We Finally Learned That Leveraged Oil Stocks Without a Cost Advantage Probably Are Bad Investments

It's "We Said What?" week for Industry Focus, and we're looking at some of our biggest on-air mistakes -- like, for example, picking a soon-to-be bankrupt company for our energy fantasy investing draft.

In this week's Energy episode, Sean O'Reilly and Taylor Muckerman look back on why they were so confident in companies that would go on to perform terribly, and what investors can learn from their mistakes. Find out why it's so important to keep track of your investing thesis, why LINN Energy and other companies like it are always toeing a dangerous line, why you need to stick to your investing rules, and more.

A full transcript follows the video.

This video was recorded on Aug. 24, 2017.

Sean O'Reilly: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. Today is Thursday, Aug. 24, 2017, so we're talking about energy and industrials. I'm your host, Sean O'Reilly, and to my left is the man, the myth, the legend, Mr. Taylor Muckerman. What's up, brother?

Taylor Muckerman: That's what you got wrong.

O'Reilly: What?

Muckerman: I'm not the myth or the legend. I am a man, though!

O'Reilly: You have to be more than just a man. [laughs] 

Muckerman: I don't know where that's from.

O'Reilly: Do you like my Bale Batman? [laughs] 

Muckerman: Yeah! [laughs] 

O'Reilly: What'd you think, Austin? Was it good?

Austin Morgan: It could have been better!

Muckerman: Oh, could have been better. Next time!

Morgan: I've heard better impressions!

O'Reilly: It's not my forte to do the Bale impressions. Sorry! I'm really more of a Michael Keaton Batman, anyway.

Muckerman: Let's have that one!

O'Reilly: No. So, today is "We Said What?" week on Industry Focus.

Muckerman: So it is!

O'Reilly: We had to work hard, didn't we?

Muckerman: We did some digging.

O'Reilly: We had to work really hard. But we're all talking about, basically, times that we may or may not have made a boo-boo, mistake, made a wrong investment call --

Muckerman: May not have? We had to have.

O'Reilly: I'm hedging. [laughs] Which actually has a bearing on my mistake that we'll be talking about in a few minutes.

Muckerman: That's true. Foreshadowing.

O'Reilly: Dun-dun-dun! And basically, the takeaway is the importance of looking back, keeping a record, journal, diary, something, reflecting on your investing thoughts and processes because that's how you grow, that's how you learn. Hopefully you change and adapt over the years. The best investors in the world, of course, have changed their tactics. Buffett no longer looks for cigar butts. [laughs] 

Muckerman: Yeah, that was gross.

O'Reilly: Well, it made him $25 million, though.

Muckerman: It did, but not billions of dollars.

O'Reilly: Anyway, who's going first? 

Muckerman: I don't know! Pick it out of a hat!

O'Reilly: All right! Drum roll, please. All right, I lost or won, I don't know which --

Muckerman: Your error was slightly bigger than mine.

O'Reilly: It was so good, though!

Muckerman: It was slightly bigger than mine!

O'Reilly: We're going to talk about this. Austin, replay the clip now.

(O'Reilly): All right, so, this is my Hail Mary pick, and it's literally the best Hail Mary pass I could think of, which is LINN Energy.

(Tyler Crowe): He's going with a dirty, dirty, dirty value play for his Hail Mary.

(O'Reilly): They're down, what, 90% in the last year?

(Crowe): Something like that.

(O'Reilly): It's very sad. But they do have some of the best hedges around. I think we can all agree on that. And it's a Hail Mary pass because, if and when oil prices recover, if that were to happen in the next year or two, they would survive and possibly come out on the other end of it OK. They're about 80% or 90% hedged on their production this year, and that tapers off next year at about two-thirds, and then they're in trouble in 2017.

OK! So, one, I think I lost the fantasy draft.

Muckerman: Yes.

O'Reilly: Yeah. Although your winner, Silver Wheaton [now Wheaton Precious Metals], has come back down to Earth, which is fun.

Muckerman: It has. I have to go back to the spreadsheet.

O'Reilly: Did you update the numbers and everything?

Muckerman: Well, one company is no longer with us, and Spectra got bought out, so I need to go back and do some math.

O'Reilly: That's kind of a win.

Muckerman: I know. I think I'm still in the lead, but Silver Wheaton was my best performing at the time we had the cutoff.

O'Reilly: It was like, we did the picks in 2015.

Muckerman: Sept. 10, 2015.

O'Reilly: Oh my gosh, I can't believe I was talking to these losers then!

Muckerman: I know, seriously.

O'Reilly: I'm sure you feel the same way! But I was like, oh my gosh, it's been a while!

Muckerman: I didn't think it was that long ago, but it was.

O'Reilly: Yeah. I was listening to it, and Silver Wheaton went up the second we recorded.

Muckerman: Yeah, I think the peak was 70% or 80%. But, the gist was, we each picked three stocks. You, me, and Tyler Crowe all drafted three stocks. We had a stalwart, our No. 1 pick, the second pick was... I can't remember what it was, and then the third pick was our wild card.

O'Reilly: Of course, my loser that we're talking about now is the Hail Mary wild card.

Muckerman: Yeah, your waiver-wire pick.

O'Reilly: So, I said a couple of things, and I knew what I was going to talk about this episode, I was like, [groans] "I have to talk about LINN!"

Muckerman: Yeah, LINN Energy.

O'Reilly: "I don't want to, but I have to!"

Muckerman: What ticker is that on now? Is it on the Mexican Stock Exchange now? Can you even buy shares?

O'Reilly: No. The bondholders own it. If you haven't figured it out, listeners, LINN has gone the way of Chapter 11, bankruptcy.

Muckerman: The way of the dodo.

O'Reilly: I forgot that Tyler Crowe owned some shares, in reality.

Muckerman: Yeah, he did!

O'Reilly: We talked about that on that episode. Anyway, long story short, it was my Hail Mary pass. I knew I had to talk about it, but upon relistening to it, I was less depressed about the move, because I said it's a bet on oil prices recovering in the next year or two. They have not. Huge MLP. They were hedged 90% for the 12 months going forward from when I picked it. So again, they had some life. It was just when those things ran out, their massive debt load was just too much. It was the largest master limited partnership, MLP, in the United States at the time, I believe.

Muckerman: It was the belle of the ball.

O'Reilly: It was. And it was the largest, most successful MLP. The problem, of course, was that it's great when oil prices are high and they can make acquisitions and expand that distribution. But when you pay out 90% of your earnings in order to expand and grow said distribution, you need access to capital markets, and therein lies the rub. So upon reflecting on this, I now have a very solid rule, which I think I've talked about in the last month or something, but any commodity stock, they have to have some sort of cost advantage. And they didn't have that. They would just buy assets from other players, borrow money for cheap --

Muckerman: Yeah, they kept leveraging up.

O'Reilly: Yeah, that was it. And it works great if ...

Muckerman: You can keep producing. Yeah, and then, the fact that they had to pay out pretty much all of their net income to shareholders, doesn't leave you much wiggle room.

O'Reilly: I actually looked at the bonds of while ago, and the bondholders got some recovery value.

Muckerman: They did?

O'Reilly: They were not wiped out. The assets were still producing oil.

Muckerman: I mean, it is still land, but it's only productive if you have money to produce it. I think I said that right.

O'Reilly: I know what you meant.

Muckerman: It sounds like, "Duh, you have to have money to produce and make money." But they didn't, so they don't.

O'Reilly: It's impossible, because they all do this, but they were heavily leveraged. I think it was one to nine, the leverage ratio. They had billions in assets.

Muckerman: That was the business model.

O'Reilly: Yeah. So I learned from it. It was, admittedly --

Muckerman: Synthesize all that into, like, one key takeaway.

O'Reilly: Leverage is bad, especially with a commodity player. You know, a company that doesn't need capital to produce free cash flow, like a Google or something --

Muckerman: Yeah, or a software business.

O'Reilly: -- you can leverage that thing up and it won't matter. It will not matter. This, the leverage is like, you're walking around with this blade, and if you trip, game over!

Muckerman: Yeah, it's always facing you.

O'Reilly: And they didn't have a cost advantage. And at the end of the day, then, I believed that oil would recover far more quickly. And you know, nobody knows what's going to happen. But you need to have some sort of advantage. When you invest in a consumer brand or a stock or something, you need some sort of brand name like a Coca-Cola or a Gillette --

Muckerman: We call that a moat.

O'Reilly: A moat. And in commodities, you have to have that, it's actually even more important. And the only way to do that is some sort of cost advantage. It's evident in my No. 1 pick from that episode, which is EOG Resources (EOG 1.07%). They're not showering money on their shareholders just yet, but they're still here and they're still kicking.

Muckerman: They're not on their deathbed, or, I guess, in the ground.

O'Reilly: Yeah. But their oil is.

Muckerman: They're not in either.

O'Reilly: Their oil is in the ground. So yeah, learned a lot. It's been a fun couple of years for oil.

Muckerman: Yeah, I know!

O'Reilly: A very good use case scenario for the business schools.

Muckerman: That price chart, man!

O'Reilly: So, Taylor.

Muckerman: I have to own up to something?

O'Reilly: Yeah.

Muckerman: All right, fine.

O'Reilly: You're good, man! You're real good!

Muckerman: What do you mean, I'm good?

O'Reilly: But you're human.

Muckerman: Oh, I know.

O'Reilly: And you occasionally --

Muckerman: We're going to talk about the same episode.

O'Reilly: It's funny that we both went back to that.

Muckerman: Yeah. I mean, we picked three stocks each, and it's a long time period, so a lot could go wrong.

O'Reilly: I'm really glad we did it! Looking back, when we came up with the idea for this theme week, I knew exactly what I was going to do.

Muckerman: Yeah. And I'm sure, at some point between then and now, we've also said something that didn't pan out. But rifling through those episodes with a few sentences of description, it's tough. This one, I knew we could turn to it and find something. And my something was... let's listen to the clip first, and then I'll talk about why it was wrong.

(Muckerman): I'm going with Devon Energy (DVN 0.78%). I'm going my first producer. I'm looking at this company, a pro in terms of enhanced oil recovery. It has a good basin coverage with Eagle Ford, the Permian, among others. Those are two of the most popular that you might know of. It's getting into reusing a lot of its own energy to lower its cost. It's still producing pretty well. They have increased the production year over year in the latest quarter. Pretty low cost in terms of what you're seeing out there, maybe not as low cost as EOG in terms of per-barrel cost, but they're still competitive, and they've been beaten up just as much of some of worst producers in the business, so I think this company could fill some nice holes.

So you heard me talk about Devon Energy, also a producer. That was also my wild-card pick, the third pick that I've made. And for a time there, it treated me pretty well. 2016 was a decent time frame for oil producers after completely bottoming out in the beginning of 2016. But 2017 just shows you that this is a very tough market to predict. My mistake there was not technically owning, but owning in a competition, an oil or gas producer. I've said several, several times on the show that I don't believe in owning oil or gas producers or miners simply because, like we talked about, they're typically debt-heavy companies, and the cyclical nature of these businesses is so hard to overcome. If you look at Devon Energy from the day that we recommended it, down 22.8%.

O'Reilly: And you picked it after a dip.

Muckerman: Yeah. We picked it toward the end of 2015, which, it had already suffered a huge drop at the end of 2014, and 2015 was still a little trickle. 2016 totally smoked it at the beginning, January and February. And then you saw the rebound. But, that rebound included, to date since we talked about it, Devon Energy down 23%. 

O'Reilly: The dividend was cut.

Muckerman: Yes, the dividend was cut. Oil- and gas-producing ETF, ticker XOP, down 20%. Then, the Energy Select SPDR from iShares, only down 5%. So that includes the whole energy industry -- services, companies, pipelines. So you see how much difference in performance there these producers had, and then you compare it to the S&P 500 and you hang your head in disgust because the S&P 500 is up 27% since we had this draft. Then you think, "That's only a couple years." But then you go back a decade, and the same oil and gas producer ETF down 32%, versus the Energy Select SPDR only down 10%, and Devon down 60%. Over 10 years. Versus 65% for the S&P 500. So there's certainly times you could have bought a producer over the last decade and made a killing. But it's tough to know when to sell, and these sell-offs for these producers generally drop much further than the previous bottom, or right around there.

So that was my big mistake, was investing in what I don't know. I mean, I know about these producers. I guess, it's not what I don't know, but investing in something I already said I would not invest in, for these specific reasons. And I took a flyer, and this shows what happens when you take a flyer sometimes.

O'Reilly: Don't break your rules!

Muckerman: Yeah. That's one thing. You have to have an investing process. Sure, you can adapt over time, but this was a hard and fast rule for me.

O'Reilly: So holding this up in the light of my lesson that I learned, which is, if you're going to do this, it needs to be a low-cost producer, was that why you picked Devon? Where do they fall in this? Because EOG, there I remember first seeing EOG three years ago, they're --

Muckerman: Yeah, we could compare EOG's ticker. Since our draft, EOG is actually up 9.7%.

O'Reilly: And that was my bedrock pick. Any report you look at is like, they're an incredibly low-cost producer.

Muckerman: Yeah, and they're someone integrated because they source some of their own sand, they have some takeaway capacity from some of their more remote well sites in terms of pipelines. So yeah, they're best in breed, and they're still underperforming the index by 18% since we drafted, the S&P 500 Index. Yeah, Devon Energy, I thought, was one of the more skilled companies in terms of unconventional drilling, and going back in with CO2 and water to really maximize well production. And they still kind of are, but having to cut the dividend really hurt their shares, and it goes to show, LINN cut their dividend a couple of times, and you've seen a lot of even the big energy producers, the integrated, cutting their dividend. Not all of them, but a handful. And that to me proves that no one is safe as an energy producer or a miner, because, I would say over 50%, I feel like, had to cut their dividend.

O'Reilly: I mean, in econ class in school, you learn that in the long run, any commodity producer, at best, you will get average returns on invested capital. It'll be about 10%.

Muckerman: Yeah. If they can't cover their capex from cash flow, how the heck are they going to continue to cut a dividend check to you?

O'Reilly: The bondholders, obviously! [laughs] 

Muckerman: Well, I guess. So, cash flow, cash flow, cash flow!

O'Reilly: Very good. Well, I think we both learned something here today.

Muckerman: Yeah. Both centered around energy producers. Kind of interesting there.

O'Reilly: Tough business.

Muckerman: Yeah, it's been especially tough the last few years. But like I said, going back 10 years, oil and gas producers as a unit have had a very rough time of it. Ten years, that's a couple cycles, and you're still in the red.

O'Reilly: Right. Cool. Well, thanks for your time as always, man!

Muckerman: We'll do better over the next year on the show!

O'Reilly: Somehow.

Muckerman: Somehow.

O'Reilly: Fingers crossed. I mean, I won't because of LINN, but -- that's it for us, folks. If you're a loyal listener and have questions or comments, we would love to hear from you, just email us at [email protected]. As always, people on this program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against those stocks, so don't buy or sell anything based solely on what you hear on this program. For Taylor Muckerman, I'm Sean O'Reilly. Thanks for listening, and Fool on!