Falling Oil Prices Source of Bargain Hunting – Oakmark Funds

Judson Brooks is a partner and U.S. investment analyst at Harris Associates. Prior to joining Harris Associates in 2001, Judson was a research analyst at Ariel Capital Management. He has an MBA from the University of Chicago and a BA from Indiana University. Judson is a CFA charterholder.

On June 13, 2014, a barrel of West Texas Intermediate crude oil traded for $107.  Six months and sixteen days later it traded for $44.53.  Slowing global demand, greater-than-expected production from U.S. shale, and the surprising decision by the Saudis to maintain market share all combined to create a glut of oil supply that exceeded oil demand.  Oil prices—the mechanism by which supply and demand are balanced—correspondingly fell by more than half.

As oil prices fell, energy-related companies saw their share prices tumble.  To some degree we believe this decline was justified, since lower short-term energy prices will lead to lower near-term cash flows, but market reactions often overstate the impact that short-term issues have on long-term business value.  As we see it, conditions such as these produce an environment made for bargain hunting.

So while many investors were scared off by the recent volatility in oil prices, we saw this volatility as an opportunity.  This isn’t to say we can precisely forecast the price of oil over the next few years—in fact, we almost certainly cannot.  However, just like any other economic variable, we can look at the long-term fundamentals and consider a range of plausible scenarios, thereby helping ensure that our investments come with a built-in margin of safety.   For oil, this starts with global demand, which in rough numbers is currently around 92 million barrels of oil per day and has been growing by approximately 1% each year for over a decade.  This demand is met by supply from a combination of existing production and new wells.  The catch is that each year existing wells produce six million fewer barrels per day.  That means large amounts of money must be spent to find new reserves, drill new wells, and safely bring the hydrocarbons to the surface.  With a few exceptions, the cost of developing marginal reserves is quite expensive.  There are many estimates of the marginal cost of production; almost all of them are above the $50 per barrel range at which oil trades today.

Therefore, we believe in order for oil supply and demand to balance over the long-term, oil prices must be high enough to incentivize this marginal development.   It may not happen tomorrow, or even next year.  It will take time for companies to respond to low prices: cutting production plans where it is not economical today, deferring development spending where production is months from starting, and cancelling exploration projects where production may require billions of dollars of additional investment.  However, such actions will, nearly inevitably, eliminate excess supplies—and oil prices will then reflect the long-term marginal cost of new production.  Such is life in a cyclical world.

Taking a long-term view, we can look past the current downdraft and consider the value of businesses across the cycle.  The value of a business to us is the net present value of all future cash flows.  Many investors extrapolate falling prices far into the future despite the marginal economics and cyclical history.  Some attempt to call the cycle to avoid the pain on the downside, thinking they can buy at the bottom.  Others simply sell a stock because they claim to know the stock is going down.  The result can be falling stock prices for healthy companies that face short-term uncertainty but a bright long-term future.  When these companies are managed by people who think and act like owners, we will consider them for investment.

This is exactly what we have been doing.  We believe we are buying companies where profits may shrink this year and next, but the profits will eventually grow as the world economy inexorably consumes more energy.  Halliburton and Baker Hughes are examples of oil services companies that have technologies and scale to efficiently find and develop hydrocarbons across the planet.  Apache, Chesapeake Energy, and Ultra Petroleum are examples of companies with management teams that we trust to produce oil and gas reserves economically.  National Oilwell Varco manufactures the necessary equipment to develop and produce those reserves.  Even companies like Flowserve and Dover have large subsidiaries providing products to the energy supply chain.  Each of these companies has seen their stock prices fall by at least 25%, while value has fallen much less than that.

While it is currently a tough period for these companies and their shareholders, our philosophy is built on the idea that excess returns go to those who have a long-term perspective and focus on intrinsic value, even though it might mean suffering through the painful side of cyclical industries.