Charles Mizrahi: Josh, thanks so much for coming on the show. I greatly appreciate it. I’ve looked forward to it for the last week or so because I have been following you for a while on Twitter and the number of people who have been following you has just exploded.

Josh Young: Thank you for having me on. Yes, social media is fascinating. I’m basically doing the same thing I did two or three years ago except I would post something and one person might notice it two years ago. Now, especially if it’s controversial, sometimes hundreds of thousands of people will see it or interact.

Charles: Wow. It just exploded. I find you are a prolific tweeter. I see a lot of tweets at all crazy hours of the day because I’m usually up at some of those hours too. I know you just had a baby. I saw one the other day at 3 or 4 in the morning or so. Keep ‘em coming. It’s really great. Really good stuff.

Josh: Thank you. Yeah, I haven’t exactly had much sleep in the last week or so. Hopefully this will be coherent.

Charles: Alright. Josh, you’ve been in the oil business or around oil – energy really – for a long time. Seven, eight, 10 years or so. Or even longer. I want to hear your perspective on this. I always admire money managers because they are the ones – anyone can say something about something in an industry, but if you don’t have your own money on the line it’s a lot different.

You have your own money, your partners’ money on the line and you take positions and you go big or go home.  You do a lot of research. Before we even begin, without even talking about different companies because I know you do real deep dive research, what is the outlook?

Let me rephrase. Talk to me about the supply and demand story of oil. What I’m seeing is it just doesn’t make sense. It’s economics 101. It’s limited supply and increasing demand. Am I missing something here?

Josh: Just to get the disclaimer stuff out of the way, I am the largest investor in the strategy that I run. None of this is a solicitation for investment or a recommendation to invest in anything. You invited me on and I’m happy to come on and chat with you and let your listeners learn more about the oil and gas industry and what I do.

I have a lot of money riding on this. We have done really well. It’s one of those things where you look at something closely and the better you do there’s sort of this weird opposite thing when you have your money invested versus if you’re just an expert pundit.

The guys getting on TV that are paid consultants or supposed whatever. They get paid to be on TV. They don’t get paid to be right. Especially when it’s really me investing and other people investing alongside me through this investment strategy we run. It’s a totally different dynamic.

Part of why I’m up late is taking care of my six-day-old. Part of why I’m up late is reading interesting data, chatting with people via social media or email or text in China and various other places. Connecting with fascinating people who sometimes are only available at 4 am Houston time.

I think it’s important to share. I think that’s one thing that’s an important filter when you think about where you are getting your information from. The other is track record. Like you mentioned, we have done very well fortunately. And done very well versus other oil and gas stocks and indexes in a way that’s considered statistically improbable.

Active managers typically only outperform – if they outperform – by a small amount versus benchmarks. Bison has done much better than that. I think skill and analytics are very hard to measure. They are often ephemeral. The starting point – we were talking about this before we started recording – with companies you look at management teams that do really well and money managers do really well.

If the performance is good, that’s a good starting point for identifying someone who may be more likely to have an insight. So I think that’s important to sort of baseline why you should listen to me. Why might I have a cogent argument in a space where everyone has an opinion.

You ask almost anyone who is active in money markets or economics and they will tell you oil is going up or down, the dollar is going up or down. People have strong opinions. I think it’s a really complicated question. I think it’s really compelling here.

The way you framed it is reasonable. The problem is that oil can move a lot. Oil prices on the margin like other commodities and the marginal supply of oil driven by price is actually very inelastic. If oil prices go up a lot or down a lot, you actually don’t get a lot more oil supply in the short term.

The demand elasticity of price is also very low. So basically you end up using about as much oil if prices are high or low and you end up producing about as much oil in the short run whether prices are high or low. So it can go both ways. That’s part of why you see so much price volatility.

It’s also why, as an investor in the space, I pay such close attention to the macro. All this is a prelude to thinking about it. I think it’s important to frame the question well. One is like hey who are you? Two, what do you know? Then, three, how do you think about this sort of really complicated problem to maybe be able to be more right than others on average over time?

State of Oil Market

The oil market is really undersupplied right now relative to a stable-state global economy. We’re not in a stable state. There are bank failures that have happened recently. There’s all kinds of disruptions post COVID. China is still reopening. There’s lots of complexities around the world that are sending demand in both directions.

Both higher than you think because of the revenge travel from reopening and revenge service consumption in China and certain other parts of the world. As well as what looks like a pretty bad recession already underway in the U.S. and Europe as measured by oil consumption and oil product consumption.

Charles: Let me interrupt you for a second, Josh. Let’s break this down. Let’s talk about the supply. I saw that for the past eight quarters or so, which is two years, that capital from major oil companies has not been being used for exploration and drilling simply because of the political environment out there.

As you know – I don’t have to tell you, I’m just telling our listeners – once you stick a straw in the ground, every day you are getting less and less because you are draining it. You are basically taking that oil from the ground. It diminishes. You have to always look for new supply.

We have not seen, and please correct me if I’m wrong, for the past eight quarters or so much money going into exploration. Is that more or less right?

Josh: I think there’s the near term like what’s happening right now and then there’s the longer-term trend. The longer-term trend is enormously bullish from a supply perspective because there’s not been exploration – forget the last eight quarters – the last 10 years there’s been massive underinvestment in exploration.

There’s been a lot of development of very short-cycle shale wells in the U.S. and Canada and certain other projects that bring on a lot of production in the short term and then see very high decline rates from those wells. They require a lot of reinvestment in order to sustain production.

The actual exploration activity that you need to do so you can delineate fields so then you can go through and drill 1,000 wells and get 1,000 barrel a day initial production rate wells, that activity has been grossly insufficient. When you talk about insufficient exploration, especially by big companies, it’s complicated.

Recently there’s been a decent amount of capital spend by especially large oil and gas companies. Let’s say in the last two to three quarters, especially after oil prices hit $130 a barrel last year. There’s been a step up in development spend, but it’s close to an inflation unadjusted number from the last top of the oil cycle from 2010 to 2014.

You’re not catching up from inflation and you’re also not catching up for the decade of underinvestment and exploration. Again, it’s a little more nuanced. It’s not like the rig count didn’t double from the low to recent levels in the U.S. It’s not like there aren’t a bunch of offshore rigs that are starting to get hired and starting to get put to work over the next two years.

It’s just a question of timeframe and then order of magnitude. I would argue after how little has been spent for how long, you’d actually need to see on an inflation-adjusted basis, all-time high capital spend. Maybe you need to see that for five to seven years before you get back to a sustainably oversupplied market.

Charles: That’s just to play catch up right? We’re really behind the 8-ball.

Josh: Yeah, maybe you’d need four or five years to catch up.

Charles: It’s not one year. It’s substantial.

Josh: It’s really big. I think there’s the short term and medium term what’s happening in China, what’s happening from a demand perspective and a supply perspective. What’s happening with shale? What’s happening with Guyana and certain others. What’s Russia doing and how much is Russia exporting?

Then there’s this bigger problem like you were talking about which is a real problem and it’s getting bigger every year while there isn’t that spend. Then there’s the other aspect that I think gets missed a lot that we start talking about and it doesn’t seem to have resonated, which is very odd to me.

There’s a giant hole in oil field services capital spend. It’s not like you’re Exxon, you’re Chevron, you’re Petrobras and you say you want to go develop a field. So you put out a tender to get the various oil field services to be able to go.

Shortage in Oil Services

Charles: Josh, describe what oil services are.

Josh: You say, “Hey, I want to drill a well.” Exxon is not actually drilling the well. Exxon is hiring Schlumberger or Halliburton to help them manage the project. Then those companies are hiring lots of subcontractors. Let’s say it’s an offshore well. Maybe they are hiring Transocean or Diamond Offshore or one of these companies that owns an offshore rig, whether it’s a drillship that can drill in deep water or a jack-up rig that can drill in shallower water.

You’re going as Exxon and you’re hiring a project manager, typically one of the global top three or four oil field services companies. So Schlumberger, Halliburton, Baker Hughes, maybe Weatherford. You’re hiring them to essentially help you manage the whole thing.

Then they’re your general contractor essentially. Then you’re hiring a rig. You’re hiring various companies to provide chemicals and drilling guidance. If it’s offshore you may hire a submarine. It may be automated or it may send divers down to ensure various aspects of the process.

There’s all kinds. There are many hundreds or thousands of steps and technologies and companies and people who are involved in getting a single offshore well designed and then implemented. Getting the drillship out and the site defined. You want to drill in the right spot.

Then you want to setup on the ocean floor. Let’s say it’s 5,000 feet down or 8,000 feet down. You are setting up a drill site down there. You run the drill rig from the surface, but the drilling has to happen on the floor of the ocean. You’re drilling down from there.

It’s very complex. There’s lots of different companies involved and lots of different equipment. When we think about it and we say, “Oil majors should be spending twice as much as they are in order to catch up for this decade of underinvestment,” even if they want to they can’t right now.

There just aren’t enough viable drilling rigs to be able to actually engage in that activity. So what do you need to do? Right now, what’s happening is a number of the offshore drilling rig companies – again, the Transoceans and the Diamond Offshores – those companies have some additional rigs that aren’t currently being used or actively marketed that they call cold stacked.

In some cases they warm stack them. If it’s warm stacked they basically have it all ready to go and they spend a little money to move it and a little money to reactivate it. Then they have to staff it and it’s ready to go. Cold stack, they could have a bunch of the parts sitting in a warehouse here in Houston or the UAE or various other places around the world.

They need to go spend, in some cases, $100 million or more and, in some cases, a year or more to reassemble this drillship. Then reequip it and order things from Dril-Quip or various other equipment providers to be able to get to the point where two years from now after all this work done in planning and preparation by Exxon’s team, as well as Schlumberger’s team to be able to have a rig to be able to engage in the drilling activity that’s desired to drill an exploration well.

Charles: Right now even if they wanted to catch up it’s like building a house, right? You can own the land, but you need a general contractor and a plumber and all that. If all the general contractors are busy and they don’t have any more bandwidth, I’m going to have to wait on line, even if I want to build a house tomorrow.

Josh: Yeah, but it’s a much more complicated process than a house because, again, there’s very big, very expensive, very specialized equipment that is so complicated and expensive that it takes months or years to get it. Then if you want to build a new one, one, you need way higher drilling rig rates, which means you probably need much higher oil prices in order to make it economic.

The big companies generally the Exxons of the world are pretty good about not engaging in these projects unless they expect a high positive return, even in a lower oil price environment. They need to be convinced that oil is going to be high enough that they can phase into these extra costs and issues in getting these wells drilled and still earn a positive return that’s risk weighted and time weighted and all that.

Charles: Right. Let me interrupt you here. You’re telling me that we have, let’s say, four years even if we did this at full steam ahead just to catch up with the underdevelopment and underspending for the past 10 years and the replacement and all of that.

Even if they wanted to go full throttle there just isn’t enough Schlumbergers, Halliburtons out there in order to make this happen. Is that more or less right?

Josh: The general contractors there’s an issue. Halliburton and Schlumberger, especially during COVID when oil prices when negative and then were low for a while, they unfortunately had to lay off a number of people in order to stay in business.

There’s a people issue, but there’s also an equipment issue. The people issue is complicated, but I believe it’s going to be addressed via enormous levels of compensation. In the same way that software engineers until recently were paid $1 million a year by Amazon or Google.

I know a few of these guys. They’re very competent. They’re around my age around 40, but they were paid a price that no one could have imagined 10 years ago. Software engineers were not paid $1 million or $2 million a year no matter how talented they were in 2010.

But they were paid that last year and they were getting hired in a tight market where there was huge demand for certain specific skills. I think there’s going to be that same wage escalation along with other cost escalations across the oil field services space as there’s this ramp up.

I think the labor part is addressable via price. The equipment part is harder from a time lag perspective. You can get the right people, you just have to pay them a lot because some of them are bitter for having been laid off at a bad time. Some of them are employed by the Amazons or Googles or whatever of the world.

Charles: That’s a big check, but that’s a solvable problem. But in terms of equipment, there’s only X amount of equipment.

Josh: The equipment is a bigger problem and it’s going to take even longer. We have some investments in the offshore drilling space. More on the equipment side. Some investments in onshore drilling and the completion space, also more toward equipment.

I just think the equipment there’s this intrinsic lag. Then a lot of the fabrication facilities and shipyards are busy building other things. Oil tankers or day rigs are enormously high, so the shipyards are all busy. You want to build a drillship, that’s nice.

Even if you wanted to, which you don’t because the day rates are too low and you need the day rates to double and you probably need $150 oil before you start building drillships. You just can’t because the Korean shipyards are busy. There’s all this backlog.

Charles: There’s capacity issues.

Josh: That all takes a couple years. Maybe they’ll do it real fast and do it in a year three years from now. You’re talking four years before you have a ship delivered. Then you have to staff it and test it. Then you have to start drilling. When you think about production from all that investment and activity, you start to push that four year number to a seven year number to maybe a 10 year number.

When you think about the complexity and cost of that problem, you understand why it took oil going from $10 to over $100 and took 15 years for the last oil bull market. I can look at oil having gone from negative to $130 to recently $65 for WTI, I can look at that and say we’re not done.

We’re not even close. We’re closer to the beginning than we are to the end. We haven’t solved this big problem. I think there’s a big supply problem and demand is not going anywhere. Demand is price inelastic.

Charles: The supply side we’re still 10 yards behind. Even if we did everything you mentioned and had the capacity, we’re still not going to be able to catch up. And catch up we need to do. Now let’s move over to the supply. Economics 101. Supply is limited to tight to be kind.

Oil Demand

We’ll use that word for now. Supply is tight. It will take some time to ramp up. Now let’s talk to the demand side. Talk to me about the demand side. You do some fascinating work with charting or following flights leaving China. Give me some insight into that.

Why do you look at China?

Josh: We do a lot of work on a lot of different demand and supply aspects. We just only talk about some of it. Some of it looks really good so it’s fun to talk about. Some of it is really important. The flight data is great because it’s free. It’s from open source providers.

Radar Nav and Airportia provide this as a part of various other things. It’s really easy to see. Weirdly, last year it was very contentious. Many people were arguing that China might never be open or that if China reopened it somehow wouldn’t have a material effect on oil demand.

Both of me to me seem nonsensical. There was just no world where I could see China staying locked down forever. They weren’t saying it, but also you could just see it was extremely unlikely. Then for oil demand not to rise from going from 500 flights a day from China to 2,500 flights a day in China, it’s just math.

You look at how much jet fuel is used per plane, per air mile or per day if it’s being fully utilized. You could see a million barrel a day potential uplift just in jet fuel demand just from China turning back on to their pre-COVID level of flights. It’s a very interesting thing because it was weirdly contentious.

It’s still apparently contentious. People have lots of politics and opinions about various things in the oil market. Part of it is just not caring and just trying to have an objective take on whatever the particular nuanced aspect or micro-thing is. This is flights in China.

My take is that China, like every other country, rebounds to pre-COVID levels and then resumes at a demand growth trajectory. There’s a lot of data on prior disruptions for oil demand. Those are supportive of this view that it was extremely likely they would pick up.

What we saw was that flights started to pick up a lot from China. First China to China flights. Then, second, China to international flights. Oil bears have been pointing to the total number of flights in China saying this number is still really low. It’s ignoring what China has said, which is we first turn on all our domestic flights, then we’re starting to award visas to 20 countries, then more.

I think one of the people I have been talking to over there, an ex-pat at a big U.S. or Canadian company – I’m blanking on it – he was saying his family is now allowed to travel to China as of yesterday. You couldn’t book your flight until you got your visa. They weren’t giving visas until yesterday or two days ago.

What you cared about is the trajectory, not the absolute number. The absolute number has been rising a lot and the trajectory is very positive. I think that’s a really important thing for today’s oil market and into later this year, but it’s always about the incremental question.

Where else is there going to be more demand than people think? Then, where is there going to be less demand. Similar to supply. So it’s less about – again, those are very visually appealing, they’re very easy because there’s open source data we can share without any copyright issues. We just tag the people that provided it and published it themselves.

But it’s not that that’s the only thing, it’s that that’s a contentious thing oddly. That may be a material price driver over the next six to 12 months.

Charles: But even further than that we have the development of countries like India for example. Many of the other developing countries are going to be consuming more fossil fuels, more gas, more natural gas, more oil. If you factor all those things in, you have supply catching up at best and you have demand resuming.

Then growing from that point. I’m not talking about a week or two, but five years from now could one make the case that there will be too much oil? I just don’t’ see it.

Josh: I think at some point there will be too much oil. Again, I think one of the things that my lived experience investing in oil and gas and then studying the full history of it – you can see my bookshelf and I have a bunch of books that aren’t up there – there’s really interesting histories of oil.

What you see is that in downturns, almost always there are folks like Cathie Wood where they say it’s going away forever or there’s a permanent glut. Then when there’s shortages there are people who say there will be a forever shortage. The reality is, it’s cyclical. High prices lead to low prices.

Low prices lead to high prices. The reason to spend so much time and belabor the supply chain issue and the underinvestment in exploration is that there’s almost no price for oil – I mean there’s some price where you could see significant demand destruction, but it would be in the multiple hundreds of dollars a barrel.

There’s almost no price where you get enough supply to meet likely demand absent a price that destroys demand. Again, because of the price inelasticity, you need prices to go wild, especially in local currencies and emerging markets. You need them to go so crazy like they did in 2008.

$150 a barrel then works out I think it’s roughly $220 or so dollars a barrel now. That’s without factoring in refining costs and other sorts of issues and inflation and stuff. You’d need much higher prices to really affect things. I think that’s why it’s important to understand the constraints because, left to their own devices, the industry will overinvest and there will likely be oversupply.

I don’t know if it will be five years or 10 years, but at some point there will be. But in between now and then, it seems extremely likely that there will be a significant undersupply and radically high prices to essentially destroy some demand or mitigate some demand because that’s essentially how the oil market works.

Charles: If I could paraphrase, we’re in the early innings of a bullish trend in oil.

Josh: Yeah.

Politics in Front of Smart Energy Policy

Charles: Cool. You put something out which I thought was really cool. Politics is getting in the way of smart energy policy. Could you expand on that for me?

Josh: Oh man, it’s so bad. Unfortunately, it’s not even in the U.S. a Democrat versus Republican thing. In Canada it’s not really a conservative versus liberal thing. There’s been this trajectory of nimbyism. You know, not in my backyard opposition to local projection and local development.

Pretending like oil from Venezuela isn’t sustaining a communist regime that’s brutally oppressive and isn’t polluting beautiful rainforests there and lakes and all these other things. There’s real significant opposition. Unfortunately, it’s bipartisan. There’s real opposition to development of natural resources across much of the western world.

There’s also some sort of utopianism that’s trying to overcome math and physics. There is a reality which is you can’t use an electric car to generate power. It’s a consumer of energy. So when they say these cars are clean it’s like well, no, they took energy to make them and then they consume, whether it’s gasoline or diesel or natural gas or electricity.

Whatever it is, they’re not generating it, they are consuming it. Then the supposed sources often also require a lot of oil, in addition to coal or natural gas or what have you to extract whatever the resource is and then put it into a form that it’s able to generate electricity, whether it’s solar or wind or what have you.

There’s some structural oil demand that I think people are just trying to pretend away. That doesn’t really work. There have been some really interesting studies on countries that have high electric vehicle adoption rates and their oil consumption per capita.

If we got to per capita oil consumption all around the world of some of the Scandinavian countries, for example, that have heavily implemented electric vehicles, very high adoption rates, I’ll be very wealthy. We can’t get there. There’s just not enough oil in the world.

Charles: I think I saw something in one of the Scandinavian countries, I forget which one, where they were telling people to not plug into the grid. The grid couldn’t support it. I don’t remember where that was. It was at the end of December. I remember reading it in Bloomberg.

The grid couldn’t handle it because these grids are – as you know – ancient. They haven’t been upgraded. The infrastructure is not there. We’re plugging in all this and sucking all that energy out. People think when you charge your car it’s pixie dust going in there.

They don’t realize many times it’s coal or fossil fuel that is generating electricity. Electricity just doesn’t come from magic dust.

Josh: For electric vehicles, the oil inputs are actually more related to the battery and the various other car parts. So it’s more the manufacturer. Then also the plastics. It’s phenomenal seeing people, the oil protestors who are wearing oil-based products, use oil to get to their protest sites.

Charles: Using plastic pens.

Josh: Or petroleum-based paint. It’s remarkable.

Charles: It’s a joke.

The Need for Petroleum-Based Products

Josh: Try to do something without oil and you’d have to learn a lot about oil. You’d learn a lot about modern society and modern life. The reality is that fossil fuels really make our lives a lot better. We’re not stopping using them even when in certain places we force using less of them through government intervention.

We just use more in aggregate because we shift the manufacturer of whatever it is that was getting manufactured locally to places that are less efficient, have fewer regulations and rules around pollution and stuff. So we pollute more and we get the same stuff.

I would prefer a cleaner planet. I would prefer cleaner air. But the mechanisms that are used toward it are not effective. The people who say you need to stop are frequently very large personal consumers of petroleum products. I think it’s an age of hypocrisy and utopianism versus math and physics.

I feel very good investing in companies that are helping with producing more oil and more natural gas because I think we’ll need it. I think the people who suffer from having less of it are some of the poorest and least powerful people in the world. They are typically very poor people in Africa or India where they are a marginal consumer of oil.

By buying a gas scooter and being able to bring their crops to market or being able to get to work they can cut out a three-hour commute and dramatically transform their lives by using a little bit of oil versus the enormous amount our environmental activists use in jetting off on private planes to go to environmental conferences.

Charles: And tell the rest of us how we are using too much fossil fuel. What a joke that is. Just an aside for a second, we were talking about the Congo and cobalt. The difference between making $1 a day and $3 a day is owning a moped. Transporting 20 kilograms of rocks you need some type of vehicle to do so.

The poorest of those people can’t. They have to make a very low wage – about $1 a day – while those who transport it a few miles away because they have the wherewithal to buy a moped make more money than the people who dig for 12 hours a day.

Every country that gets more electrified, more infrastructure, have a higher standard of life. Far be it from us to tell people you don’t want that. Of course they want that. Of course.

Josh: You first, right? Like, you stop and then tell other people to stop.

Charles: But people forget it’s electricity, it’s fossil fuel that allows incubators to run, have lights turned on for surgery, create medicines. All of this stuff. To say that they can’t have it because we want to save the planet is just the wrong argument. I think it’s more than hypocrisy; I think it’s arrogance.

Josh: Honestly, I think ironically and sadly it’s racist. I think it’s colonialist.

Charles: Ok, I’ll go with that.

Josh: When you think about who the incremental consumer is and you hone in on that – I don’t talk about this much because people feel very strongly about it. My job from a Bison perspective is just to find great investments that are really undervalued and buy them with my money and my clients’ money and do well on them.

The people who have oil withheld because the price is high or have natural gas withheld because various banks won’t fund projects in Africa or what have you, it’s really tragic. I think there is actually a good that is done by investing in companies that produce through that investment incremental oil that helps affect the world’s supply.

I think there are a lot of people who are going to suffer from higher oil prices over the next couple years. On one hand, I will make more money. On the other hand, I would prefer they suffer less. One of the ways to deal with that and that I can affect most directly is to invest in these companies and facilitate more rapid development of oil and gas resources.

I think it’s truly a humanistic aspect. I think it’s a good thing to do to invest in these companies. I think it’s highlighted by focusing on that incremental consumer. You see Indian oil consumption is near or at all-time highs and you look at where that’s going. It’s literally, like you said, a moped user.

It’s going to be someone in rural India, typically a farmer, being able to bring their produce to market. Whatever that is. Whether it’s milk or eggs or rice. Whatever it is they’re producing. Their quality of life improves dramatically. The price they receive improves dramatically if they can bring their produce to market versus selling it at an equivalent of a roadside stand.

It’s just a dramatic change in life for those incremental consumers. How dare I or you or anyone prevent them from elevating their life from subsistence living to a little more than subsistence living.

Charles: I forget where I saw this, but 2.6 billion people in the world fuel their ovens with biomass. Wood, cow dung, whatever it might be. The women and children who are in this little bubble, they’re the ones who suffer with terrible breathing problems and die much younger while the husbands are out working.

Here, gas or electricity will change their lives. Just putting an oven in their house. But they’re not even hooked up to an electrical grid. They don’t even have electricity. Here we are…

Josh: Yeah or propane grill or there’s various things that could dramatically change people’s lives with minimal cost. The problem is they are either not allowed to or the barriers to that are very high. When you think about oil and gas investment, from my perspective it’s really just reducing those barriers for higher affluence for the poorest people.

Everyone else sort of comes along for the ride because it’s a commodity, but really it’s that marginal consumer, that incremental consumer really sets the price. That price is set based both on supply and demand, but also just on availability.

It’s really important I think to be able to allow that to be available so people can go from if you burn wood in your single room house you are going to live half as long or something.  It really destroys your lungs. You get all kinds of other issues.

Charles: And the children. And the pollution of the environment. People don’t get that. It’s destroying. Definitely. We’re on the same page with that. Supply/demand. We’re in the early innings with oil. China reopening is just one factor. It’s a short-term factor but you can see where that’s going.

Politics is just clogging this whole system up. Be kind to them. They don’t realize. Leave it at that. When you’re hunting, when you’re – pardon the pun – drilling down and trying to find a good investment because, bottom line, you’re a capitalist – I see behind you The Snowball by Alice Schroeder. Great book.

You take a value approach to investing. You hunt for great companies that are totally mispriced by the market in the small-cap space. Share with us why you hunt there and not in the large cap.

Small Cap Oil and Gas Mispriced

Josh: I actually look at all oil and gas companies – large ones and small ones. Right now small oil and gas companies are historically mispriced. Right now we’re buying small oil and gas stocks primarily because they are so, so cheap. There’s different ways to measure cheapness.

One is just on an absolute basis measuring likely intrinsic value measured by likely free cash flow. People build these discounted free cash flow models. I typically don’t build free cash flow models. Occasionally we will for really specific purposes. If it requires a model to understand it’s cheap enough to buy…

Charles: It’s not cheap.

Josh: It’s not cheap. Right.

Charles: That’s what Buffett said. Buffett said if you have to think too hard about it, it’s not cheap enough. It should be so obvious to you that you can figure it out in 30 seconds. If you can’t then …

Josh: Yes, it has to be overwhelmingly. Again, it’s not that we won’t build models, but we’re not building them to figure out if they’re cheap enough. There’s other reasons to do that sort of work. There’s another way to look at these things, which is based on replacement cost.

How much would it cost to recreate this asset? Let’s say for an oil field to explore. Risk adjust the exploration’s success to develop it, to get access to infrastructure and then to have this profile of production stream with these operating costs and these royalties. What would it cost to do that?

Then what’s the time cost to do that as well. Because even if you decide you want to create a new oil field, you are going to take years of exploration and there’s a lot of risk involved to actually hit oil. Or if you are buying an existing field that’s not developed there’s a high price to go and buy it and develop it.

We find replacement cost is not something people talk about too much and it’s very relevant both for producers as well as oil field services companies with their rigs or drillships or what have you. One of the things happening right now is you have these small companies that are not just cheap on replacement cost, they’re cheap on intrinsic value.

The likely cash flow out of their existing assets without very much new production or delineation just out of their crude reserves. Then they’re also in some cases very cheap relative to the current transaction market. There was a company we talked about recently – that we disclosed owning recently – in west Texas where assets have recently transacted around 3.5 times run rate cash flow and they were trading under two times run rate cash flow.

Charles: Hang on. Let me make this simpler for those who aren’t finance majors or hedge fund managers. What you are basically saying is you are comparing apples to apples and saying these two companies, one is trading at a multiple of four times cash flow and the other one is trading at two times.

The one two times apparently is much cheaper than the one four times. Why would that discrepancy happen?

Josh: To be clear, that is also true where I say the small caps are cheaper than the large caps. This one that I own, Vital, which I’m not recommending but using as an example for the types of things we’re finding on the small cap side. Let’s say they are at roughly 2.5 times cash flow at the current forward curve for oil.

Versus let’s pick on Diamondback or Devon where they’re at, let’s say, 6 or 7 times cash flow.

Charles: Those are much bigger companies.

Josh: Much bigger companies. Exactly. But what I was saying was actually not that aspect. I was saying there are transactions happening where asset bases that are assets that are similar to the entire company are transacting, typically the people come along with it. You buy the company, you pay out the bonuses and you try to retain the people to continue running it to the extent they are necessary for those operations.

Those companies that are getting bought, the private assets that are transacting are transacting at a multiple that’s far higher than where Vital Energy, Inc. (VTLE) is trading. It’s not just that there’s other companies…

Charles: Vital being a company you own in your portfolio. You’re not recommending it but you are using it as an example.

Josh: Using it as an example.

Charles: Let me clarify so I make sure I got this. So companies similar to Vital are being bought and sold in the private marketplace or even mergers by a bigger company for X times where Vital is comparable to it but missed the market. The stock market is trading it at only half that amount.

Is that more or less right?

Josh: Yeah, more or less.

Charles: Why does that happen? Why that discrepancy?

Josh: It’s a great question. Partly because there haven’t been many buyouts at premiums of small public companies recently in oil and gas. The market just doesn’t believe that they will get bought out any time soon at a price that’s similar to the price private oil and gas assets are getting bought at.

Charles: So one part is – just to review quickly – Mr. Market doesn’t believe that company that gets bought out or taken out in a private transaction. Public company? Eh, maybe won’t happen. I’m not going to give it that much.

Josh: Yeah.

Charles: Good. OK, second reason.

Josh: To be fair, there haven’t been many big premium transactions for publically traded oil and gas companies in the last few years.

Charles: That’s true.

Josh: So it’s not wrong that that hasn’t happened. I think what’s wrong about it is there are a limited number of private oil and gas companies that are producing more than 20,000 barrels a day of oil in the U.S., especially in West Texas. There’s a very small number, relatively speaking, of those companies.

The valuations on those transactions, up until this recent pullback in the last few weeks, but the general trend over the last two years has been a move up in valuation from two times cash flow on assets to closers to 3.5 times cash flow on assets. There is a trend.

If I owned a private oil company and I wanted to sell it right now, my expectation would be that I’d sell it around the price that the other guy got plus some amount. I’d always try to get a little more. So the last transactions I’d look at would be around 3.5 times. Similar to you going to buy a house and you look at what the prices of the houses were in that area on recent transactions.

So comparable transactions indicate a much higher value than the public market is giving for some of these small companies. Yeah, there haven’t been many premium buyouts recently, but that doesn’t mean there won’t be. In the meantime, if the company is on a positive trajectory, if it’s continuing to add value – let’s say it’s paying down debt or paying a dividend or buying back stock or growing its production or some combination of those – the value that it sells at eventually could be growing.

If you could sell for X, which is let’s say two times your current share price, maybe in a year you could sell for 50% more than X. Then if valuations continue to rise, maybe you wouldn’t sell for 3.5 times, you would sell for 4 times or 4.5 times. There’s multiple expansion on transactions.

And there’s value accretion at these small companies. So the combination of those sets up really nicely for when there will be more buyouts. But you also don’t need buyouts of public companies to make money. The public market is ultimately a great place to realize value and it’s just one of the ways to tell how much value there is.

These comparable private transactions measure them and see how cheap or expensive they are versus these public companies.

Charles: Small companies are just not as followed. I think the average company under $1 billion, I think there are only three analysts covering them. Large caps have close to 22 or more than 20, I know that. So you have less eyeballs on these small companies. More price inefficiencies.

Real opportunity. Would you agree with that?

Josh: Yeah. I think these days research analysts covering companies as long as there’s more than a couple I don’t think that’s as much as a differentiator. I think the bigger thing is that there’s been this move toward passive management.

Because active mangers do typically underperform, which is what we talked about at the beginning of this conversation, there’s been a shift of investors over to ETFs. The most popular are the large-capitalization ETFs. The S&P 500 ETFs like SPY. Similar ones in Canada. There’s world market ETFs.

Almost all the money goes into the largest few publicly traded businesses. So you end up as there’s more passive investment – which again, for most people, it’s not a bad idea for them. If you’re a dentist or a lawyer or whatever and you can make more money spending time on your main business, you might do better.

You’re almost definitely going to do better than trying to actively purchase or have somebody manage your investments without any sort of edge just putting money in passive ETFs. The problem with that is that money all congregates in these large companies.

The more that continues, the more outperformance there is available, especially in small-cap niches where specialists like we are at Bison are able to find these really undervalued companies that have their own catalyst that are likely to revalue because they are buying back a bunch of their stock or they are doing something else that’s forcing the value up.

So I don’t think it’s research coverage anymore. I think it’s sort of the investable universe for investment funds that are still active, as well as this overwhelming fund flow of exchange traded funds and index funds being directed almost entirely to large-capitalization funds.

Charles: If you’re putting billions to work you are not going to buy a $300 million market cap company. It’s just too small. It will move the needle and they can’t absorb that kind of money. The money gets all clustered around. It’s like FANG stocks when everyone was buying the Nasdaq 100, QQQ.

It’s where the big money can go. It’s not where they want to go. It’s the only place they can go to. That leaves a whole universe for guys like you.

Josh: One important thing, similar to your question about the small caps, like hey, what’s going to change? How do you actually make money on these things? Small caps versus large caps, historically, have shifted where sometimes large caps do well and sometimes small caps do well.

When there’s too much money on one side of the boat or the teeter-totter or whatever, you end up with there being extra returns on the small-cap side. As that starts to happen, as you have bonanza years like we did in 2021, you start to see money come in.

Oil and gas is weird. It’s weird in the sense that the smart money, the institutions, have promised to divest from the space. Normally what would happen is you’d have the university endowments and the pension funds allocating to hedge funds and mutual funds to be able to go find these niches and reprice them to buy these really cheap stocks.

Because of some of the politics and it’s a very complicated issue, there’s money still leaving the space rather than coming in. It would normally be arbitraging this. It’s really extending this opportunity, particularly in oil and gas. But also broadly, small caps have done worse over the last decade or so in the broader market.

It’s like that that changes. As money comes into these small-cap ETFs, they are going to go into small oil and gas companies too. In addition to small tech companies and small whatever other companies. There’s this potential for a significant passive rerate of oil and gas and public equities as we have this shift in assets from the S&P 500 ETFs to the Russell 2000 or other ETFs.

Charles: We’re seeing that now. Small caps outperforming since July or August of last year. We looked at the start of a recession in a certain amount of time, let’s say a year or two, one year after the start of a recession, small caps outperform large caps 11 out of 11 times since the 1950s.

Josh: I was not aware of that. That’s really interesting. What I do know for small caps for oil and gas is historically at this point in the cycle, let’s say we’re in inning two or three of a nine-inning bull market for oil and gas, at this point in the cycle you would have small-cap producers trading around seven times cash flow.

You’d have them at a slight premium to the larger-cap, publicly traded oil and gas companies for various reasons. The smaller ones are more dynamic. They are better able to do acquisitions. They are better able to grow. They’re typically more aligned where the management teams and boards own more of the stock.

Generally you get a premium valuation for those attributes. Here we are at roughly that part of the cycle and we’re at a giant discount. It’s like, am I crazy or is this cycle different? When you look at every other cycle for small caps in oil and gas, every other oil cycle, over and over again you see the significant rerating up in small caps.

I don’t think this time is different. I think this is just there’s weird fund flows right now.

Charles: It’s delayed. It’s one of those things where you do your work and you look at your numbers and say, “I must have missed something. It shouldn’t be trading where it’s trading. Something is wrong here.” We have that on so many stocks.

Last year we were looking at, especially in the micro-cap space, at valuations that didn’t make sense. I was telling my analysts I think we missed something. He goes, “No, we got everything in here.” And then eventually our thesis did play out. But you’re spot-on.

Especially now there are so many crosscurrents the way we see it in the energy market that have nothing to do with the fundamentals of the business or the fundamentals of supply and demand, but it has political, ESG, a whole bunch of factors which are just muddying the waters now.

Eventually it will all play out the way it should be.

Josh: That’s right. And this time isn’t different in the sense that, like you were saying, I think it’s more a lag. The wonderful thing about lags is they give you the opportunity. I was a little frustrated a year ago that small caps are not rerating. As I look at it now as we deploy more money it’s wonderful.

We get to go buy more stocks for a cheaper price than we should be able to. And the businesses are moving how we were expecting. And they are improving how we were expecting. Commodity prices, other than this recent pullback, are generally on the right trajectory.

The supply issue is becoming bigger. The demand issue is becoming bigger. So we’re on this right path. There’s a discount sale. A flash sale. The stock market, they say, is the only place where when things are on sale they want it less. It’s wonderful.

Charles: The way we see this is this sale was only for 10 days and now they extended it to 30. You’re going to be upset with that? Then again, it tries the temperament. It really measures the person investing because this requires the hardest part of investing, which as you know is patience.

Doing nothing. Just waiting there. Usually it’s been going the opposite way and it just doesn’t make sense. Most people would sell at a loss and move on. The smart investor, the intelligent investor, who knows what the market knows, the price of everything and the value of nothing.

Intelligent investors are just the opposite. If you see the valuation here, buying something at two times cash flow is not a bad thing, especially when you originally bought it at three times and the price went down. You’re going to get a better deal. That’s something most investors just don’t get.

Charles: Beautiful. Josh, man, this has been really great. We’ve got to have you on again. Maybe another six months or eight months from now just to see how these things work out. I love your take on the energy market, your knowledge of oil, and hunting in an area where the big money is not going.

That creates huge opportunity in going to the small caps. I wish you continued success. People can find you on BisonInterests.com. Highly recommend it, folks. He puts out white papers there and I read some of his white papers. How much time and energy goes into this?

I look at some of your white papers and go, gosh, these are term papers. These are research papers that you give away for free.

Josh: This is just a fraction of the research we are doing. This is the stuff we feel comfortable with writing up and putting out. There’s a balance of what we think matters and then what are we comfortable with sharing. That’s sort of that balance. That’s the result.

Charles: Josh, continued success. Lots of luck to you. On a personal side, with your growing family, God bless there. Keep doing the good stuff and keep making money for your partners.

Josh: Thank you very much. I really appreciate it.

Charles: Alright, man, take care.