Our Q1 2024 Letter & Look Ahead
April 12, 2024
(Note: Our Quarterly Letter below is an excerpt of our investor letter sans our performance data. If you are an accredited investor and would like a full copy of our letter, feel free to send us a message to confirm your accreditation along with your email address and we can forward it along).
Dear Limited Partners,
“Every generation needs their bubble.” It’s something we wrote a few months back after witnessing the explosive growth of AI and semiconductors stocks. GPUs computing at nearly the speed of light, or whatever speed transistors compute at. Even the quickest of them pale in comparison to Wall Street’s hype machine as the banks all jump in unison to tout the latest investment theme. While we’re never really ever short on them, the bevy of themes lately seems bountiful. AI, Ozempic (GLP-1s), near-shoring, defense, Japan and India, take your pick. Choose wisely though. When picking holy grails, everyone knows that melting portfolios become testaments to poor choices.
As the excess liquidity sloshes around the world, the sheer number of themes have had to match. Someone has to get the money, and there’s sure a lot of it. “A lot” being the operative word as we run federal deficits near pandemic highs . . . after the pandemic is over. Which is why the excess liquidity has to flow somewhere. Without truly productive avenues, the liquidity simply stays bounded, churning and moving from one financial pocket to another, bounded by the craps table and Wall Street. Couple that with the gamification of gambling (i.e., Draft Kings, sports betting, Robinhood, 0DTE options, etc.) , this generation is primed to speculate constantly and casually. The rising liquidity and leverage inevitably means higher asset prices, which translates to higher net worths. In turn, that net worth starts to affect the psyche. The excess liquidity also begins to find its way, seep its way to main street, unbounded by the croupiers in the casino. Why not? Why not buy this or that bauble, or take this or that jaunt, when your account has a few extra zeros at the end. We are flush and this is EASY.
Feeling flush is where we’re at. Sure it’s limited to 2/3rds of our populace (i.e., the haves vs. the have nots), but no worries, it’ll trickle down eventually no? Nobless oblige. Flush times though never last, but don’t tell that to the kids. “Things are cyclical,” you’ll say, but those words land cynical old man. As my son says, this isn’t the 19’s (i.e., the 20th century, the ‘99s). As if that was a whole century ago. The water is seeping out now. What was necessary during the pandemic has itself become unnecessary, and with excess fertilizer sprouts thematic weeds. Every bad idea will be funded, and every venture launched. Every generation needs its bubble.
Every generation needs to experience their own de-generation as they ride the wave up. This time the stories being told around the campfire are about AI and the riches that sector will bring. How Nvidia and SMCI are forever transforming their businesses to enjoy permanently higher margins. Never mind that their higher margins, come at the cost of someone else’s capex. If you think their customers (FAANMG which comprises 50% of their sales) won’t try to claw that back, then you don’t understand business. Now this isn’t true if FAANMG can charge their customers more, but AI is in its infancy. We’re not there yet. Nonetheless, tales will be told and fortunes will be transferred. Every generation wants its bubble.
Given the historic quantum of excess liquidity, this time will be different. Mind you, we’re talking about the size of the bubble, not the eventual outcome. Lest you think we’re chicken littles, we’re not. The sky isn’t falling, heavens no. We’re saying that we’ll reach the heavens . . . then fall from it. It is inevitable.
Still, this is your bubble. You can bet on it.
Level Set
The supply surprise that wreaked havoc on oil prices last quarter abated in Q1. Helped in part by a winter freeze that slowed drilling, US production fell considerably in January, but recovered in February/March. Despite weather returning to normal, production has retreated from previous highs, and are hovering ~300K bpd lower than the peak we saw last year.
It’s still to early to definitively conclude that US production has peaked. We’ve been humbled too many times for that. A fairer reading would be that replacing barrels to supplant the decline rates are increasingly harder to come by. Especially when private producers surged production last year. These companies largely drove the material production growth in the US, and after a consolidation wave in 2023, their core acreages are now owned and controlled by larger players. With fewer private companies hellbent on maximizing growth to attract a suitor, the pace of new production growth should slow. Additionally, the Permian basin is maturing, and with the most prolific acreages concentrated among the larger producers, development activity has shifted to milking the reservoirs for cash flows.
Make no mistake, this doesn’t mean US production won’t continue to grow, but the rate of growth will slow, and that’s enough as new production will largely arrest the decline rates of the older wells brought online in the last few years. The treadmill is taking a toll.
Unless each new well drilled is significantly more productive, which they are not, the lower number of rigs and frac crews drilling and completing the wells will inevitably translate to lower production growth. Eventually physics catches-up with everyone, and if we overlay rigs/frac spreads over US production, maybe it has.
Nonetheless, maybe it’s too early to tell. Who knows if the Permian can come roaring back. We’re skeptical though because with flattish rigs/frac counts Permian growth is slowing (left), and in turn, US growth (right).
Internationally, Saudi Arabia’s export cuts are also solidifying the oil price floor. What about the OPEC+ cut that was so prominently announced? Well it’s more of a Saudi cut as they’ve borne the brunt of the reduction.
Take a look at the chart below, Saudi exports have dropped significantly since 2023 as its discipline has held.
Since Iranian and Russian exports increased, the overall OPEC+ cuts have been largely blunted. Interestingly though, as Iran and Russia produce flat-out to fund their geopolitical endeavors, Saudi Arabia increasingly becomes the producer of last resort as growing demand absorbs inventories. Chatter from OPEC+ indicates that they are willing to continue this strategy into the year end. We’d rhetorically ask why wouldn’t they when the Saudis are carrying everyone. Free piggy-back rides are fun, though the Saudis are the only ones really getting stronger here as supplies stay flat.
What do those look like? Well this . . . OECD inventories (via Goldman).
In a seasonally weak Q1, global inventories should build as refineries shut-down for maintenance, but petroleum liquids have stayed largely flat. OECD draws have been offset by higher oil-on-water as tankers get rerouted given the turmoil in the Middle East. As we progress through refinery maintenance season in April/May, a lack of material builds in OECD (i.e., the high demand industrialized countries) may portend to higher prices as they pull barrels off the waters. Onshore inventories are low and about to tighten in the summer. If so, then the floor for oil prices will rise, supporting the $85s-90/barrel range for Brent.
Beyond that? Global instability may come into play.
Brent prices recently touched $91/barrel and that’s likely aggressive given where we’re currently at for inventories and how refinery margins are performing. Recently though, the oil market has been moving up to account for higher geopolitical risks. Ukraine’s attacks on over 20 Russian refineries has taken an estimated ~10% of Russia’s refinery production offline. Furthermore, Israel’s bombing of an Iranian embassy (or at least structure adjacent) in Damascus has led to talks of an Iranian retaliatory strike.
In the palace of truth, we think this will fade. What matters is the physical barrel. Iran’s attack on Saudi Arabia’s Abqaiq refinery a few years back, Russia’s invasion of Ukraine, sanctions on Venezuela, and shipping disruptions in the Middle East, just to name a few, all of these geopolitical risks have been more headline than substance. This isn’t to say that they won’t ever matter, it’s just that they’ve never materially reduced the flow of oil. So although Russia has claimed that it will reduce production after the attacks (ostensibly for maintenance, and not because lower refinery throughput stemming from the attacks and strengthened sanction enforcement), we’ll conservatively assume that Russian production/exports will flow unabated. As for Iran? We wonder if talks of retaliation is bluster. A direct and heavy attack from Iran will assuredly force Israel’s hand to retaliate dramatically. Is Iran willing to engage in a direct kinetic exchange when it’s historically relied on its proxies to do the dirty work? We don’t think so, which is why we believe the embedded geopolitical premium will eventually recede. What matters is physical flows, and that continues to be uninterrupted.
The crux is that if we’re right about peaking US production, steady global demand, OPEC+/US producer discipline, draws will begin to occur as spring turns to summer. If any of the above factors were to reverse, then we’d have to reconsider. What could also detour the train is the Biden Administration. So close to November elections, would they allow oil prices to runaway? Doubtful, so if oil price cross $100/barrel because of a geopolitical spike prices, expect the administration to appeal to the Saudis to release its spare capacity. Barring that, the administration will likely release crude from the Strategic Petroleum Reserves (“SPR”). Since Russian’s invasion of Ukraine in February 2022, the US has released ~230M barrels from the SPR. With ~360M barrels remaining, it could easily release 60M-100M barrels at 5M barrel per week to cover any shortfalls. Sure it would leave the SPR depleted, but for swing state voters, the economy and their perceptions will be key factors in deciding the November election.
Tumultuous times indeed.
Net-net this all means that we’re likely range-bound at least for a bit. Inventory levels again suggest that fair value is nearer the mid-to-high $80s, thought it’s likely to move higher. We’re currently above that as we write this letter, but it should trade around this range. A rising price floor because of inventories capped by an SPR safety net/Saudi spare capacity. The Saudis themselves would need a giant quid pro quo to increase production if this were to come about, but that was the plan all along wasn’t it? Yes, indeed.
So while last quarter we were waiting alone with the Saudi’s at the claw machine, this quarter we’re starting to see their haul. As my daughter says when she sees those machines . . . stuffies galore . . . as the Saudis start plucking their prizes. We’ll see if it spurs the broader market to get interested. We think it’ll happen. Winners always attract a crowd.
Portfolio Review
So a quick spin through our portfolio from a high-level. We don’t normally dive through our holdings in detail for various reasons, but as always, we welcome our partners to reach out and we can provide additional information. What we do want to say is that even at range-bound oil prices, our companies will greatly benefit as they pay-down debt and/or return cash to shareholders in the form of dividends and share buybacks. We certainly prefer the latter as it buttresses the stock and mitigates any tax impact. After all if we like the stock, why shouldn’t the companies themselves? We consider ourselves owners, and one of the best ways to get more of the pie is to reduce the number of slices and people eating it. At $85/barrel Brent, or thereabouts, the companies we own will generate healthy cash flows. Cash flows that will underpin the market valuations. If oil prices rise (as we think they will) then bonus, because anything above today’s level falls to the bottom line. What else do we like? Free optionality.
For one of our holdings, their recent forays into Carbon Capture, Utilization and Sequestration (“CCUS”) (specifically via Direct Air Capture (“DAC”)) represents a “free option” on green energy as the market for carbon credits mature. CCUS and the related development of net zero fuel/sustainable aviation fuel/carbon offsets will be a critical for many companies that wish to fulfill their net zero climate pledges. As our company continues to add customers interested in carbon offsets, we’re beginning to see this market further develop, allowing them to fund/build additional plants. It’s not unlike the LNG business where if you build it, they will come. Moreover, like the LNG business, operational excellence and a culture of continuously grinding the operational costs of the plants lower will be the key to success. We think certain energy companies, including ours, are well suited to that. Suffice it to say, there are a lot of customers waiting. Ironically many have called this endeavor “Net Zero,” but that moniker can also be applied to the value Wall Street has assigned the venture. This despite already signing customers to long-term agreements and successfully courting strategic investors. So we think back to the Buffett adage that the market in the short run is a voting machine, but in the long-run a weighing machine. We believe once they start firing-up the DACs next year, the weight of what can be achieved will start to filter into the market. This is a real-world, physical solution to a global issue. It’s not planting trees, burning biomass, nor other dubious types of carbon offsets being peddled today. It comes down to costs, and so long as the plants can be operated efficiently, this business can be a profitable one. Again all for the bargain basement price of . . . net zero.
As for our Canadian investments, the imminent (?) (and yes that question mark is intentional given the problematic planning/construction), line fill of the Trans Mountain Express (“TMX”) pipeline in Canada is providing a tailwind for our holdings north of the border. Once the pipeline goes into service, transportation costs for Canadian crude should fall as it’s cheaper and safer to move oil via pipelines vs. trucks/rails. Narrowing the price gap between Western Canadian Select (“WCS”), for which much of Canada’s oil is priced at, vs. the WTI US benchmark means Canadian oil companies will capture the additional margin/profit. Moreover, by increasing the crude takeaway capacity in Canada, TMX mitigates the risk that the WCS/WTI price differential will “blow-out” in the future if transportation is unavailable and producers are forced to store barrels, or worse, shut-in production. Consequently, our Canadian oil holdings are rerating as they’ll soon enjoy not only higher profits, but a higher chance that those profits are stable. The market values your ATM cash machine (which let’s face it, is basically any company) higher if your ATM is reliable. In sum, the Canadian energy sector returned 17.9% in Q1 as the TMX overcame some drilling challenges, and are in the last phases of operational checks before coming online in Q2. May 1st is the operational date, investors though have started buy-in their tickets for the show, but we’ve been waiting with popcorn in hand.
Parting Thoughts
The funny thing about getting older is that you don’t actually feel older. Most people are who they are by the time they’re in the late-20s. Sure your circumstances change, but your personality, your personal proclivities, and the essence of who you are stays the same. So in some sense, you stay who you are at the core while your shell physically ages. It’s why weekend warriors at the gym lament that they can’t “do what they used to” even when their minds think they can. It’s the bane of aging, experienced by everyone.
For investors this can be especially true. Those who love tech will generally always love tech, those who love media will gravitate back to media, etc. Investors or speculators who love the latest thing will always ride the next bubble, and degenerates will always degenerate. Now that’s not a knock on any degenerate, we love a good malcontent. Contrarians? They’ll just hate it all and gripe about it. For us, what’s important isn’t that we always “catch the next thing.” No, that’s never been our style, nor will it be. We simply aren’t built that way. We’ll never buy bitcoin when it’s at $2K and ride it to $68K, or SMCI at $200 on its way to $1,200, speculation is tough when you’re not a speculator. What we will do is be a bit more discerning. Just because we don’t buy Nvidia at $850, doesn’t mean we don’t think artificial intelligence (“AI”) is a “real thing.” Even though we haven’t committed capital yet, doesn’t mean that we never will.
In truth, the way we think about AI is to say “there’s something there.” There’s something there because it’s the evolution of data analytics except sped-up exponentially and tailored to your requests. Data sets have exploded in the past two decades as the internet’s evolved, memory/storage has been commoditized, and the devices for collecting data have become ubiquitous. In a sense, AI will not only allow us to search those data sets faster, but more importantly analyze them. Moreover, that’s today. Once general AI comes to fruition (i.e., an AI that has human-like intelligence and the ability to self-teach), then a whole world (or pandora’s box) opens up. We don’t know where that leads us, but we’re certainly going to start digging in. What we do know is that this is early stages even though the landscape is evolving fast. This is akin to R&D (research & development), except we’re in the early “R” phase.
ChatGPT has gotten everyone excited, but we’re fairly certain ChatGPT won’t be how companies monetize AI in the real world. It’s the “you’ve got mail” AOL version of the internet bubble. The first to attract real attention, but it won’t be the last. Eventually the Amazons, Google, Apple, and Netflix-es of the world, and one’s we’ve never heard of or formed yet, will figure it out. Given FAANMG’s superiority in collecting data and deep pockets, we have to assume that they’ll eventually emerge as a force in the space. Like a pharma drug, when R shifts to D, he who commercializes will get the lion share of the profits, that’s when R switches to D. While the stocks of the companies building the infrastructure (i.e., Nvidia, SMCI, etc.) are inflecting today, we’re cognizant that it wasn’t Cisco, Lucent, or JDS Uniphase that carried the day for the internet. Infrastructure, chips, chipsets, data centers will be commoditized as margins retreat back to historical trends. Again, your sales and roofing margins are someone else’s costs, and whether they develop the capabilities in-house with in-house designed chips, or another competitor comes along/catches-up, the industry will reset itself. So in the end, the real winners? Those that followed, those that became the FAANMG.
We bring this up because as a thematic fund we’re constantly sifting through themes and ideas. AI is an interesting one and we’ll begin to probe a bit further as we move forward. There’s something there, and it’s always great to step-back and get a reality check on things. Something I’m reminded of after inviting my ten year old son and some of his friends to watch their dads attempt to play basketball . . .
Me: That was a tough game to watch eh? Man, I should’ve made those easy put backs . . .
Mason: Bro! (which has replaced “Dad” these days), you missed like a thooooousand of those . . .
Me: Now, now . . . 6, I missed 6 haha.
Mason: Bro! You guys don’t do ANYTHING you tell us to do!
Me: See? We’re teaching you what NOT TO DO. It’s just good parenting.
Mason: How does that make any sense?
Me: Yeah haha it don’t . . . but will you come to my next game?
Mason: . . . sure.
Good buddy.
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