More money makes more problems in commodities

J.P. Szafranski, BridgeTower Media Newswires

Mo Money. Mo Problems. I don’t think The Notorious B.I.G., Mase and the artist formerly known as Puff Daddy were contemplating the fate of commoditized businesses with their hit song in the late 1990s.
“It’s like the more money we come across

The more problems we see;”

But, so it goes for companies seeking to produce a non-differentiated commodity for a profit. Let’s apply this lyrical wisdom to a couple of different industries: oil and gas production and bitcoin mining.

The price of West Texas Intermediate crude oil spent much of 2014 north of $100 per barrel. Halcyon days. Unsurprisingly, global capital investment into developing energy supply peaked that year at $1.1 trillion, according to the International Energy Agency’s World Energy Investment 2020 report.

This surplus of available capital mixed with high commodity prices and some perverse management compensation structures that incentivized short-term production growth over long-term profitability and sustainability.

One only needs to open a copy of The Journal Record to peruse the epic level of destruction imposed upon that invested capital and, more impactfully, upon so many hardworking energy industry professionals. The years since have seen scores of layoff announcements and Chapter 11 filings from operators with too much debt and/or marginal assets (even “Chapter 22s” with companies having to restructure debts twice in the same half-decade!).

Capital was already on strike before COVID-19 hit, with U.S. producers being forced to live within the means of cash flows to sustain themselves in lieu of accessing reasonably priced external debt and equity capital. The demand shock from COVID-19 and the unbelievably ill-timed food fight inside the Saudi-Russia cartel probably marked the nadir of this industry downcycle.

The IEA reported that global investment cratered to just $511 billion in 2020. We’ll only know for sure in hindsight, but I’m betting this will look like under-investment in the future. The shift to renewable energy sources is a reality, but it’s unlikely that industry and policymakers will successfully re-wire global energy supply quickly enough to forestall a new upcycle in conventional energy. In fact, the next large run-up in oil prices will probably be a useful catalyst for growth in renewables.

In the meantime, oil and gas operators with the scale, asset quality and financial wherewithal to survive the prior downturn are likely positioned to enjoy another significant bull run in oil prices and returns on capital investment.

Let’s shift from mining for hydrocarbons to mining digital currency. Full disclosure: I am not a cryptocurrency expert. Far from it. But mining for bitcoin has some similarities to drilling for oil. The miner has no control over the price of the produced commodity. As bitcoin prices increase, the incentive to deploy computing power to mine new coins strengthens. Said processing power then gets more expensive. As more processing power gets deployed, it becomes more difficult to mine new coins.

With no control over the price of their production, miners seek to control costs through scale. When I’ve looked into bitcoin mining in the past, it appeared that one had to depend upon the price of bitcoin to rise in order to generate any meaningful return. That’s a tough business model. Things are currently going splendidly. In fact, it appears if one is able and willing to pay up to buy an ASIC miner and gain access to reasonably priced electricity, he could hedge the price of bitcoin and fully make back his investment in the mining equipment in about a year. This sort of profitability seems unsustainable. The CEO of publicly traded Riot Blockchain Inc., a mining company that has yet to earn an annual profit, seems to share a bit of this caution in a Jan. 19 press release, with some sage advice that some shale executives could have used back in 2014:

“As Riot evaluates its strategy for 2021 and beyond, we are very excited and focused on the significant opportunities created by current market conditions, but also mindful of the potential impacts on our business that highly volatile bitcoin pricing trends can have on operations and values, combined with competitive, market and regulatory factors that need to be monitored and considered.”

Ten years from now, will they still be on top?

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J.P. Szafranski is CEO of Meliora Capital in Tulsa (www.melcapital.com).