I bought CH Offshore on 25th May 2009

Before I go into the rationale behind my purchase, I will like to share some thoughts on the oil & Gas industry (from the investment context) and value investment in general. I had quite a fruitful discussion on the above topics in one forum thread and exchange of comments with a reader on my blog entry when I purchased SPC.

Oil & Gas Industry from an investment point of view

The first thing that came to mind when one discussed about the industry is crude oil price. As far as investment is concerned, unless one buys a crude oil index exchange traded fund (ETF) or equivalent, using crude oil price as an indicator is not so straight forward.

The meaning behind crude oil price

It is quite easy to miss the forest for the trees. Once the crude oil price surge, the immediate sentiment is that oil and gas industries must be making money but this is not so. Crude oil price is just a barometer for supply and demand. Whether emotional, speculative or real, it just signifies meeting point between them. And it is that simple.

Oil and gas activities can be divided roughly into 3 categories:

1. upstream (oil and gas exploration and production)
2. downstream (crude refining)
3. support (offshore support, rig manufactures etc)

When real or anticipated demand exceeds real or anticipated supply, oil price surges and vice versa. The movement of the supply and demand curve moves the crude price and had varying effect on players in the above 3 broad categories. Note that demand and supply curve (whether real or emotional) must move first before crude oil prices barge.

Upstream

Players in oil & gas exploration and production players are the first to benefit when price surge and first to suffer when price plunge (especially so when price plunges below production cost, i.e.

Profit = function (crude oil price)

Downstream

Players are mostly refiners who use crude oil as raw material and sells refined products. Their profit are heavily dependent not on crude oil price, but crack spread (the profit margin between crude and refined oil). Most of the people I talked to focus on this, but that is only part of the picture. The next part is demand. Profit is a function of sales volume and profit margin:

Profit = function (crack spread, sales volume)

Downstream players are more sensitive to crack spread and sales volume rather then crude price. When economy is booming, the demand for crude generally rises (emotionally or real) more than supply can keep up. The effect is rising prices. The crack spread might suffer, but profit can still go up if the increase in sales volume more than make up for the declining spread. Problems arises when the crude price surges to a point that affects demand, then both sales volume and crack spread drops and hurt profitability. It is these dual factors that gave people the wrong impression that profitability of refiners had nothing to do with crude oil price. It does, but indirectly via demand and supply curve instead.

Support

Support players are very much affected by crude prices but lags crude price cycle a big deal. When the economy starts booming after a recent recession, it will take some time before demand catches up again with supply. It will take even longer before crude price surges again to a point that makes oil and gas exploration or extractions lucrative. Further lengthening the cycle is that support projects typically have long gestation periods. It takes many months to build support vessels or oil rigs and sustained efforts during exploration. Activities can persist for months after oil bubbles burst.

Actions

Thus, once the euphoria for oil and gas industry subside with the collapse of the oil bubble, I believe there are opportunities to look for bargains. First, I bought SPC, now I bought CH Offshore. The former is a typical refiner (though it has some exploration and production segments) and the latter is a typical support player. Compared to other companies (such as Ezra and Swiber) operating in the support segments, CH Offshore stands out with its less (nearly none) leveraged business model. The downside is its growth will not be as speculator during the upturn. I could have got it way cheaper a few months ago, but alas spare cash don't come easy these days.

A few words on Value Investing (and fundamental analysis)

From the forum discussion, it becomes apparent that some believers of value investing would ignore cyclical businesses because they find them hard to value. Value investing preaches buying things below their intrinsic value with sufficient margin of safety. Intrinsic value is an estimate. Just because cyclical businesses's intrinsic values are difficult to ascertain due to the highly fluctuating profits and losses does not mean value investing cannot be applied.

Look at it another way. Highly cyclical businesses have such huge peak to through fluctuations in earnings (and hence share price) and these fluctuations are recurring in nature. Hence, the magnitude in the fluctuations safely assumes that purchases near the through when a cyclical sector collapses (not price bottom since one cannot predict the bottom) should provide the sheer margin of safety.

It is for this reason I bought Courage Marine when BDI crashes below 800 when I believe the shipping bubble had more or less burst.

Conclusion

There are always many routes to a destination. Some are more established while some are less travelled. By sticking only to the established route, one misses out the many hidden opportunities that could have been better.