Capital Allocation Problem in the Oil and Gas Industry

There's a capital allocation problem in every company run by agents, but there's some reason to believe that the oil and gas industry is especially bad.

There are a total of 1,042 public companies in the Oil & Gas Exploration & Production industry (GICS:10102020). There are 429 with market capitalization between $5 million and $250 million. Of those, only 72 have positive retained earnings. Just under 17 percent.

Glenn Chan has figured out how oil and gas managements work. Read his posts: How would a sociopath fleece investors in oil and gas? and Why would anybody want to invest in independent oil and gas?. This is looking smart, too:

What makes things difficult for the honest E&Ps is that the dishonest E&Ps are raising lots of capital. Much of this capital is spent on drilling. This creates an oversupply situation that hurts the honest operators. The honest operators have to compete against irrational competition. As well, there is a shortage of honest management teams. The smart people often give in and play the game of selling overpriced stock like everybody else.

Eventually, there may be a situation where the shale boom turns into a bust. If that happens, it will be worth looking at the operators with integrity and unusual skill in being the low-cost producer. The old Contango Oil and Gas was such a company, but its talented CEO passed away. It may be worth looking at Southwestern, an old joint venture partner of Contango’s. However, you will need to wait for the day when silly shale stocks implode and end their irrational drilling.

Review of Cadillac Desert: The American West and Its Disappearing Water by Marc Reisner

There are several reasons to read Cadillac Desert: The American West and Its Disappearing Water: to understand why the western United States was settled the way it was (sparsely populated and always will be), for a thorough account of public corruption that discredits the very concept of government, and as an illustration of the intractable principal-agent problem in human affairs.

By the mid-19th century, it was possible to know that the western US - west of the 100th meridian - had an "inexhaustible supply of land but far too little water". Reisner writes that

"John Wesley Powell, the first person who clearly understood this, figured that if you evenly distributed all the surface water between the Columbia River and the Gulf of Mexico, you would still have a desert almost indistinguishable from the one that is there today."

Powell thought that only a tiny proportion of western lands - closest to water sources - were suitable for agriculture. He proposed to irrigate as much as could be irrigated economically, and to redraw the western states' boundaries based on their watersheds. His proposed map is great but would never appeal to people who like straight lines. For those lands that couldn't be irrigated economically, he thought that they should either be "conserved" or grazed with cattle.

But guess who did not like that idea and wanted the land irrigated to the greatest extent possible, at public expense? The railroads, with their gigantic holdings of free land that they wanted to flip for a profit to farmers with irrigation. At the same time, people were also falling for the delusion that "rain follows the plow".

So, the lands were settled with farmers after the Bureau of Reclamation built countless - many hundreds - of dams and irrigation projects. (It was called Reclamation because irrigation projects were said to "reclaim" arid lands for human use.)

There were a small number of irrigation projects that made economic sense, but they were quickly built and for decades the art of dam building consisted of political log rolling to get funding for uneconomical dams, and also various machinations to conceal from the public the fact that these projects were huge transfers of wealth from the public to farmers and construction companies in the west. Reisner says that "to a degree that is impossible for most people to fathom, water projects [were] the grease gun that lubricate[d] the nation's legislative machinery."

Even once a great many uneconomic dams had been built, there was still an institutional imperative to build more of them. The Bureau of Reclamation chief Floyd Dominy would go to the senile Senate Appropriations Committee Chairman Carl Hayden's office and sit with his legislative aide to script Hayden's questions and his answers in advance of hearings. Create a bureaucracy and it never goes away.

Reading about the theft of the Owens Valley water more than a century ago, one realizes that the government has always been a wealth distribution tool for sale to the highest bidder. Corruption is nothing new. If anything, things may actually be better today because of ability of the internet to shine a light on crooked deals. There is no monopoly on information the way there was when Harry Chandler could easily fool the public with propaganda in his newspaper.

Even today, farmers in phoenix are growing hay and cotton while farmers in wetter parts of the country are being paid not to. And value investor favorite Boswell "has consistently received more money from agricultural price support programs than any other farmer in the entire nation".

By the way, the farmers who complain constantly about water (and labor) shortages are basically parasites who want something for nothing. The west's water shortages - past and present - are "the sort of shortage you expect when inexhaustible demand chases an almost free good".

I wasn't aware that "Northern Idaho is the banana belt of the Rockies - warmer than the mountains of new Mexico a thousand miles to the south, wetter than eastern Oregon and Washington to the West."

The book points out some longer term problems that we have to look forward to, unless technological ways are found to defeat them. Number one is mineral salts. The water cycle strips these from mountains via weathering and carries them to the ocean.  (In fact, the oceans are growing saltier over geologic time because of this runoff.)

What irrigation projects do is carry rainfall on a more circuitous route back to the ocean; running them through much more land as opposed to efficient drainage channels taking the path of least resistance. Along the way, quite a bit of water of lost to evaporation, obviously depending on how many times the water is diverted. That means that the salinity of the water grows, and these minerals are deposited in the land that is irrigated.

The history of irrigated desert civilizations is that irrigation is great - for a long time. You can feed more people, the oases in deserts are more difficult for enemies to approach, and the sheer numbers of people meant military power. But what always happened was that the irrigated lands eventually became too salty and had to be abandoned.

The other long term problem with dams is silt collecting in the reservoirs. The hundreds of dams built during a brief period in the 20th century will all be silting up at the same time, someday.

Maybe the most urgent potential problem mentioned in the book is one that will exist a bit east of the 100th meridian, which is not as dry in terms of rainfall as west, but more dependent on groundwater, and which has been "mining" the Ogallala aquifer for water for irrigation. As they say, "surface water can be compared with interest income, and non renewable groundwater with capital".

Meanwhile, the western states may be able to make a go of desalination, a question we've pondered in the past. Desalination cost is a function of salinity and dissolved solids, temperature (inverse), electricity cost, and technological improvements. If we ever have a breakthrough in electrical generation (fusion, 10x cheaper solar), we could create a Lake Yuma and make Arizona and Nevada lakefront without needing California to fall into the ocean!

4/5

Review of Barbarians at the Gate: The Fall of RJR Nabisco by Bryan Burrough and John Helyar

From y0ungmoney's review of Barbarians at the Gate

"Johnson was able to take over successively larger companies despite doing badly for shareholders because he excelled at corporate politics. RJR had become increasingly dysfunctional in the years leading up to its merger with Nabisco, and that made it the perfect environment for Johnson to rise to the top. Once there, he bought off the board and other executives with freebies and favors. Good to Great lionizes Philip Morris's management, but after reading Barbarians at the Gate one gets the impression that their success was largely the result of having a really dysfunctional competitor."

I won't bother to review it, but it's probably a 3/5 just for the scenes of corporate excess and the demonstration of the principal-agent problem at RJR under Ross Johnson.

Bryan Burrough is also the author of The Big Rich: The Rise and Fall of the Greatest Texas Oil Fortunes, another 3/5, although it did tell us that the Texas oil dynasties were the result of pure chance and the great depression.

Och Ziff Takes Position in Genco $GNK

Och Ziff filed a 13D showing a 7.32% stake in the Genco equity. This is exactly why I covered:

The Genco restructuring is inexplicably generous to the equity, and the problem is that if you give them an inch they'll take a mile. There's a big risk that they will view what they are being offered as a floor and agitate for more.

If I wanted to own ships, I'd order some newbuilds. At least they'd be brand new and fuel efficient and wouldn't arrive for a couple years, giving my bullish shipping rate scenario time to materialize. Of course, a hedge fund PM isn't allowed to buy actual dry bulk ships, they have to buy claims on ships at a higher level of abstraction, and that creates a principal-agent incentive problem to overpay for ships so that they can engage in some "action".

"Sinkhole of Bureaucracy" - A Principal-Agent Problem

Hilarious quote:

"'The reports [from the contractor] just asserted that they had written X lines of code. . . . For an executive, that’s just invisible; you don’t know what it means,' said Curtis Smith, who oversaw retirement processing from 1989 to 1994. He was a longtime federal employee with a PhD in English literature, supervising a massive technology project.

'I had no idea [if] they were making progress from month to month. And I just sort of took it on faith that they could make it work,' Smith said. 'And they never did.'"

Maybe O'bamacare has been having the same problem?

"Leaked company memo from Yahoo HQ shows even employees refuse to use Yahoo email"

"Following thousands of complains from furious users following a redesign in October, it has now been revealed that Yahoo mail is not even resonating among company employees, with only 25 per cent using it as their email destination, according to a leaked memo"

The redesign was totally botched. It looks like there is a principal-agent problem with these web companies (GOOG, YHOO) where the best thing for shareholders (and users/customers!) would be for the user interfaces of the sites to be left alone once they are completed. But management and the programmers employed benefit from constant tweaking of the features in order to justify their employment.

If Yahoo need something to do, why don't they fix Yahoo finance so that historical quotes and the message boards do not vanish when a company files for bankruptcy?

Three Papers on Protection of Investor Rights

Debt Enforcement Around the World by Simeon Djankov, Oliver Hart, Caralee McLiesh, and Andrei Shleifer.

"We present insolvency practitioners from 88 countries with an identical case of a hotel about to default on its debt, and ask them to describe in detail how debt enforcement against this hotel will proceed in their countries. We use the data on time, cost, and the likely disposition of the assets (preservation as a going concern versus piecemeal sale) to construct a measure of the efficiency of debt enforcement in each country. We identify several characteristics of debt enforcement procedures, such as the structure of appeals and availability of floating charge finance, that influence efficiency. Our measure of efficiency of debt enforcement is strongly correlated with per capita income and legal origin and predicts debt market development across countries."

It is amazing how long it can take to start a business or collect an undisputed debt, and also how greatly the amount of time varies from place to place. As these authors observe, no matter where they look in the world, the resolution of the insolvent hotel (a simple, single asset case) is "extremely time consuming, costly, and inefficient."

The Nordic and common law countries are the best at debt enforcement, while French law are the worst. Also, French law countries and poor countries are most likely to deviate from absolute priority of the senior secured creditor. In Singapore, Netherlands, and Japan, enforcing the debt only costs about five percent of the estate. In Turkey and Angola, enforcement is so costly that less than seven percent of the estate is left!

Tunnelling by Simon Johnson, Rafael La Porta, de Silanes, and Andrei Shleifer.

"Tunnelling is defined as the transfer of assets and profits out of firms for the benefit of their controlling shareholders. We describe the various forms that tunnelling can take, and examine under what circumstances it is legal. We discuss two important legal principles -- the duty of care and the duty of loyalty -- which courts use to analyze cases involving tunnelling. Several important legal cases from France, Belgium, and Italy illustrate how and why the law accommodates tunnelling in civil law countries, and why certain kinds of tunnelling are less likely to pass legal scrutiny in common law countries."

French/civil law countries seem to be systematically inferior to common law countries for investing, because this paper finds that civil law is less protective of minority shareholders, specifically in the legal treatment with respect to looting by insiders.

I do not understand why investors tolerate these legal regimes where the rules of the game put them at a disadvantage. The goal of investing is to receive coupons, payments of cash, not annual reports with nicely escalating accounts (that you will never touch). Investing in Brazil or China is like buying a noncumulative preferred stock. They are trick securities, unsafe at almost any price.

What Works in Securities Law? by Rafael La Porta, de Silanes, and Andrei Shleifer.

"We examine the effect of securities laws on stock market development in 49 countries. We find almost no evidence that public enforcement benefits stock markets, and strong evidence that laws facilitating private enforcement through disclosure and liability rules benefit stock markets."

This is a tricky one because there are so many variables. I am pretty sympathetic to the idea that private enforcement works better, though. But for private enforcement to really work you need efficient, fast, predictable courts.

That is why the first two papers are important, the acid test of a country's property rights and legal system. Can you collect your collateral when a company fails to repay you? Can you stop a crooked management from looting a company? In many countries, the answer to both is "no".

Two Papers on the Principal-Agent Problem in Public Companies

These are both coauthored by Shleifer who we mentioned in the previous post. The first is "What Do Firms Do with Cash Windfalls?" by Olivier Blanchard, Andrei Shleifer, and de Silanes.

They were interested in what happens if a company receives a cash windfall in the form of a won or settled lawsuit. They screened and came up with 11 firms that won lawsuits that gave them cash but did not change their investment opportunities.

They wanted to study empirically whether "selfless managers acting in the interest of all shareholders" would return the windfalls to shareholders. (Which they call the "asymmetric information model".)

The alternate hypothesis, which the principal-agent conflict model would predict, is that even firms without attractive investment opportunities do not spend the windfall on dividends or share repurchases. Also, the share repurchases that do take place under that model would be targeted at large shareholders or the management, rather than small shareholders.

What they find is that two of the firms pay out large percentages of the award to the shareholders, but both of these firms have very large management and family ownership and a substantial fraction of the dividend goes directly to controlling shareholders.

They conclude generally that "dividends are used mainly when managers stand to collect a lot themselves, and share repurchases are used to eliminate potential challenge to insiders' control from large shareholders," and that "managers strive to ensure the long-run survival and independence of their firms with themselves at the helm. They do this by keeping the resources inside and investing them in unattractive projects just to avoid giving up cash or having an outsider lay a claim on it".

Corporate governance is a huge problem! It's why I'm so skeptical of some of the value trap tech firms like Microsoft that trade at ostensibly cheap valuations. They show little inclination to return cash to shareholders, rather doing crazy things like buying Skype for $8.5 billion. Even Apple is mysteriously reluctant to return cash! It's as if they know the good times won't last forever.

The second paper is "Agency Problems and Dividend Policies Around the World" by Rafael La Porta, de Silanes, Andrei Shleifer, and Robert Vishny. One way of looking at dividends is a way to address the principal agent problem. Since the severity of the principal agent problem obviously varies worldwide according to the protections for minority shareholders, they look at whether the way dividend policies vary is consistent with the agency theory of dividends.

They find that companies operating in countries with better protection of minority shareholders pay higher dividends. Another test was whether fast growing firms pay lower dividends than slow growing firms in countries with better protections. They do, which suggests that investors in these countries are willing to wait for dividends (and allow companies to reinvest earnings) when investment opportunities are good. In countries with poor protections for minority shareholders, they find that shareholders prefer to take whatever dividends they can get, regardless of investment opportunities. 

P.S. Something else interesting is that between them, these papers have fewer than 300 downloads on SSRN. The first one has been cited 368 times and the second 113 times. I'm not sure if the CFA curriculum even mentions the principal agent problem, but if it does it is certainly much less than the EMH-assuming capital asset pricing model.