Admittedly, we at Fortuna Advisors have a bit of an obsession
with “buy low and sell high.” Everybody should. However, in the
midst of a downturn, the “recency bias” takes over, where many
E&P executives aren’t convinced that investing at the low end
of the cycle actually works, so we decided to examine the facts,
which is the perfect antidote to overcome this bias.
After the oil price peaked at $145 in mid-2008, it dropped
below $100 in the fourth quarter and stayed there until the first
quarter of 2011. We studied the investment record of 56 E&P
companies from Q4 2008 through Q1 2011 to see if those that
invested while the oil price was down fared better in the stock
We sorted the companies based on their Total Reinvestment
Rate into high, medium, and low buckets. The Total Reinvestment Rate is defined as total capital expenditures and cash
acquisitions as a percent of EBITDA. Then we examined the
median total shareholder return (TSR includes share price
changes and dividends) of the high, medium, and low groups
during this period and for the three years that followed. These
extra three years are to ensure we examined a long enough
period to allow companies to realize the benefits of their
During the last downturn, high reinvestment resulted in the
best stock market performance over the following years. The
low reinvestment group reinvested a median of 56% of their
EBI TDA into capital expenditures and cash acquisitions, while
the medium group invested 106% and the high group invested
216%. These are big differences in the level of reinvestment and
they resulted in big differences in TSR. The low, medium, and
high groups exhibited median TSR of 22%, 63%, and 102%, respectively. Then we examined acquisitions and capital expenditures separately, the high reinvestment rate group also had
the best median TSR in each case. So “buy low” worked last
There are many reasons why buying low can lead to better
share price performance. Adding reserves at a low cost per
barrel tends to lead to better profits when the market rebounds.
Returns on capital tend to be higher due to this profit increase
but also because the asset value in the denominator tends to
be low. These investments tend to fuel growth, which is necessary to grow not just profit margins, but also the dollars of profit
long term. And beyond the actual purchase of reserves, all sorts
of drilling and other services tend to be much cheaper during
a downturn too, so these economical expenditures can also
benefit current and future profits and returns.
How has investment trended in the current down cycle?
Total capital expenditures and cash acquisitions by E&P companies over the last 12 months (LTM) is down 58% versus June
2014, the last month oil was priced above $100. The natural
question is, if it worked so well last time, why aren’t E&Ps investing more during this downturn? One explanation is the
recency bias discussed above. Oil prices have been down for a
while so behavioral finance predicts that corporate executives
will tend to behave as if the oil price will stay low indefinitely.
Another important human bias that affects behavior in down
cycles is “loss aversion.” Behavioral finance researchers have
conducted tests showing that we tend to feel losses over twice
as strongly as we feel equivalent gains. This loss aversion bias
tends to manifest itself in indecision and procrastination rather
than taking any sort of bold actions. So although most industry
executives undoubtedly agree that future oil prices will be higher,
loss aversion tends to bias them against making seemingly
Financial leverage tends to exacerbate the loss aversion bias.
From December 2010 through June 2014, aggregate EBITDA
for the E&Ps increased 13% and yet, despite the strong cash
generation over this period, net debt increased 40% to $134
billion. By the end of 2015 LTM net debt peaked over $30 billion
higher, largely attributable to over $36 billion in aggregate share
repurchases. Currently, aggregate net debt to LTM EBITDA is
4.7x, over four times the 1.1x in June 2014. This debt burden
intensifies the conservative thinking behind the loss aversion
bias, which in turn leads to the sharp reduction in investment
we have witnessed.
There is one more relevant behavior bias known as “herding.”
People tend to find it easier to follow what others are doing, or
seem to be doing, so the capital deployment strategies chosen
by one group of E&Ps tends to track the choices of other E&Ps
quite well. Interestingly, this bias also predicts that once a few
E&Ps start investing more it will give others the signal and they
are likely to increase their investments too. This herd mentality
affects the investment community as well, and with this combination of managers and investors following the pack, it is easy
to see how the herd mentality aggravates the commodity cycle
by driving up-cycles higher and down-cycles lower.
We cannot predict future commodity prices any better than
anyone else, but we can say with confidence that at some point
in the future the oil price will be meaningfully higher than it is
now. And at another point after that, it will be below where it
is now. And then after that… you get the point. We expect there
to be cycles so we recommend management teams act as if
they expect cycles too.
During the next market high, recognize that although you
don’t know when or why a downturn will happen, you know it
will happen at some point and when it does, there will be all
sorts of risks and also attractive investment opportunities. So
avoid the temptation to juice up your EPS growth in an up-cycle
with buybacks and instead focus on reducing net debt, creating
financial flexibility and building a war chest for use in the subsequent downturn, whenever it happens.
“The natural question is, if it worked so well last time,
why aren’t E&Ps investing more during this downturn?
One explanation is the recency bias discussed above.
Oil prices have been down for a while so behavioral
finance predicts that corporate executives will tend
to behave as if the oil price will stay low indefinitely.”