Things have been better for the world's oil producers. Oil colossus Saudi Arabia is losing $14 billion a month and was recently forced to borrow money for the first time in eight years--a desperate move it tried to keep on the down low. Oil companies, meanwhile, have slashed capital spending by more than $200 billion dollars, with even more cuts expected in 2016. In other words, it's getting ugly. But some investors saw the writing on the wall and have made a killing as the oil industry has crumbled. Here's the who, what, and why of these investors' oil-shorting riches.
I'm sorry for you...
Zach Schreiber, who runs hedge fund PointState Capital, stood in front of an audience in May of 2014, while oil was still at lofty levels, and told the group of investors that he felt sorry for anyone who was long oil. Why?
While everyone was excited about oil's sky-high price, Schreiber took a different angle. He said that high prices had led to industrywide complacency. In other words, companies and countries stopped watching costs and just went on a drilling binge that extrapolated high prices until, well, forever. All of the cost cutting and debt-led financial troubles we've seen since the drop pretty much confirm that hypothesis.
The thing that Schreiber was really pointing out, however, is that problems like this take a long time to build to a crescendo, which lulls investors to sleep. But when the peak is hit, the fall usually comes hard and fast. He reportedly made a killing of around $1 billion in 2014 alone. With oil still on the decline, his 2015 profit could be even larger.
Red light at Greenlight
David Einhorn of Greenlight Capital was a bit more specific in his concerns. Although, overall, Einhorn has had a rough go of things lately, his call to short Pioneer Natural Resources (NYSE: PXD), which he described as "the mother of all frackers," and other U.S. drillers has worked out quite well.
The reason why Einhorn was picking on frackers came down to simple math. According to the hedge fund manager in early 2015, "Pioneer is burning cash and its reserves are not growing." In other words, the fracker was spending money just to tread water. With oil prices high and getting higher, that works fine. Oil price increases can cover up the fact that production isn't going anywhere. But as soon as oil prices fall, it turns ugly fast. Just look at the Pioneer graph above and you'll see what I mean. Looks like an incredible call for Einhorn.
The black box
Schreiber and Einhorn are human beings looking at fundamentals and making judgment calls. It's impressive that they were able to see what so many couldn't, or perhaps didn't want to, see. But these guys aren't the only ones who made money betting against oil.
Another oil winner was, reportedly, Man Group's AHL Diversified fund. This fund uses an algorithmic approach to investing. Basically it got a bunch of math geeks to write complex programs that try to predict where the market is going based on huge volumes of trading data. You and I can't do that.
But AHL Diversified's black box started to detect a problem in oil in the summer of 2014 and went short. The computer's oil call helped the fund amass a 34% gain in 2014. While it's too soon to call 2015 performance, oil certainly hasn't shifted into rally mode. So, if Man Group's black box is still calling the shots, there's a good chance 2015 will be equally impressive on the oil front at AHL Diversified fund.
Two other algorithmic hedge funds that spotted the oil trends and went short were reportedly Marshall Wace's Eureka fund and Michael Platt's BlueCrest. Makes you wish you worked harder in math class, doesn't it?
Fresh lows and other woes
With oil prices hitting fresh lows, it would be easy to say that the oil industry is down for the count. Perhaps you're even considering joining with the shorts. But don't run with the crowd just yet. It's just that type of complacency that led Schreiber to call the oil top and Einhorn to question the fracking business model. (I won't pretend to know what's in a hedge fund's top-secret black box program...) Following the crowd would be missing the real takeaway here, which is that you need to look past "Mr. Market" and create your own, independent view of the world. Even if that view runs counter to what everyone else is thinking.
Reuben Brewer has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.