(MEMO) Memo - Shitty Businesses
A memo from a decade-long energy investor that’s too familiar with the definition of a shitty business.
Happy Thanksgiving everyone! Thank you for reading and I hope you have a great Thanksgiving!
By: Wilson
Energy is one of the few sectors in investing with the highest amount of shitty businesses. For most investors, the allure of energy is that it offers:
Inflation protection.
Dividend.
Cyclical upside.
Boom-bust swings.
What kills most energy investors is the following:
Constant inventory replacement (oil and natural gas wells deplete over time).
Operational execution risks (drilling results may vary from one region to another, i.e., different levels of “tiers”).
Management execution (inventory runs low, management either drills/explores organically or “acquires”).
Macro commodity risks, i.e., the boom-bust cycle of energy commodity prices.
Most of the risk in energy investing can be defined by two easy-to-understand financial categories:
Revenue: The price you receive for the commodity you sell (oil, natural gas, NGL, etc).
Capex: The cost to replace existing production and the cost associated with creating incremental production growth.
Obviously, during the good times, revenue vastly exceeds capex, producer discipline go out the window, and capex ramps. Those are usually signs of the end of a bull cycle. Similarly, when capex drops, producers push production down, then we start to see the cycle turn.
The differentiating variables here that make an oil/natural gas producer better than a competitor can be summarized below:
The repeatability and consistency of the reservoir. How consistent are the drilling results from one region to the next?
How long do the inventories last? Is it capital-intensive? Does it require a lot of “de-risking”?
Is the management team consistently improving drilling results over time? Is the management team improving the cost structure over time?
Finally, what is the broader capital allocation policy? Does the management “chase” ideas (acquisition mentality) or does the management focus on organic idea development (buying land, etc)?
So if you want to boil down to what makes a shitty energy “producer” investment, you have to look for the following:
High capital efficiency (not a good term in this case): the cost of replacing production.
If an oil or natural gas producer has a very high capital efficiency, it means that replacing 1 boe/d of production decline would be more costly than for a competitor.
If we use Canadian oil sands as an example, the cost to replace production is between C$18k to C$30k boe/d. And since Canadian oil sand production has a low decline rate (usually less than 10%), the yearly “maintenance” capex is low.
Similarly, a producer from a US shale region might have capital efficiency of $18k to $24k boe/d, but because the decline rate is usually 3-4x that of the Canadian counterpart (30-40%), the “maintenance” capex would be much higher.
I’m not saying US shale oil producers are shitty businesses. I’m just saying that from a capex standpoint, the higher the cost of “maintaining” your business, the shittier you are, relatively speaking. More on this later as I will branch off into the tech sector.
Reserve Life: The lower it is, the shittier it is. The higher it is, the better it is.
This is obvious for many reasons. Every oil and natural gas producer has to publish a year-end reserve report. In the reserve report, reserve evaluators publish a figure called “reserve life index.” This RLI determines how long the reserves will last using a base production rate. You can calculate this yourself using the current production run rate and dividing it by the total reserves.
If certain oil or natural gas plays have a lot of variability and unpredictability in their operation, then it will be difficult to “model” the expected inventory level. I’m going to use oil sands as an example again because it is the best example here.
Oil sand producers like MEG Energy that just got sold to Cenovus had a reserve life index close to 50 years. Most of the reserves were proven, so it makes it very easy to predict just how much oil will come out with each new well (oil sand is a bit different, but please bear with me here). In the world of energy investing, assets like these are considered “high quality” because MEG had one of the best capital efficiency metrics in the energy sector, and the free cash flow generation ability was high. Couple that with a high RLI, and you have a high-quality producer.
Note: Yes, I’m bitter that CVE bought MEG out.
So if you want to understand what a shitty business looks like, then all you have to do is look for the exact opposite of MEG. A producer with less than 5-6 years RLI usually means trouble. It’s not rocket science.
Now it needs to be said that just because you have a reserve life index of 5-6 years doesn’t actually mean you will run out of reserves in that timeframe. Every year you spend capex on drilling and de-risking inventory, you will “add” to your reserves, and every day you produce oil or natural gas, you will reduce your reserves. At the end of the year, you tally up all the differences, and you come to a final figure.
As a result, a producer with a 5-6 year reserve life index might just keep chugging along at 5-6 years for 5-6 years. That’s not a joke. But the difficulty here is that they need to constantly de-risk or buy land. This makes the execution part more risky, and anything more risky is shittier by definition.
Editor’s Note: There is a lot more to cover on this topic, but that’s for another day. Below is really the point I wanted to make.