|
Dear Tarpon Investors,
Since the beginning of the year through the end of July, the Tarpon Folio is down 4.3%. August is also off to a rocky start. For reasons explained more below, however, I expect our portfolio's performance to soon begin to self-correct.
It has been a frustrating summer.
The world's largest oil producing country imposed sanctions on the third- and fifth-largest oil producers. It then started a trade war with the seventh-largest producer. The world's second largest oil producer began an all-out economic embargo on the fourth-largest producer. And the world's sixth-largest oil producer is Iraq...the Charlie Sheen of oil market stability.
Lately, Tarpon has felt like the avocado of portfolios. While we wait and wait for it to mature enough to be enjoyable, it sneakily morphs into a disappointing mess.
Our returns have been driven by people playing a different game than we are. And there has been more noise than usual to sort through lately, so staying patient can be difficult if you're not seeing the whole board.
First, though - an update on some of our companies, and then some thoughts on oil.
Company Updates
First, here is a link to a write-up on one of our newest positions, QEP Resources, a dramatically undervalued oil producer with exceptional assets in the Permian basin. Shares currently trade at $9 versus my sum of the parts valuation of $16 per share. The market is effectively valuing QEP’s top-tier Permian assets at sub-$13,000 per acre, in spite of a comparable acquisition just last Wednesday that valued similar acreage at ~4x that level. It can be hard to see the value at QEP unless you dig. But the company is undergoing an activist-investor driven transformation to sell off its non-Permian assets, reduce debt, and return cash to shareholders through a $1.25 billion share repurchase program. I’m pleased to add them to Tarpon. Download my write-up as a PDF here.
Also this summer, two of our holdings in Tarpon announced they are being acquired. Not long after presenting the company to you at our investor meeting in May, Energy XXI (EGC) announced that it had agreed to sell itself in an all-cash deal at an attractive premium to our cost basis.
Also this summer, two of our holdings in Tarpon announced they are being acquired. Not long after presenting the company to you at our investor meeting in May, Energy XXI (EGC) announced that it had agreed to sell itself in an all-cash deal at an attractive premium to our cost basis.
Then, Gulfmark Offshore (GLF) also announced it was being acquired in a stock-for-stock deal by larger competitor Tidewater (TDW). Recently out of bankruptcy, GLF, which owns and operates offshore service vessels, was just too cheap - trading at half of net asset value, poised to materially increase its earnings power, and with a base of investors that wisely saw the need for consolidation in the sector.
While that transaction lacked the same premium we saw at Energy XXI, it was nonetheless very good news for us longer-term. I intend to hold our shares through the merger, as Tidewater, too, is significantly undervalued, giving us another low-risk way to benefit from a recovery in oil prices. Should TDW’s fleet activity levels reach their pre-crash average, and the market value the company’s equity at a level equal to just the midpoint of its historic range, TDW shares, currently priced at $30, would trade north of $150. That will take some time, but I’m happy to wait.
Also notable were recent developments at Contango Oil & Gas (MCF). It turns out we were not alone in seeing the significant potential value at the company, yet being frustrated by the pace at which it was being realized. Activist investor John Goff bought 18% of Contango shares, joined the board, removed the CEO, and installed a hand-picked new chief executive to kickstart the next phase of the company's future. I admit it: I was a little ashamed how good it felt to hear that someone had gotten fired.
One particular disappointment this summer was Gastar (GST), at the time our smallest holding in Tarpon. Gastar's controlling shareholder, the private equity firm Ares - who you may remember also owned a significant stake in our previous ten-bagger Clayton Williams - had apparently seen enough. In late July, Ares unexpectedly filed a proposal forcing the Gastar board to essentially either sell the company or restructure in court.
That came as a surprise; GST had operational runway, liquidity, attractive assets, non-core acreage to sell and seemed to be incrementally improving its drilling results. With roughly 70,000 net acres in the STACK basin, a value of $14,000/net acre would have equated to a common share price of ~4x where shares traded the day before the Ares filing. That value, however, rested largely on the success of the company’s most recent drilling efforts, which – after the Ares ultimatum, and not long after I sold our shares – were revealed to be disappointing. Given that GST will likely now have to sell itself under duress, we exited that position.
Finally, a few comments on our largest position in Tarpon, Resolute Energy (REN). To the extent you are frustrated by Tarpon, you may really be frustrated by REN’s stock price behind-the-scenes - or more pointedly, by me, for so stubbornly holding onto these shares.
You'll recall that REN was (in addition to Clayton Williams Energy) our second ten-bagger in 2016. REN is a pure-play Permian operator that owns some of the mostly highly prolific, most valuable onshore oil acreage in this hemisphere. I have yet to sell a single share of our holdings, even as REN shares retreated from a high of $48 per share in early 2017 to settle in a range of $30 to $36 the past year. And as a reminder, our cost basis in REN shares is $4.15 per share.
There are a number of ways to value an E&P company, but in the spirit of simplicity, I’d just point out here that the company is trading today at a value of $28,000 per standalone Permian acre. I believe that REN's assets are actually worth $50,000 per acre. I also believe that – due to the efforts of several activist investor firms - there is a high probability that the company will soon be sold at a level approximating that price. And a sale of REN at that level would translate into $55 per share, compared to $30 per share at market close on Friday.
REN will significantly grow revenues in the second half of this year. The value of its Delaware basin acreage in the Permian will also keep increasing. It is dramatically undervalued whether it gets acquired or not. So the only downside to holding REN shares is that they get caught up in the same silly volatility that has plagued all energy company stocks the last several years. Whenever Resolute’s day in the sun finally arrives, however, due to the valuation gap that now exists, the size of our REN position in Tarpon and the magic of compounding off a very low cost basis, we should be well-rewarded for our patience.
Incidentally – and standby for heavy speculation here - my hope is that Resolute Energy gets acquired in an all-stock deal by larger Permian peer Centennial Development (CDEV). Centennial is run by arguably the best CEO in the industry, owns a complementary set of assets, and has a stock price that is moderately overvalued…which would make a stock-for-stock deal for REN at least theoretically plausible.
Just spitballing here. I have no facts to support this might happen - ever. So for more wild speculation, catch me on my new podcast, "Talkin' Crude In Tinfoil Hats."
Anyway - in that possible scenario, our significant gains in REN would continue in CDEV (no taxes, y’all!) and a new CDEV/REN combo would then have the scale needed to grow very efficiently during the rest of this oil cycle.
So, first of all - knock on wood and shake some chicken bones.
Second, in the short-term, the size of our REN position can obscure positive developments at our other companies - like at EXXI and GLF, for instance. Those overshadowed positives will absolutely still matter to our long-term performance, though.
Finally, regardless of what happens with REN, I’d like to underscore this broader point:
I am willing to forgo smooth, year-to-year results in Tarpon in order to achieve better overall performance over the long haul. I am willing to concentrate heavily in the best investment opportunities I can find - and because that requires such an exhaustive search, and demands such constant, low-grade paranoia - it would be a source of deep regret to let go of those opportunities prematurely. I strongly believe we will outperform the broader market again. Our results will bounce around much more than the market, but our long-term margin of superiority over the market will be that much greater, too.
So, I cannot beg the market to provide us with deeply mispriced stocks, and then complain when those mispricings aren’t fixed by a convenient date on the calendar.
Which brings me to the most common question I’ve gotten this summer: “When is Tarpon going to finally pick back up again?”
And that brings me to this.
What's Up With Oil Lately?
In late May, the U.S. announced it would reinstate sanctions on Iran - an unequivocally bullish development for oil which will officially begin in November. That news was soon followed by U.S. pressure on Saudi Arabia to increase oil exports - to replace lost barrels from Iran and keep a lid on global oil prices. Then, as U.S. - China rhetoric about tariffs heated up, China unexpectedly reduced the amount of crude it imported and began to "de-stock," or chew through its own existing oil inventories, rather than import new barrels.
All of which put a pause on the historically massive drawdowns in global oil inventories the market had been witnessing the previous eighteen months.
China is important to U.S. oil, and U.S. oil is important to China.
In 2017, U.S. crude exports to China jumped tenfold from a year earlier, reaching an average of 224,000 bopd. During the first six months of 2018, U.S. crude exports to China increased further, to an average of 377k bopd - making the U.S. China's top supplier of crude - until the last two months, when U.S. oil shipments into the country fell significantly (down to 189k bopd in July, and set to fall again in August, as per ClipperData). And in the first half of 2018, China accounted for 20% of all U.S. crude exports.
So China has relatively quickly become a significant market for U.S. crude, and when it suddenly stopped buying U.S. oil, our oil traders got twitchy.
That cessation of U.S. imports by China had two causes. First, Beijing recently increased taxes on the country’s small, independent refineries in an attempt to fix the industry’s chronic overcapacity. China is home to many small independent (“teapot”) refiners that run at only ~50% capacity. That is terribly inefficient and crimps the margins of the country’s larger, state-owned refiners. So that tax issue started to cause some angst among small refiners in March. Then, a few months later, several large Chinese refiners stopped buying U.S. crude outright – specifically to avoid getting jammed by an unexpected price increase if oil tariffs were announced while ordered crude was in transit between countries.
As an aside, I also find it interesting that several private oil data-tracking services recently reported that China has ceased sharing its oil inventory data. That, at least to me, raises the possibility that China may be using headlines about tariffs to shrewdly advancing its own energy security interests. Beijing was, in retrospect, uniquely positioned to exert downward pricing pressure on crude this summer. But, well, that’s another speculative discussion better suited for the podcast.
Regardless, all signs point to this summer dip in oil prices being temporary.
Signs This Dip Should Soon Be Over
First, U.S. crude not sent to China has been finding a welcome new home in India - rising from a paltry 17,000 barrels a day this April to 261,000 bopd in June and likely reaching 319,000 bopd in August (Reuters Oil Research). The opportunity for U.S. crude in India will further expand later this year when Iranian sanctions take effect.
That U.S. crude can easily be sent to India means, among other things, that China is the more vulnerable party when it comes to U.S. tariff negotiations. Forbes has reported that it was specifically the large Chinese refiners that lobbied the Chinese Ministry of Commerce to remove U.S. crude from its sanctions list last Monday.
Second, as reported last Friday, China is sending a delegation to D.C. this coming week to begin low-level trade talks. While we shouldn’t expect anything material out of these talks, it is nonetheless another signal by Beijing that should alleviate Chinese refiners’ recent fears of importing U.S. oil.
Third, in the third and fourth quarters of 2018, three Chinese companies will be bringing online new refining capacity of up to 900,000 bopd (in Hengli and Zhoushan, each with 400k bopd, and Huabei at 100k, as per Reuters). Assuming that even communists love NPV-positive projects, they’re going to have to start feeding those refiners imported oil soon to begin recovering those investments.
All of which speaks to the broader reason why I believe China imports will pick up and reinvigorate global oil prices relatively soon:
Rational self-interest.
Specifically, China needs to import a looooot of oil, due to the massive and increasing demand from its developing middle-class economy – while China's own domestic oil production declines. Oil imports are simply too important not to resume soon, or else China’s economic growth will suffer. And once Chinese imports do bounce back, declines in global oil inventory levels will resume…which should satisfy even the twitchiest speculator counting crude barrels in Cushing, Oklahoma every Wednesday morning.
So what we've been seeing in the oil market this summer has been, in a word, noise. It has been the sloshing around of global oil inventories between opaque countries, like Saudi Arabia and China, and transparent markets, like the U.S. Though it certainly hasn't been obvious.
Interestingly, Saudi has also recently stepped back into the picture as well - signaling a 100,000 bopd reduction to their own oil exports in August, and underscoring their expectations for substantial declines in global oil inventories in Q3.
And if in fact this summer dip in oil prices is nearing its end, that would start show up in three leading indicators:
1. Chinese refiners will start processing more oil.
Check that box. Specifically, research firm SCI99 reported last week that operating rates at independent Chinese refineries jumped by 5% over the prior week – a big jump, reaching the highest average utilization levels since June of 2015. Game on.
2. Floating storage will drop - as the June surge of Saudi exports is absorbed by the market.
Check this box, too. One data provider showed floating storage drop from 50 million barrels to 36 million in just three days this past week.
3. The spread between Brent and WTI oil prices will increase.
We can’t check this box quite yet, but it appears imminent, and there are a ton of eyes watching it. On a chart, that spread looks like it could be bottoming out at the moment…or it could just be bouncing around. Best to give it a little more time to tell for sure.
At this point in the oil cycle, though, that spread is really a proxy for U.S. exports. And given that Saudi is throttling back on exports, while China will be throttling up imports, we can at least have reasonable confidence that this spread, at worst, shouldn’t get much tighter, which would be bearish for oil. Let’s stay patient and see what happens. Because once that Brent-WTI spread does start to increase again, the market is going to suddenly gain a lot of confidence that this summer dip is behind us - and then start to panic about $150 oil.
Kidding. Or. Am. I?
The Bullish Big Picture
It’s obviously a challenge to guesstimate exactly when this latest decline in oil prices will inflect. But we don’t need to be exact, either – as long as we stay patient.
Oil remains in a bull market. The world now uses almost one billion barrels of oil every ten days. And the far bigger problem for oil, extreme underinvestment, continues to lurk in the shadows - and likely got incrementally worse the last few months. Fears of trade wars, actual sanctions and heightened volatility only continue to push out much-needed investment in the industry.
In the meantime, global demand for crude is growing at 3% year over year, OPEC+ has the lowest level of spare capacity in modern history, production from Venezuela is cratering, Libyan supplies are dwindling, 1 million barrels a day of supply will soon be lost from from Iran, and global oil inventories are at their lowest levels in years.
Plus, the major driver of oil supply growth in the world - the Permian basin in the U.S. - will soon see its growth slowed by pipeline capacity - as the U.S. Energy Administration cites record U.S. depletion rates of 6 million barrels of oil a day. And then Iran's proxies in Yemen continue to lob missiles over all sorts of critical oil facilities in Saudi Arabia.
All of which seems, I don't know, kind of important, amiright?
Yet, here we are – witnessing the largest disconnect in history between oil company valuations and the price of oil.
Great googily moogily. Where's the Tylenol?
I, too, grow tired of the volatility. But it is a mistake to confuse our recent returns with our potential for absolute gain. And it would be a tragedy to waste this opportunity. We have it in hand, and we cannot lose it - unless we either give up, or walk away.
So, please hang in there with me a little bit longer.
And in the meantime, please let me know of any questions.
Thank you for your continue patience.
- Cale
|
Cale's Notes: 
