Endless Summer

Endless Summer

Now that we are having the summer that July forgot to bring us, I thought I would update the background photo for the website. It was taken this week at our place on Georgian Bay and it reminds me of a movie (the iconic photo shown above) that was popular in the 60s, The Endless Summer. The movie follows the exploits of a couple of surfers who travel around the world to surf in an endless search for warm weather conditions. It evoked a nostalgic feeling that comes from a simpler, more optimistic time, one less prone to the narrative of negativity we have today.

The surfers' quixotic quest is similar to the investor's search for a warmer investment climate. It is a search for conditions in which to surf the alpha generation wave that helps them outperform the market. Sector rotation, as it used to be called, is starting to work. The recent relative performance of energy stocks versus tech stocks is stirring up interest in just such a technique. The de-Fanging of the market has begun.

ENERGY vs TECH

After having lunch last week with some great friends, we got to talking oil markets and I realized that I have not had an oil stock in my portfolio for at least 9 months. Oil to me was on the sidelines, taking a knee (not during the anthem mind you) while other players carried the ball. I have barely mentioned the topic of oil stocks since starting this blog, as I always found more interesting things to blab about.

As the bull markets age, in this case slowly and gracefully, there is a natural inclination to 'buy the laggards'. This can be a dangerous and unrewarding strategy, mainly because the fundamentals are working against you. But maybe not this time.

Back in the mid-eighties, a period of weak oil prices forced an industry wide cost control reset. After years of strong inflationary energy prices, a Saudi-initiated price war erupted, resulting in a 75% price collapse. For investors in the over-leveraged and highly valued oil stocks that dominated the TSX, it came as a complete shock.

Business models that had been based on hockey stick commodity pricing were obsolete within weeks. What followed was a nearly 15 year period of flat range bound pricing for crude oil. Except for the Kuwait invasion of 1991, oil prices remained subdued with only temporary rallies.

Underpinning the structural collapse were technological advancements in seismic, measurement and drilling techniques that shifted supply curves to the left and made $24 oil in 1988 as profitable as $40 oil in 1984. Today, in a similar fashion, the growing exploitation of shale resources through the use of fracking technologies has generated a similar step function in oil extraction costs.

But the Eighties was also a golden era oil oil stock investing. Many new and aggressive entrepreneurs such as Al Markin, Ron Greene and Clayton Woitas cut their teeth during those days. They learned to create value not from the price forecast but from drill bit. They profited from some of the very techniques that caused prices to stay low. Efficiency in drilling and strong cost controls on production allowed them to make money while the slow moving major oil companies wallowed in their high cost structures.

I was struck by the similarity of the current environment with that era during the conversation at our boys lunch. A comment, from one of the invitees about a certain drilling stock that was not performing, despite strong earnings, rang a bell with me.

I believe the current infatuation with current leadership groups, like technology, has blinded investors to new opportunities. Just like the period following the first oil collapse, investors are ignoring the fundamental improvements because they have been recently burned by the this group. Not to be dismissed, the rally has been helped by improved inventory data, as well as surprisingly disciplined output compliance from OPEC.

The previously negative oil price momentum has now bottomed out. I use a momentum model to control for factor risk in commodities. Momentum of the futures markets has been a better guide than using biased estimates from oil analysts.

So I'm long some oils for now, but just for a trade. The chimerical market correction that has been talked about for months is tantalizingly close. The major tailwind of rising bond yields that will push the rotation to the next level has yet to arrive. The Copper/Gold ratio has stalled and seasonality is still working against the long side. Trade with tight stops.

In surfing, the biggest risk is staying with the wave too long as it inevitably peters out and collapses. The best part of a wave is early in its formation. For AAPL investors, the iPhone X wave has hit the shore. For oil stocks, surfs up! Cue the beach music and get up on your board.