dylan grice 19th december 2019 … · 2019. 12. 19. · cargo cult finance 19th december 2019 | 2...

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19TH DECEMBER 2019DYLAN GRICE

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Here’s a summary of today’s oil market: distressed; dumb money selling; smart money buying. Interested? You should be. We check out the current situation in the oil field services sector and find some extraordinary value.

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05Postcards from the depths of despair: jack-up edition ..........................

Richard Feynman warned academia of the dangers of research malpractice in 1974, effectively predicting the “replicability crisis” currently sweeping across university research departments the world over. Those departments complain that the pressure to meet funding requirements and to publish ‘something’, and ideally ‘something novel’ is to blame. But those same pressures apply to the financial industry too. Why should it be immune? Actually, it isn’t. The academic evidence for factors is dubious at best. Yet the ‘smart beta’ industry has sold over $1tr worth of it to investors. Is the breakdown of the “value factor” merely the beginning of a slow burning scandal?

WORDS

01Cargo Cult Finance and the smart beta bubble

"The world is at all times the dupe of some bubble or other." - Col William Rafter

.................................................

“There’s Renaissance Technologies and there’s everyone else” opined the Economist newspaper once, when referring to the phenomenon that is Jim Simons and his team of scientists. Unlike the charlatans peddling smart-beta, the guys at Rentec do real science, and operate on a different plane from the rest of the industry. Indeed, so unique are they that you might have wondered, as have I, if there was anything mortals like us could learn from their story. Well, wonder no more. I just read Zuckerman’s fascinating book, and it turns out there is.

From all of us at Calderwood we’d like to say thank you for your support and wish you all a very Merry Christmas and a Happy New Year. See you in 2020!

BOOK REVIEW

10The Man Who Solved the Market by Greg Zuckerman ..................

Percentage of asset ownersadopting smart beta strategies

Source: FTSE Russell

2014 2015 2016 2017 2018 20190%

10%

20%

30%

40%

50%

60%

1 See http://calteches.library.caltech.edu/51/2/CargoCult.pdf for the entire pdf, or the final chapter of his book “Surely you’re joking, Mr. Feynman!” For an adapted version.

Cargo cult financeand the smart-beta bubble

In 1923, Robert Millikan won the Nobel Prize for Physics for his oil drop experiment, measuring the charge of an electron, conducted with PhD student Harvey Fletcher between 1909 and 1913. It remains a controversial episode in the history of science though, partly because it appears that Millikan forced Fletcher to relinquish his claim on co-authorship as a condition for receiving his PhD. Fletcher, it seems, should have been a co-prize winner. But it is controversial for other reasons too. We now know that the measure he calculated was slightly too low (by about 0.6%). But if you plot other scientists’ estimates of the charge of an electron in the years following Millikan’s 1913 paper, we find that the first one is a little bit bigger than Millikan’s, the next a little bigger still, the next a little bit bigger than that, and so on. They only converge on the higher (correct) value several decades later.

Why didn’t they discover that the number was higher right away? During his commencement lecture at Caltech in 1974, Richard Feynman offered the following answer:

Feynman’s description of the mindset of the scientists following up on Millikan’s experiment would today be a textbook example of what psychologists call motivated reasoning in which people believe things because they want to believe them (ie they are motivated to believe them). Motivated reasoners get trapped in a kind of loop,

“It's a thing that scientists are ashamed of - this history - because it's apparent that people did things like this: When they got a number that was too high above Millikan's, they thought something must be wrong and they would look for and find a reason why something might be wrong. When they got a number close to Millikan's value they didn't look so hard. And so they eliminated the numbers that were too far off, and did other things like that.”1

19TH DECEMBER 2019 | WWW.CALDERWOODCAPITAL.COM

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justifying new arguments by basing them on arguments that they already like to believe in (to the extent that people then believe their own motivated arguments, they get trapped in a kind of internal echo chamber.)

Psychologists believe the effect of motivation in reasoning is strongest for beliefs which intertwine with how a person sees him/herself. For example, suppose I go out and buy a second hand car. I might start out being very rational about it: reading lots of online reviews, renting a similar model for a weekend just to be sure I’m going to like what I buy, evaluating its service history etc. But then suppose that after I’ve made the decision and bought the thing I find that it’s uncomfortable, sluggish to overtake and more difficult to handle than I remember. I can’t get as much luggage in the back as I thought either.

If I was super rational I’d admit my mistake. I’d take the car back to the dealer and start the process of buying a new car again. Except doing that will involve a time cost, because I’ll have to start all that research from square one. Worse, I’ll take a financial hit because the dealer will only buy the car back at a lower price than that which I paid for the car. But worst of all, I spent ages telling everyone how clever I was doing all this research, and how excited I was about my impending purchase. If I return the car I’ll look like a bit of a dummy, and I don’t like to see myself as a dummy.

So I don’t take the car back. I keep it, and I double down. I tell myself how much I love it: its lack of acceleration is actually great, because it disciplines me into driving more safely; the cushioning isn’t so bad either once you get used to it; and there’s plenty of space for everything you might need on a trip, so long as you pack carefully; etc etc.Obviously, I’m just paraphrasing from the textbook examples, because I’ve never actually done anything like this before … but the

motivated reasoning literature highlights that there are many factors which influence a decision or judgement. Critically, ‘the truth’ is only one of those factors, and often subordinate to emotional ones. We’ve all seen investors go public on a banner investment, only for it to blow up in their faces. Have you ever wondered if they’d have stuck with their losing position for so long had they not gone so public about it? The public show of cleverness having the effect of adding to their cost of reversing the position when the investment seems to be going wrong, thus increasing the motivation for them to reason that they are in fact right, notwithstanding the onslaught of contrary evidence?

My car example was made up (honestly). But I’ve stuck with hires, stayed in jobs, and held onto views and investments for too long because I didn’t want to admit to myself that I had been dumb. In Feynman’s example, the physicists seem to have been motivated by the fear of looking like idiots for straying too far from the conclusion of one of the day’s great scientists. Other ways researchers might be motivated to find untrue ‘truths’ might be the pressure an academic department faces to publish new and exciting findings, as in Feynman’s example of the situation he encountered at Cornell’s psychology department:2

Cargo cult finance


2 Gregory Zuckerman, The Man Who Solved The Market, Penguin, Random House, UK, 2019

Feynman’s description of the mindset of the scientists following up on Millikan’s experiment would today be a textbook example of what psychologists call motivated reasoning in which people believe things because they want to believe them (ie they are motivated to believe them). Motivated reasoners get trapped in a kind of loop,

“When I was at Cornell, I often talked to the people in the psychology department. One of the students told me she wanted to do an experiment that went something like this - it had been found by others that under certain circumstances, X, rats did something, A. She was curious as to whether, if she changed the circumstances to Y, they would still do A. So her proposal was to do the experiment under circumstances Y and see if they still did A.

I explained to her that it was necessary first to repeat in her laboratory the experiment of the other person - to do it under condition X to see if she could also get result A, and then change to Y and see if A changed. Then she would know the real difference was the thing she thought she had under control.

She was very delighted with this new idea, and went to her professor. And his reply was, no, you

02

justifying new arguments by basing them on arguments that they already like to believe in (to the extent that people then believe their own motivated arguments, they get trapped in a kind of internal echo chamber.)

Psychologists believe the effect of motivation in reasoning is strongest for beliefs which intertwine with how a person sees him/herself. For example, suppose I go out and buy a second hand car. I might start out being very rational about it: reading lots of online reviews, renting a similar model for a weekend just to be sure I’m going to like what I buy, evaluating its service history etc. But then suppose that after I’ve made the decision and bought the thing I find that it’s uncomfortable, sluggish to overtake and more difficult to handle than I remember. I can’t get as much luggage in the back as I thought either.

If I was super rational I’d admit my mistake. I’d take the car back to the dealer and start the process of buying a new car again. Except doing that will involve a time cost, because I’ll have to start all that research from square one. Worse, I’ll take a financial hit because the dealer will only buy the car back at a lower price than that which I paid for the car. But worst of all, I spent ages telling everyone how clever I was doing all this research, and how excited I was about my impending purchase. If I return the car I’ll look like a bit of a dummy, and I don’t like to see myself as a dummy.

So I don’t take the car back. I keep it, and I double down. I tell myself how much I love it: its lack of acceleration is actually great, because it disciplines me into driving more safely; the cushioning isn’t so bad either once you get used to it; and there’s plenty of space for everything you might need on a trip, so long as you pack carefully; etc etc.Obviously, I’m just paraphrasing from the textbook examples, because I’ve never actually done anything like this before … but the

motivated reasoning literature highlights that there are many factors which influence a decision or judgement. Critically, ‘the truth’ is only one of those factors, and often subordinate to emotional ones. We’ve all seen investors go public on a banner investment, only for it to blow up in their faces. Have you ever wondered if they’d have stuck with their losing position for so long had they not gone so public about it? The public show of cleverness having the effect of adding to their cost of reversing the position when the investment seems to be going wrong, thus increasing the motivation for them to reason that they are in fact right, notwithstanding the onslaught of contrary evidence?

My car example was made up (honestly). But I’ve stuck with hires, stayed in jobs, and held onto views and investments for too long because I didn’t want to admit to myself that I had been dumb. In Feynman’s example, the physicists seem to have been motivated by the fear of looking like idiots for straying too far from the conclusion of one of the day’s great scientists. Other ways researchers might be motivated to find untrue ‘truths’ might be the pressure an academic department faces to publish new and exciting findings, as in Feynman’s example of the situation he encountered at Cornell’s psychology department:2

As Charlie Munger has said, “Show me the incentive and I’ll show you the outcome.”

Anthropologists have developed the concept of “cargo cults” to describe the phenomena of pre-industrial cultures briefly encountering more technologically advanced ones, and then trying to replicate the wealth of their departed visitors by replicating their material trappings. For example, in some of the South Sea islands Americans used as landing bases during WW2, the natives built mock runways, communication towers, a wooden man for a controller, complete with wooden headphones. They thought that if they faithfully imitated the form of the Americans’ technology they would coax more cargo drops from the sky. Feynman used the term Cargo Cult Science to refer to a form of pseudoscience, specifically about those mimicking the form of science (ostensibly careful experiments, equations,

cannot do that, because the experiment has already been done and you would be wasting time. This was in about 1947 or so, and it seems to have been the general policy then to not try to repeat psychological experiments, but only to change the conditions and see what happened.

Nowadays, there's a certain danger of the same thing happening, even in the famous field of physics. I was shocked to hear of an experiment being done at the big accelerator at the National Accelerator Laboratory, where a person used deuterium. In order to compare his heavy hydrogen results to what might happen with light hydrogen, he had to use data from someone else's experiment on light hydrogen, which was done on different apparatus. When asked why, he said it was because he couldn’t get time on the program (because there’s so little time and it’s such expensive apparatus) to do the experiment with light hydrogen on this apparatus because there wouldn’t be any new result. And so the men in charge of programs at NAL are so anxious for new results, in order to get more money to keep the thing going for public relations purposes, they are destroying - possibly - the value of the experiments themselves, which is the whole purpose of the thing. It is often hard for the experimenters there to complete their work as their scientific integrity demands.”

technical language), but not its substance (data openness, calculation sharing, code auditing, and basically bending over backwards to show where you might be wrong in conception, experimentation, simulation etc). To anyone reading his lecture today, his description of Cargo Cult Scientists reads like a prophetic warning of the “replication crisis” currently sweeping through academia.

For those not familiar with this crisis, it’s what it sounds like: an embarrassingly large number of academic findings in esteemed journals from various disciplines don’t bear up to scrutiny. In some cases this means that there have been no attempts to reproduce results and in others, attempts to replicate findings have failed. Chart 1, constructed using one presented by Fiona Fidler and colleagues3 suggests that as few as 40% of findings in the psychology literature can be independently replicated (suggesting the other 60% might be made up). Cargo Cult Science seems to be alive and well.

Percentage of results which weresuccessfully replicated

Chart 1

Economics(n=18)

Psychology(n=151)

Science & Nature(n=21)

Source: Fiona Fiddler et al

0%

10%

20%

30%

40%

50%

60%

70%

80%


3 https://www.youtube.com/watch?time_continue=993&v=26rznwTa3cE&feature=emb_logo4 At least there seems now to be an acknowledgement of the problem, as well as various attempts to root the problem out. The University of Melbourne’s RepliCATS project for example, is leading with an attempt to estimate the replicability of 3,000 published claims in social science, including economics, psychology, education and sociology (the CATS in RepliCATS stands for Collaborative Assessment for Trustworthy Science)

03

5 See “Does academic research destroy stock return predictability?” By David McLean and Jeffrey Pontiff, Journal of Finance, October 2015

Anthropologists have developed the concept of “cargo cults” to describe the phenomena of pre-industrial cultures briefly encountering more technologically advanced ones, and then trying to replicate the wealth of their departed visitors by replicating their material trappings. For example, in some of the South Sea islands Americans used as landing bases during WW2, the natives built mock runways, communication towers, a wooden man for a controller, complete with wooden headphones. They thought that if they faithfully imitated the form of the Americans’ technology they would coax more cargo drops from the sky. Feynman used the term Cargo Cult Science to refer to a form of pseudoscience, specifically about those mimicking the form of science (ostensibly careful experiments, equations,

The causes of this crisis have been attributed to the pressure to publish and the bias towards publishing something novel (only 0.1% of psychological papers attempted to replicate the work of others) much as Feynman described in his address. This may in part be because of the way that research is currently funded, but a culture which permits and even encourages Questionable Research Techniques (QRTs) like

cherry picking, p-hacking and hypothesising after results are known (HARKing) has been cited too.4

So there seems to be something fundamental to research, beyond the domain of that research, which pushes it to ‘over-claim’ knowledge. Feynman illustrated it in the physical sciences over forty years ago. Fiona Fidler is drawing attention to it in the social sciences today. Why should financial research be any different? Where might we expect to find a replication crisis in finance?

Well, we’d have to look for a corner of the market with a large incentive to push spurious conclusions while at the same time making the work appear rigorous and dare we say it, ‘scientific’. Perhaps a corner of the industry which stood to meaningfully gain from selling its own repackaged version of such academic looking research without actually consuming those products itself. Perhaps that industry might use the cover of calling itself “smart”, to conjure up an image of being technologically advanced, like a “smart phone” or a “smart watch”. Maybe that industry would call itself something like “smart beta”. But maybe we should think of it more as Cargo Cult Finance.

Smart beta vendors all have two things in common. The first is that they flaunt their ties to academic finance. Dimensional Advisors, whose website touts its success in “putting financial science to work for investors” and which is advised by none other than Ken French, one of factor investing’s founding fathers is far from atypical. Blackrock’s factor team is run by a former Prof at Columbia Business School. The second is that the smart beta “providers” are typically asset gatherers. In other words, firms that have made their money selling smart beta products to others, not by investing in smart beta themselves.

No wonder. When McLean & Pontiff (2015)5 looked into the claimed returns of 85 published “anomalies” documented in a range of financial, economics and accounting journals (they started out with 97 but found that they

technical language), but not its substance (data openness, calculation sharing, code auditing, and basically bending over backwards to show where you might be wrong in conception, experimentation, simulation etc). To anyone reading his lecture today, his description of Cargo Cult Scientists reads like a prophetic warning of the “replication crisis” currently sweeping through academia.

For those not familiar with this crisis, it’s what it sounds like: an embarrassingly large number of academic findings in esteemed journals from various disciplines don’t bear up to scrutiny. In some cases this means that there have been no attempts to reproduce results and in others, attempts to replicate findings have failed. Chart 1, constructed using one presented by Fiona Fidler and colleagues3 suggests that as few as 40% of findings in the psychology literature can be independently replicated (suggesting the other 60% might be made up). Cargo Cult Science seems to be alive and well.

couldn’t replicate the statistical significance of 12 of them) they found that documented in-sample returns of an annualised 7.2% fell to 4.9% out-of-sample but still before publication (typically a period of 56 months). Note that this is strongly suggestive of the Questionable Research Practices (QRPs) highlighted by Fidler and her colleagues at the University of Melbourne. A decent chunk of academically reported ‘financial anomalies’ appear to be made up.

Interestingly, following publication, the returns dropped even further, to 3.2%. To the extent there was substance to the anomalies, market participants soon eliminated them in their rush to capture them. In other words, there is little merit in this academic literature, and there is commensurately little merit in the vast array of financial products which are largely based upon it.

Reported factor returns before,during and after publication

Chart 2

Source: McLean & Pontiff (2015)

Annu

alis

ed re

turn

s

In sample Out of sample(pre-publication)

Out of sample(post-publication)

0%

1%

2%

3%

4%

5%

6%

7%

8%

Percentage of asset ownersadopting smart beta strategies

Chart 3

Source: FTSE Russell

2014 2015 2016 2017 2018 20190%

10%

20%

30%

40%

50%

60%


04

The causes of this crisis have been attributed to the pressure to publish and the bias towards publishing something novel (only 0.1% of psychological papers attempted to replicate the work of others) much as Feynman described in his address. This may in part be because of the way that research is currently funded, but a culture which permits and even encourages Questionable Research Techniques (QRTs) like

cherry picking, p-hacking and hypothesising after results are known (HARKing) has been cited too.4

So there seems to be something fundamental to research, beyond the domain of that research, which pushes it to ‘over-claim’ knowledge. Feynman illustrated it in the physical sciences over forty years ago. Fiona Fidler is drawing attention to it in the social sciences today. Why should financial research be any different? Where might we expect to find a replication crisis in finance?

Well, we’d have to look for a corner of the market with a large incentive to push spurious conclusions while at the same time making the work appear rigorous and dare we say it, ‘scientific’. Perhaps a corner of the industry which stood to meaningfully gain from selling its own repackaged version of such academic looking research without actually consuming those products itself. Perhaps that industry might use the cover of calling itself “smart”, to conjure up an image of being technologically advanced, like a “smart phone” or a “smart watch”. Maybe that industry would call itself something like “smart beta”. But maybe we should think of it more as Cargo Cult Finance.

Smart beta vendors all have two things in common. The first is that they flaunt their ties to academic finance. Dimensional Advisors, whose website touts its success in “putting financial science to work for investors” and which is advised by none other than Ken French, one of factor investing’s founding fathers is far from atypical. Blackrock’s factor team is run by a former Prof at Columbia Business School. The second is that the smart beta “providers” are typically asset gatherers. In other words, firms that have made their money selling smart beta products to others, not by investing in smart beta themselves.

No wonder. When McLean & Pontiff (2015)5 looked into the claimed returns of 85 published “anomalies” documented in a range of financial, economics and accounting journals (they started out with 97 but found that they

Yet according to FTSE Russell, 58% of “asset owners” have adopted some kind of smart beta strategy. Most cite the need for cost reduction as a primary motivation. By the end of 2017, BMO reported that over $1tr was globally managed under smart beta mandates, along with its prevailing mantra that active management is dead and that the best an investor can do is pay as little in fees as possible.

Maybe. But how can it be smart if everyone is doing it? We have already stated our strong view that what has “worked” in recent decades will not work in the decades to come. Our belief at Calderwood is that active management is exactly where the returns will be going forwards, and that what people ultimately care about is net return, not

couldn’t replicate the statistical significance of 12 of them) they found that documented in-sample returns of an annualised 7.2% fell to 4.9% out-of-sample but still before publication (typically a period of 56 months). Note that this is strongly suggestive of the Questionable Research Practices (QRPs) highlighted by Fidler and her colleagues at the University of Melbourne. A decent chunk of academically reported ‘financial anomalies’ appear to be made up.

Interestingly, following publication, the returns dropped even further, to 3.2%. To the extent there was substance to the anomalies, market participants soon eliminated them in their rush to capture them. In other words, there is little merit in this academic literature, and there is commensurately little merit in the vast array of financial products which are largely based upon it.

absolute fees paid. If you were offered the chance to invest in a fund returning close to 40% per year net, for example, you’d likely be less bothered that you were paying a 5% management fee and a 44% performance fee. In other words, you’d be quite happy to be an investor in Rentec’s Medallion fund despite the very high fees because your objective is getting value for fees, not low fees per se. As it happens, this month’s book review is of Greg Zuckerman’s latest on Jim Simons and Renaissance Technologies, unarguably the most successful hedge fund of all time and driven by scientists in the truest sense of the word. Tellingly, before the team “cracked” equity markets they spent months trawling through as much academic literature as they could on anomalies and supposed inefficiencies. They concluded that none of them worked.

So how will the smart-beta bubble burst? Probably not in the same dramatic fashion that the sub-prime bubble did. And probably not by being unpicked by the awkward questioning of probing academics. The financial products which are based on Cargo Cult Finance will ultimately return negative alpha as today’s army of supposed ‘value investors’ (ie those following the value ‘factor’ strategy) have already discovered. It will die a slow death, as the eventual realisation sets in several years hence, that poor performance is intrinsic to its shoddy research approach. Active managers, prepare yourselves. The next chapter belongs to you.

The shale-shock legacy

Postcards from the depths of despair: jack-up edition

Last month on these pages we articulated why we were so bullish about the Uranium market. It wasn’t a bet on any kind of nuclear renaissance but a more modest observation that prices are currently way short of what is economically sustainable. Of course, a nuclear renaissance would nicely juice returns but the macro was more a cherry on top of what is essentially a micro story.

The month before we argued that defaulted Venezuelan bonds are cheap if you think that Venezuela will need to come to terms with its creditors in order to get its oil fields producing again. Again, this wasn’t a bet on any macro scenario involving Venezuela meaningfully restructuring its economy, or becoming Latin America’s next ‘darling’, although of course we’d love to see such a scenario, for humanitarian reasons as well as investment ones. But fundamentally, this was another situation for which a favourable macro tailwind, while welcome, was not necessary to make good returns.

This month we have something similar. A constrained size, ‘niche’ set-up in which the macro is very interesting, but it is the micro which is compelling: shallow-water offshore oil services (I got a lot of help from our friends Steffen Dietel and George Nadda at Altana Distressed Opportunities Fund with this idea, but any mistakes which follow are Calderwood’s).

It wasn’t so long ago that the world’s primary concern was “peak oil”. US oil production had fallen steadily from its 1970 peak of around 10mbpd to below 4mbpd in September 2008, and some geologists and commentators predicted that what had happened to US oil production was inevitably about to happen to the world at large. Many thought we were living on borrowed time, and apocalyptic visions of life “after the peak” were in many ways a smaller scale forerunner to some of today’s more catastrophic climate warnings.


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It remains to be seen how accurate the climate alarmists’ predictions will be, but for peak oilers the evidence is in: they got it completely wrong. Today the US is the largest oil producer in the world and is producing more oil now than it ever has. This has singularly been down to some of its oil companies figuring out how to economically “frack” shale rock. A good way to see just how much of a shock this came to an unprepared industry is in Daniel Yergin’s book The Quest published in 2012. For those of you who don’t know, Yergin is an energy industry luminary: oil historian (his book The Prize is in my top ten investment books of all time); entrepreneur (he founded Cambridge Energy Re.search Associates, which he then sold to IHS); and one of the most connected people in the industry. He’s as close as you get to a one man institution in the oil market, and his views are a pretty good barometer for those of the industry. As he wrote his panoramic view of the challenges faced by energy producers in the 21st century he thought hard about peak oil, climate change, the growth of emerging markets, the rebirth of renewables, electric vehicles etc. In this tour de force he covered every conceivable base of the energy markets, except one: shale oil. There was no dedicated section and no dedicated chapter. In fact, there was barely even a mention of shale oil. Shale gas got a few pages, but not as much as Qatari gas, LNG or indeed the rise of the “petro-state”. The other place to see how this sudden surge in US supply, this “shale-shock”, caught out pretty much the entire industry is in the oil price collapse from a high of $115pb in mid-2014 to nearly $25pb in early 2016. The oil industry was sent into one of the biggest tailspins in its history and has yet to recover. Nearly four years since the oil price reached these new lows, OPEC is continuing its struggle to stabilise prices by reducing output (the latest output cuts were announced a few weeks ago). North American shale producers continue to go bankrupt. Indeed, there have

been more US shale-oil producer bankruptcies by August of this year than there had been throughout 2018, even with modestly higher crude prices in 2019. And in the stock market, energy looks like it will close as the worst performing sector this year, its current 4% S&P500 weighting comparing to 13% ten years ago.

Worse, the world seems determined to wean itself off its products. According to Reuters, over one thousand funds with nearly $9tr in assets have now committed to divest oil and gas holdings, including Norway’s sovereign wealth fund, New York’s public pension fund and the Rockefeller heirs. In October, 300 British MPs called for the parliamentary pension fund to rid itself of all fossil fuel assets.

Politicians vs billionaires

Offshore oil and the jack-up opportunity


It wasn’t so long ago that the world’s primary concern was “peak oil”. US oil production had fallen steadily from its 1970 peak of around 10mbpd to below 4mbpd in September 2008, and some geologists and commentators predicted that what had happened to US oil production was inevitably about to happen to the world at large. Many thought we were living on borrowed time, and apocalyptic visions of life “after the peak” were in many ways a smaller scale forerunner to some of today’s more catastrophic climate warnings.

06

It remains to be seen how accurate the climate alarmists’ predictions will be, but for peak oilers the evidence is in: they got it completely wrong. Today the US is the largest oil producer in the world and is producing more oil now than it ever has. This has singularly been down to some of its oil companies figuring out how to economically “frack” shale rock. A good way to see just how much of a shock this came to an unprepared industry is in Daniel Yergin’s book The Quest published in 2012. For those of you who don’t know, Yergin is an energy industry luminary: oil historian (his book The Prize is in my top ten investment books of all time); entrepreneur (he founded Cambridge Energy Re.search Associates, which he then sold to IHS); and one of the most connected people in the industry. He’s as close as you get to a one man institution in the oil market, and his views are a pretty good barometer for those of the industry. As he wrote his panoramic view of the challenges faced by energy producers in the 21st century he thought hard about peak oil, climate change, the growth of emerging markets, the rebirth of renewables, electric vehicles etc. In this tour de force he covered every conceivable base of the energy markets, except one: shale oil. There was no dedicated section and no dedicated chapter. In fact, there was barely even a mention of shale oil. Shale gas got a few pages, but not as much as Qatari gas, LNG or indeed the rise of the “petro-state”. The other place to see how this sudden surge in US supply, this “shale-shock”, caught out pretty much the entire industry is in the oil price collapse from a high of $115pb in mid-2014 to nearly $25pb in early 2016. The oil industry was sent into one of the biggest tailspins in its history and has yet to recover. Nearly four years since the oil price reached these new lows, OPEC is continuing its struggle to stabilise prices by reducing output (the latest output cuts were announced a few weeks ago). North American shale producers continue to go bankrupt. Indeed, there have

been more US shale-oil producer bankruptcies by August of this year than there had been throughout 2018, even with modestly higher crude prices in 2019. And in the stock market, energy looks like it will close as the worst performing sector this year, its current 4% S&P500 weighting comparing to 13% ten years ago.

Worse, the world seems determined to wean itself off its products. According to Reuters, over one thousand funds with nearly $9tr in assets have now committed to divest oil and gas holdings, including Norway’s sovereign wealth fund, New York’s public pension fund and the Rockefeller heirs. In October, 300 British MPs called for the parliamentary pension fund to rid itself of all fossil fuel assets.

But if politicians and large institutional fund managers are saying loudly and clearly that hydrocarbons don’t have a future, some self-made billionaires and entrepreneurs disagree. In May of this year, when Warren Buffett funded $10bn towards Occidental’s bid for Anadarko he told CNBC that it was “a bet on the fact that the Permian Basin is what it is cracked up to be.” Sam Zell, who sold his commercial property assets to Blackstone in 2007, just before the market collapsed, is buying oil assets in California, Colorado and Texas in a JV with Colony Capital founder Tom Barrack. As he told Bloomberg TV in an interview a few weeks ago, his investment vehicle, Equity Group Investments has a history of investing in “dislocated situations” in which there is a shortage of capital:

Closer to home, legendary Norwegian tycoon John Fredriksen - Norway’s (actually, now Cyprus’) richest man with a net worth estimated at $10bn earned mainly by aggressively and opportunistically trading boom-bust cycles in the shipping and drilling industries – recently formed a dedicated investment company to buy off-shore rigs

“I compared it recently to the real estate industry in the early 1990s, where you had empty buildings all over the place, and nobody had cash to play. That’s very much what we’re seeing today.”

which, like the rest of the energy complex, has been in one of its worst slumps in history. So politicians are selling, industry tycoons are buying. Which group would you rather invest along side?

So let’s recap: an industry in one of the worst downturns in its history; blood in the streets; dumb money selling; smart money buying. This is very obviously an alpha-rich environment. But the ‘energy sector’ that we’ve been talking about until now is very broad, and not a particularly useful term. So let’s drill down (.. sorry) into a more specific area. In particular, I want to focus on the off-shore services sector, and a good way to look at that is through the jack-up market.

Jack-ups are rigs which operate in shallow waters (typically less than 120m, but some can go as deep as 190m). They are usually pulled into position on the site by tugs, before planting their legs on the sea-bed, jacking up their hulls to above the sea surface and from here, sinking their drills.

The important thing to understand about jack-ups is where they fit into the hierarchy of risk when it comes to oil projects. The riskiest are the biggest and most capital intensive (typically) deepwater projects, which can require tens of billions of upfront capital without any payback for four or five years. In contrast, more shallow water projects, especially those which drill in, or close to existing fields are some of the least risky: the infrastructure is already in place, the waters are known and the cashflow can be expected within a year or so of project commencement. Jack-ups, in other words, tend to be associated with the less risky offshore projects.

But how healthy is the market for offshore oil projects? One of the stranger effects of the surge in shale production is the assumption that it is low cost output. Commentators see the low market prices caused by the increase in shale output and assume it means that the shale output has a lower cost of production. But the two things are not the same. True, North American shale gas is cheap to produce, and seems to be sustainable at around

$3/mBtu. But onshore shale oil isn’t. Once you account for the amount of fluids you have to truck back and forth, and the short life span of each well, you end up with North American shale oil breakevens of around $60/barrel. Which isn’t too dissimilar to the breakevens you see in offshore projects.

The jack-up melt-up?

Offshore oil is easily economicat current prices

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Source: Clarksons Platou

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So let’s recap: an industry in one of the worst downturns in its history; blood in the streets; dumb money selling; smart money buying. This is very obviously an alpha-rich environment. But the ‘energy sector’ that we’ve been talking about until now is very broad, and not a particularly useful term. So let’s drill down (.. sorry) into a more specific area. In particular, I want to focus on the off-shore services sector, and a good way to look at that is through the jack-up market.

Jack-ups are rigs which operate in shallow waters (typically less than 120m, but some can go as deep as 190m). They are usually pulled into position on the site by tugs, before planting their legs on the sea-bed, jacking up their hulls to above the sea surface and from here, sinking their drills.

The important thing to understand about jack-ups is where they fit into the hierarchy of risk when it comes to oil projects. The riskiest are the biggest and most capital intensive (typically) deepwater projects, which can require tens of billions of upfront capital without any payback for four or five years. In contrast, more shallow water projects, especially those which drill in, or close to existing fields are some of the least risky: the infrastructure is already in place, the waters are known and the cashflow can be expected within a year or so of project commencement. Jack-ups, in other words, tend to be associated with the less risky offshore projects.

But how healthy is the market for offshore oil projects? One of the stranger effects of the surge in shale production is the assumption that it is low cost output. Commentators see the low market prices caused by the increase in shale output and assume it means that the shale output has a lower cost of production. But the two things are not the same. True, North American shale gas is cheap to produce, and seems to be sustainable at around

$3/mBtu. But onshore shale oil isn’t. Once you account for the amount of fluids you have to truck back and forth, and the short life span of each well, you end up with North American shale oil breakevens of around $60/barrel. Which isn’t too dissimilar to the breakevens you see in offshore projects.

The offshore project pipeline actually looks in reasonably good shape too. The slump seen from 2014-2016 is evident in Chart 2, but so too is the recovery. We’re not at the boom time levels seen in 2011-2013, but we’re at what look like quite healthy levels nevertheless. Healthy enough for the remaining players to make some kind of a profit, one would have thought.

We’ve already seen that shallow water projects are much less risky. So in an industry which remains emotionally fragile, low on confidence and generally cautious, one would expect the shallow water market to revive sooner than the deep water market.

Indeed, this seems to be the case. According to Borr Drilling (the Norwegian driller founded by Tor Olav Trøim, the former right hand of John Fredriksen) the market for modern jack-up rigs is already strong. The utilisation of the world’s premium jack-up capacity has already reached 90% with day rates running at around $100kpd (compared to $50k during the late 2017 nadir and nearly $250k during the 2007 boom). To some degree too, presumably, this tightening is related to the contracting supply of available jack-ups.

So it feels like everything is beginning to fall into place - decent offshore pipeline, capacity utilisation rising, supply contracting, smart money moving in … You might think that shares in the companies exposed to that market would be in a sweet spot. But you’d be wrong.

To understand why, we have to understand that even if the jack-up market is plugged into the lower-risk part of oil producers’ capex plans, that’s not the same as saying that the jack-up market itself is low risk. It really isn’t.

It’s actually more like the oil market on crystal meth.

First, it sits quite low down in the oil market food chain, being completely dependent on the capex plans of the producers, and especially the Majors (eg Exxon, Chevron, BP, Shell) and the National Oil Cos (Pemex, Rosneft, Petrobras, CNOOC). Of course, those capex plans are themselves highly dependent on the oil price, so the drillers are like a second derivative of the oil price. Second, there’s no obvious scope for any kind of competitive advantage in the jack-up market: you buy a fleet of vessels; rent them out to oil companies as a pure price taker; do well when the market is tight; and do badly when it isn’t (like now). Third, given the upfront capex required to buy such a fleet, owners typically take on large amounts of debt. So when the cycle turns unexpectedly, as it did a few years ago, the industry can rapidly find itself starved of capital and unable to repay its creditors (also like now).

Indeed, today, the off-shore sector remains mired in work-outs, restructurings and bankruptcies, not so different from the early 1990s real estate market Sam Zell described when “no one had cash to play.” The problem isn’t the lack of opportunity. It’s the lack of capital.

Chart 4: shows the aggregated balance sheets of the largest four offshore drillers (Transocean, Diamond Offshore Drilling, Valaris and Noble Corporation). As an industry it is largely priced for bankruptcy, its leaders in no shape to lead any kind of industry consolidation.

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1 “U.S. Drilling Slowdown Triggers Oil Bankruptcy” The Wall Street Journal, July 1st, 2019

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To understand why, we have to understand that even if the jack-up market is plugged into the lower-risk part of oil producers’ capex plans, that’s not the same as saying that the jack-up market itself is low risk. It really isn’t.

It’s actually more like the oil market on crystal meth.

First, it sits quite low down in the oil market food chain, being completely dependent on the capex plans of the producers, and especially the Majors (eg Exxon, Chevron, BP, Shell) and the National Oil Cos (Pemex, Rosneft, Petrobras, CNOOC). Of course, those capex plans are themselves highly dependent on the oil price, so the drillers are like a second derivative of the oil price. Second, there’s no obvious scope for any kind of competitive advantage in the jack-up market: you buy a fleet of vessels; rent them out to oil companies as a pure price taker; do well when the market is tight; and do badly when it isn’t (like now). Third, given the upfront capex required to buy such a fleet, owners typically take on large amounts of debt. So when the cycle turns unexpectedly, as it did a few years ago, the industry can rapidly find itself starved of capital and unable to repay its creditors (also like now).

Indeed, today, the off-shore sector remains mired in work-outs, restructurings and bankruptcies, not so different from the early 1990s real estate market Sam Zell described when “no one had cash to play.” The problem isn’t the lack of opportunity. It’s the lack of capital.

Chart 4: shows the aggregated balance sheets of the largest four offshore drillers (Transocean, Diamond Offshore Drilling, Valaris and Noble Corporation). As an industry it is largely priced for bankruptcy, its leaders in no shape to lead any kind of industry consolidation.

But if yesterday’s large caps are today’s small caps (Chart 5), where are yesterday’s medium and small caps? No longer with us, is the short answer. The WSJ reported in July1 that 180 service companies have gone to the wall since 2015. The slightly longer answer is that those which are left have dropped off the radar, are busy in creditor negotiations, and are no longer covered by most of the sell-side commu-nity.

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I’m not going to go through each name in the sector, or give a laundry list of things to go look at, but in situations like this, babies typically get thrown out with the bathwater. That is exactly what is happening here. For example, if we drop down yet another notch in the food chain and look to those companies which servi-ce jack-ups - the Offshore Supply Vessels (OSVs) - we find firms which lost access to credit markets earlier in the cycle, have already gone through their Chapter 11 restructuring, and now have pristine and largely equity finan-ced balance sheets. Thus Tidewater merged with Gulfmark in 2018 and sits today with a balance sheet so pristine it is ideally placed to take advantage of its peers’ distress. Yet it is trading at a depressed multiple of depressed earnings. Where is the downside?

Or take Standard Drilling, which began to invest in platform supply vessels (PSVs) in 2016. It now owns 6 large vessels outright, and minority interests (26%) in another 8 medium sized ones. It recently sold two of its older larger vessels for $13.5m and $15m (for a roughly $3m and $4m profit respectively). When you use these valuations to benchmark its existing fleet you get a total fleet value of around $75m. Yet the current market valuation of $80m includes net cash (!) of $57m. So that fleet is valued by the market at only $21m. Again, where is the downside? Of course, holding such a small company isn’t scalable for most managers, and so is not relevant. But this is the point. The sector is so utterly devastated, so minuscule, that people are no longer paying it any attention. Why should it stay minuscule? That pipeline of offshore projects we saw in Chart 2 is going to need to be serviced by someone. It wasn’t a small sector ten years ago and it is unlikely to be so small ten years from now, because the extreme cyclicality which has led to its near destruction works in both directions. After the melt down comes the melt up.

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The Man Who Solved the Market,by Gregory Zuckerman

After poking around the grubby world of Cargo Cult Finance it’s nice to spend some time in the company of real financial scientists, by which I mean of course, Jim Simons and the team he assembled at Renaissance Technologies (Rentec). I doubt anyone reading this doesn’t know who Jim Simons and Rentec are so I’ll skip the detailed introduction. Nevertheless, since it’s important we’re all on the same page, and that we fully grasp the enormity of the returns achieved by his team, the following chart lays it out quite clearly.

As can be seen, Rentec’s performance beat that of Warren Buffett and George Soros hands down. Rentec outperformed Steve Cohen and Peter Lynch too even though those investors’ record covers a much longer time horizon. These eye-popping returns - 39.1% net over a thirty year period - don’t tell the whole story. On a gross (pre-fee) basis, Medallion fund returns averaged a scarcely believable 66.1%. How did he do this? How is it even possible? And what, if anything, can mere mortals like us learn from it?


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Comparing the greats: annualisedannual lifetime investment returns

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We’ll get to some of that in a moment. But let’s get a few priors out of the way before we do. The first is that while The Man Who Solved the Market is a compelling read (I think “page turner” is the appropriate phrase) don’t expect to come away thinking you’ve found the “secret sauce”. Rentec are incredibly (and understandably) secretive and Simons himself only reluctantly agreed to talk to Zuckerman when he realised that the book was going to be written with or without him. I couldn’t help wondering how much more there really was to the Rentec story.

The second, and related point to make, is that notwithstanding its title I didn’t find the book so much about Jim Simons ‘the man’ as about Rentec ‘the firm’. Simons’ pre-Rentec existence, for example, is covered in just two chapters. Yet during this stage of his life he proved himself a prodigious mathematical talent, winning the prestigious Oswald Veblen Prize in Geometry aged just 38, and developing with Shiing-Shen Chern what is now known as the Simons-Chern form, which would prove central to the development of string theory, among other things. He was a code breaker at the Institute for Defence Analysis (IDA) where he assembled and ran a team of mathematicians and scientists to crack Soviet codes for four years, before running foul of his boss for speaking out against the war in Vietnam. And he set up an all-star team of mathematicians at Stony Brook, turning a hitherto run-of-the-mill state college into one of the most prestigious mathematics departments in America.

So don’t read this expecting Zuckerman to have really gotten inside Simons’ head in the way that, for example, Alice Schroeder did with Warren Buffett in The Snowball. To be clear, I’m only saying this as an observation, not a criticism. Schroeder got several years of access to Buffett himself, his inner circle, his family, and was even granted time in his office watching him work. Zuckerman got a few

grudgingly agreed hours. But he isn’t trying to be Robert Caro, and it works incredibly well indeed as a more narrowly focussed financial story.

So with that out of the way, I’m not going to go through the whole Rentec story because I don’t want to spoil it for you. But I will say that I have followed the firm for some time now and that Rob Crenian, my partner in the Capital Management business we’re aiming to launch next year is a Rentec alumni. So before sitting down to read the book, I felt I already knew a lot of the story. But it turns out I didn’t. From the firm’s beginnings as a traditional macro/CTA fund with Simons at the head, punting around on the gold price with Lenny Baum and James Ax (as Barry Ritholz exclaimed in his fascinating podcast interview with Zuckerman1, “He was a macro tourist!”) to the state-of-the-art de facto signal processing unit it seems to be today, there were twists and turns, successes and failures, dramas and heartaches along the way which I’d expect most people wouldn’t be aware of (eg accidentally cornering the potato market).

There are some incredibly colourful characters too. For example, Bob Mercer, the computer scientist who is as brilliant as he is socially awkward, and perhaps now more famous for his role in bringing Donald Trump to the US Presidency, features throughout. It’s difficult not to be mesmerised, as Zuckerman clearly is, by the guy’s apparently bizarre contrast of hyper-rationality (when it comes to data processing), but oddly motivated reasoning (when it comes to niche politics and conspiracy theories). Peter Brown features heavily too. First working with Mercer at IBM and almost subliminally in-sync with him, despite being more outgoing and ‘normal’. Together, they make some of the firm’s key breakthroughs in equity markets. Or David Magerman, the lost-soul computer scientist who never quite finds a home at Rentec, despite his accomplished work with Mercer and Brown. He becomes so outraged by Mercer’s involvement in Trump’s politics that he commits the cardinal sin of going public on the firm with a letter to the WSJ. When his time at

Rentec ends in a cringeworthy confrontation at a charity poker match, what he’s hoping for is his chance to rebuild bridges with his old pals, to shake hands and move on. What he gets is a scowling Rebekah Mercer (Bob’s daughter) “You’re pond scum … get out of here!” But having such a cast of characters isn’t what makes the firm what it is. Rentec is fundamentally not like other financial firms. Indeed, it sees itself as a science company, hiring pretty much exclusively hard scientists: mathematicians, physicists, astrophysicists, computer scientists. But not just any physicists, astrophysicists and computer scientists, the very top people in their respective fields, including Nobel Prize winners. The MBAs, financial economists and investment theorists who populate the industry at large (ie people like us, the triers) are typically given a wide berth. Is there anything people like us can learn? I think there is. The first is that it’s not enough to be good at what you do. Being smart, focused and hard-working is a necessary but insufficient condition. You also have to be different. In the 1980s Sandor Straus gathered, cleaned and stored huge (generally but not exclusively) financial data sets from libraries around the world to store on Rentec servers. This was before Bloomberg existed, or Reuters sold its data to the industry. They didn’t even pay much for it because the value of data wasn’t yet appreciated. As part of this effort, Rentec quite possibly created and maintained the world’s first tick-database, to which they then applied their data science and big-data skills long before Google and Facebook. As Rentec continued to find its feet in the 1990s, the prevailing investment wisdom was that since trading was costly, the number of trades should be minimised. Excess returns would only accrue to long-term investors who kept portfolio turnover low. But Rentec thought differently. Henry Laufer pointed out that from a data-science perspective, long term signals were too few to be properly and reliably judged. The shorter-term the strategy, the larger would be the sample size of signals which was statistically robust enough to be convincingly tested.

The second is that being different isn’t an easy sell. After ten years in the hedge fund business Simons was running only $43m and was struggling to raise external capital, so different was his approach. Luminaries like Donald Sussman and Paul Tudor Jones passed on making an allocation because it was unproven. To be fair, Rentec’s futures trading business wasn’t spectacular, and they spent years trying to crack equity markets (they knew this was where the capacity was, and where the potential for much larger returns would be) before figuring it out in the late 1990s. But when Simons told Sussman that he’d finally cracked it, Sussman passed again. Success didn’t come quickly.

The third is that alpha is a zero-sum game, and that alpha strategies stop working the moment you go around telling everyone about them (actually, it’s not so much a lesson as a master-class illustration). We already saw in the section on Cargo Cult Finance that as soon as academics published papers documenting “pricing anomalies” those “anomalies” basically disappeared. In the same section, I also mentioned that when Rentec were trying to crack equity markets they spent several months trawling through the academic literature on financial anomalies for hypotheses to test, before reaching the conclusion that nearly all such studies were worthless. Indeed, it’s interesting to contrast the approach of smart beta “providers” who openly publish their findings in academic journals, trumpet their work through regular appearances on the conference circuit and hire business school professors as “senior consultants” with that of Rentec, who are highly secretive, tie their staff into tight non-compete and confidentiality terms and compete for talent with Ivy League level academic science departments, not investment banks. When Rentec find anomalies they don’t go around telling everyone about them.

But it goes deeper still. Consider that as Rentec evolved their systems they eventually gave up trying to make intuitive sense of their signals. If the science was sound, and the signal deemed valid and robust they were happy to allocate capital to it. This is an interesting

comparison to many financial economists who will only accept statistical correlations which make intuitive sense on the very reasonable grounds that signals which don’t make intuitive sense are more likely to be illusory. For example, between 1999 and 2009 the number of people in the US who drowned by falling into a pool each year correlates very well with the number of films Nicolas Cage stars in. Most people would say that this correlation is obviously spurious, and building a model to predict pool deaths using Nicolas Cage appearances wouldn’t be a good way to predict annual pool deaths. Requiring some kind of intuitive relationship between data series isn’t a dumb way of avoiding falling into the trap of depending on a spurious correlation.

It’s just that Rentec have figured out much smarter ways. Their techniques have not only allowed them to get comfortable backing correlations others wouldn’t trade even if they could find them, but also ensured that their most profitable and reliable signals are so precisely because they make no sense. If they made sense, others would trade them. In other words, they’re literally operating on a level which is completely inaccessible to most of us. Even the cleverest alpha strategies are scale constrained however, and Rentec are precise about just how much profit they can squeeze out of a signal over a given amount of time. By Simons’ own estimation, they don’t think they’re the best at trading, but they are “the best at estimating the cost of a trade”.2

Beyond these financial insights the Rentec story provides food for thought in the wider domain of money and society which is especially pertinent today. For example, is it right that a financial fund removes world-class scientists from their noble pursuit of eternal scientific truths and places them instead in the pursuit of transient financial ones? What scientific knowledge has been lost to society, sacrificed for the creation of a few more billionaires who haven’t even made their money by benefitting customers like pension funds or endowments, but by benefitting themselves (the Medallion fund today is

reserved only for employees of Rentec, external investors having been kicked out many years ago)?

And, it is no exaggeration to say that Mercer dollars and influence put Trump into the White House. Is it right that one of these billionaires who has made his money not by solving a problem for consumers, but by winning a zero-sum financial-market game wields such power in the political destiny of any country, let alone the most powerful in the world?

I have my own opinions as I’m sure you all do too, but I didn’t raise these ideas to explore them here, I raised them to show that there is an awful lot going on in this book. If you’re like me you’ll find yourself reflecting on it long after you finish reading it.






1 https://www.bloomberg.com/news/audio/2019-10-30/gregory-zuckerman-on-the-quant-revolution-podcast

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2 Gregory Zuckerman, The Man Who Solved the Market, Penguin, Random House, UK, 2019, pg 349

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No liability whatsoever is accepted for any loss arising whether directly or indirectly as a result of the recipient acting on such information or opinion or estimates. Calderwood Capital Research employees may have or take positions in the markets, securities or other investments mentioned in this document. The stated price of any securities mentioned herein is not a representation that any transaction can be effected at this price. Investing entails risks. The investments referred to are not suitable for all investors and should not be relied upon in substitution for the exercise of independent judgment. This material is not directed at you if Calderwood Capital Research is prohibited or restricted by any legislation or regulation in any jurisdiction from making it available to you. Calderwood Capital Research and its analysts are remunerated for providing independent investment research to financial institutions, corporations, and governments.

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dylan grice 19th december 2019 … · 2019. 12. 19. · cargo cult finance 19th december 2019 | 2...

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