Titan Logix – revisited….

Following my original post about Titan Logix, I received an email that questioned the thesis of the post. I’ve extracted an excerpt from the email, as follows:

“…sure the company is cheap, but aside from book value, what makes you so sure the price will go up ?”

That is a totally valid question, and I’ll try & address the “whys” here. To (very quickly) recap the original post, there were a number of things that indicated to me that Titan was a relatively low risk buy. Note that I use the same green, amber, & red format, and that I simply list the points rather than going into a detailed explanation. Anyone that wants to review the original post can simply take a look at the prior Titan post to get the details. The distinct areas that I highlighted were as follows:

• Attractive technical chart
• Lots of cash & low debt
• Reasonable cash burn
• Clean earnings
• High insider ownership
• No institutional ownership & no analyst coverage
• No self promotion
• No share buyback
• Out of favor sector
• Business is easily understood
• Potentially disruptive technology

One can quickly see that the positives outweigh the negatives. However, not every investor is the same, and not every reader of this blog will have the same understanding of investing, or of this particular sector. This is where I may have come up short in my last post, so I’ll try to flesh things out a bit more here.

The price of a commodity distracts us from what is really happening. We are bombarded by price information all the time, because people can easily identify with the concept of paying too much or getting a bargain. However, when it comes to investing in companies that produce commodities, or companies that are affected by the commodity price, it’s often better to look behind the scenes. The good folks at the U.S. Energy Information Administration must have anticipated my post, because they just updated their forecast for liquid fuel production & consumption, which is shown below.

The first thing that should become apparent here is that production and consumption are always dancing with each other – sometimes one gets ahead of the other, but not by much. The two lines are tightly interwoven, constantly moving in & out of synch. That being said, while consumption & production tend to be intertwined, price is the signal that screams at us that one of them is slightly out of whack. Or, to put it succinctly, the price of crude oil is very sensitive to slight changes in either production or consumption, and therefore can be very volatile.

We have all seen this, as anyone who watches the news is constantly told that WTI is either up or down, and only a few years ago we cursed high oil prices (and high gasoline prices), whereas now we are less likely to do so. To highlight this, a 2nd chart from the EIA illustrates my point:

If you look at the first chart, the difference between the production & consumption isn’t particularly striking. However, you can still see that the blue line (production) gets slightly ahead of the khaki line (consumption), and that this gap persists into early 2016. During this time, excess production was likely put into storage, to be slowly worked off later. However, the impact on price is far more volatile, as the 2nd chart indicates. Even though the excess production isn’t enormous, it eventually craters the price by ~ 50%.

So, while both production & consumption tend to move up over time, one is driven by millions of people who tend to consume at a fairly even pace every day,  whereas the other is driven by exploration programs that take a long time to analyze & execute. For instance, if a major project is announced today, that production may not make it to the gas pump for a number of years. In essence, while consumption continues to slowly ticks upwards, producers may slow down or halt production entirely when prices are weak. 

OK. So producers slow down or stop production. What does this mean for Titan ?  A producer company is always trying to balance how much it produces and when. Although many companies employ hedging to get away from the price roller coaster, rarely are companies 100% hedged, and some can be totally unhedged. A quick look at the price cycle since the year 2000 allows us to walk through what happens with both producers and service companies.

• During the “low, flat price” part of the cycle: 
  • Producers are keeping a lid on costs, as price signals aren’t so strong that they are clearly signalling boom times. They are likely trying to keep service costs as low as possible, because price can’t cover up poor fiscal discipline. Additionally, because producers are so cost conscious, they are hesitant to spend to bring on new supply. At the same time, demand continues to grow, setting the stage for a demand-supply imbalance, and sowing the seeds for higher prices.
  • Service companies are reasonably busy. However, because prices are relatively flat, there are likely no new entrants into the marketplace. The number of competitors is probably fairly static. Anyone considering entering the market to compete is either well capitalized or has a strong business plan in place, as they know they will have to compete with existing service companies in an environment where producers are cost sensitive. Service companies are, for the most part, price takers.

• During the “rising prices” part of the cycle:
  • Producers slowly start to see stronger price signals, and become more aggressive. Since they are always compared to their competitors, they are keenly aware of whether or not competitors are producing more than they are. Eventually, this combination of stronger pricing signals and “not wanting to be left behind” causes them to expand activity and bring on more production. In turn, their need for services increases, and they become less cost sensitive, as they can justify paying more given that the commodity price offsets increased service costs.
  • Service companies see their business increase. New service companies may enter the market, seeing increased activity and increased prices. Costs for services may go up, as the equipment of existing services companies is likely seeing higher utilization. New entrants may provide the incremental equipment required by producers, as existing companies may not be able to expand their fleets as quickly.

• During the “rising & sustained high prices” part of the cycle:
  • Producers are all making money, as the sustained high prices hide all cost overruns. The most poorly capitalized/managed producers (usually chasing the highest cost projects) enter into the market, as with strong prices in hand, they can more easily sell their story in order to raise capital. With all producers running at “full tilt”, competition for services becomes fierce, and the most poorly managed producers drive up the price of services, as they likely lack fiscal discipline. The “produce at all costs” mentality sets the stage for oversupply.
  • Service companies likely have difficulty keeping up, and can therefore become price makers. Sensing the frenzied level of activity, they can effectively name their prices, knowing full well that producers have little choice. Like their producer brethren, even the most poorly managed service companies can turn a profit.

• During the “low prices..again” part of the cycle:
  • Producers are likely stuck with high cost structure projects that were initiated during the high price environment. Saddled with the costs of these projects (that are not easily shed), they look for any costs they can easily and quickly reduce or eliminate. Negotiations with service companies become an exercise in “passing down the pain”, as they again become price makers out of necessity. New projects are either pushed off into the future or shelved entirely. Inventories of oversupplied commodity are slowly worked down.
  • Service companies see revenue declines and margin compression. Well capitalized service companies whose management (likely) have long tenures and anticipated the end of high prices are prepared, and can weather extended periods of low revenues. Poorly capitalized & poorly managed service companies exit via bankruptcy, or are swallowed by competitors. The pool of available companies shrinks, with only the strongest and best managed companies surviving. Once the cycle begins again, they are the ones that producers will turn to.

So, to answer the question “…what does this mean for Titan ?”, the answer is that the slowing (or stopping) of crude oil production means three things for Titan:

1. Titan is surviving because of its strong capital structure.
2. Competitors are leaving (or have left) because they are poorly managed or have a weak capital structure, or both.
3. When the sector starts to turn, there will be less companies to compete with, which means a higher concentration of business will fall into the hands of Titan.

So these are the reasons, in conjunction with those factors I indicated in the prior post, that make me reasonably certain that Titan will see increased business as the sector turns around, and that in turn will lead to an increase in share price.

As always, I can be reached at: mark@grey-swan.com.