The Lessons Of Oil

Not many outside the investing business have heard of Howard Marks. He is a very successful money manager at Oaktree Capital with a reputation built mostly around distressed debt investing.  

He also writes very well and publishes Memos that I eagerly read.

His latest is on the fall in the price of oil and what lessons we can learn from it.

I highly recommend it to anyone who wants clear thinking on the subject.

If you don’t want to read it, here are some quick highlights:

“…what ‘everyone knows’ is usually unhelpful at best and wrong at worst.”

“Not only did the investing herd have the outlook for rates all wrong, but was uniformly inquiring about the wrong thing.”

“Asset prices are often set to allow for the risks people are aware of.  It’s the ones they haven’t thought of that can knock the market for a loop.”

“Forecasters usually stick too close to the current level, and on those rare occasions when they call for change, they often underestimate the potential magnitude.”

 “This is an example of how hard it can be to appropriately factor all of the relevant considerations into complex real-world analysis.”

“Most people easily grasp the immediate impact of developments, but few understand the ‘second-order’ consequences…as well as the third and fourth.”

“…it’s hard for most people to understand the self-correcting aspects of economic events.”

“If you think markets are logical and investors are objective and unemotional, you’re in for a lot of surprises.”

“A well-known quote from economist Rudiger Dornbusch goes as follows: ‘In economics things take longer to happen than you think they will, and then they happen faster than you thought they could.'”

“The key lesson here may be that cartels and other anti-market mechanisms can’t hold forever.”

“…it’s hard to analytically put a price on an asset that doesn’t produce income.” 


Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

The Lessons Of Oil

Picking natural resource investments

It’s hard to avoid headlines about the price of natural resources.

Oil has been hitting new highs almost every day this week. Iron ore and coking coal have become hot investments because they’re major inputs for steel production. Even stodgy agriculture is seizing the headlines.

So, how should one go about picking a natural resource investment to benefit from the boom?

First, it’s probably too late to join the party because prices reflect a lot of the boom already. There may be some bargains to be had, though, if the global economy continues to slow down.

What should one look for in a natural resource investment?

The first thing I like to find is low costs. Low cost producers, especially in commodity products, have a huge competitive advantage. The companies with the lowest costs to extract oil, gold and iron ore, or produce wheat, soybeans and corn will exhibit higher profit margins and returns on capital.

Scale may be one reason for such an advantage. Another may be a proprietary production process or unique access to geologic locations. Yet another may be a management team that can motivate and hire more productive employees. One of the most important advantages is a management team that knows how to allocate capital to the best returning projects.

The second thing to consider is the sustainability of such costs. Some advantages are easily competed away as soon as others recognize them. To benefit from a specific cost structure, it must be sustainable over time.

One example is oil sands. Oil sands have much higher costs of production than other oil extraction projects. But, they have reserve lives of 50 years versus reserve lives of 10 to 15 for most large, integrated oil companies. (full disclosure: my clients and I own a position in an oil sands company)

Low costs and the sustainability of a cost structure are very important in looking for natural resource investments. Does that mean you should find the company with the lowest, most sustainable cost structure and purchase it? Emphatically: NO!

It depends on the price you pay for that company. The math behind investing is simple, but not easy to implement. To find the best investment, you have to compare the economics of a business to the price you pay for it. Frequently, this means buying a second tier company whose price doesn’t currently reflect its cost structure and sustainability. The best company in an industry rarely goes on sale for a rock bottom price.

Picking a natural resource investment requires a focus on the economics of a business and its sustainability, its management, and its price relative to economics and management. If that sounds like a generalization for picking any investment, that’s because it is.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.