“Allow yourself to stand back to see the obvious before stepping forward to look beyond” – Adrian McGinn “The fact is, America needs energy and new energy infrastructure, and the Keystone XL pipeline will help us achieve that with good stewardship.” – John Henry Hoeven III, is an American politician serving as the senior United States Senator from North Dakota “Is it in our national interest to overheat the planet? That’s the question Obama faces in deciding whether to approve Keystone XL, a 2,000-mile-long pipeline that will bring 500,000 barrels of tar-sand oil from Canada to oil refineries on the Gulf of Mexico.” – Jeff Goodell, American author and contributing editor to Rolling Stone magazine “When a measure becomes a target, it ceases to be a good measure” – Goodhart’s Law

A concept that frequently occurs in the study of thermodynamics – the branch of physics concerned with heat and temperature and their relation to other forms of energy – is that of irreversible processes. An irreversible process is a process once initiated cannot return the system, within which it occurs, or its surroundings back to their original state without the expenditure of additional energy. For example, a car driven uphill does not give back the gasoline it burnt going uphill as it comes back down the hill. There are many factors that make processes irreversible – friction being the most common.

In the world of commerce when a supply- or demand-side shock occurs in a particular industry, it sets into motion a series of irreversible processes that have far reaching consequences not only within the industry which the shock occurs but for adjacent and related industries as well. The commodity complex, more so than most other industries, is typified by regular occurrences of supply- and demand-side shocks.

When a positive demand- or supply-side shock occurs for a certain commodity, the immediate impact is felt in the price of said commodity. As the price of said commodity re-rates, the net present values and prospective returns from investing in new production capacities for the commodity obviously improve. Once return prospects start to cross certain arbitrary thresholds – be it cost of capital, target internal rate of return, or a positive net present value – the investment case for the new production capacities strengthens. In response to the strengthening investment case a new capital formation cycle starts to take root and the amount of capital employed within the industry begins to increase, in turn impacting both supply-side dynamics within the industry and the demand-side dynamics within other supporting industries.

Conversely, when a negative demand- or supply-side shock occurs for a commodity, existing producers of the capacity start to feel the pain and suffer from declining earnings as the commodity’s price de-rates. A sharp enough decline in the commodity’s price can lead to marginal producers selling at prices well below their cash cost i.e. cost of production excluding depreciation and amortisation. At this point the capital employed within the industry begins to decline – this can occur in a number of ways including shuttering of supply, bankruptcies, suppliers changing payment terms, or lenders recalling or withholding loans.

The capital cycle set in motion by either demand- or supply-side shocks are difficult to reverse. Once capital starts entering an industry, it continues to flow in until the vast majority of the planned capacity additions are delivered, even if the pricing assumptions that underpinned the original decision making have changed for the worse. The continued flow of capital despite the adverse change in return expectations is due to what Daniel Kahneman and Amos Tversky call the ‘The Sunk Cost Fallacy’. The sunk cost fallacy is a mistake in reasoning in which decision making is tainted by the investment of capital, effort, or time that has already been made as opposed to being based upon the prospective costs and benefits. It usually takes a shock of epic proportions to alter such a behavioural bias, such as oil falling below US dollar thirty per barrel in 2016 forced OPEC to switch from a strategy of market share maximisation to that of production rationalisation.

In the scenario where capital starts fleeing from an industry even though the sunk cost fallacy may not necessarily drive decision making – unless of course the decision makers have emotionally invested themselves in the negative prospects for the industry – reversing the tide of capital outflows can still be extremely difficult even in the face of improving prospects. This is partly explained by the lingering remnants of the emotional, psychological, or financial trauma that decision makers may have suffered through when the industry went through the negative shock. It often takes a sustained recovery either in terms of length of time or magnitude of price for the trauma to give way to rational decision making.

The turns at which behaviour begins to adjust towards more rational decision making often provide the most profitable trading opportunities.

Investment Perspective

Investing in commodities or equities of commodity producers is not for the fainthearted. Even the most sound investment thesis can be derailed by any number of factors, be it geopolitics, innovation, tax or subsidy reform, cartel-like behaviour, or simply futures markets positioning. Particularly in times of high levels of uncertainty, extreme investor positioning either long or short, or after a sustained move higher or lower in the price of the commodity, investors can be exposed to very high levels of risk. It is at such times that investing in companies that form part of the commodity’s supply chain can be a superior expression of one’s view as opposed to taking a direct exposure in the commodity or its producers.

We think that given the sustained move higher in oil, that has clearly wrong footed many, extreme positioning on the long side in futures markets and impressive revival in US shale oil production, one may be able to better express a medium-term bullish view on oil prices by investing in companies that service the oil and gas industry. Specifically, we consider, at this stage, being long equities of companies with products and services targeted towards oil and gas pipeline infrastructure to represent a more balanced risk-reward trade than simply being long oil or a generic energy ETF.

Brent Crude Oil and WTI Midland Price Spread Source: Bloomberg

To quote Bloomberg from its article Crude in West Texas Is Cheapest in Three Years Versus Europe:

Oil traders with access to pipelines out of West Texas to export terminals along the Gulf Coast are raking it in from the rapid supply growth in the Permian Basin. The 800,000 barrel-a-day output surge in the past year has outpaced pipeline construction and filled existing lines, pushing prices of the region’s crude to almost $13 a barrel below international benchmark Brent crude, the biggest discount in three years. That’s about double the cost to ship the oil via pipeline and tanker from Texas to Europe, signaling U.S. exports are likely to increase.

The infrastructure bottlenecks pushing down WTI Midland prices relative to Brent Crude prices are the direct consequence of underinvestment in pipeline infrastructure. This underinvestment is the result of either (1) the expectation that oil prices would remain lower for longer or (2) that shale production would not recover even if oil prices recovered. We think the reason is more likely to the former as opposed to the latter.

Oil prices have recovered both in terms of the magnitude and the duration of the recovery to such a degree that investors and decision makers are beginning to overcome the trauma caused by the sharp decline in oil prices between 2014 and 2016. And only now are they starting to invest in pipelines and other oil and gas infrastructure to benefit from the recovery in both oil prices and shale production. Just as there was inertia in the change in investor attitudes towards oil and oil related investments, there is likely to be inertia – should there be a significant decline in oil prices from current levels – in stopping projects that have started and gone through the first or second rounds of investment.

Companies that manufacture components such as valves, flow management equipment, and industrial grade pumps, that are essential in the development of oil and gas pipeline infrastructure, we think, will be the primary beneficiaries of the recovery in oil and gas infrastructure investment. We also think companies specialising in providing engineering, procurement, construction, and maintenance services for the oil and gas services are also likely to benefit.

We are long Flowserve Corporation $FLS, SPX Flow $FLOW and Fluor Corporation $FLR.

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.