Recently, Warren Buffett has made headlines by selling all of his shares
in Exxon Mobil (NYSE: XOM), the
rest of his position in ConocoPhillips (NYSE:COP), and reducing his stake in
National Oilwell Varco.
This has people wondering if the glory days of oil investing are over.
Warren's opinion of oil investments carries a lot of weight, because over
a 32 year period, Warren Buffet's Berkshire Hathaway portfolio has generated
an average annual return of 24 percent. His most
famous investments are Coke, American Express, and Gillette (which is now
Proctor and Gamble). These investments have made him over 3 billion dollars each.
This is why when Buffett buys or sells a stock, everyone takes notice. The
problem with this generally accepted assumption is that it hasn't been proven
that his equity investing success equates to success in the resource sector.
In order to find out if this accepted assumption is correct, we first have to
visit Warren's history of investing in the resource sector.
His first foray into the resource sector began in 2002, when he took a
$500 million dollar stake in Petro
China (NYSE: PTR). In 2007, he sold it at a profit of $3.5 billion
dollars. This investment was successful because he bought it when it was
undervalued. He thought the business was worth $100 billion dollars, and it
was trading at a value of $45 billion dollars.
That is value investing 101; buy when it's undervalued, and sell when it's
fairly valued.
His next venture into the resource sector began in 2008, when he purchased
shares in ConocoPhillips. This investment was made because Buffett claimed
that the energy sector provided him the product stability that he desired.
This investment ended up costing Berkshire Hathaway several billion dollars.
The first reason this investment failed was he broke his own rule; and that
is "if you can't understand it, don't do it." Although a great
investor he maybe, he clearly didn't understand the resource sector. Look at
this chart below.
As you can see from the chart above, the price of oil is anything but
stable. In the middle of 2008, the price of oil was near its all-time high.
The resource sector is the most cyclical sector in the equities market.
Warren Buffet's ConocoPhillips investment cost Berkshire Hathaway billions of
dollars because he didn't follow the cyclicality that's involved when
investing in the resource sector. This is also why his investment in Energy
future holdings failed.
He purchased their bonds when Natural Gas prices were near their high.
To achieve success in this sector, you have to buy oil and gas stocks when
they are out of favor and the price of oil or gas is at a multi-year low. In
2009, the price of ConocoPhillips reached a low of $35 a share, and in 2014,
it reached a high of $80 dollars a share. If Warren had purchased
ConocoPhillips in 2009, and not 2008, it would have been one of his greatest
investments ever.
Buffett's most successful oil investment was his railroad company
Burlington Northern Railroad. This is considered an oil investment, because
this rail road company transported oil from the Bakken to its refiners. Since
2009, Berkshire has collected more than $15 billion dollars in dividends from
Burlington Northern Railroad, while its annual revenues have increased by
57%, and its earnings have more than doubled.
The main reason his investment in Burlington Northern Railroad was
successful, was due to the fact that he made this investment during the 2008
crisis, when prices were low. This Buffett quote explains the success of this
investment perfectly, "Be greedy when others are fearful and fearful
when others are greedy." This company also fits the Buffett investing
mantra of buying stable, boring, and predictable businesses, with steady cash
flows.
Other notable oil investments include Suncor and Phillips 66, which he has
recently added to his already existing positions.
As you can see based on past history, Buffett's success in the resource
sector has been a mixed bag. To understand why his success has been a mixed
bag, you have to first fully understand Buffet's investing philosophy, and
then fully understand the resource sector as well.
In order for Buffett to buy a stock, the company has to pass this set of
criteria: high margins with a low amount of debt (it doesn't take a genius to
run them); strong franchises and freedom to price, with predictable earnings.
This set of criteria sounds great when investing in a consumer goods
business, but when investing in the resource sector, it's almost impossible
to achieve. Look at this chart below.
The energy industry has higher capital spending requirements than other industries.
To be successful in the resource industry, you have to readjust your
investing strategy so you're able to succeed in a high capital spending
environment. This also means you have to be comfortable with companies
possessing higher amounts of debt and lower margins than what you are
normally accustomed to.
Another Buffet criterion that won't be fulfilled when investing in the
resource sector is buying franchises that have the freedom to price. When it
comes to oil and gas, this commodity is traded on exchanges all over the
world. Exchanges, which speculate on world production and consumption, are
the only things that influence the price of oil and gas.
Lastly, when trying to fulfill his criterion of "not needing to be a
genius to run it", this is impossible when trying to grow, or maintain
oil production. Running an oil and gas company, requires numerous amounts of
geoscientists, chemical engineers, mechanical engineers, and petroleum
engineers to maintain or grow the business.
Buffet's successes in the resource sector demonstrate that you should buy
when prices are low, the sector is out of favor, company cash flows are still
stable, and companies are selling for less than its book value.
