Energy, Oil, Natural Gas, Pipelines, Refining, Coal and Timber

One of the things I'm struggling with that is keeping me from investing more in energy is the future price of oil. The advent of fracking opened up a flood of new supply for nat gas and decimated the price. It seems like it could do the same to oil. The reserve figures for eagle ford and the bakken are just mind boggling. We're talking billions and billions of barrels. That doesn't even include the gulf of mexico where COP just found a hole that they consider to be "material".

It will be interesting to see how that plays out. One redeeming grace is that, besides the fact energy consumption is set to rise by 80% through 2050, when energy prices collapse, people stop worrying about using it efficiently, greatly increasing the actual quantity consumed. Look at the miles driven relative to the price of gasoline to see what I mean. The same thing happened in Rockefeller's time, when oil collapsed to 10¢ a barrel, but the world will always need energy. Only now, most of the extraction is done by a handful of companies that are more rational about when and how they take the stuff out of the ground. As a continuous net purchaser who is very young (relatively), I'm not terribly worried about it. That's not to say it couldn't be a real problem in the short-term.

It is very clear from the Malaysian experience of palm oil shares that, the best time to buy palm oil shares is after the commodity prices fell incredibly a lot. Then palm oil shares will trade at a far lower price. Some palm oil companies will lose money. But the survivor will always be 1.) The company with the strongest balance sheet 2.) Company with the lowest cost per tonnage of oil palm. Back in 2008, that was the right time to buy, as prices of the commodity rises, far exceeding the fixed overhead costs, profit margin expanded greatly. And its share prices shall reflect the same, along with its dividends. Its really really hard to increase capacity, as it takes years to grow, and the scarcity of quality land at reasonable prices. The odd thing is, as Philip Fisher says, it is the higher cost producer stock prices that increased tremendously far outpacing the lower cost producer, as the commodity price increases, making their 1% profit margin into ten fold 10% profit margin. Well, as long as they survived, of course. Very similar to a bank. But yeah, in short, the only time to go for it is when the commodity price is deeply in the tank, and when the share prices reflected that too. Maybe within the next 10 years or so. Who knows.

I wrote an article about that years ago, Making Money In Bad Companies. It's not something the inexperienced should try. It's one of those pieces that was buried and not referenced anymore, anywhere, because it might be too advanced for the beginner, who would be tempted to speculate.

The energy fund has to be firing up right about now. I started buying a little too early about a week ago but could not resist royal dutch shell A shares at $73. I think a lot of that new CEO and think they can really improve their financial metrics. I also bought CVX at $117.

I have a soft spot for Royal Dutch Shell. My father has a very big position in Shell, he started accumulating shares in the mid '70 when he just had a degree in dentistry. He calls it "His personal oil well".

I calculated that he will get about 50,000 euro in cash dividends in the next 12 months (we live in the Netherlands, he buys his shares at the Dutch stock exchange and he gets his dividends in euros in his broker account). That's about twice the average person makes in this country!

He's DRIPing, he has still about 6 to 7 years until he wants to retire and has to live off those checks, imagine the size of those dividend checks he'd receive each quarter by that time!

Shell is traded at the Dutch exchange, at the London stock exchange and at the US stock exchange as A and B ADR shares. My question, does it matter where someone buys his Royal Dutch shares? Are there any major differences between British, Dutch and US shares different from the currencies they're traded in?

Love the blog, very educational!

I love stories like this. I am so happy for your father! This is exactly what successful long-term investing looks like in the real world.

For those of us living in the United States, the most efficient way to hold the shares are the Royal Dutch Shell Class B ADRs (American Depository Receipts). Because they are listed on the London exchange, they are able to take advantage of the cross-border tax treaty between the United States and the United Kingdom, resulting in a dividend tax of only 15% instead of the 25% that is incurred on Class A shares from The Netherlands. The ADRs collect dividends in the native currency here (the United States dollar) and have more than sufficient liquidity. Each ADR represents two (2) shares of the underlying stock.

If I were living in The Netherlands, I would do what your dad did and just buy the local shares since it would be the simplest, and least complex way to do it. I have no idea what the brokerage protections are like (e.g., here in the United States, you don't want to hold more than $500,000 in a brokerage account because if the broker fails, SIPC insurance will only reimburse you up to that limit, with some notable exceptions) so large positions are better when held in segregated custody or directly registered with the business itself. But, otherwise, yeah, I'd just buy the local shares if I were a native of The Netherlands.

Hey Joshua
I have a concern. I am pretty sure that any other non-conventional forms of energy may not be able to replace oil & gas in next 10-20 years. But what if there is a black swan event, like discovery of something unique or increase in efficiency or decrease in costs of non-conventional resources? How do we mitigate that risk. I am sure you would agree with me if I say that as investors, we can never eliminate the risk of being wrong.
Looking forward for your reply.

Hi Stable Investor, Hi Joshua,

this is exactly what worries me - the influence of renewables. If the technology continues to develop in the future like it has been developing for the last couple of years, it could happen that the world doesn't need oil and natural gas any more.

Take a look what is happening in Germany now. Nuclear Power plants are being disconnected from the grid. Coal and natural gas power plants are too expensive to maintain. Energy giants, like E.On, are struggling, their business model shakes in foundations.
On the other hand more and more solar and wind farms are being installed. Also by private housholds, which are not only electricity consumers any more but they've become electricity producers.

Moreover, more and more car manufacturers are tinkering on electrical vehicles. If they succeedd, there will be no need for oil. People will "tank" their cars from their solar panels from their rooftops. Of course, nowadays we are very far away from this point (poor car batteries, very long battery charging times, short traveling distances on one charge, no "tank stations" infrastructure for e-cars, etc) but who knows what it will be like in 10 - 25 years?

Of course the renewable energy sources have thier issues: electricity storage, power shortages, etc. But if people continue working on this technology, it may happen that in 15-25 years renewable energy sources will replace completely oil and natural gas.

If the renewable energy revolution does happen, what would it mean to Royal Dutch Shell, ExxonMobil, BP, E.On, GDF Suez....

Isn't investing in Royal Dutch Shell now comparable to investing in Kodak in the year 2001, when there were signs that Kodak analog film technology was about to extinct?

I'm looking forward to your reply. What are your thoughts on this?

I'd say that there are already diverse sources of energy out there, with different advantages, disadvantages, cost profiles and risks (e.g. coal, nuclear, renewables and others), and yes, in time we will likely discover new alternative sources to add to the energy mix. However, this will not happen overnight - new technology takes a significant time (and cost) to be developed, and even longer to be able to economically compete with the resources and infrastructure we currently have (usually). Also, even excluding the energy generation side, the hydrocarbon business will still have an vital role to play in terms of feedstock for petrochemicals (for as long as I can imagine) as well as in transportation fuels (for at least the foreseeable future).

Furthermore, as you'll notice, Joshua isn't saying above that he would focus exclusively on oil and gas - he also mentions coal, timber, associated energy infrastructure etc, and also only strategically investing when he deems something is an attractive long-term holding.

Yes, there is always the risk of some unforeseen turn of events, but this is true in any sector - nothing is 100% guaranteed. You mitigate against it with a some sensible diversification, and the good old margin of safety.

Well said Matt. 🙂
Thanks a lot.

I couldn't have said it better myself.

When the natural gas boom threatened traditional crude in the same way, the oil giants began to think of themselves as energy companies instead. Royal Dutch Shell, for example, now derives a considerable amount of revenue and profit from natural gas. It's not accurate to call it purely an oil company, anymore.

If alternative forms of energy were to arise in a meaningful and viable way, it would happen slowly enough that these supermajors, with hundreds of billions in cash, would be the first ones to buy up the technology and slowly implement it. I imagine there would be BP and Shell electronic charging stations.

The graduates of the energy industry are among the brightest minds in the entire United States, giving it a huge human capital advantage. The incomprehensibly large cash flow - it would take 3-4 Berkshire Hathaways to make 1 ExxonMobil in terms of liquid cash profits that could be taken out of the business every year - mean that they can self-fund their entrance ticket to wherever the new party happens to be.

Their head start is so enormous that it would take an incredible amount of stupidity, over a long and sustained time period, to destroy these firms.

Then what do you think of Quebec (Canada) , a particular case? Electricity and heating is totally dominated by hydroelectricity, but oil and gas still has its place with Petro-Canada, Shell and Esso (Exxon Mobil kept its old name internationally).

The province has one of world's largest water reserves and makes 97% of its electricity from hydro dams. Ever since the province nationalized electricity in the 1960 by buying all the privately owned plants, Hydro-Québec became the world's largest hydroelectric provider and made Quebec one of the cheapest places in North America for electricity.

Any thoughts on this mixed formula?

I think it is probably going to happen a lot more in the future. Cities like Las Vegas should have large solar farms to augment the power, while cities surrounded by wind will have windmills. I'll have to study the Hydro-Quebec story as I don't recall much about it. Thanks for adding something interesting to my reading list =)

Josh, one of the things I have come to truly appreciate is the concept of a 5% entry dividend yield from a company that is going to grow its dividend over time. While most of my current disposable income is going towards BP these days, I think it's similar enough to Royal Dutch Shell to make the following comment: it's fun owning these high yielding oil supermajors that missed the "stock prices are supposed to skyrocket this year" memo and are allowing for reinvestment at these relatively depressed prices.

(You can tell I was born, raised, and live in the Bible belt because my first inclination was to raise my hand and yell, "Preach!").

I bought some BP for the fund this afternoon, actually. It always strikes me as weird that every ADS represents 6 shares on the London exchange. It's such an odd ratio. Buy 100 ADS's in the United States and you're really buying 600 shares of BP on the London stock exchange. Who thought that up, I wonder? Nestle's 1-1 ratio seems to make more sense, though I suppose it doesn't really matter.

I'm the biggest hypocrite preacher ever, then. I was going to buy some more BP today, but I got an alert that IBM had fallen below $200, saw that it was trading at $190, said to myself "Hot diggity dog!", and bought some. I'll get back to my regularly scheduled BP programming soon enough, I just figured that, since I'm working with limited capital, I'd have a longer time frame to buy BP around $40 than IBM around $190.

But who knows. I could be wrong. I'll hand the pulpit back over to you.

*And PS it's secretly still "British Petroleum" to me, too.

I looked at IBM, and under most circumstances, would have bought it but between personal and business taxes, pension funding, the recent acquisition, and some of the shares I've been picking up personally in the stock market, I hit my personal conservative "liquidity threshold" somewhere around 12:52 p.m., Central Standard Time. That's the level of cash reserves I don't like to fall below in the event of another Great Depression. It's a lot more conservative than most people would think is necessary, but I like being prepared for a 1-in-600 year event.

I'm going to take 5-6 months, sit on my hands, and let the profits from the private businesses, the dividends from the stockholdings, the copyright royalties, and the other sources of income flood into, and pile up within, the CCDA. This is going to coincide with a period when I get personally involved in one of the companies for a project we're working on this summer, which I'll probably talk about on the site in the fall, so I'll be distracted enough not to notice. When I get back to the investing later this year, there should be plenty of new money sitting, waiting for me to do something intelligent.

On the upside, the pension funding requirements mean that, though it is a liquidity drain over the coming months, it represents a pile of money that will get kicked into the KRIP portfolio. I imagine by September or October, I'll be looking for some new significant additions to it, so I'll still be able to pick up things during the cash regeneration season.

I did go ahead and sneak shares of BP and Total into the new energy portfolio, though. I'm still nervous about the socialist French government, but the discount, after accounting for the 25% French withholding tax on dividends for Total, is so large relative to intrinsic value that I can't help but add some to the balance sheet. It's a small position, both relatively and absolutely, but it's something I'm going to watch and think about for awhile. If I could be certain of the government's policies there, it would be a steal. My parents' have nearly 4% of their retirement assets in it, so I'd be watching closely, anyway, but now I'm hitched to the wagon, as well.

After the On the subject of liquidity thresholds, how much cash would you say it is prudent to have on hand as a percentage of assets (or is it an absolute number)? I always have trouble figuring out how much to have on hand, especially if markets are at high levels, in which case it makes me nervous not having cash in case of a crash.

This is worth its own post, and I have a lot of thoughts on it, especially after having run companies for a decade.

I think a big part of it depends on the fixed level of expenses in your life. Under the worst possible scenario, if you had $0 in income or cash coming in the door, how long could you survive with no change in your standard of living or business based on current liquidity reserves? I think a good number for most people if you are in the top half of income distribution is at least 12 months. A year is enough time to adjust and do something intelligent to come up with more money. Two years is even better. Five years is magnificent. This isn't potential investment capital - this is just what is necessary to cover your bills. (Obviously, this isn't possible if you are living on $14,000 a year as a checkout person at Wal-Mart, so this is by no means a subscription for the masses; I'm talking about the sub-niche of people that read a blog like this and who are, or will at some point in the future, be financially independent.)

Obviously, it stands to reason that under such a system, you can decrease your liquidity reserve requirements by decreasing the amount of cash that leaves your hands. If you have no mortgage, the figure will fall in an amount equal to the annual mortgage outlays multiplied by the number of years of security you desire.

Then, you need to add in the potential investment capital you would want to take advantage of opportunities. (If Coca-Cola is trading at 3x normalized earnings, even a small investment is going to make a lot of money over decades so, really, it won't take as much dry powder as you think.)

Another way to think of it: Some of the most conservative value investors always have 20% to 25% of their resources in some form of cash of short-duration fixed income securities. Graham recommended never dropping below the 25% threshold. Running portfolio models back through 1926, you see that the returns aren't much lower than they would be for 100% equity portfolios and they provide a massive decrease in overall volatility for the portfolio itself, as well as a huge protective cushion during collapses.

You can also factor in the security of your employment situation. There is a nice book on the subject called Are You a Stock or a Bond? that makes a compelling argument that someone with a bond-like income stream, such as a tenured professor, should be able to acquire more equity exposure and have lower cash reserve levels than someone who has a stock-like income stream, such as a car salesman who makes a lot of money in boom times but then sees income dry up during a depression.

Finally, if the banks and ATMs were closed for two months, how would you pay your bills? You need to have an answer to that. Banking holidays have happened before and there is no reason they couldn't happen again.

Those are the places I would start. Maybe I'll write about liquidity someday.

In terms of "Are You a Stock or a Bond?", what would income from equities classify as? It seems that if you have a large enough portfolio of high quality diversified stocks, you will continue to have decent income even through a recession. As for banking holidays, making an account at the federal reserve you talked about in a recent post would work, right?

1. Stock. Even if large, I'd still qualify them as a stock. If things go tumbling down the mountain, the dividends will get cut long before the bond interest is defaulted.

2. Theoretically, yes. I'd much rather be in that position than have my money sitting in a bank. But what if a cyber attack happened and there was no electricity - meaning no banks, no wires, no ATMs - for a week? How would you pay for your groceries? How would you buy things you needed? That's the question.

Thanks for the response, Josh.

Yeah, Total has caught my attention as well. Unfortunately, I have missed out on that opportunity (and will likely continue to miss out on it) because I do not know what to make of the French government.

Total is one of those "almost investments" that for me never seem to materialize. In a way, it kind of reminds me of my relationship with Big Tobacco. I come close to buying, but can never go through with it b/c of the political risk. I've flirted with Philip Morris International a few times, but I've never had the balls to bring her home from the dance.

HINT: For anyone reading this years later, just roll your mouse over the "2 years ago" at the center top of each post. You can then see the date and time... and then you can go to something like Yahoo finance to look at what the market was doing.

I'm a rookie at this so I must be misunderstanding something... How did you get the $140 and $170 figures you mentioned in your post?

It's a projection of the current nominal dividend return in absolute dollars compounded by a low rate of increase in per share cash distributions.

For example: Royal Dutch Shell Class B shares pay $3.44 in cash today. Though energy dividends fluctuate wildly - it could be down 20% next year - they tend to produce long-term increases that at least keep pace with inflation, though in a very volatile way. If the average dividend increase over the period works out to 4% per annum, the total aggregate cash you'd collect over the next 25 years would be almost $140.00. Plus, you'd still own the share and it would be producing annual dividends of $9.17 per year.

To get the figure you're asking about, think of it this way:

Year 1 = $3.44 dividend
Year 2 = $3.58 dividend
Year 3 = $3.72 dividend

etc. Continued for 25 years at 4% increases per year.

At the end of the period, you'd have collected checks for $134+ assuming no reinvestment. Again this is a little bit deceptive because energy stocks don't work that way. The 4% average increase could come as a $3.44 dividend this year, a $2.10 dividend next year, a $5.00 dividend the year thereafter, all the way out to 25 years, providing very lumpy results along the journey.

You can run various scenarios using your own economic analysis - 3% increases, 4% increases, 5% increases. Then, you can also try to model in reinvestment. Obviously, your total dividend accumulations are going to be much higher if you are plowing back your dividends to buy more shares, which themselves pay dividends, creating a virtuous cycle of compounding.

How do you compare the oil business to say, the mining business? It seems that they are both volatile commodity businesses (oil maybe less so because of the more stable demand), but you seem partial to energy and don't talk much about mining. Is there something more unfavorable about the mining business compared to energy? (Only thing I can see is perhaps more stable demand, you still have high concentration in a few large low cost producers in mining with BHP and Rio Tinto.)

Is there something more unfavorable about the mining business? I think so, yes. It can still be a decent business but it is nothing compared to energy.

It's possible that the rise of a firm like BHP could change that. It's the first time mining has a powerhouse on scale with Exxon or something comparable. I've looked at them for awhile but never added them to any of the portfolios.

Part of it is the simplicity. For a giant like Exxon to make a lot of money, it requires focus and specialization in only a few things: crude and natural gas; transporting and refining; marketing. It's clean. It's easy. To generate those numbers across other commodities requires a lot of disperate activities, skill sets, commodity price fluctuations ... it's just more complex.

All else equal, if forced for a long period of time, I'd much rather have my entire net worth in energy stocks, along with their fluctuations, than I would mining stocks. It's entirely a personal thing. That doesn't make it right or preferable, it's just that I'd sleep better at night and feel more comfortable with what I owned.

I imagine at some point in the next decade, I'll end up with shares of BHP, though. It just hasn't ever been high enough on my buying list relative to the other opportunities.

Another interesting post that triggered me to comment! I did some calculations in Excel based on the numbers in this post. If I assume a starting share price of 66,5 and a starting dividend of 3,44 combined with an annual dividend increase of 4% for the next 25 years and the assumption that all dividend is reinvested (at a share price that I calculate based on a constant Price/Dividend ratio of 66,5/3,44 = 19,33), I arrive at an annualized return of 'only' 9,38%.

Did you base your Shell purchases on different assumptions (higher annual dividend increase / different share price developments)? Or was an expected return of almost 10% enough for you in this case?

I have a question regarding the creation of one of these portfolios. If someone currently had the ability to add funds into a Roth IRA (but didn't expect to be able to contribute after a few years due to income levels) would the Roth be the best place to start such a portfolio? The downside would be that eventually one would not be able to add additional cash to the portfolio, but the tax-free nature would allow for additional compounding.

I notice you have nothing in this energy investment strategy regarding renewables. In 2011 investment in renewables, that is non fossil fuel energy sources exceeded that in fossil fuels and it has continued and grown. In 2005 the oil industry informed the US president that it did not foresee being able to meet demand beyond 2030. The most respected geologists in the world have pointed that failure to meet demand could come as early as 2020, depending on improvements in extraction and demand. Currently it is possible to extract about 43% of oil from a deposit, and there is growing concern that there may not be as much natural gas as suspected. Finally, virtually every single statement of amount of oil in reserves are exaggerated, and often by a factor of 2, 3 or 4.

I should also add that most timber presently harvested is used in the construction of homes. Within 20 years we will likely see mass production of printed homes via 3d printers. Already ones exist to produce plastic, metal, and concrete structures, and a number of additional compounds are being experimented with. The continued use of timber as a construction material will likely decline, which is well as the existing supply cannot possible maintain pace with demand.