Oil Has Too Many Plumbers (Smead)

Oil Has Too Many Plumbers (Smead)

Napkin 13-09-13 9.08.42 AM
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by William Smead, Smead Capital Management

Dear Fellow Investors:

We’ve never quite understood why most sensible people don’t apply the same economic logic to investing that they do to any other business. Take plumbing for example. If your town has 10 main plumbing companies and 10 more move into town, your economic mind tells you that the added competition will drive down profits. On the other hand, if five of the plumbing companies go out of business, profits should rise over time.

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This is especially true when it comes to industries with numerous publicly- traded companies. Not only are profits squeezed by added competition, but stock ownership is diluted through public offerings of new shares via IPOs and secondary offerings. For instance, the advent of the internet and explosion in technology in the 1990’s caused a huge number of companies to enter the information tech arena. Profit growth for companies like Cisco (CSCO) and Microsoft (MSFT) were stratospheric. To this day, we believe an unusually large number of bright software engineers wake up every day and attempts to obtain part of those profits for themselves.

Therefore, the number of new companies being birthed through venture capital and/or IPOs exploded in the second half of the 1990s. A fever took hold of investors. They called it a “new era” and the feeling of being a pioneer caused them to pour money into these new companies. Added competition eventually caught up to the existing companies and profits ultimately declined. On top of the negative affect this had on stock prices, the dilution from having a plethora of new info/tech choices in the stock market served to torture the investor concentration. Put this all together and you had an 80% decline from March of 2000 to late 2002 in the info/tech-heavy NASDAQ index—too many plumbers indeed. Investors got destroyed by something that they should have learned in their undergraduate economics classes.

As we travel the country speaking with investors, we constantly get asked why we aren’t trying to take part in booming oil production in Canada and the central parts of the US. What is our answer? There are too many plumbers in the oil business. Much like the fever associated with the internet, there seems to be a fever which has been created by the emergence of China as an economic power and the huge multiplier effect it had on other emerging market countries which produced the commodities used by the Chinese. China’s oil usage doubled between 2000 and 2011. How many times will the largest population country in the world double its use of a commodity in eleven years? We suspect the answer is very rarely. It is like asking how many times the internet is going to be introduced.



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