Monday, September 01, 2008

My Investing Journey: Hurricane Katrina 3 comments

(P.S: Sorry for any disturbances the advertisements above may have caused you)
If late-2004 and early-2005 are remembered for the corporate debacles of CAO, Citiraya and ACCS, the later part of 2005 will be remembered for the attention that centered on oil and refining. The catalyst was Hurricane Katrina, which was the worst-ever storm to hit the Gulf of Mexico and caused extensive damage to the refining facilities in the region, exposing the deep global capacity crunch in refining capacity.

Katrina formed over the Bahamas in late August 2005 and due to the unpreparedness of the authorities, caused severe destruction along the Gulf of Mexico coast from central Florida to Texas in the form of a Category 5 storm, with the most severe loss of life and property damage occurring in New Orleans. Of more interest to oil traders was the damage to the oil production/refining infrastructure in the most important offshore oil production area of the US, where numerous oil platforms were destroyed and refineries were forced to close; approximately half of the Gulf's oil production was shut over the subsequent 6-month period.

Oil prices making new highs had been the talk of town throughout 2005, but Hurricane Katrina brought into focus the glaring global tightness of refining capacity. Simple and complex refining margins spiked up several dollars per barrel after Katrina which bloated the profits of refineries across the world for 2H05.

Allied to this tale is the story of SPC. The story is told in my writeup on "Bull stock: SPC". Struggling with razor-thin margins and stagnating revenues in its refining business in the late 1990s when oil prices were in the pits, it was a massive beneficiary of the burgeoning demand for petroleum products after 2003 that translated in steadily rising refining margins from 2004 onwards. Net profits for SPC jumped an astonishing fourfold from S$60M in 2003 to S$250M in 2004, and within the year 2004 alone the stock shot up from 1.50 to 4. Remember that 2004 was a relatively tame, mildly bullish year, so this was a meteoric rise, reflecting the rewards that can be reaped when the investor recognises a single trend and bets on it.

Unfortunately, I did not see the trend, and so missed out on the bulk of the gains. There was plenty of talk online about this though, but I only read through the threads after the bulk of the price gains were done. Nonetheless, I got into the stock in early 2005 at $4 because of what I felt was an under-recognised strength of SPC: its being a complex refinery which meant it could handle heavy sour grades from the Persian Gulf countries, which were in abundant supply, while simpler refineries in other countries could only handle the more expensive sweet light grades. You can really learn a lot through good analyst reports especially those that cover an industry on the whole; typically such reports have less of a "sales" agenda compared to reports on individual companies: I learnt all the facts from several such reports on the refining industry before parlaying my bets in early 2005.

The stock did relatively well throughout 2005 but really spiked up post-Katrina when it shot from the high 4s to $6, when the tightness in refining capacity was revealed in its entirety and Singapore complex refining margins shot from US$5/barrel to US$15/barrel. In fact, it had been tight throughout 2005, with US and Asian refineries operating at above 90% capacity. Katrina was merely the catalyst that pushed it over the edge by knocking out spare capacity (and then some). The dramatic reaction of refining spreads is a manifestation of how prices for commodities can surge when demand just slightly tips over the thin margin previously existing between it and supply capacity.

It also is an example of the moral dilemma that often surfaces when one invests in stocks whose potential price catalyst could be some disaster that exposes the deficiencies in the industry and brings market attention to the particular niche that the stock serves. Offhand, I can remember stocks that benefited from such phenomenae such as Medtecs (which sells gloves, facial masks and medical consumables) during SARS and defence stocks during the US-Iraq war. Some might even see the glee that short-sellers exhibit in every new bite of bad news hitting the US banks currently as an example of such morbid moral ambiguity. How does one reconcile one's morals with one's market position?

I reckon the crux lies in whether one is actively hoping that a disaster will happen which he perceives will benefit his stock as a consequence. For SPC I had never bought in with such hopes so I never suffered any guilt pangs when Katrina struck and had a positive uplifting effect on prices of refining stocks across the board. However, I have seen people who, for example, bought Medtecs after the SARS crisis blew over and then hinted that SARS might come again, with the subtle hope that it WOULD indeed strike again. That is contemptible behaviour which is akin to building your happiness on public misfortune. On the other hand, it does not mean that the investor/trader cannot position himself in a fundamental trend which he feels is going to persist, even though this trend might be generally detrimental to society. The investor/trader might be betting on the inevitability of a development, and there is nothing morally wrong about that. Or he might be hedging his portfolio, which is even less reprehensible. But once he crosses the line between dispassionate betting based on return/risk/odds calculations to an active desire that something bad will actually happen to humanity, he will have lost the essence of being a human being in itself. Never put money above your own humanity.

For the record, I eventually sold SPC at the end of 2005 at about $5, when the stock retraced its steps back from $6 and I found other better stocks to switch to. I had also come to the view that the continually rising oil prices would not be good for refiners, because although in the early stages they reflected strong end product demand which basically pulled the entire supply chain (including refining margins) along, high crude prices in fact constituted high raw material prices for refiners which would actually harm their margins eventually if end product demand stagnated (see my writeup on refining margins). Ultimately, of course, SPC would reach $8-9 in 2007-8. But that would be more due to hopes for its upstream segment plus a bull market for commodities --- another thing altogether.

Katrina was the precursor to the annual August/September hand-wringing over potential hurricane impact on oil prices/refining capacity ever since, and the world have had scares now and then over approaching cyclones in the Gulf of Mexico, with the latest one being Gustav (which has turned out to be a mouse). In my view, the fact that people have worked themselves into a frenzy already guarantees that these storms will never again likely have the same impact as Katrina, because they will have prepared themselves to handle any crisis emanating from these storms (eg. shut down facilities, evacuated the coast). A bit like the stock market, where selldowns lead the real event, whether it does eventually transpire or not.




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