In 1952, Princeton mathematician John Forbes Nash Jr. discovered what would later become one of the preeminent fields of study in economics: Game Theory. Game Theory is defined by the Oxford dictionary as: “The branch of mathematics concerned with the analysis of strategies for dealing with competitive situations where the outcome of a participant's choice of action depends critically on the actions of other participants.”

One of the most applied scenarios in Game Theory is called, ‘The prisoner’s dilemma’. The scenario is rather simple and goes as follows:

· Two prisoners are pitted against each other by authorities to the find out the truth

· Given their solitary confinement, neither knows if the other will confess or not

· Both are incentivized with just parole if they are to blame the other to the crime. If this were to occur the other gets life in prison

· If they both confess, they both receive 20 years

· If neither confess, they each receive 1 year

If you add up the cost of each cell above, you will find the aggregate cost to the prisoners is lowest (2 years) when they both do not confess. Then second lowest summation (40 years) occurs if both prisoners confess. Finally, the highest cost comes if only one prisoner blames the other, leaving the other to spend their remaining life in prison.

Another example of this idea is depicted in the movie “A Beautiful Mind” which shows a young John Nash and his pals at Princeton scheming to get dates for each man. It’s really a great clip and worth a few minutes of your time: https://www.youtube.com/watch?v=LJS7Igvk6ZM&t=7s

Commodity markets

Over the last number of months, I’ve been thinking about Game Theory and how is applies to the North American energy industry.

In 2009, CIBC chief economist Jeff Rubin wrote a book called “Why your world is about to get a whole lot smaller” which argued that the era of cheap oil prices experienced in the late 90’s and early 2000’s would never be seen again. As these things tend to go, it was a great contrary indicator as prices meandered lower for the next decade, plummeting to an all-time low of negative $40WTI in spring of 2020. It was really quite something.

In addition to Rubin’s book, there were several other more obvious red flags that could have foretold oil’s inevitable decline. This included the high price of oil itself, which encouraged investment, but also new and more efficient drilling and completion techniques, and perhaps worst of all cheap capital.

Fresh off a near 10 year run in increasing oil prices, Investors were thirsty for growth in such a scarce and valuable resource. Investors and bankers handed the industry money faster than its roughnecks could hammer it into the ground.

Moreover, management teams- spurred on by antiquated short-term-incentive packages that emphasize production growth over returns on investment- presented a major principal-agent problem that influenced further unprofitable production that only further exacerbate the problem. Still Investors brushed off these governance issues, as the shares of many shale companies climbed without abandon.

This was peak competition, when each executive team trying to out-drill the next to show the highest growth and receive the highest short-term compensation.

Consolidation

This intense environment continued up to 2014 when OPEC decided against supporting prices and forced North American shale drillers to cut production the old fashioned-way, maintaining their market share .

While the 2015 crash felt like the heavens opening, the Pandemic has been biblical. And while the economic outcomes of the pandemic are still coming to the fore, we have witnessed a dramatic wave of consolidation that is extremely positive for the industry.

As much as this consolidation helps the individual companies become more resilient and efficient, the real benefit is to the industry itself. Higher quality management in control of larger swaths of assets leaving fewer producers to get drunk on cheap wall-street money. Just like John Nash says in A Beautiful Mind, “The best results come when everyone in the group does what’s best for himself, and for the group” Not just what is in his own best interest. When it comes to oil and gas this is especially true, just ask OPEC.

It’s been brutal but the pandemic has done the impossible, forced the shale drillers to come to heal bringing us back full circle to a now anti-competitive environment where all investors, bankers, and management are aligned in their focused on free cash flow not production growth.

Technicals:

As I outlined in my last two posts, I’m playing this theme by being long specific Canadian oil and gas names. Technically speaking, the Canadian energy equities (as represented by XEG.TO) experienced a golden-cross this December when the 50 day moving average crossed the 200 day. This speaks to a longer-term bullish trend, which I believe is confirmed by positive fundamentals coming in H2 2021.

At the time of writing, I am waiting to add to my existing positions until there is a clean break above the $6 level and a re-test of that same level. As witnessed last week, the $6 level could not be held, though it appears poised to be make another run here again post-holidays. Disclosure. I’m long TVE.TO, WCP.TO, PXT.TO in the Canadian oil space. Reminder that this is not investing advice.

I wish you all a Merry Christmas and a happy and healthy 2021!

The Dutch Explorer