Articles and Essays by Eric D. Wanger

This essay by Eric D. Wanger was originally published in a newsletter for the financial clients of the multifamily office he ran in Chicago. As analysts predicted, oil prices fell by the end of the year, to $95 per barrel.

June 1, 2011

Our analyst team attended Global Hunter’s land-based oil drillers conference, an overview of industry economics that included presentations by four firms that own, lease, staff and operate land-based oil rigs. These are small public companies that provide contract drilling services for clients that need gas and oil wells drilled. As one might expect, there was a lot of discussion about the prices of gas and oil. The price of oil was high based on a dramatic increase in Middle East unrest, heavy speculation and big money flows looking for a place to invest. Likewise, the price of natural gas was impressively low.

Crude Oil (WTI) & Natural Gas Prices: December 2008 – May 2011

Source: Bloomberg

Some of the more interesting things we learned:

• Few in attendance believed that oil could maintain its $110 to $120 per barrel price for long, believing that such high prices represented short-term speculative bets and Middle East risk premiums, not underlying supply and demand.
• On the flip side, the same analysts seemed to think that $60 to $70 is about as low as oil can go given actual supply and demand.
• Conservative balance sheets are in fashion among this crowd. While capital is plentiful and avail­able to these land drillers, they are terrified of taking more money than they can put to work right away. The last crash was so severe that it “put the fear of God” into their CFOs. None of these smaller land drillers are will­ing to get “overbanked” again.
• Natural gas is once again a fuel of choice for electricity generation, especially in parts of the country (such as the Northeast) that have underinvested in nuclear power and can’t safely and cleanly burn coal.
• As one might expect, the gas rig count continues to drop while oil-seeking projects are exploding in number.

Admittedly, that’s all mundane stuff. Competent, in­teresting, possibly useful, but certainly dull. Dry as dust.

Want something a bit more interesting? What did every single senior executive in the room mention as his number-one concern after trying to get and retain customers? Every man­agement team in the room agreed:  Finding and keeping com­petent employees is the toughest problem. The reason? Rampant drug use!

Rampant Drug Use

Working on an oil rig is a tough job. It’s dirty. It’s hot. It’s cold. It’s wet. It’s icy. But it pays really well. Here is a job that doesn’t require a high school diploma that can start at over $50,000 per year. Hard-working, experienced rig crew mem­bers can make in excess of $100,000 if they are respon­sible and can manage others.

These companies must maintain a zero-toler­ance posture on drug abuse. Their people are operating heavy machinery in tough outdoor conditions. The equipment is heavy and prone to difficulties. Injury is common and safety is a constant concern. Yet, in a world where populist politicians complain that American workers can no longer get a decent job without a fancy education, I am listening to senior corporate officials telling me that they can’t find enough workers that will come to work sober for $50,000 per year.

Admittedly, there’s not much to do for fun on your days off, but that’s hardly a new problem. When did bored, lonely and recently-paid oil workers, coal miners, loggers or cattlemen behave like Eagle Scouts on their personal time? The suits at the conference were not complaining about whiskey or vene­real disease among the lowly, poorly paid or disenfranchised. They were complaining about the rampant, recreational use of cocaine, methamphetamines, heroine, and other ad­dictive illegal drugs among unionized workers earning middle-class wages.

One official told us that merely announcing mandatory drug testing dramatically lowered his job application rate. An­other told us that his firm went to hair follicle testing because urinalysis only caught marijuana abuse and was too easy to fool.

Americans demand drugs—lots of drugs. So it is a basic law of economics that there will be huge efforts put into supplying drugs to Americans—and the policy regime keeps it so profitable that it is worth killing people for the right to sell drugs. It was no different with oil, booze or even newspapers in the old days. People beat and even killed each other for the right to own the channels of distribu­tion.

Basic economics guarantees that as long as Americans are willing to pay high prices for drugs, illegal or not, nearly infinite effort will be put into meeting that demand. No honest free marketeer can deny this fact.

In 1931, Aldous Huxley wrote Brave New World, a science fiction novel rooted in social commentary (“Praise Ford!”). He foresaw an eerie utopia whose population popped state-sanctioned recreational narcotics. Psychotropic drugs were as much a tool of political control as medication. As far back as 1931, Huxley saw taking pills as part of the fabric of our society.

What We Think About Energy and Other Commodities

In the long run, the price of oil will keep ramping higher, but the short term will inevitably see the same zigzag pattern we have always seen. In the short term, the price is as likely to head back down to $70 per barrel as it is to jump back up above $110. Many oil and gas stocks have or will become cheap again after coming off huge bull-market run-ups. Stocks like Double Eagle Petroleum (DBLE) and Venoco (VQ) can be pur­chased at or below the value of their proven hydrocarbon re­serves. It might be a while before these stocks peak again, but it’s hard to argue with tangible asset value.

America continues to be rich in coal. But Americans, at least now, despise this abundant natural re­source. Why aren’t we investing in the technology necessary to burn coal cheaply and cleanly? The answer is political. In any case, high quality coal is expensive and dirty coal is cheap. And coal is expensive to export to the countries clamoring for supplies of it. Unfortunately for us, coal stocks are hard for us to buy, because they are so cyclical and momentum driven.

Food prices have soared. Droughts in China and other parts of Asia have caused food shortages. Weather problems have coupled with market-distorting subsidies (such as America’s ethanol subsidy for corn farmers) to create the wealthiest American farmer we’ve seen in a long time. One result: American farmland is selling for huge prices, maybe even at bubble levels. We are hard at work looking to invest in things that wealthy farmers want to buy.

Corn Prices: January 2009 – May 2011

Source: Bloomberg

Lastly, there is another tech bubble under way. This time it’s the social networking companies like Facebook, Groupon, LinkedIn and others. Are Groupon and LinkedIn going to be Googles or Alta Vistas? Are they going to be Yahoos or NeXTs? Hard to tell. But I doubt any of the investment banks will return any of their hefty fees when we find out.

Eric D. Wanger, JD, CFA, President,
Wanger Investment Management, Inc.