Value Investing: Commodities, Contrarianism And Conviction

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Following is a common dialogue at recent investment meetings with our Canadian clients.

“Where is the price of oil going?”

“The price of oil will increase.”


“We are not sure; it may decrease some more before the inevitable increase.”


“How can you be sure? And if you don’t know when, how can you invest in oil-related companies?”

Let’s break this last question down into its two parts.

“How can you be sure?”

The cure for low prices is low prices.

From economics 101 comes the old supply and demand equation, visualized graphically with Quantity on the x-axis and Price on the y-axis.  Where supply meets demand in the graph below is at the marginal cost of production for per-day consumption – approximately US$80 and 90,000,000 barrels.  As prices fall, we slide left on the supply line and right on the demand line.

This graph is not drawn to scale – demand should be more vertical because shifts in demand are less price sensitive than the graph indicates – but what it highlights is the coming shortage in production.  And no, Saudi Arabia/OPEC cannot produce enough to fill the medium- and long-term voids. Currently OPEC produces approximately 30,000,000 barrels per day, or a third of global daily consumption.

At the time of writing, profit-maximizing oil companies are canceling the development of oil projects all over the world, which will eventually decrease supply. Indeed, the longer the oil price stays below the marginal cost, the higher the likelihood of eventual supply shortages and price spikes. While this will take time, it inevitably means the price of oil will increase.

“If you don’t know when, how can you invest in oil-related companies?”

Despite perceptions, Burgundy actually has a long and successful history of investing in commodity companies. While infrequent, these investment decisions were made with conviction.

Burgundy’s playbook for successful commodity investing is to invest in companies with:

  1. Low-cost production
  2. Strong balance sheets
  3. Long reserve life that leads to production growth
  4. Excellent capital allocators at the helm

The playbook identifies companies that will survive depressed commodities (1 & 2). But, it is not enough to create long-term growth in intrinsic value. For that we need both 3 & 4 from our playbook.

While these characteristics are key, the best opportunities arise when the commodity price is trading below the marginal cost of production.  At these junctures, shorter-term investors typically extrapolate the weak prices far into the future, thereby depressing the stock prices of even the best operators.

Today, we find ourselves in one of those periods for the price of oil.  Accordingly, now is the time to act decisively.  In line with previous periods of distress, we believe our ability to act with conviction will allow us to make money for our clients.

Some people may feel this approach is too simple – if it were that easy, why isn’t everyone taking a position? To this, we would remind them that simple is not the same as easy. In order to take advantage of the short-termism of others, we must be contrarian – going against the grain – we must be patient, and we must be willing to accept some short-term losses. Timing the exact bottom is impossible and value investors, including Burgundy, are often early.  We remain patient by acknowledging that money in the stock market should have a time horizon of longer than five years.


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