The Black Swan
Consider the Horizon
Opportunity: Ultra-deepwater drilling ships
Expect the unexpected. This has been one of my life experience’s top five lessons (I’ll leave the other four for another day). Unfortunately, too many people do not adhere to this one certainty: That what you least expect can and does eventually happen.
Too many people discount what is highly improbable and dismiss it as unimportant. As a student of capital markets, I have seen exactly the opposite.
Let me name a few: the Oil Price Hikes of 1974 and 1979, double digit inflation in the late 1970s and early 1980s, a stock market crash in October 1987, and successive market collapses in 1998 (the Russian-Asian financial currency crisis), the Long-Term Capital Management collapse in 1998, the Tech bubble in 2000-2001, the 9/11 terrorist attacks, and the mother of all global financial meltdowns, the 2008 global credit/market tsunami that rivaled the stock market collapse of 1929.
Each time, they said it could never happen again.
Students of probability argue from atop their Gaussian bell curves that events at the outermost tails of the bell curve have such a low probability that “the odds” of them occurring are nil to insignificant. Well, tell that to people who lost their investments in 1987, 1998, 2000 and 2008.
These “unforeseen” events do and can happen, and often with overwhelmingly destructive consequences. Nassim Taleb, in his book “The Black Swan,” argues exactly this point more convincingly than I can in this brief column. He describes “Black Swan” events as highly improbable or unforeseen events with a high level of destructive impact.
We cannot predict the future, particularly the unforeseen, despite our increasing reliance on ever-more-sophisticated mathematical models, where perhaps the error lies in the underlying assumptions.
We often see this modeling bias, as we rely more and more on “precision” in our estimates—by their very nature uncertain—in modeling spreadsheets that bury us deeper in the forest. Consequently, we often cannot and do not see the forest for the trees. Put differently, we need more generalities and fewer specifics (which are frequently wrong).
The language of the battlefield may capture it best: We need to remain nimble and flexible in our thinking, and “fluid.” Indeed, this type of mental attitude is very appropriate for investors in today’s highly volatile and chaotic financial markets. Today, increasingly volatile capital markets simultaneously present high downside risk and high upside opportunity—or in the language of the statistician, events at the outermost “tail” portion of the bell curve.
The critical awareness or relevance in investing as Mr. Taleb points out is to “know what you don’t know,” or expect the unexpected. By its very nature, the unforeseen is unpredictable—so how do we prepare for such events?
We prepare by by lifting our heads from our detailed spreadsheets to reconnoiter the horizon. Consider events that are unfolding now across the macro–global landscape, and consider how those events might present dangers—or opportunities—in the future.
Global macroeconomic signposts—such as increasing global monetary liquidity, weakening currency valuations, investors’ increasing leverage, rapid run-up in commodity and land prices—can point to heightened speculative activity in the markets and can point to possible market bubbles.
Over the last few months, I have cautioned my readers to err on the downside rather than the upside, to invest cautiously, use firm stop-order limits and look for sound companies with strong balance sheets and realistic growth plans behind their earnings projections. I’ve urged my readers to take a long-term approach to investing, but remain flexible and never wedded to any investment.
Specifically, I’ve advised my readers to think long-term, focus on growth opportunities in energy, look at the horizon against the backdrop of oil supply and demand, and seek out companies that stand to benefit the most from the search for more difficult to find oil.
Two companies that fit that bill are Seadrill Limited (SDRL) and Pacific Drilling S.A. (PACD). Both are companies that rent out “ultra-deepwater” drilling ships (rigs). The growth outlook for this business segment is bullish, necessitated by the ever-growing need to find crude oil in more remote and deeper waters.
Seadrill is the more established major player in the sub-sector, while Pacific Drilling is the small niche start-up. While SDRL sports an impressive 9.8% dividend yield, PACD has no dividend, but its low share price could offer more bang for the buck.
Long term, both stocks stand to benefit from rising crude prices when global demand accelerates as the business cycle moves forward. Both companies are building new drill ships now, ahead of the cycle. Indeed, so intense is the long-term quest for oil in deeper waters, that 70% of the ultra-deepwater fleet is doing exploratory drilling, indicative of the strong future demand for drilling.
Remember, forewarned is forearmed, and what you don’t know can hurt you—so keep your head up!
Your guide to global energy investing,
Editor of Cabot Global Energy Investor