Footsie. Some of these miners seem very very dubious. Shooting from the hip here – take ESSR (Essar Energy), floated in May 2010. When it first reported, in March 2011, it had net cash flows of £207m. A year later, it reported negative cash flows (£-407m). It’s net debt is £3.6bn, against a market cap of £1.7bn. The largest shareholder is "Essar Global Limited", whose holding value is £1.3bn. Hmmm. I admit I don’t know what the story is behind all this, but I presume I wont like what I saw if I dig further.

There’s a lot of smarts in the oil industry, but I fear that they make the same basic mistakes as all commodity producers in cyclical industries: spending capital to increase capacity at the top of the cycle, and reducing it at the bottom. It’s logical behaviour in terms of how the participants think, even though it’s probably the opposite of what they should be doing.

Having said that – I have no insight into the direction of commodities – despite my scepticism. For all I know, the commodities cycle could have many more years to run. I think it’s highly likely that we’re more than half-way through any supercycle that might exist.

If I was to choose one type of company within the oil sector, I might be tempted to hunt for companies providing non-discretionery services and equipment to the oil majors. Maybe Weir would be an interesting choice, although I don’t know anything about them. The premise is that oil exploration must necessarily get more expensive – all of the low-hanging fruit has been plucked, and older platforms such as in the North Sea will need new equipment (although that assumes that the price of oil stays high and justifies the cost of maintenance).

One area that I would avoid is "alternative energy", which seems too "promotional" to me. As far as I can tell, none of them have shown actual commercial success, able to stand on their own feet with government windfalls. I suspect that eventually – and I stress the word eventually – alternative energies will become viable – BUT NOT YET. The reasoning is that, marginal costs increases are inevitable with conventional sources, making alternative source relatively more attractive. But like I say: EVENTUALLY, NOT YET. I think we will also dislike the world where alternative energy does become mainstream, because energy costs will inevitably be higher. So we’ll all be the poorer for that.

Coming the end now … Ken Fisher looked at the relationship between oil prices and stock market action. Although lower oil prices are generally considered good on account of lowering input costs, what he found was that high oil prices are associated with a buoyant stock market. The logic being that oil prices are high due to high demand, which is a function of a buoyant economy, which leads to a stock market. His conclusion was along the lines of: if you want high stock markets, you’d better hope for high oil prices.

It would be interesting to see blogs from other investors about their specialist fields, don’t you think?

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About mcturra2000

Computer programmer living in Scotland.
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