The Vampire Squid is described by Wikipedia as a deep sea cephalopod that resides in the deep dark depths between 2,000 - 3,000 feet below the ocean’s surface. This habitat is known as the oxygen minimization zone. An area so deprived of oxygen that it cannot support the metabolism of most complex organisms. The creature survives these depths by virtue of a couple of adaptations: proteins in its blood binds and transports oxygen more efficiently, while ammonium body tissue matches the density of the surrounding water. These adaptations allow the animal to not only survive but to thrive in an environment normally hostile to other sea creatures, in particular their apex predators or competitors.

The creature’s existence has captivated capitalists for generations but its inspiration seems to be lost these days by all the glitz and glamour currently in the markets. The concept is rather simple, it’s one of Fragility. Or more specifically, anti-fragility. The concept was famously coined in an economic sense by Nassim Nicholas Talab. It effectively refers to a system or organism that is by its very nature difficult to be eliminated. From cockroaches to Rocky Balboa, these entities are not subject to the same level of entropy as others and therefore do not play by the same rules normally associated with their peer group. Whether that be Thermo-Nuclear war or a big frigging Russian, these creatures have adapted to be the last one standing.

So what does this have to do with investing in oil and gas, or commodities in general? The answer is: everything. In a world of passive investing and factor ETFs, identifying the quality “factor” has become a lost art and therefore represents a significant opportunity to provide higher risk-adjusted returns to your portfolio. This is because when investing in cyclical or commodity like businesses, the quality of the enterprise becomes an even greater determinant of investment returns given the price-taker nature of the industry. These Alpha companies should trade at a premium to their Beta peers given their advantageous position in the marketplace. Low debt to cash-flow, low debt service costs, low-cost production, and low-decline rates are all markers of quality oil and gas enterprises.

Canadian Natural Resources Ltd.

Fundementals

When I look through the universe of oil and gas production companies, one in particular strikes me as a Vampire Squid. Not just for the qualities discussed above but by its very nature. CNRL eats when everyone else is starving. CFO Mark Stainthrope recently announced that the company is break-even at $30 -$31 WTI and will cover its very generous dividend at $35 WTI. This gives the company the opportunity to be counter-cyclical when all of their peers are struggling to breath, just like the Squid.

Even more incredibly is that the company also just announced that in 2021 they would generate between $2 and $2.5 Billion dollars in free cash flow after the dividend, based on estimated $45 WTI pricing! That would give the company a free cash flow yield (before dividend) of approximately 11.3% at $45 WTI and 14% at $50 WTI. Where else can you find anything like this, let alone with a company that owns a world class asset?

I anticipate that this cash flow will be used to either (1) pay down debt or (2) acquire great assets at deeply discounted prices. It’s always sound judgement to pay down debt, as it would only make them more indestructible. We just saw the company successfully thrive in a awful oil price environment that consisted of a month of negative pricing. In fact, they even increased the dividend and rolled a 10 year bond at 2.75%.

So if I’m the curmudgeon capitalist that I think Murry Edwards is, what would I do? I’d eat and and I’d eat, but nothing but Filet Minot and why not? It’s not like they haven’t been doing this already. Just consider the last three years. The company made major acquisitions of the Shell and Marathon Oil’s AOSP assets, Devon- Jackfish oil sands assets and most recently took out Painted Pony Ltd. who at one time owned what some considered to be the most prized liquids-rich lands in the Montney, much of which is still waiting to be developed.

How has all this been possible, you ask? Well very simply it’s the zero-decline to low decline rate oil sands mining and in-situ operations. In fact 79% of the company’s production comes from long-life, low decline assets. Counter this with the fact that many U.S. shale drillers are getting 40% - 50% decline rates on current wells and you can see why CNRL is able to maintain production during low oil price periods. Further, given the upfront nature of the investment, these assets generate excess cash-flows during hard times, due to the fact that so much of the investment is the upfront cost of the mines. This cash-flow reminds me a lot of the insurance float that Warren Buffett and Berkshire use to be counter-cyclical.

What are the alternatives?

When I look out on the landscape of possible high quality oil and gas companies (other than CNRL), I see very few that meet the definition of a Vampire Squid. Arguments could be made for Gazprom, Lukoil, and Aramco but the very location of these international giants brings into question the anti-fragile nature of the business. Meanwhile, US and European Super-Majors are stuck either in high-decline shale or high cost deep-water offshore basins that do not offer the same brown-field growth options as CNRL. This leaves us with Suncor and Cenovus. Both have great low-decline assets but their massive refining capacity has proven to be a major drag on margins during COVID and increases their break-even costs to the point that they are unable to be counter-cyclical like CNRL. At this time CNRL is my favorite and I think out of all oil and gas companies out there, offers the best risk/reward available.

Technicals

I’m a buyer on pullbacks. I see support for the stock coming in at the $30 June high (also the November 30 re-test). Upside resistance first at $35 and then between $37.50 -$40. At time of writing I see short-term risk at 6% downside (to $30) and upside of 17% (to $37.50) if oil stays flat or up to $60WTI. $65 WTI would cause me to reconsider a potential breakout above $42.