Be an hero and invest in oil

Everytime someone tells me oil will absolutely keep falling, I ask the exact same question:

“So, then, you are shorting oil, right?”

… and every timeI get the same answer.

“No.”

Why not? If you are absolutely sure oil will keep falling, why aren’t you taking the free money by shorting oil? In other words, with oil currently at $44 a barrel, why don’t you take a short position in a future? If oil fell to $40, you’d make $4 per contract and the typical futures being 1,000 barrels, that’s $4,000 in “free” money right here and there.

Of course, in my entire life, I have never, ever met or even heard of a person who predicted oil would fall and actually followed his prediction. Never, ever. I dare you to name me a single person announcing on every roof that oil will fall lower than is actually shorting the commodity.

That kind of person doesn’t exist.

Why?

Because, of course, there is absolutely no guarantee whatsoever oil will keep falling and anybody who says otherwise is a complete idiot. Furthermore, only a complete idiot would short one of the most valuable commodity on Earth after it fell over 55%. It just doesn’t make sense. Unless you are aware of a new invention that will make oil obsolete and useless, you are basically gambling the house to win a landmower. Let me explain.

Let’s say you truly believe oil will keep falling. You are so sure, in fact, that you are ready to take a short position. You sell 1,000 barrels at $44 and all of sudden, oil kicks up to $54. Oops! You just lost $10,000! And don’t tell me this isn’t possible: mere months ago, oil kicked from $44 to $60 within weeks. Suddenly, your “I’m absolutely certain to make at least $4,000!” turns to “I just lost $10,000… and I might lose even more.”

You don’t know what will happen to oil and all those fancy “analysts” have no clue either

Nothing pisses me off more than an analyst on TV. I can barely stand those guys with those crazy two-sheet Excel models during meeting, so you can bet I can’t stand those morons spitting crazy impossible “scenarios” that are about as likely to happen as the latest Fallout game. Just today, some crazy lunatic was on TV stating oil could hit $20 a barrel. His evidence? “There was volume on a contract at this price.”

My doctor  told me to watch my blood pressure, so I’m not even going to try commenting such an idiotic line. I will conclude by saying analysts have no idea what they’re talking about. For all that matters, oil price is a stochastic process, and stochastic means random. This means oil could kick up 5% tomorrow, or 10%, or 15%. Furthermore, commodity pricing is extremely complicated and depends on so many factors it would take entire financial  teams to even develop the most basic predictive model - and even there, I can tell you, after being part of such a team, that those models are wildly inaccurate at best.

Nobody knows where oil is going. It may head back at $100 by the end of the year or it might never hit $100 again.

That being said, here is why you should be investing in oil right now

Right now, I have a list of five oil stocks I literally CANNOT wait to invest in. You read that right: I literally cannot wait for the market to open tomorrow to be able to invest into them. In fact, over the following months, I will be investing a massive amount of money into them.

Here’s why:

Right now, I can’t think of a single reason to be “bullish” on oil prices

It seems every single thing is going horrible when it comes to oil these days. Saudi Arabia kicking up production, Iran coming back into the game, shale oil maintaining its production, oil glut worsening, China consumption not growing as fast as expected, Europe not growing as fast as expected, etc, etc, etc.

No matter where I look or what I read, I cannot find ONE article being even slightly optimistic when it comes to oil. In fact, my own personal view of oil right is, at least when it comes to what I’ve read, is 100% negative.

This means it’s the perfect time to buy

One thing I leaned after many years of trading is that the most lucrative strategy is ALWAYS to go against the herd. In my entire life, I cannot think of a single large gain that I’ve done after following the trend, yet I can think about several large losses. Whenever a lot of people agree on something, I tend to do the exact opposite. Whenever I hear analysts say that it’s time to sell, I immediately look at buying. Whenever analyst get positive about something (“GoPro is headed for $100 a share! Shake Shack doubled since its IPO! China breaks the 5,000 barrier!”), I get anxious and worried.

Most of the money I’ve made in my life comes from investing at moments where everyone had given up. My biggest gain is without a doubt Apple (“Steve Jobs is dead! Apple is finished!!!!) on which I’ve somehow managed to make a 102% return so far. That’s right: a 102% return on a $700B company, just because I wasn’t dumb enough to do what “analysts” told me to do. My second biggest gain comes from mass buying financial companies during the financial crisis, mostly canadian banks. I still remember when Bank of Nova Scotia, despite having zero exposure to the housing meltdown, offered a 12% dividend. That’s right: one of the top banks ever offered an almost-guaranteed 12% return JUST in dividend. Somehow, investors were expecting the entire financial world to vanish.

In any event, here are a few thoughts about oil

1) Oil is not going anywhere

It’s the most important commodity in the world. Forget the “one of the most important,” it’s plain and simply THE most important commodity right now. People massively underestimate how important oil is and the role it plays in our economy. In simple words, oil is everywhere, from your typical plastic wrapping to fertilizers, the role it plays in the economy is fundamental and it’s nowhere near stopping. Many people mention more efficient cars to forecast lower oil consumption, but they forget many countries don’t have that kind of limitation. As for electrical cars, they are still 10 years away from hitting mass production and perhaps 15-20 years from hitting adoption. Don’t believe me? Tesla sold 10,300 cars in the first three months of this year, out of roughly 3M in the US alone. Woohoo! Market share!

Oil might have fallen out of favor due to the price crashing, but there is still a massive amount being consumed every day and this amount will keep rising up.

2) Demand for oil will grow up massively

I haven’t found a single article mentioning that as oil prices go down, demand will go up. It’s simple economics: if something is cheaper, the demand will it will go up, and vice versa. Now, there are some exceptions to that rule (inelasticity in demand, for instance), but for oil, the relationship is much more linear.

With cheaper gas, for examples, comes a higher tendency to drive. The lower the price, the less attractive public transit becomes. A bus ticket at $5 might be attractive with oil at $4 a gallon, but with a gallon under $2? A lot less. Oh, and that trip to the other side of the country you wanted to take suddenly becomes much more affordable with lower gas.

Similarly, when a plane ticket is half the price it used to be a year ago, it is clearly more tempting to fly. The same goes for heating oil (heck, I’m considering the idea myself) and even shipping product overseas. This doesn’t even include the growth in population AND the massive demand growth from India, China and other emerging economies.

3) Oil is massively oversold

Oil cannot stay at $44 for very long. It just won’t happen. New shale oil projects in the US require a WTI of $70-90 to be profitable and with a barrel of oil so low, they simply won’t be realized. Even with the massive cost savings that have been realized so far since last November, we are looking at projects that require a WTI of $55-70 just to cover their costs. With a WTI so low, these projects will be cancelled and/or delayed. With cancelled projects, production in the United States will plateau (optimizing old wells to maintain production) or decline. With a lower supply and a demand that will keep rising, oil prices will recover.

4) Oil stocks are massively oversold

Oil stock companies today trade at ridiculous valuations. CPG, one of my top 5 picks, is currently valued at $9B - this is the same company that, in 2014, had a cash flow, before CAPEX, of $2.1B. Yes, it is trading at 4.1 times last year’s cash flow. Unbelievable.

“But oil price is much lower than it was last year at this period!”

Yes, but you wrongfully assuming oil will never recover. Sure, if oil stays at $45, CPG trades at a fair value - probably even a slight overvaluation. But you are looking at a company that, currently, has 15+ years of oil production in assets. And that’s not even considering their production growth, which it has solidified with two excellent deals.

“But hedges are expiring!”

Low oil prices will not last forever. It’s quite obvious than when your cost per well is $60 and oil goes for $44, you won’t drill new wells. Production will go up and oil prices will go up. Saudi Arabia cannot keep pumping more and more oil to depress prices forever; it is dealing with problems of its own already, including billions of dollars lost in their stupid price war (see: #6). Some oil producers will falter, but the most solid ones will come out even stronger (from a few acquisitions at rock-bottom

People today are looking for any reasons to liquidate their oil stock holdings. They are even ready to sell them at ridiculously low valuations. This creates the perfect time to invest.

5) Iran’s concerns are massively overblown.

The new deal with Iran, even if approved, will add around 600k barrels per year. Saudi Arabia increased its output from 9.5M barrels to 10.4 in the first six months of the year. Yes, by itself, it raised global production by more than this so-called “Iran deal.”

6) Saudi Arabia’s strategy is stupid.

When Saudi Arabia refused to cut its production last Novembers, writers everywhere wrote that it was “protecting is market share.”

At the time, for a few minutes only, the idea made sense. Then, the more I thought about it, the more crazy it seemed. Let me put things in context. At the time, the oil glut (higher supply than demand) was 1M barrels per day (or boe/d, to be specific). OPEC produces 30M boe/d. All it had to do was agree on a 3% cut and the oil glut would have vanished. Oil would still be at least $70-80 today and we wouldn’t even have been having this discussion right now.

Yet, it maintained its production guidance (and have, so far, been exceeding it significantly). Why? Because it was afraid that if it was to cut production by 3%, Russia or some other country would increase its production to replace the “missing” barrels. In other words, OPEC would cut its production by 1M barrels but someone else would increase its production by 1M barrels in return. That might make sense at face value, but the mistake here is both elements are not necessarily perfectly codependent. Russia might still increase its production by 1M barrels even if OPEC maintains its production, for example. Just because OPEC would cut production doesn’t mean every other country would rush to fill the void, especially in an oversupplied market. If really OPEC has so little control on prices, then what is the point of a cartel in the first place? Might as well let every country sets its own price and production.

Saudi Arabia’s strategy seems to be one of a frustrated child and is bound to completely fail. I don’t even think Arabs themselves expect it to work. Oh, it might and will force some junior shale oil players out, but it will not stop the US shale industry. Far from it, it will help consolidate it, and the shale producers than remain will be stronger, leaner and much more resilient than SA had hoped. Shale oil, by cutting costs, has managed to not only survive, but thrive in a very low price environment. New technology, more efficient drilling and lower salaries and cost have led to lower and lower production costs per ballers. US oil producers have realize that they can be profitable with a WTI at $60, $55 and perhaps even $50. The end result will be more US shale oil, certainly not less. When oil will kick back to $70, US oil production will jump again.

Some people mention the high debt shale players have and how many of them could go bust. I have to say many small players will without a doubt go bankrupt but, to SA’s dismay, they will be acquired for pennies by big corporation. There will no “meltdown.” It annoys me when people don’t realize that debts with a higher interest rate also comes with higher defaults rate. Sure, some banks will lose money, but that’s exactly the point of debt and loaning in general - you know, managing your risks and your losses. All in all, Saudi Arabia grossly misjudged how producers would react and its latest production ramp-up is a childish and pointless strategy that will also, in my opinion, fall flat. It may lead to a few small cap players disappearing in 2016, but the oil industry will adapt.

OPEC’s strategy would work if it could somehow produce the entire 90 millions barrels per day the modern world needs, or at least close to that. Want to wipe out your competitor? Sell oil at $20 per barrel - hell, sell it at $10 per barrel for a few years, wait for all other producers to be wiped out, then raise the price back to $100, $200, $1,000 for all you care. But with only 33% of the world’s production under its aegis, their strategy is bound to meet an untimely end.

Think about it this way: OPEC can either sell 30 millions barrels at $40 per barrels (incl. a $4 shipping cost) or 29M at $80. Somehow, it convinced itself the former was better. I don’t believe OPEC had forecasted oil falling so low, but they are picking the results of their terrible decision and ultimately extremely bizarre strategy.

7) Oil is a limited commodity

At last, we come to the main reason I believe now is a good time to invest in oil. Oil is a very limited commodity: once burned, it’s gone. It’s even even worse than zinc or iron, which can be recycled: once oil is gone, it’s gone for good, into smokes.

Furthermore, oil is getting more and more costly to extract. Take artic oil, for instance, which costs in excess of $90 a barrel to extract. Eventually, all the cheap oil (including SA’s $20 per barrel oil, including shipping) will be gone and what will remain will be the oil sands, the deepwater oil and so on. Even shale oil is relatively costly to extract despite recent cost savings and you can bet oil companies today are pumping their oil from the cheapest source. With a limited supply comes rarity and scarcity and, for those reasons, current low prices are simply not sustainable.

8) … and, at last, oil cannot fall much further.

We are either at a bottom or very close to a bottom. During the financial crisis, where demand for oil plummetted, oil fell to $39.50 a barrel. Keep in mind this was during the worst economic crisis of our generation, if not of the last two. Whether people want it or not, demand for oil is going up, not down, and the better the economy does, the higher the demand for oil. The economy should keep doing quite well for a “little while” and I see no rationale for oil being at recession-low levels.

Extraction costs are also dependant on inflation due to the cost of equipment, wage increases and so on. It is simply not correct to compare current oil prices to their bottom in the 1990s and so on as extraction costs are much higher. All in all, I would put an hard bottom at $38, simply because traders love to test stop losses that idiots might have. That being said, I wouldn’t gamble on oil going further down as it could as easily jump 10% in a day for any reason whatsoever, or even no reason at all (at least that we can pinpoint).

So, what are my top picks?

First, a few things to note before you blindly invest in it. Consider the following points as “general guidelines” when looking at which oil stocks to buy:

1. Choose companies with hedged positions in 2016, if possible. The oil softness is unlikely to progress much past the beginning of 2016. Many still have positions locked in the higher $80 per barrel
2. Choose companies with natural gas production, if possible. Natural gas hasn’t crashed as harshly as oil and is pretty stable in the $2.75 range.
3. Choose companies with low debt. Debt will be the biggest problem for many junior players because even if they stop drilling due to low oil prices, they will have to make debt interest payments
4. Choose companies with a history of being “survivors.” Don’t go for that company that started drilling in 2013. Go for companies that survived at least one period of low oil prices if possible
5. Choose companies with the lowest producing costs. For the same barrel, production costs (incl. shipping and royalties, when applicable) can vary from $25 a barrel to $55!
6. Choose companies with low-decline assets. After low production costs, this is the second most important point. You want companies that can maintain their productions at their current levels (with no massive new investment) for at least 4-5 years. Shale oil can decline anywhere from 10% to 70% per year, meaning a well producing 100 barrels today can be producing anywhere from 30 to 90 barrels next year.
7. Choose companies with large P+P (proved+probable) reserves. I use a 90% ratio for “probable” reserve and I am being very conservative as the actual number is often higher than 100% (companies only consider 50% of “probable” reserves in its calculation)
8. Choose companies with large acreage! Remember that P+P (or 2P) reserve only apply after there has been a seismic survey over the area! If there is a lot of oil at A, then there’s a good cost there is a lot of oil a mile  away from A. It always amazes me when analyst only look at proven and probable reserves without even looking at the lands the company holds in reserve!
9. (Optional) Go with Canadian companies. Canadian companies pay their operating costs in CAD, yet sell in USD. With the (much) weaker CAD, this makes the situation much better for them
10. (Optional) Go with companies with a dividend. While a dividend does not mean a company is safer (or even remotely better in any means), this will help you to make a little bit of money as your energy portfolio will significantly trail the broad market for at least a year. In other words, even if the energy market stagnates, you will earn a return on your investment. I tend to believe (but have no former proof other than my personal experience) that dividend-paying companies outperform non-dividend paying companies in the energy sector.
11. (MANDATORY) Choose companies with excellent management. This is by far the most important point! At the end, it doesn’t matter if you are the lowest-cost producer or if you own the best oil fields in the world! If the management sucks, don’t even look at the company. How do you know management sucks? Several factors: look at acquisitions, risk management, hedging positions, past history, etc.
12. (MANDATORY) Choose a company whose stock price crashed significantly from its peak! This would seem obvious - you are, after all, wishing to invest in oversold positions. PEY, ALA, ENB, SU are all extremely solid companies, but they didn’t crash enough and there are better picks around. Choose companies that are more oversold. Really, right now, you can be selective and only pick the companies that will offer the best returns!

That being said, here is my cut. All companies below meet all the criterias bove.

My oil picks

Didn’t make the cut:

1) TSE:KEL One of the most solid junior players with exceptional management. Pretty much didn’t make the cut due to not having a dividend in place. Still an outstanding choice

2) TSE: RMP Incompetent management with no business strategy or vision.

3) TSE: BTE Solid company that is massively oversold. Prefer my other picks. Balance sheet is not solid enough for me.

4) TSE: PGF Lindbergh is a masterpiece and this stock WILL double within 10 years. Still, management is not good enough and the debt is too high for the current environment. Still, their Lindberg project is outstanding and even if it only delivers half of what management promises, it will be fantastic. Way oversold. Would be my 6th choice.

5) TSE: CVE A very solid producer that isn’t going anywhere, but I prefer others. Excellent balance sheet, excellent management, but there are better choices.

6) TSE: COS LOL, no.

7) TSE: HSE Great company. Compares well to my #2 and #1 pick. Prefer those in my lsit.

My choices

Every pick includes a fair value at WTI=$60 and USDCAD=$1.30, followed by its current dividend yield and what I expect the yield to be should oil stay at WTI=$45 until the end of the year.

5) TSE:SGY - FV=$5.00, Yield=12.55%, Target=7.53%

This small E&P company is without a doubt one of the most promising  emerging players in the Canadian oil market. SGY holds very valuable land, is managed by an excellent team and has very low cost, even for a small producer. It screens favorably on all my criterias and is very, very undervalued. Now that they sold $400M worth of properties, SGY’s debt is quite low and I believe they have a bright future ahead.

I fully expect its mensual distribution to be cut to $0.015 per month should oil not recover to at least $50 by year end, and to stay there for a little while. It would still grant a generous distribution at 7.5%. Definitely will survive the current downturn (or be bought out).

4) TSE:TEI - FV= $10.00, Yield=20.00%, Target=12.00%

Toscana is a strange business, one that is very difficult to properly analyze. And yet, being down by over 60% from its top, it is massively, massively oversold.

This is a royalty play, so there is no management risk. Oil comes out, the company takes its cut and that’s it. To be honest, I usually don’t like that kind of companies, but Toscana is in a league of its own. The recent stock price crash creates a fantastic investment opportunity. At WTI=$45 US and natural gaz at $2.75, it offers an extremely generous 20% yield, yet its current payout ratio is only 68%. It should be rather clear to any reader that the market does not expect the dividend to be maintained, but I am much more optimistic when it comes to this company.

It is true that TEI is a very small player, with only 2,100 BoE per day - and that’s not even production since TEI only invests into royalty play, non-working interest or unitized production (i.e. they get paid from the oil production). It is also true that the payout ratio doesn’t consider depletion and that production will drop rather sharply within 3 years (if there is no new acquisition), from 2,100 barrels today to 1,650 in 2019 and 1,100 in 2023. Obviously, the payout ratio will soar should production go down. However, TEI has a lot going for itself:

1. A strong buyback program; its land value is $14.50!
2. A long record of successful acquisition (many with a 200% return) and
3. Manageable debt ($47M incl. debentures or 4.5x times its annual FCF, this includes internalization and purchases).
4. It recently internalized management, which will save some money going forward. However, it paid $4.75M cash to save, at the moment, $475,000 per year. Still, as production ramps up (and as more assets are added), however, TEI will save more money.
5. $25M left on its credit facility for possible acquisitions
6. At last, TEI can maintain its production through 2017 which, when coupled with its cash position, should allow it to grab at least 3-4 wells/producers at a low price. In 2017, I believe oil should have recovered enough for the dividend to be sustainable, even with lower oil.
7. TEI is 50/50 gas weighed, which I like a lot.

Toscana might eventually cut its dividend by 40% (which would be its second cut since the oil price crash), but mostly to protect its cash positions and future production. Such concerns are already well baked into the price and I would be a buyer of this stock today. It is massively oversold and any hint of a significant recovery in the oil price will easily send this one above $10. And even without recovery, you are looking at a 12%-20% dividend for least 3-4 years.

3) TSE: CPG - FV=$28.50, Yield =15.21%, Target=8.18%

This is it. The legend itself, Crescent Point Energy. Led by the God of Canadian Oil, Saxberg itself. There is just too much right about TSE:CPG to begin discussing it, so I will be quick:

1. Some of the lowest production costs in North America
2. Insane production
3. Insane acreage and reserves
4. Insane acquisition (LEG, Coral Hill, etc.)
5. Insane balance sheet
6. Insane management (I mean that in a good manner. As in, insanely good)
7. WAY, WAY, WAY, WAYYYYYYY oversold!
8. The best large cap oil company in North America.

The only reason this one isn’t higher is because it’s such a volatile company. Also, it is almost pure light crude (91% oil 9% gas) and I believe my #1 and #2 are slightly more conservative in the current environment. Everything this company does is perfect and if you bought this company today and warped 5 years in the future, it will be very hard for you to lose money.

Cenovus (TSE:CVE), which I would refer to as “Crescent’s brother,” recently cut its dividend by 45% and I anticipate CPG would cut its dividend by a similar amount should oil orbitate around $45. Now, CPG recently said it wouldn’t cut its dividend and IMO the dividend is sustainable until mid-2016 without hitting production too much, but I fully expect a 45% dividend cut early in 2016. The company did not cut its dividend the last time oil was $40 during the financial crisis, so who knows.

2) TSE:ARX, FV=$25.00,Yield = 6.32%, Target=6.32%

How exactly can ARC resources report SOLID results during an absolutely horrible period for energy producers? I don’t know, but ARC has somehow done it. One of the most solid energy companies in North America, ARX is 60% natural gas weighed and screens extremely well on every criteria on my list. Its Monteney project is phenomenal and very long term. This is a company you can own until the day you die without even being slightly worried.

ARX will not cut its dividend unless the weakness in energy prices persist well into 2016. With strong hedge, great production and great production growth, ARX is without a doubt one of the best energy picks at the moment. A safer bet than CPG (with a lower dividend), the utter quality of its assets make this my second best pick.

1) TSE: WCP - FV=$15.00, Yield=6.47%

Here we go. The most solid oil company in Canada. Perhaps not the best-placed company to benefit from a recovery in oil prices (with a $60WTI, I price them at $15), but certainly THE best oil company in NA. The management is the best in its class and this company screens favorably on every single point, from its low production point to outstanding balance sheet.

Whitecap will not cut its dividend or, at the very least, will be the very last to do so. It can easily withstand 2-3 years at current oil prices thanks to its extremely strong balance sheet. I find it hard to refuse a 6.5% yield for an underpriced and oversold company that will withstand 99% of oil companies on the TSXS. My top, top energy pick.