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Talking Oil With Cale Smith: Geopolitical Influences In The Middle East, China And What's Ahead

Talking Oil With Cale Smith: Geopolitical Influences In The Middle East, China And What's Ahead

BENZINGA: We're on today with Cale Smith down in Islamorada, down in the keys. He's the manager of the Islamorada Investment Management. Cale, we've met a few times, talked several times, and you've just done something very unique. You've gone all in on oil, haven't you?

Cale Smith: Yeah, we have, and it's a little bit unusual. We are a long-term bottoms-up value shop and we have done a lot of work on this. Where we are, it's the result of a year-long process of looking at a ton of these companies, and it is what it is. We have a lot of conviction and confidence.

BZ: I know that, like me, a lot of what you actually manage is family and friends' money. How was Thanksgiving?

CS: It was interesting. I think it'll be a much more positive Thanksgiving next year.

BZ: Yeah. If you want to come up here and hide out in Orlando for a while over Christmas, feel free. I understand how that is.

CS: I will be there tomorrow.

Related Link: Here's How The Rate Hike Will Affect Oil And Inflation

Oil Market Drivers

BZ: Let's talk. In your last shareholder quarterly letter, which you've always been kind enough to share with me, outlines your case. What is the big driver on this getting into the oil market as deeply as you are right now?

CS: I guess there's probably a couple of them. I would start with diagnosing why things are cheap to begin with. This is a similar process. What I emphasized with you is, we're not really changing our internal process at all. It's not a focus on oil as any sort of macro call, it's the same process I've used every day for the last seven years that has resulted in this focus on US E&Ps in particular. Things seem to be mispriced, and in the shareholder letter I shared with you, I certainly went into great detail on a lot of reasons why.

But if I had to summarize them, I'd say there is an overabundance of speculative capital at work in the oil markets, both only oil, primarily on the financial side of that, so its distorted price is a little bit, and I presented some evidence about what the algos have been doing in the oil market specifically. I talked a little bit about some of the public model fitting that the EIA, the Energy Information Administration, which is probably the most respected provider of oil data here in the US – it's been sort of a slow motion exercise in model-fitting for those guys to get their numbers to line up on a monthly basis, and that has certainly caused some distortions. But, by and large, if I had to characterize all those things, I would say, to some extent, it's just the dominance of short-term money and panic.

When you have those two things coalescing as they are right now, it's just a natural tendency almost to stare at just the six inches in front of your feet rather than to lift your gaze up a little farther and remind yourself, "This is, in the end, a cyclical business." Even if everything in my letter proves to be way off, it is, ultimately, a cyclical industry. To some extent, prices are inevitably going to rebound. The question is really, is that sooner or later?

BZ: If it makes you feel any better, because I know it did for me, on this morning, Jacob Wolinski and his team do a great job, were reporting that some of JPMorgan's guys had turned bullish on oil for 2016. And they pointed out that momentum in energy had not been this negative for this long since 1998. If you recall, we had a lovely bounce after 1998 in energy prices. Now, you're really focusing on E&P producers, I know that. And you said something in your letter that I found really interesting, and I'd like to have you explain it to folks. You said the real key to the E&P companies was finding good rocks with good management. Can you expound on that a touch?

CS: By the way, a little bit of background – since I started this firm seven years ago, we've always had some exposure to energy, that's typically been in the E&P space I do feel like analyzing those companies is within my circle of confidence. What has changed, I guess, in my own analytical mindset, really in the last year or so, are a couple of fairly wonky tools that we can get into as you see fit.

The importance of good rocks has really been underscored as a result of this collapse in oil prices. Just from the engineering perspective, there probably could be 500 percent greater production possible out of core areas. If you're looking at the more predominant plays in the United States, there is no joke about the importance of being in the core. In general, I think as a value investor a year ago, I was almost too focused on the concept of companies that had more undeveloped acreage. The reality is, these days, because of the price collapse, I think the conversation is rightly that much more on internal returns. In the end, there's just not a lot of levers that are specific to one company in the oil patch, even if costs come down because of lower rigs or whatever.

Those sorts of things will eventually be copied by competitors. The thing that can't be copied, and the real competitive advantage, is on the rocks. You'll see guys even today, they're earning 50 percent, maybe 60 percent IRRs on some of those rocks on the Permian in West Texas. While management was very smart to acquire acreage there early on, the reality is, it's also – to some extent – out of their control. I think you'll see, assuming prices stay a little bit low here, the strong getting stronger and the weak getting weaker just because of geology. There's only so much they can do, in many cases, around that.

'Bad Rocks' And Price Wars

BZ: It looks like a lot of the marginal players that have "bad rocks" are already starting to feel it. I read yesterday that there's already been 18 bankruptcies by drillers in 2015, and that should accelerate at least through first quarter of 2016 as hedges continue to roll off. Now, here's the big question. You hear the commentators, and I keep CNBC on, frankly not so much as for market data as because I've got a lot of friends that go on CNBC from time to time, and I like to hear what they have to say and make fun of their ties, of course. The big question: Are we over-supplied with oil right now, or is this just simply a Saudi price war?

CS: In my opinion, it is unequivocally a price war led by Saudi Arabia. The headlines of the oil glut, the oil over-supply, have been, in my opinion, blown way out of proportion. To be clear, there is currently, call it about a 1.3 million barrel a day oversupply right now. That's down from call it 1.75 million earlier this year. But, if you just go back and look at how that over-supply, given the lack of spare capacity that's in the industry right now, how that compares to what was a true multi-year, almost decade-long over-supply back in 1986, there simply is no comparison.

I do get into the math a little bit in my shareholder letter, I'll spare your listeners that for now. The point is, the key difference— the key thing to realize in my mind is that this is not an oil glut. It is a price war. And, it's allowed by Saudi for reasons that we can (only) speculate about. But, the difference is, this could, in theory, end tomorrow if OPEC on Monday morning decides that they're going to have a policy change. That wouldn't really be the case if we were in a true glut.

So, gluts make for fancy headlines and a lot of eyeballs, but just the math would show you that compared to the real gluts we've had in the past, this is not one. And, if you just look forward a little bit and take some numbers about, well, what should U.S. production be this time next year? What about non-OPEC production if we have any sort of meaningful drop for increase in the decline rate? Well then, you can see that the 1.3 million dollar barrel over-supply – it's effectively gone on a forward-looking basis. So, it's a unique time, but to your original question, no, I am very firmly in the camp that it's a price war, not a glut. If that's true, and I believe it is, then we should come out of this fairly soon.

BZ: Yeah. It looks to me like there's starting to be cracks not only inside of OPEC, but inside Saudi Arabia itself about how much longer they want to continue. This is starting to stretch some folk's budgets. Are you seeing the same thing?

CS: Absolutely. Especially today, we've hit another miserable low here. But, I have to think that the conversation that's going on in Saudi, as well as some of the former Saudi allies on the OPEC council there. It's just a little bit hard to figure, and almost incomprehensible why Saudi is pursuing the strategy they are. And to be clear, while it's technically OPEC on paper, the reality is it's the Saudi overproduction specifically that at least for this year has been consistently high.

We've had spikes out of Iraq, most recently and Libya, but it is absolutely on the shoulders of Saudi, and that's where the "problem" production is coming from. It's not quite clear I think to anybody, including people in OPEC, why Saudi is overproducing. I have to think that they are probably feeling the effects. Whether they do anything about it? Probably not, at least in the short term. But, it speaks to a lot of geopolitics that aren't immediately obvious and that are consistent with having a somewhat bullish position on oil here.

I think the sheik vs cowboy battle is overplayed. My opinion is not that the Saudis are specifically targeting U.S. shale, even though it makes for nice headlines. I do think, though, that they probably are targeting somebody, and my hunch is that somebody is actually Iran.

Our U.S. E&Ps do happen to be caught in the crossfire there, but I think once this is over and we look back in a few years, my strong suspicion is that this will have proven to have been an economic war, if you will, between the arch enemies of the house of Saud and Iran. Russia, to some extent, in Saudi's mind, probably needs to be disciplined a little bit, to the extent you could even trust the numbers coming out of Russia, frankly. But that's a whole other discussion.

House Of Saud And Iran

That being said, the elephant in the room, if you will, is this brewing conflict between Saudi and Iran. If you're asking, "Why is this coming up now?" I think it's frankly because the sanctions are coming off, Iran is about to come into the market and I don't think Saudi— Saudi is many things […] but I don't think they're stupid when it comes to the oil market.

I think they're trying to get ahead of Iran a little bit in terms of their emergence to the scene, lock up some contracts in Asia, lock up some things in Europe that they can, to the extent that they take that business from Russia, that's okay too. So, all of that is a wicked potent brew. The problem, of course, is that Saudi is being a little bit covert about all of this. While I feel like this seems to be the logical approach they must be taken, it's hard to prove because they're not commenting on it, but I suspect over time, and in the rearview mirror, that geopolitical angle on things will probably become a little bit more apparent, I would suppose.

There's a lot of deep thinking you can do about oil prices in general. When you expand that scope a little bit, that's one of the areas that has seemed the most out of whack to me, the fact that there is no risk premium whatsoever on the price of a barrel of oil right now, in spite of— it's a joke in the letter, it's almost like a Tom Clancy novel what's going on in the Middle East right now. It is as potentially volatile as I can recall in my lifetime. You have basically this de facto Shia-Sunni war in a slow-motion burn, you've got the house of Saud literally under attack, whether it's in Yemen or a country south. Saudi, I think any military strategist will tell you, is nearly impossible to defend between that coastline and on a forceful border. I feel like the house of Saud is probably in some trouble here. Who knows which way that goes. My point is only that, well, that certainly should show up in the price of a barrel of oil at some level, and right now it's clearly not. That, to me, is an opportunity, as an investor.

BZ: Yeah, [the geopolitical unrest] is not reflected in the price of oil at all […] it could easily create supply shock.

CS: Absolutely. And it's got the feel – I can only imagine like 1915 in Europe. It's got a little bit of those elements. Obviously, I hope that doesn't happen. It doesn't have to happen to do really well in oil anyways. But the reality is that there's a lot of complexities. I confess, I'm too naive to understand them all. But when you get to the Middle East, you could certainly say there's some similarities between what's going on there now, and what happened back in 1915 in Europe, where we in the West don't really grasp all the intricacies of what's about to happen. It's a rabbit hole that's easy to go down. Again, from my perspective, it should show up in a number, specifically that risk premium, and it's not there. So, let's sit back and see what happens, and hope for the best, I suppose.

China's Demand And Oil Pricing

BZ: Okay. The other thing is, I think you call it the greatest myth of the year, and that is the fact that the demand from China is slowing so dramatically that it's really going to keep oil prices down. Is demand really slowing that far?

CS: It's not. It's a particular pet peeve of mine, as you might expect. Clearly, China is becoming economically so significant that, I think any sort of investor needs to keep some kind of eye on it, just because it's as big as it is.

But, just look at the data. Q3 of 2015 demand for oil in China was up just under 7 percent year-over-year. If you were to look at the histogram of demand for oil in bar chart form from China over the last four years, it is up and to the right each year. There's that strong, healthy demand there. I also would expect that it should continue to be strong, really just for a handful of reasons. The first and foremost, that country's efforts to fill their own SPR, the Strategic Petroleum Reserve, they are –bent, if you will, on transitioning more from an industrial economy to a consumer driven economy, so that consumer demand should also be a little bit of a tailwind for oil over there at least, and ostensibly elsewhere.

More broadly and in the bigger picture, they're in China doing this slow-motion transition to what is really a mass-automobile culture, and I feel like that is certainly relevant at the margins at least. The issue with China is, the economic data coming out of there, at least from my perspective, it's what I call a cherry pickers dream. It has both bullish data points, bullish on the consumer side; and then really bearish data points, which are really more from the industrial side of that economy. Either way, I feel like both of those data sets should probably be kept distinct from the Chinese stock markets. They are not markets at all in the traditional sense. There's so much heavy government involvement. The markets in general seem to run not on capitalism, but on this series of liquidity driven asset bubbles, and the point is, they have very little relationship to the fundamentals of the real Chinese economy, which is still growing twice as fast as our own.

There's not nearly as much to be concerned about when it comes to oil demand from China as concerns about the Chinese economy might suggest. In the end, while that economy may have some challenges and growth is almost certainly going to slow, I do think it's entirely plausible to be pessimistic about the Chinese economic growth near term, and still be bullish about oil demand from China in the medium and long-term, and that's how I'd classify my take on that.

Recent Capacity Figures

BZ: You're in up to your neck, I'm about hip deep in oil. So, I'm right in there with you to a degree. It looks to me like capacity is coming off at an alarmingly fast rate. Do you see that as well?

CS: Absolutely. Earlier this week, we got some updated numbers. In the last week we got OPEC. The whole concept of capacity in the oil market, it's almost akin to inventory on the shelf. What is the number in millions of barrels per day form of essentially oil that's just sitting there that can readily be tapped? This also seems to get a lot of attention in the media of late. There are often a lot of headlines and angst about storage capacity filling up in the United States, specifically people talking about Cushing. It's relevant to keep an eye on, but Cushing only represents about 20 percent of the storage capacity of the United States in total.

More to the point, the pipeline system that has been developed for this country of the last four or five years, predominantly by the same MLPs that have also been getting punished in the market lately, has just expanded significantly. There is a lot of angst and gnashing of teeth around storage capacity, specifically of late. But, again, if you just do the numbers, you'll find, and I tried to do this in my letter, it's really not too big of a concern. We should be okay under just about every conceivable scenario. Then, there's the issue of that inventory, that supply capacity. That, to me, is where things get really interesting, because typically, the premiere provider or owner of that excess supply capacity has been Saudi Arabia.

But because they have been over producing for such relatively long period of time, when I wrote my letter only a month or two ago, Saudi Arabia had about 2 million barrels a day of spare capacity. Now, as of that last OPEC meeting, one of the highlights in my mind that came out that nobody seemed to notice last Friday was that they're down to about a million barrels per day of spare capacity. That is significant in the context of those other things we talked about, because if there is some sort of sudden conflict in the Middle East, if there's some sort of incident that were to spike oil prices, the world needs that spare capacity to turn it on, flood the market with more oil, and keep the prices down. But right now, there's a handful of scenarios that you can dream up, or that Tom Clancy could dream up, that means that capacity not only would evaporate in an instant, but we would be as a globe and world oil market unable to handle some of the more dire scenarios should a terrorist attack some of the premier Saudi oil processors.

Looking Into 2016

BZ: I know the heads of Chevron, ConocoPhillips, and Saudi Aramco have all pretty much said that they're not sure how much they think oil will be higher next year, while some of the more nervous ones are going with the "I don't know" and "around this level." What kind of time frame do you have for recovery in oil prices to the 60 or $70 area?

Related Link: What To Expect From Oil In 2016

CS: Again, a caveat first, I don't spend a lot of time trying to predict things in the short term. But, to your point, I absolutely think that there is a scenario over the next three years where oil does get back to that $100 per barrel level. The marginal cost of a barrel of oil, which is still unchanged despite all of this, is right around $80 per barrel. If you presume that there is or should be a risk premium on top of that barrel, $5 or $10 or whatever, then there is – at least in the economic theoretical sense – support for prices that are significantly higher than where they are today.

As a value investor, I feel like one of the luxuries I have and one of the advantages we have is time. I would not and I am not saying that oil tomorrow is going to bounce back to that high, simply too much would have to align. But there is fairly clearly a scenario where that is a high probability event, as you look a little bit further out. Part of the difficulty in answering that question is, it depends a lot on decline rates, and how quickly people are laying off those risk, and I think you mentioned Chevron, even this week, they decided they were going to set their upstream global budget of about $24 billion out of a total budget of about $26 billion, which is down 25 percent this year for them. Chevron, by my count, spent about $2.5 billion in the United States alone, just in the third quarter. They spent about $7.5 billion in the first nine months. Which means, effectively, as of this week, Chevron is cutting their U.S. spending in half next year in 2016. So, hard to quantify in time when exactly those cuts should result in production coming off, yada yada yada. The point is, it is somewhat inevitable. My strong suspicion is that it's going to be in 2016, and arguably sooner rather than later.

The Power Of Recovery

BZ: There's lot of talk, but people point to Europe, they point to a stagnant or slow recovery in the United States, weakness in emerging markets. Is oil demand really declining had some rapid rate, and we're just missing it?

CS: No, that's a great question. Oil demand is growing slower now than it was at the beginning of the year, but even in the most recent expectations call it 1.2 million barrels per day on average next year. Even that is still a healthy dose of oil demand. It's one of those cases where I think people, to the extent that it's rational and they're even thinking about, I think they're a little confused between decreased growth and demand, and a follow up in demand. But there's absolutely going to be growth demand for oil next year under just about every conceivable scenario, barring some sort of widespread global recession, things that are too improbable to even attempt to handicap.

No, global oil demand should definitely be strong next year and from then on. We can talk more about decline curves as we see fit; it's a bit of a wonky exercise. But the reality is there are just some real factors that should increase that demand for next year and the next few years after that, that just aren't at all being captured by any of the histrionic headlines. If you just think that oil use in the developed world right now, average use is about 14 barrels per person per year. In the developing world, though, emerging markets oil right now is used at a rate of about 3 barrels per person per year. It's an interesting question to ask yourself: What do you suppose will happen when millions people go from consuming those 3 billion barrels per year to, never even mind the 14 that we do in the United States, to six barrels per year? The world's appetite for energy in general is going to be staggering over the next few years. In spite of a lot of talk and speculation about renewables, just about any credible forecast you can wrap your arms around says that over any conceivable horizon here, 80 percent of that need for energy is going to be met by oil, gas and coal. It'll be more efficient than today, but the point is, oil demand will remain strong for the foreseeable future, and it's just math. It's not any mystery.

Alternative Energy Plays

BZ: A lot of people have made a big deal of Jeff Bezos and Bill Gates and a bunch of others putting money into a fund to find an alternative energy project. But one statement is that the reason that Gates said that he's doing it is because, as bright as the future of alternative energy is, it's not here yet, and it's not cost favorable at this point in time. So, I don't think alternatives are going to pick up any slack at all in the short term.

CS: They're competing with hundreds of years of a global hydrocarbon foundation. That is not easy, as a capitalist, to make a dent into. Renewables, solar specifically, at the end of the day, it is a technology, so investing money in it should be useful in terms of driving those costs down, helping gain those efficiencies, but just the scale of energy that's consumed by the world is so staggering, and it's so strongly in the favor of fossil fuels, that it's simply going to take a long time for renewables to eat away a considerable market share, in my opinion. It's just a tough road to hoe. For the three to five year horizon that I'm considering in this current investments, I'm not particularly concerned much at all about it.

Disruptive Technologies

BZ: The big problem, I think my grandkids will really benefit from solar and wind, but the real problem as I understand it is distribution, and more importantly, storage of the power. I could keep a barrel of oil anywhere. I cannot bottle sunshine.

CS: Absolutely. While, I guess, as a technologist or somebody looking to invest in disruptive technologies, I can see the attraction of trying to be the one who helps fund the device that cracks the code on battery storage, energy storage in particular. At the same time, it is by no means an easy task. You have to root for those guys, as an American and the capital, that's what it's all about. […] But at this point in time, a lot of that still resembles a bit of a science experiment, and I don't feel that is a real risk with my investor hat on, at least not anytime in the short term.

Bear Market Cycles

BZ: Now, on top of all this, you had a chart in your letter from Matador Energy that talked about bear market cycles in oil. Can you expound on those numbers a little?

CS: It was a great chart, and I don't own any shares in Matador Resources. I do very much respect that management team, it's just one of those things that caught my eye. They basically put together a table comparing all the major oil corrections since back in 1980, I believe. There's seven or eight line-items on there; the bottom one being the current dip that we're in, it's just interesting to look at that table and see a couple things. The first being, what was the percentage change in oil price in each of these events? These events, had you been alive and paying attention then, you would have recognized that in 1986, the Saudi market share war; back in 2008, we had the Great Recession; a global recession back in '01— so, they're all fairly significant events if you were to look at this thing.

Each of those events was significant in terms of a specific cause, they're significant because oil prices got hammered over the ensuing three to nine to 12 months. The thing that jumps out at you though, if you look at this table, if you look at the most recent price collapse – and right now, we're hitting new lows again, so this would bump that number up even more – the thing that's most unusual is just the length of the oil price decline in trade. In other words, from the time this current oil price decline began back in mid-2014 to now, that in and of itself, it's not quite at the most historic level, it doesn't quite reach the 1998 Asian crisis level, but it's second, and it's approaching that.

Related Link: Two-Day Rally In Crude Oil Ends With A Thud

It's just odd to look at all these other historic explicit events that you can unequivocally grasp would cause the price of oil to collapse, and then contrast it with today. It's just a little bit odd. There clearly was an event late last year that caused oil prices to start, but there's nothing that really explains why it has dragged out as long as it has, with the exception of a lot of little reasons, if that makes sense. It started as a snowball, it's just kept on growing and growing. And at a certain point, particularly if you're of the opinion that this is a price war, and not a glut, like I am, then you have to think to yourself, "Boy, it's getting really long in the tooth here."

Bullishness And Names

BZ: Once we decide that we like the long-term picture of oil, we think it's going to go higher over time, what kind of stocks are we going to buy?

CS: That's the value investor's conundrum. It's a good problem to have. I feel like my own criteria for selecting those stocks has changed quite a bit in the last six months. The way that I approach it is, in general, if you were to shotgun all of the U.S. E&P, all the U.S. expiration production names up against a wall, I feel like you want to focus on that quadrant that contains the company is that really have three things. The first is that they have what is called high recycle ratios.

The recycle ratio is the cash earned barrel of oil equivalent, relative to the investment required to basically bring that oil out the ground. It's kind of an operating margin on a per barrel basis divided by your finding and developing cost, to stay truly wonky. It's essentially a proxy for ROIC. That to me is critically important as a value investor, and it's sort of a modified view of ROIC, again, which is important to a lot of other non E&P companies.

I think the second attribute that you want to look at is production per debt-adjusted share, and that's essentially to make comparisons easier between firms that may have financed their previous growth with debt. It doesn't take a genius to realize that if you just start throwing money around all over the place, eventually you can get a company, any company, to grow. The difficulty when it comes to E&Ps is that a lot of times, they will use debt to grow and while well-intentioned, they don't want to dilute their equity holders. The reality is they may not have the production base to really support that, as some of these guys are finding out right now.

I think that production growth per debt-adjusted share is also an important hack to make when you're looking at these things. In addition to those two as a minimum, then you would add your favorite valuation overlay. I tend to look at things a little bit more and a typical value investor basis, a more normalized cash flow approach. I will also personally take another hack at evaluation on a net asset value, NAV approach. You just have to keep in mind that NAV is probably not as important except for that one day in which you get bought out.

But, just taking a traditional, fundamental look at things. Then, looking at the multiples that you would pay for that cash flow in light of geology, specifically, are these guys working with stack pays here? What do the IRRs look like? Growth rates? EBITDA margin? Debt to EBITDA? And then, above all that, keeping in mind, and this is more of the classic Buffett compounder idea, it can be worth it to pay up a little bit for guys who are in the cores of those plays. There can be a huge different, again, in well production from core areas. It can outpace or out produce marginal areas by, in some cases, up to 500 percent. It's ok, in my mind, to pay up a little bit for that, especially when things are so depressed down here. Those are just kind of the two or three new tools I've added to my own analytical framework for looking at these things, and I really think you have to be thinking about it like that if you're looking at these E&Ps. Otherwise, there's a ton of them to look through. It can be hard for the layman to differentiate between who's got their act together as a management team and who doesn't, who is run by salesm

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