The Smallest Company

in the Lowest Cost Oil Play

in the USA

Advertorial by Keith Schaefer

Small oil producers have been shunned by the Market, making them EXTREMELY cheap now—giving the whole sector lots of leverage for investors.

The one I’m focused on this year is Jericho Oil Corporation, JCO-TSX.V; JROOF-PINK. It’s the smallest company I can find in the best play—which right now looks like the STACK play in Oklahoma.

They were a rare micro-cap that had cash in 2015/16, and were able to buy STACK assets for pennies on the dollar. They now have over 70,000 acres across Oklahoma, and are just completing their first two wells in the STACK.

STACK is an acronym; it stands for Sooner Trend Anadarko Canadian and Kingfisher (the counties involved).  The STACK is located in the Anadarko Basin in Oklahoma where there’s three stacked formations—the Meramec, Osage and Woodford.  In total they’re about 900 feet thick—that’s A LOT of oil (and very importantly, a lot less gas).

As the charts below will show, it’s the lowest cost play in the USA.  And Jericho Oil is the smallest pure play I see on it—with just 450 net barrels production right now.

That will change quickly now that Jericho is switching from growing its land base to growing its oil production.

They’ve just drilled their first two wells in the STACK, and results are pending. And all through 2018, Jericho will drill one well every six weeks into this lowest cost oil play in the United States.

There’s a lot to like here:

1. Being a micro-cap, nobody has heard of the company or the stock.
2. Stocks are so cheap in the sector that when you double or triple production—which Jericho should do this year—your stock can also double or triple.
3. Backed by Big Money who can get deals done incredibly quickly—as I’ll explain below
4. In the lowest breakeven cost oil play in the USA
5. They bought their land so cheap, their full-cycle returns should be well above average.

With a steady string of well results and triple digit production growth this little company will quickly gain a much larger audience.

Jericho Oil Is The Smallest Junior Player In The STACK

Jericho’s entry into the STACK is a lesson in how to exploit a cyclical business.

Their acreage came indirectly from Samson Energy – a leveraged-up KKR buyout that went bust when oil collapsed.  Jericho knew the play very well, so when they looked at that acreage on a Thursday morning they were able to put in a solid bid that evening.

No other junior could have lined up capital and turned around a deal that fast.  In fact no other junior could have done that deal at all back then.  That’s where The Big Money backing comes in, and I’ll explain who that is shortly.

But with this transaction Jericho was able to acquire core STACK land for $2,300 per acre — a fantastic price then and an even better price now.  Today, nearby STACK transactions are being valued at almost 10X that price, up to $20,000 per acre.

Getting acreage in this play is tough.  That’s one reason why investors don’t hear as much about the STACK play: 5 large independent producers—Devon Energy (DVN-NYSE), Continental Resources (CLR-NYSE), Marathon Oil (MRO-NYSE), Newfield Exploration (NFX-NYSE) and the newly-listed Alta Mesa (AMR-NYSE) have all made the STACK their primary focus and own almost all of it—and all except AMR don’t issue promotional press releases on drill results.

(This is actually why the Delaware sub-basin in the western Permian, potentially the best part of the Permian, only came on investor radar screens in 2016, years after the Shale Revolution began.)

The map below from Alta Mesa shows that those five big independents control most of the acreage in the STACK—which means that getting into the play at this point is extremely difficult.

The real core of the play is in Blaine, Kingfisher and Canadian counties.  You will notice that almost all of that acreage in those counties is colored or spoken for by one of the five independents.

An exception to that are the white blocks in northern Blaine County between Newfield (grayish/blue) and Alta Mesa (yellow).  A lot of that acreage belongs to–you guessed it—Jericho Oil.

That is a very enviable place for a junior oil company. There is always someone ready to buy your land position—especially now that the oil price has moved up from the $40/b it was back when Jericho bought this land in mid 2017 to $60/barrel today.

Better still—Jericho CEO Brian Williamson believes that because they have such a dense land position, there are many opportunities for the company to make what’s called “tuck-in” acquisitions; small adjacent acreage positions.

With Jericho controlling most of the parcels of land it doesn’t make much sense for larger competitors to chase the remaining available acreage.

How significant are these small “tuck-in” opportunities to a small company like Jericho?  According to Williamson it is big…“our goal is to see ourselves double our acreage position by the end of the year”.

The whole point in buying a beaten-down micro-cap is that if you double your assets, the stock should have a similar jump.

The STACK – It’s Like The Permian, But With A Lot More Oil

There’s a simple reason why The Big 5 Operators in the STACK grabbed such big land positions—because that is where the highest returns in the USA are.

The chart above from Newfield shows the STACK over-pressured oil window having a break-even oil price of just $25 per barrel.  The average STACK well is not much more than that – as good or better than everything else in the United States.

The chart below from Continental shows that STACK IRRs at $50 oil range between 82%-146% depending on whether the wells are in the over-pressured oil or condensate windows.

My rule of thumb is that it takes 75% rates of return to get me interested.  The STACK meets that test easily and does so at $50 WTI – so imagine how profitable STACK wells are now here at $60 and if oil prices were to rise.

One of the main reasons for the STACK’s great economics is its higher oil weighting than the Permian (the Permian actually gasses out very quickly). And with natgas production in the US skyrocketing up some 6 bcf/d (billion cubic feet per day) this year and the same in 2019—energy investors want “oily” stocks.

Jericho Oil’s 2018 Will Be Growth, Growth and More Growth

Jericho Oil has already accomplished the hard part.  The company got into the STACK in a big way at a very low price, quickly and quietly, and off investors’ radar; all the while being surrounded by large E&Ps with billion dollar budgets.

They were able to buy a lot of land because they could raise money from a wealthy group of backers…who still own huge chunks of stock today.  If you scan through the shareholder filings—all in the public domain but takes some time—you’ll notice a shareholder with more than 10% called The Breen Family Trust.

That’s affiliated with Ed Breen…former President of Motorola, then he took over Tyco once it fell down…and he now finds himself as CEO of DowDupont (DWDP-NYSE).  And he’s a large Jericho Oil shareholder.

Jericho’s other Big Supporter is Oklahoma’s own Michael Graves, who sold his two oil companies to Chaparral Energy in 2006 for just over $500 million.  Those companies—Calumet and JMG Oil—had land positions in the area where the STACK is now. So he knows that area.

That is Some Big Money behind little Jericho…which allowed them to write 7-figure cheques in the worst oil market in 20 years, grabbing land everyone else wanted but no one else could afford.

But now the land buying is over.  Now they are drilling, and drill results will flow…well, like light oil.

Williamson expects Jericho’s first well results from the Meramec formation to come in mid-late March.  The second well—into the Osage formation—will be done this spring as well.

Then investors should get results from one well roughly every eight weeks over the remainder of the year.

In doing so, CEO Williamson believes the company will quadruple production from 450 boepd  to over 2000 boepd by year end.

That kind of production growth will obviously be a big catalyst for Jericho’s share price.

Normally I’d be inclined to think that when a company triples its production it can triple its share price.  We’ll see if the Market agrees with me.

That drilling isn’t just going to drive production growth but reserve growth as well.

Williamson believes each well drilled proves up a minimum of 7 surrounding drilling locations.

That will mean a HUGE increase in the reserve report for 2018—which will get the company its first big operating line of credit (read: non-dilutive capital).

CONCLUSION

As the oil price stays in the low $60s, investor attention will move downmarket.  Micro-cap oil shares are so cheap that once bids start piling in–the first moves will be big.

It’s the smallest company—backed by the biggest investors—in the lowest-cost oil play in the US. That’s where the best leverage is—time and time again.  I’m long, I’m excited and as drill results hit the Market—very soon.

DISCLOSURE: I am long Jericho Oil.
Management at Jericho Oil has reviewed and sponsored this story. The information in this newsletter does not constitute an offer to sell or a solicitation of an offer to buy any securities of a corporation or entity, including U.S. Traded Securities or U.S. Quoted Securities, in the United States or to U.S. Persons.  Securities may not be offered or sold in the United States except in compliance with the registration requirements of the Securities Act and applicable U.S. state securities laws or pursuant to an exemption therefrom.  Any public offering of securities in the United States may only be made by means of a prospectus containing detailed information about the corporation or entity and its management as well as financial statements.  No securities regulatory authority in the United States has either approved or disapproved of the contents of any newsletter.

Keith Schaefer is not registered with the United States Securities and Exchange Commission (the “SEC”): as a “broker-dealer” under the Exchange Act, as an “investment adviser” under the Investment Advisers Act of 1940, or in any other capacity.  He is also not registered with any state securities commission or authority as a broker-dealer or investment advisor or in any other capacity.

One of my most fruitful investing themes is—buy the smallest producers in the best oil plays.

And it’s one of the few times I’m willing to go really small—like, companies under $250 million market cap.

By definition, the best oil plays have great economics; wells that can payback quickly so producers can recycle that cash into a new well.

There has never been a better time to do that, than right now.  Small producers have been left for dead by investors since the oil price crash in late 2014, and with good reason. Small producers must conserve cash during periods of low commodity prices, so generally, their production and cash flow contract.

They basically get priced to bankruptcy. They are literally penny stocks.

But with US$60+ oil, these companies are making money again.  They’re drilling again. Investors don’t care—yet.

The reality is though, for small companies in big plays, even 1-2 good wells can have a huge impact on production, cash flow…and maybe now even stock prices.

I talk to institutional desks in Calgary and Toronto and there is a definite uptick in US and generalist fund buying in smaller oil stocks.

I showed you this chart a couple weeks ago that outlines just how cheap commodities are compared to the Market:

Commodities as a whole have never been so cheap.  We have seen Jeremy Grantham (a value investor) and Goldman Sachs (a promotional investor) have both been pounding the table on this.

Junior oil stocks are easily the most ignored group in that sector…but that will turn, and when it does, there will be some serious catch-up and investors will see some quick moves up.

I’m already seeing micro-cap oil names come up on the eight different morning letters I get from brokerage firms around North America.  They’re just little mentions of small companies with great management teams and good properties…but no critical mass yet.

So yes, The Big Money is starting roll down-market, getting their stock picks ready.  So it’s time to get positioned on a couple and be ahead of the crowd.

The only question is…which stocks will get the Market’s attention?

I’ll tell you the one I found. But first I want to tell you how I found it, and what I liked about it…so you can figure out how to research these companies on your own.

The first factor that drew my attention was…this team raised the cash to

1) buy a lot of land

2) really cheap

3) in a great US play

4) at the bottom of the Market.
Land in this play is now selling for very close to 10x what this micro-cap paid for it when oil was $28/barrel.

This management team actually used the bear market in oil in 2015-2016 to prey on much larger companies—who were going bankrupt.

This team raised over $40 million to put together their land package—bought from several distressed producers.  They were buying when there was blood in the streets. It impressed me even more they did it through friends and family; they didn’t use a broker.

Further research—through the share registry and in speaking with management—revealed they had a billionaire backer and two other oil families who are close enough to billionaires.  These strong shareholders put in money and exercised warrants without selling stock…so the “inside” ownership position in the stock is HUGE.

That’s why they were able to buy this land; nobody else had money and they had a billionaire backer whom allowed them to close deals very quickly—that always keeps the receivers happy.

This micro-cap is now funded, has one billionaire family and two near-billionaire families as the largest investors…with a great land position in one of the best US plays…and I’m going to tell you which one it is.

It’s the STACK play in Oklahoma. I consider the STACK to be the most under-appreciated play in the States because there are so few juniors in it…it’s dominated by Continental (CLR-NYSE), Marathon (MRO-NYSE), Devon (DVN-NYSE) and Newfield (NFX-NYSE)—and those companies don’t put out promotional releases.

Remember Continental’s Harold Hamm stopping work in the Bakken—where he became a billionaire—and moving all his capex to the STACK back in 2015 and 2016?  Here’s a chart that shows why—the rate of return in the STACK was the best in the USA:

And not only is the STACK one of, if not the best play in the USA, I think it’s about to get a huge promotional boost.

You see, the legendary Jim Hackett came out of retirement to run Alta Mesa Holdings, (AMR-NYSE)—and it just started trading on February 9.

Hackett, who used to run both industry titans Anadarko (APC-NYSE) and Devon Energy (DVN-NYSE), did the exact same thing that former EOG CEO Mark Papa did: he formed a SPAC (Special Purpose Acquisition Candidate), basically a blank cheque public shell—he even named it the same as Mark Papa’s shell, Silver Run II—and they ended up buying 130,000 acres in the STACK.

Hackett and his team were given a blank cheque worth hundreds of millions of dollars and could go buy a big position in ANY play.  They chose the STACK.

This chart shows why; Alta Mesa is getting incredible growth out of the STACK:

I expect Alta Mesa will attend a lot of industry and investment conferences in the coming months, getting their new name out there. My junior pick in this play will certainly benefit from all that noise.

The last reason I really like this micro-cap: They’re drilling themselves, right now.  The first set of drill results are likely no more than weeks away.

I think their timing here, and strategy, has worked out for investors.

1. Accumulate land in USA’s highest-return-play when oil and land prices are low.
2. Keep buying throughout the downturn.
3. Get funding from big money families with patient time horizons.
4. Drill when prices are at 3-year highs and oil is highly profitable again—but stock prices for these small producers are still on the floor.

So that’s my thesis.  Timing is right; team is right; asset is right. I’ll give you the name and symbol in my next story.

I can’t lie; it has not been easy making money in energy in the last 12 months. Oil stocks haven’t followed oil up, natgas prices are at the mercy of fast growing production and pipeline & logistics companies are suffering from too much debt and rising interest rates.

In 2017, I was lucky to post a 19% gain, creating $570,000 in capital gains from a $3 million portfolio.

Today, I want to outline the problems with investing in the most common sub-sectors in energy, and then at the bottom, remind you that I have been giving away my top pick for free for months on my website…and it has been one of the best performing energy stocks for the last year.  And I think it will continue that way through 2018.

I focus on smaller companies, where I can speak with management, and where there are not so many people following the company.

Let’s start with natural gas, which has the most obvious problem:  supply is up over 10% Year-Over-Year—and is increasing about 0.8-0.9 bcf/d per month right now.  See this chart on US natural gas supply:

Long awaited pipelines out of the mammoth Marcellus gas play in the US northeast are now going onstream. Drilling efficiencies are steadily increasing at an astounding 20-30% a year, dropping breakeven costs (says Chesapeake) to $2/mcf.  Footage drilled per natural gas directed rig increased an average of 22.2% per year from 2011 through 2016 (from 132,000 feet per year per rig to 355,000).  Not even the most bullish drilling engineer predicted that.

And of course we have the long standing issue that more frac sand in a well, and longer wells, is bringing up more natgas per lateral foot every year.

On top of all that, investors have had to deal with management teams who have no discipline and just increase production with no thought to increasing shareholder value.  It has been so sad to watch these stocks get decimated; crushed…even from the sidelines.

To this day, my only investing ideas in natgas are from the short side.

In Canada, the natgas situation is even worse as we have not built up markets other than the USA, which needs our gas less and less.  Last year, natgas in Canada had negative pricing for several days in the summer and I expect a lot more of them in 2018.  Everytime I speak with a Canadian oil & gas management team I ask them to send me their 2018 projected cash flow, pricing natgas at ZERO; $0.00/mcf.  I know they’re doing it internally.

Moving over to to oil….the problem with oil stocks are…many.

First, oil did well in the second half of 2017, rising 50%, but oil stocks did not.  I moved into oil stocks in September and October…and the sector as a whole did not move up with oil; serious underperformance.  That has been really frustrating.

Second—in the USA, most “oil” stocks are very gassy—and get gassier as time goes on. See notes on natgas above. I expect natgas prices to remain very low through 2018, keeping the actual realized price for “oil” producers to be just over half the WTI price you see quoted on your screen every day.

There are a couple exceptions, including the oil stock I’ve been been allowing my “free-list” subscribers to download for free for months—the oiliest stock in the USA.  You can go now to www.oilandgas-investments.com and right in the middle of the site you can see where to click to download my report on it for FREE.  The Most Profitable Oil in the USA.

In Canada, it’s a different problem(s). Canadian oil is shallow compared to the US, so it’s a lot easier to find true oil stocks (as oil gets deeper and “cooked” more with more pressure & therefore heat on top of it, it turns to natgas).  The economics for Canadian oil stocks are even quite good at current oil prices…but nobody wants to buy Canadian oil stocks.

Special interest groups have succeeded politically in driving anti-oil agendas in both Ottawa, the capital of Canada, and in the far western province of British Columbia.

As a result, international capital—which is the institutional money needed to make these Canadian oil stocks go up–has zero interest in Canada right now.

I only own one Canadian oil producer; my other Canadian-listed stocks are producing oil in other countries.

The third problem with oil of course is…there’s lots of it.  There will never be a shortage of oil. Industry
economics based on a cartel holding back production.

Ethanol—I have made a lot of money in ethanol over the years, specifically Pacific Ethanol (PEIX-NASD).  But I don’t really feel I need to focus on ethanol stocks until inventories start to come below the support line on this weekly EIA chart:

Ethanol inventories have been slowly but steadily increasing every year since 2014…when Pacific Ethanol went from $3-$23 in eight months. Arguably, January-February is the time of year to buy ethanol stocks, but production keeps increasing.

Producing oil, gas and ethanol are what’s called the “upstream” part of the energy sector. Upstream is where the energy is closer to being in the ground, and downstream is when the energy is closer to the consumer. I also look at downstream markets; electrical power companies and refiners are downstream-type companies.

Some refining stocks—particularly Valero (VLO-NYSE) did well last year, on the strength of high (but not really rising) crack spreads—until Hurricane Harvey hit.  Then these stocks went into overdrive; the Valero chart in particular was a textbook breakout and I should have bought it.  But I couldn’t have called the Hurricane or its impacts.

As I watch different small-cap power companies—whether it’s energy storage or solar inverters or hydrogen or software for peak power management—I notice that a lot of press releases go out with multi-million numbers in the headline and then I check the income statement for the next few quarters…nothing.

No increase in revenue; nothing from these big-number-press-releases hits the income statement.  I watched one TSXv-listed small-cap company last year announce over $7 million in contract announcements in 2017.  Q4 revenue was $75,000.  The whole sector loses credibility when that happens, and it happens often.

So those are some of the pitfalls of owning energy stocks—upstream and downstream.

But there are exceptions to every rule (except natgas sadly).  Successful investor have to find a business model that’s a bit different from the norm, or have exceptional economics.

With oil stocks, that means you have to find producers with wells in their main field, their growth engine, that pay back their cost in well under a year.

Very few companies can do that—but one of the few who does, is available for free at my website—www.oilandgas-investments.com.  You don’t have to sign up to trial my paid service—you just get it for free, so I can show you the type of research I do.

Download the report, and read about a stock that I think ticks all the right boxes.

Keith Schaefer

Original Thinkers–that’s whom you want to read.  Here in Part 2 of Tocqueville Asset Management’s Rob Mullin’s article, he outlines why small-cap oil stocks could play catch up very quickly now.

by Robert Mullin, Tocqueville Asset Management

Despite extreme pessimism regarding the production cuts of a year ago, both OPEC and non-OPEC have achieved better than 100% compliance every month since. We also believe compliance will be less important, and indeed unnecessary, as global oil balances continue to tighten in 2018.

The fear of restricted volumes returning to the market should be scaled to account for the “gaming” of the system as all parties maximized production before cuts were implemented, thus the 1.4 million barrels per day “reduction” was really only 600k-700k bpd from sustainable production levels. That represents the supply that can easily and sustainably be returned to the market, and equals roughly 6 months of global demand growth.
And while the growth of US shale production over the last year has been significant -though below most expectations- incremental productivity seems to be flattening out. The rest of the world (which represents the remaining 40%+ of current global crude production) has been unable to grow supply even with $100+ oil from 2010 to 2014, and the 40% decline in global capex since then would imply that even steady production from the “rest of world” may be difficult to maintain. It appears to us that the large projects brought online which were greenlighted in that 2010-2014 period have mostly run their course, and the dearth of projects approved since then will leave a large hole to fill in global decline rates from 2020 on.

While EV’s now represent approximately 1% of the global fleet, and have only achieved that with significant subsidies that have still left economics mostly unfavorable to traditional internal combustion engines. The financial burden of maintaining those subsidies as well as the infrastructure buildout necessary to support fleet expansion makes extrapolating that growth rate difficult.

In terms of consumer preference, trucks and SUV’s continue to expand market share despite oil doubling in price over the last 2 years. It should be noted that, despite the attention and enthusiasm for EV’s, Ford still sells more F-150’s in a month than Elon Musk sells vehicles in a year.

There is an argument to be made that the current fuel efficiency mandates are accentuating this bifurcation of the market, where auto manufacturers produce more low-profit EV’s and quickly offset that gain in fleet efficiency by selling more high margin SUV’s.  T

his is supported by the total US fleet efficiency statistics chart above, courtesy of Ben Salisbury at FBR, which exhibits a notable flattening over the last 5 years.

Large Caps Show Signs of Life, Laggards to Play Catch Up?

There was a severe divergence between natural resource index/etf/mega-cap stocks and the rest of the resource stocks in mid-2017, and that trend not only persisted but accelerated through the end of the year. The S&P Global Natural Resource (GNR) index did its best to keep pace with the broader S&P500–powered by the BHP and Glencores of the world, while smaller companies across the resource spectrum struggled to recover their 1H losses.

This impacted the majority of actively managed natural resource funds, whose returns severely lagged the benchmark. The chart at right is illustrative, showing the GNR moving in relative tandem with the Russell 1000 Energy Index (largest energy companies) and the Russell 2000 Energy Index (small to midcap energy names) in two prior cycles. Historically all three have bottomed at the same time, with the smaller names subsequently outperforming during the upcycle by 1.4x to as much as 4x.

The story since 2016 has been very different, with the mega-caps leading the way, energy lagging and smaller energy names badly underperforming over the last 12 months. It is worth noting that other resource sub-segments (diversified metals & mining, etc.) have exhibited similar market capitalization skew over the last year but lack the historical data over prior cycles to include above.

We are also aware that this isn’t a unique occurrence, as the broader market has exhibited many of the same performance skews in what has been a FAANG dominated period.

Below left you can see the divergence between energy equities (relative to the S&P500) and the oil price which is , according to industry veteran Mike Rothman from Cornerstone Analytics, the largest such spread he has seen in his 30+ year career.

He also notes that both prior times the gaps reached similar levels that they were resolved by stocks rallying to catch up with oil. The chart at right below illustrates the last 16 years, showing exactly how extended this relationship has become.

Summary

1) Commodities are at their lowest levels versus equities in almost 50 years.

2) Commodity stocks in general have underperformed the commodities themselves, leaving them at their cheapest valuations relative to the broader equity markets in over 100 years.

3) Small and midcap resource equities have significantly (and unusually) lagged their larger brethren despite consistent historical upcycle outperformance.

Most market forecasters see a continuation of 2017 conditions, with modest earnings growth, low inflation, low volatility, expanding multiples and little, if any, impact from reduced QE or rising rates.

The case for coordinated global growth nudging inflation expectations higher may well be gaining some traction. Over the last few months broader commodity indices as well as commodity currencies have been acting quite well. The largest commodity stocks have continued their upward bias, and thus far in 2018 the catch-up in small/midcap resource equities appears to be gaining momentum.

At the same time, Eurasia Group’s Ian Bremmer, a leading political risk analysts, states, “The markets don’t recognize it. They’re hitting records on a regular basis. The global economy feels pretty good, but geopolitically we are in the midst of a deep recession. Heightened geopolitical risks have the potential to stir up the volatility pot and markets are not priced for any of those probabilities.”

These include a regression in global trade relations (EU/NAFTA), Super Power tensions between the US, China and Russia as well as a multitude of regional conflicts, many of which have the potential to impact global commodity markets.

Where most analysts see the risk to oil on the downside as a result of returning OPEC barrels and US shale production, we see the implosion of Venezuela (see below), unrest in Libya, Iraq and Nigeria as well as political intrigue (and Yemeni missiles!) in Saudi Arabia as more significant risks to the upside.

Similar catalysts could be identified in other commodity segments we favor, such as cobalt, platinum and palladium, and even diamonds.

These concerns are in addition to the elephant in the room, which is exactly how does the slowing down or reversing of $10-$15 Trillion of coordinated global central bank accommodation impact the debt, equity and currency markets?

As we are no more certain of the outcome than anyone else, we continue to believe that a significant allocation to natural resource equities offers investors considerable upside to a “catch up” with the rally in the underlying commodities.

At the same time the group’s depressed multiples should provide substantial downside protection in a rather universally expensive asset price environment should markets reverse course.

In particular we favor reasonably valued, high free cash flow/income generating resource equities, which in addition to carrying the aforementioned characteristics also represent a unique “rising coupon” in a world of loftily valued income alternatives.

Robert Mullin
Portfolio Manager, Tocqueville Asset Management

Reprinted with permission

When I find Original Thinkers in the Markets, I read everything they write.  Philip Treick and Rob Mullin of Tocqueville Asset Management are two such Original Thinkers.  Like me, they have a tight mandate in the resource sector, but I’m always intrigued at their stock picks and market views.

In their last note to unitholders, they outlined just how cheap and under-owned resource stocks really are, compared to any other time in history.  (I knew they were cheap by looking at my own portfolio, but I didn’t know they were THIS cheap.)  With their permission, I am sending you a 2-part precis of their letter that lays all the facts out on the table.

By: Robert Mullin, Tocqueville Asset Management

For the third time in our resource focused careers (the others being 1999 and 2008) it feels like investors are willfully ignoring signs of resource sector recovery as inconvenient and temporary. Our read is that it is a typical cyclical low which offers those willing to invest as value-focused contrarians an exceptional entry point.

An Historical Context for Resource Company Valuations

We have argued for some time that natural resource equities are quite cheap, both on an absolute basis and relative to the overall market.

Jeremy Grantham and Lucas White of Grantham, Mayo Von Otterloo authored what appears to us to be a very thoroughly researched and fascinating White Paper entitled “An Investment Only a Mother Could Love: The Case for Natural Resource Equities.”  The findings of the analysis could be summarized as follows

1. Resource Equities provide diversification relative to the broad equity market, and that benefit increases over longer time horizons.
2. Resource equities not only protect against inflation but significantly increased purchasing power in most inflationary periods.
3. By some valuation metrics, resource companies appeared to trade at their cheapest valuations relative to the S&P500 in almost 100 years, and if history is any guide their future returns may well significantly outpace the performance of the broader market.

The two charts immediately below graphically illustrate point #3, as it showed natural resource stocks had only been this cheap relative to the rest of the market once since 1926.  Further, the typical average annualized return of the sector relative to the rest of the market from levels like this have averaged 700bps a year for the following 5 years (2nd chart below), a huge number in an assumed low-return environment like we have today.

Since this chart was published 18 months ago the acceleration of natural resource cash flow and earnings have significantly outpaced those of the broader S&P 500. Energy earnings and cash flow have roughly doubled since then, and materials have risen 35% and 18% versus gains of 8% and 1% for the broader market* while resource equities have broadly underperformed.

This leads us to believe that relative valuations have likely fallen “through the floor” to even lower lows.

*Source: Bloomberg

Investor Exposure to Resources, How Low Can You Go?

Despite the attractive characteristics mentioned in #1 and #2 above (and likely due to the perceived irrelevance of diversification and inflation protection in the current market environment), investor allocation to resource equities has continued to fall over the last several years.

The S&P 500’s exposure to energy and resources has fallen by 60% over the last decade and now sits right on the 25-year low.  The MSCI All Country World Index has shown a similar trend.

In March 2017 Bridgewater Associates published a note entitled “Contemplating a Secular Bottom in Real Assets vs. Financial Assets.” In it, they noted that “a broad basket of commodities as well as gold were at 100-year lows versus financial assets.” They also opined that the recent poor performance of the sector had led institutions to significantly reduce their exposure to it, illustrated by the chart below:

It is our understanding that what little allocation there is to natural resource assets from pensions/endowments is highly skewed towards energy infrastructure and credit, with very little allocated to liquid public equities in the sector.  This in many ways would explain the recent underperformance of commodity stocks, and would imply considerable incremental buying power should attitudes toward the sector reverse.

History May Not Repeat Itself, But Often Rhymes

The most recent cycle has been typical in many ways. High commodity prices which peaked in 2011-2014 drove innovation, higher capital expenditures and resulting overcapacity.

Subsequent sector underperformance led to investor underweighting, which inevitably elicits the return of commentary that “it’s different this time” and will never recover. By at least one measure which is charted below, this underperformance of commodities vs. stocks is reaching cyclical lows almost precisely matching ’99 and ’08.

Worth noting is that this chart was cited as support for the “favorite trade of 2018” by Jeff Gundlach of Double Line, a notable choice for one of the largest and most successful fixed income managers in the world.

At each of these lows there were reasons put forth that posited a “new world” where demand would never recover as justification for permanently avoiding the sector. In the early 2000’s the Economist declared “The End of Oil” with the coming technological wave of hydrogen fuel cells and bioethanol. At the time the world consumed 70 million barrels per day. It is now closer to 100 million.