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Do Buffett's Actions Suggest the Bottoming of Oil Prices?

Feb 17, 2016

In this issue:
» Are public sector banks adequately provided?
» Crisis in China bigger than the US subprime crisis
» ...and more!
00:00
Radhika Pandit, Managing Editor of ValuePro

Oil is in the doldrums. Led by excess crude supplies in the global market, the price of oil has crashed below US$30 a barrel. This is the lowest in twelve years. And nobody really knows whether this is the bottom or if we are to expect more pain.

Not surprisingly, stock prices of most oil companies have suffered. But that hasn't deterred Warren Buffett. Indeed, Berkshire Hathaway has been stepping up investments in the oil sector in the past several months.

At the start of the year, Berkshire Hathaway started to add to its holdings of oil refiner Phillips 66. Today, news is Berkshire disclosed a new investment in pipeline operator Kinder Morgan. As reported on CNBC, Kinder Morgan's shares have fallen by nearly two-thirds since April as oil prices have cut profitability.

Given the substantial fall in the price of oil stocks, Buffett is seeing this as the perfect opportunity to step up investments in the sector. It only makes sense, then, to go some years back and evaluate Buffett's investments in the energy space. Has he been successful?

Not always...

As reported in Oilprice, Buffett's first foray into the energy sector began in 2002, when he took a US$500 million-dollar stake in Petro China. In 2007, he sold it at a profit of US$3.5 billion dollars. This investment was successful because he bought it when it was undervalued. He thought the business was worth US$100 billion dollars, and it was trading at a value of US$45 billion dollars. This made the stock hugely undervalued.

Another of Buffett's successful oil investments 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 US$15 billion dollars in dividends from the company. Its earnings have more than doubled.

But there have been failures too. One that comes to mind is ConocoPhillips. This investment cost Berkshire several billion dollars and turned out to be a loss-maker.

A closer look at these three investments throws up an interesting fact. When Buffett purchased PetroChina and Burlington Northern Railroad, oil prices were depressed. ConocoPhillips was purchased in 2008 - when oil was trading above US$120 a barrel.

So if one were to rely on history, Berkshire's increasing investments in oil companies during the current low oil price environment could turn out to be successes in the future.

Of course, the idea here is not to predict the top or the bottom for oil prices. That is a very tough call to make since oil is influenced by so many global factors. As we have discussed many times before, oil prices are not sustainable at such low levels for a long time because it doesn't encourage the kind of investment the industry needs. The long-term trend suggests that oil prices will average somewhere around US$60-65 a barrel with many spikes and plunges along the way.

Buffett ultimately invested in energy sector companies because he believed that the sector provided the stable cash flows he so desired. And because they were grossly undervalued at the time, he bought them. Thus, assuming that oil prices rebound going forward - and logic suggests that they should - his current oil bets are likely to play out well for him.

In the ValuePro portfolios too, my team and I have included some oil stocks that have been taken to the cleaners in the last few months. We believe they are grossly undervalued. But these companies boast strong balance sheets. We expect them to become strong performers when oil prices start to move back up.

Do you think you think that Buffett's recent oil bets will become successful in the long run? Let us know your comments or share your views in the Equitymaster Club.


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03:03 Chart of the day

Spiraling bad loans has hit the public sector banks (PSBs) hard. As a result, the provision requirements for these banks has risen. But with the credit offtake remaining tepid, higher provisioning has dented their earnings. The fallout of this has been a drop in the provision coverage ratio (PCR) of PSBs in the last three years. PCR is the funds that banks keep aside to act as a contingency fund against bad loans. The higher the ratio, the greater is the risk preparedness and resilience of the bank's balance sheet.

The Reserve Bank of India's Asset Quality Review (AQR) in the December 2015 quarter has been the proverbial last straw in the bad loan crisis. As banks have been asked to recognize bad loans and provide for them in the last two quarters of FY16, the provisioning requirement has shot through the roof. This inevitably has led to further fall in the PCR of PSBs. Barring State Bank of India, the coverage ratio has fallen sharply for most of them.

As banks would be re-classifying loan accounts in the March 2016 quarter as well, the PCR ratio is expected to remain low over the medium term. The RBI has set a deadline of March 2017 for banks to clean up their balance sheets. However, this exercise is likely to impact smaller banks more thereby setting the stage for a consolidation in the industry.

Are public sector banks adequately provided?

04:01

On the problem of mounting bad loans, while the RBI has cracked the whip on banks to expedite its resolution, China seems to be completely unfazed. In a diametrically opposite stance, the Chinese authorities are considering a proposal to reduce the provision requirements of banks against bad loans to enable them to lend more aggressively. This too when the total stressed advances in China's banking industry has snowballed to US$645 billion, more than the US$600 billion subprime mortgage crisis in the US in 2008.

Moreover, considering that China is notorious for being opaque in disclosing data and with the large presence of shadow banking, the real debt woes of the dragon nation may largely be understated. While these stop-gap measures can temporarily help mask the slowdown pangs, China may well be on its way towards building another global financial crisis.

4:45

Indian markets largely languished in the red in today's trading session. At the time of writing, BSE Sensex was trading lower by around 80 points. Barring oil & gas, all the sectoral indices were witnessing selling pressure, with stocks from metals and banking facing the maximum brunt. Stocks from both the smallcap and midcap spaces were not spared either. The BSE Midcap and BSE Smallcap were trading lower by 1% each.

04:55 Today's investment mantra

"Owning stocks is like having children; don't get involved with more than you can handle" - Peter Lynch

This edition of The 5 Minute WrapUp is authored by Radhika Pandit (Research Analyst) and Madhu Gupta (Research Analyst).

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3 Responses to "Do Buffett's Actions Suggest the Bottoming of Oil Prices?"

Yuresh

Feb 18, 2016

Agree with your analysis. Oil stocks of refining companies-not producers-have a situation where their operating margins must be jumping. it also seems fairly clear that there is a huge oil supply in the world which as i am told, will last 100's of years. so competition from alternate technologies will go down. Therefore oil will remain the main fuel for a long time and therrefore refiners are looking at as rosy long term future...

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Balakrishnan R

Feb 17, 2016

Dear Sir,
The daily wrap up initial writing time is shown as 0:00. I guess it is 12 noon. Generally market writing time is shown as 04:45. As we know the market closes at 03:30. I wonder why about 2:30 time info is given at 4:45. Better, either give full information of market at 4:45 or give the correct time of the information being written. The wrap up comes only at about 5.30 pm.
I feel much efforts are being put to market value pro. It is quite boring to read the same information again and again.
I understand Mr. Buffet is not investing in oil exploration companies; he invests only in auxiliary companies such as Refinery, piping etc. You may also start recommending such Indian companies.

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R K Sharma

Feb 17, 2016

I think it is a play on dividend. Valuepro has ONGC which is available at 4.5% dividend yield. If I hold it for 5 years I get 22% payback. In 5 years oil can be expected to come off the lows.Other sources of energy cannot replace oil in this span of time. The Geopolitical direction is also likely to be resolved. Oil is a Geopolital story and the crash of prices a weapon to force some political interests.

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Equitymaster requests your view! Post a comment on "Do Buffett's Actions Suggest the Bottoming of Oil Prices?". Click here!
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