FPA Capital Fund 3Q15 Letter: Should You Continue To Trust Us?

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FPA Capital Fund commentary for the third quarter ended September 30, 2015.

H/T Dataroma

Dear fellow shareholders,

We are not happy with our performance over recent quarters. However, after our poor relative results in the fourth quarter of 2014 and first quarter of 2015, we are pleased that our relative performance in the past two quarters has improved substantially. At the end of the first quarter, our Fund was trailing Russell 2500 by 10.09%. That underperformance decreased to 9.25% in the second quarter and to 8.29% in the third quarter. This was a particularly hard-earned achievement in the third quarter as oil prices declined 24%. Furthermore, we are encouraged by the fact that since the beginning of this very volatile period (since August 17th), our Fund lost 6.01% vs. Russell 2500’s decline of 9.28%. Ultimately, though, what matters to us is our absolute performance over a cycle.

We know that there are three principal questions on our shareholders’ minds:

  1. Are we nuts to devote such a large allocation to energy?
  2. Is for-profit education destined for a slow death?
  3. Why should we continue to trust you to manage our capital?

Let us respond to each of these questions.

Question 1: Are we nuts to devote such a large allocation to energy?

We think that some of the best investment opportunities available today are in energy and we have
positioned our portfolio accordingly. We believe the following:

  • There is currently excess supply in the world, but the factors detailed below will eventually result in a world with a supply shortage
  • In an undersupplied world, we expect prices will eventually move higher
  • Once prices move higher, surviving firms will be revalued higher than today

The factors:

  • The marginal cost of oil production is around $80/barrel
  • Many firms and countries will curb their search for new sources of oil below $80/barrel
  • We believe demand for oil is relatively fixed and grows with GDP
  • Oil is a depleting resource so if we don’t actively drill for new sources, supplies will decrease

Fundamentally, the cure for low prices is low prices and time. We already have criteria #1 – low prices.

FPA Capital Fund – The marginal cost of oil production is around $80/barrel

The marginal cost of oil production is the total cost to find and extract the last barrel of oil from the ground to satisfy the demand for that last barrel. The mid-cycle marginal cost of oil production is around $80 per barrel (although current marginal cost levels may be below $80/bbl simply because of temporary service company price reductions due to the downturn).

Many firms and countries will curb their search for new sources of oil below $80/barrel

Over the last 10 years the industry spent nearly $3 trillion on upstream investments2, but was only able to grow crude oil production by 5.2 million barrels per day (from 72.6 mmbbl/d to 77.8 mmbbl/d). This growth mainly was achieved thanks to North America and OPEC. The rest of the world struggled to increase production even though prices more than doubled during this time.

Between 1999 and 2014, global upstream capex only fell twice; in 2002 when it fell by 5%, and 2009 when it fell by 16%. In 2015, upstream capex is expected to be down 23%, the largest decline in 20 years, and is expected to be down in excess of 10% again in 2016 if Brent oil is below $60/bbl. Within North America specifically, capex is expected to fall by 40% in 2015 and more than 20% in 2016. We have already started experiencing the impact of lower spending in the U.S., where total crude production is down over half a million barrels per day as of September 2015 after hitting 9.6mm in early June6. We expect these declines to continue as the U.S. companies started cutting expenditures earlier this year in earnest.

FPA Capital Fund

The rest of the world is not having it any easier. According to the International Monetary Fund (IMF), in 2015, Saudi Arabia will have a budget deficit equal to 20% of its gross domestic product up from 3% in 2014. In Saudi Arabia, net foreign assets fell every month since the end of January to July and stood at $661b – down from $725b in January. After a long hiatus, the Kingdom decided to borrow long-term debt (35billion riyals) to combat the effects of the large oil price decline as oil income makes up about 90% of the government’s revenue. In addition, they have also redeemed over $50b (some estimates go as high as over $70b) from their investment managers overseas. The number of oil rigs operating in Iraq decreased by almost 55% after hitting a peak a year ago. In Brazil, Petrobras cut their 5-year capital expenditure plans by over 40% from $221b (2014-2018 period) to $130b (2015-2019 period) and their 2020 production target from 5.3mm boepd to 3.7mm. In Norway, oil companies cut 20,000 jobs.

With Brent oil below $50/bbl, very little money is being invested in exploration activities, which is a key leading indicator of the industry’s ability to meet future supply requirements. Exploration budgets are expected to decline by about 30% globally in 2015 with the number of exploration wells drilled or planned in 2015 down 26% vs. 2014 to the lowest level in five years.

FPA Capital Fund

We believe demand for oil is relatively fixed and grows with GDP

Yet, the demand for oil is robust. In its September 2015 Oil Market Report, the International Energy Agency estimated the global demand for oil to increase from 93.9mm barrels in Q4’2014 to 95.5mm barrels in Q4’2015 and to 96.8mm in Q4’201614 – a 3mm barrel global demand increase from the end of 2014 to the end of 2016.

FPA Capital Fund

Source: IEA September 2015

Oil is a depleting resource so if we don’t actively drill for new sources supplies will decrease Unlike commodities such as gold where virtually all of the yellow metal that has ever been mined still exists, virtually all the oil that has ever been produced has already been consumed and is therefore unavailable to satisfy future demand. And, unlike mines or factories that generally maintain their productive capacity from year to year, production from oil wells is always declining due to natural depletion. In other words, new money needs to constantly be invested in repairing old wells and drilling new wells just to maintain existing production levels, let alone grow them.

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