Odyssey in 2020s

Odysseus could have returned Ithaca earlier if he had not put himself under Calypso’s spell. The US economy has found itself on the island of Ogygia, lured by the bull market which was fuelled not so much by the fundamentals as irrational shares buyback schemes. When the world becomes too rosy (or, should I say green given the amount of Benjamin Franklins we have been printing), the imminent danger not even worth a frown. Now with the pandemic and rising unemployment, people are waking up. Or, are they? As much as the optimism, I think the Odysseus might not return unscathed.

2020 is the year when histories are made. Asides from the record-making stock market movements, the oil sector is particularly interesting. With $18/bbl, or 43 cents a gallon, the black gold is cheaper than drinking water. At this price level, few can break even. Majors are slashing CapEx budgets and halting productions, but at least they have midstream and downstream business lines to buffer the blow. Individual E&P companies, however, are scrambling to combat their existential crisis. Small companies might draw down their revolvers and sell their assets, but who’s there to buy their rigs and reserves? Not to mention the amount of debt ladening their balance sheets, seems like going bankrupt is the new normal. Pipeline companies are telling upstream operators to not use their pipes to store their oil, because all storage facilities are at full capacity.

Downstream companies should be struggling as well. Although there is some demand for industrial chemicals, but the manufacturing activities around the world are stepping on the brake pedal. So, no matter how much the producers cut their productions, the oil price shouldn’t see any upward room because of the bleak demand-side vacuum. Perhaps we might be lucky to see a negative oil price within our life time as companies have to pay buyers to get rid of those worthless liquid.

Going forward, though, we should ask some questions:

  • Will the demand go back to the normal level when the virus goes away?
  • Would the oil price improve at all, given the amount of stored oil available to consumers?
  • How many pure-oil players will survive after the pandemic?
  • Will there bail-outs for the energy sector?
  • What impact does the energy sector have on the credit cycle?
  • Will there be political or military actions in OPEC countries and the United States?

I think the pain will be elongated even after the pandemic because people would just consume oils stored in those facilities and even pipelines. That means the oil price might not go up immediately to reflect the demand side spike. Without production activities, some drilling focused OFS companies might go out of the business if they don’t have a resilient balance sheet or diversified business lines. Imprudent capital structures might kill some top companies. And many lenders will get hurt from the bankruptcies as the value of collateralized reserves is written down. That would just make the access to the capital market more difficult for the remaining strugglers.

The geopolitics is an interesting topic. For countries that depend on oil exports, the current price level is a falling knife to them. Out of desperation, some countries might borrow money, which is incredibly hard if their economies are energy dependent. Some might start pointing fingers at each other, but I don’t think waging wars would be a reasonable choice because there’s nothing to gain. The US used to flirt with Middle Eastern countries to tighten its grip on regional oil sources. But these days, OPEC countries are worthless and their influence on the oil price is diminishing because the supply side can’t really do much about the price anymore. Nevertheless, those countries shouldn’t be that worried because the virus is temporary; it would just be a matter of solvency.

On the bright side, many prudent energy companies and investors are positioning themselves for the recovery. Empire Petroleum’s acquisition is a perfect example. Many good assets and reserves can be sold at bargaining prices, and buyers usually have power to install more terms beneficial to them but detrimental to sellers in the contracts, but who cares? As long as I can get rid of my cash-eating rigs, I’m willing to do whatever the buyers want. I believe some companies don’t even have the choice under the pressure from lenders and shareholders. They have to sell their good assets just to cash out because, unfortunately, many investors are short-sighted.

Another bright side, in my opinion, is that this pandemic defers the development of alternative energies. Consumers have little reason to switch over to EVs when they can drive from Oklahoma City to Chicago for just $50. Some gas stations are offering below $1 gasolines. On a side note, a physical barrel of oil may only cost $12, meaning that the futures price still has room to drop. Alternative energies might appear to be cheap on a going-forward basis, but there’s a high sunk cost as electric vehicles or solar panels or wind blades are expensive to build.

On the investing side, things are interesting as well. Now, let’s shift gears to talk more about the investing landscape.

Let’s begin with the public market. Stocks are inching up these days to compensate the over reactions in early March. While common sense tells us that this might be a once in a lifetime opportunity to buy quality businesses at a discount, I think we should caution that the recovery might leave some scars on some businesses. Some industries might see their Waterloo coming up. I think traditional entertainment industries like movie theaters, theme parks, or any venues that require gatherings might not go back to normal that quickly, if there’s no change to such ‘normal’ at all.

Humans are innately lazy, it takes something as disruptive as COVID-19 to change our habits. If the younger generation is used to the streaming services, they might find it laboring to watch a movie at a theater. Psychologically, people might start distancing themselves even when vaccines are distributed. It takes time for people to return their previous ways of social interacting, and with technologies like Zoom, communication and information are so cheap and seamless that many physical interactions are unnecessaries.

But just as when more businesses start realizing the importance of digitalizing their products and services, we should consider the risks. What is the one thing that Zoom, deliveries, and basically everything we do everyday depend on?

The internet.

Sure, the virus exposes vulnerabilities for those who only rely on physical business lines, but there’s a possibility that a future crisis disables the national or global internet. What then? People interestingly will have to be more physical again. Food deliveries are coordinated through telephones, businesses are conducted using telephones or mails. Everything would return to the pre-internet age.

Practically, though, we cannot possibly factor in all risks and crisis in the future. Otherwise, we might as well not invest in any thing. But the implication of this virus again rewards those who have done their homework, have been disciplined in their investment approach, and have been prudent enough to make decisions early. Since I don’t own a hedge fund, I don’t have any fiduciary duty to anyone. That gives me the luxury of buy and hold on something. As Howard Marks mentioned in one of his memos, you shouldn’t be worried about what the market say. The prices are merely a reflection of the public’s sentiment when it comes to chaotic times like this. There’s no point of reacting to the market crash if your circumstance allows you to hold on your investments for long term.

Agreed, this is a great time for people who have cash to invest. But I don’t really see many good opportunities after the rebound from the trough. Hot companies in tech, restaurant chains, and life science sectors are obviously overvalued (we see three-digit P/Es for many companies). Other depressed companies might not mean good investments. Some companies might have good businesses but they can be killed by insolvency. One may argue that some good businesses with bad balance sheets can consummate their nirvana by restructuring. But in today’s credit environment, significant disruptions to their operations might leave a permanent scar. Be aware that many companies are strategically position themselves for the recovery; today’s leader might be a prey in the future. So, when it is very important to diligence a company’s current plan as well as its competitors’ agenda.

In the private equity world, though, the pandemic might be a key to unlock the dry powder as many distressed businesses are flooding the market. However, deals are delayed or hard to get done these days due to physical limitations. You can’t really visit a factory over Zoom to do your due diligence. But for big players like Carlyle, Blackstone and KKR, they have the platform and cash cushion to get deals done more easily. On the other hand, PE funds that have made rush deals last two years might see themselves using dry powder to cure distressed investments. Cheap prices does not mean a discount to the real value. It’s the same thing for private equity investing. But again, players with a diversified portfolio might focus more on asset acquisition to create value to existing investments, rather than doing corporate level acquisitions.

For LBO buyers, things might be tricky these days as lenders are reluctant to give out money. Creditors are suffering, too. We might see some restrictive covenants that might suppress the potential value-creation initiatives for new investments. But people are definitely buying stuff under the hope that this virus is a one-time event and that people are forgiving when Act of God happens. The overall economy has not seen any thing worrisome like in the Financial Crisis. Some businesses are over levered, but those are more individual issues rather than systemic flaws. A company might die, but it won’t cause too much detrimental chain reactions to the overall economy.

PE-baked companies are tapping the government aid programs, that should be a good thing for PE investors, but it invites criticism as people have concern over the use of those rescue packages. We will see how it goes.

Whether it’s L-shaped, V-shaped, or W-shaped recovery, the global economy and businesses might not return to normal. We should expect new normals and react prudently to these new changes. The winners are those who have patience and temper to sit through the storm; having an objective perspective towards everything will help us steer away from Calypso. Politicians in the US should not let the partisanship blind the interest of the majority over long-term. We see too many bigotries and too few actions. Our Odyssey will not be a glorious story, but a cautionary tale of human frailties.

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