LearningMachine

Thanks @Ulti for re-posting this today what @Viking had posted earlier. Even though Bison Interests totally missed calling out Buffett's purchase of COP at peak in 2008 (despite leaving the link to COP purchase in their Sources section :-)), it caused me to go back and look at Buffett's 1956 article on The Security I like Best (more readable in text form here). Really amazing how Buffett calls out that he should have titled the article "The Inflation Hedge I Like Best." valuing the company based on oil & gas reserves, not just the income it was generating how "leverage" resulting from both oil payments (I'm thinking he meant royalties) and loans, made the returns much much bigger how payments are obligations of the specific property not the company (shows how amazing he was at ironing out each specific risk). Compares the inflation hedge to owning rental income properties with fixed mortgage payments Buffett was recognizing all of the above when he was 25 years old back in 1956. Just amazing! By the way, I think Bison Interests also miss-attributed that Buffett called out the peak in oil stocks in https://www.berkshirehathaway.com/letters/1983.html. What Buffett was saying was that "Asset-heavy businesses ['natural resources, plants and machinery, or other tangible assets'] generally earn low rates of return – rates that often barely provide enough capital to fund the inflationary needs of the existing business, with nothing left over for real growth, for distribution to owners, or for acquisition of new businesses." Meaning stay away from companies with high PP&E!

How about if we determined it based on American goods & services a barrel of oil can buy? At $60 per barrel, pre-covid, Saudis & Emiratis studying in U.S. could buy about 10 subway sandwiches. To buy the same 10 subway sandwiches with a barrel of oil today needs at least $120 price per barrel.

Thanks @Spekulatius for sharing your experiences and bringing a cautionary perspective. Really appreciate. Please keep it coming. You're right, once price is high, supply can start showing up. Buffett has also been burnt by it before. He made a big bet on COP in 2008 at the previous peak in oil and gas prices, and then got burnt. As I have said before, I think Buffett is late to the oil party this time also, but this time, I think he is late because he got burnt before. I think he has been thinking about this since inflationary 1970s, when oil stocks out-performed all sectors, and he has had his finger on the trigger for oil stocks since then. He pulled the trigger in 2008, and got burnt. Next time, even though he realized heavy inflation happening in 2020 and 2021, because he was burnt before, he kept his hand off the trigger, until he finally realized that this time inflation is really happening, and that it is getting baked in society's psyche. I think Buffett realized that this time is really different from 2008. In 2008, normal goods & services you buy in economy had not doubled in price, unlike this time. The word "inflation" was not getting baked in society's daily vocabulary unlike this time. "Inflation" is one of those words that the more it gets mentioned, the more self-fulfilling prophecy it becomes. See https://trends.google.com/trends/explore?date=all&geo=US&q=inflation . Another thing to keep in mind this time is that FCF yield is so high at the new fair oil price (that just conserves buying power of OPEC-member countries), that you might be able to get your entire investment out in FCF before new oil supply shows up.

Thanks @Spekulatius for sharing how markets are pricing in much lower oil price when valuing oil companies. I think oil futures are really hard to predict with high probability. We all know what happened during covid times, and can't predict what future events might bring at what moment. I think owning oil reserves through oil companies are easier to predict because they can do well as long as we have an effective cartel because even if there will be unpredictable volatile times when oil prices would drop, just give the cartel some time to adjust supply to get the prices up to get its fair share as the cartel proved during covid times. And, don't forget you are getting all that FCF during that time with the oil companies, unlike oil futures that will just sit there like gold. If I were to measure value of USD roughly, based on just Subway food prices, USD has lost more than 50% of its value compared to before covid. In 1973, OPEC decided to price oil in gold. Now, If OPEC were to price oil in terms of subway and other equivalent items provided by US economy, I think they would want to be able to keep their buying power as it was before covid. So, they would probably want to price oil at roughly twice it was before Covid, and who knows how long this inflation runs going forward.

Couple of things: #1. The global price of oil is based on the highest cost barrel it needs. #2. Oil demand is very inelastic. So, if the world needs 100 mboe per day, it can't live on 63 mboe. So, that 37% share effectively gives OPEC the power to set the global price. I think OPEC has actually done pretty well for its member-countries. Look at how well Saudi royal family is able to live and have money left over for the country for doing nothing but just having oil reserves. I wouldn't measure OPEC's success by OPEC being able to maintain the oil price every day, e.g. during the covid time, but whether over long times, it is able to get its member countries and producers a fair share of the world economy. Even during covid times, within a few months, they were able to get the price moving back up. In 1973, they were able to bring the western world to its knees and get their fair price in gold. Yes, due to some infighting, they were not as effective in 1980s and 90s, but they started getting effective again as time went by. If it were not for OPEC's power, Biden wouldn't have to go to begging there. You don't see Biden going and begging BHP and RIO. If BHP and RIO tried to collude, the legal system would just take care of it right away.

If BHP and RIO were legally allowed to collude on prices, or if Brazil and Australia were to form a cartel, iron could be interesting. Until then, only one commodity in the world has a cartel to look out for prices long term to make sure producers are getting their fair share of the world economy.

Bulish or bearish: it will depend on the company and valuation at the time. If unemployment starts to go up, I think Fed is going to stop raising interest rates, let inflation continue, and if inflation accelerates too much again, get back to raising rates, i.e. continue playing catchup without getting inflation in control like in 1970s, because until the pain from inflation is so long and heavy that people want to get rid of inflation while bearing high unemployment, we may not get someone like Volcker.

I think we shouldn't ignore the probability of inflationary psychology setting in. Here is a commentary from someone's point of view: https://www.barrons.com/articles/inflation-consumer-prices-sentiment-51649268928 . You could choose to decide that the author is not credible, but I think it is still worth a read. Inflation may not happen in each category every month. Even if it is "episodic" in Munger's words, i.e. happens in spurts here and there, it is still inflation. I'm seeing inflation all around, and I'm seeing my own behavior change to be less price-sensitive because my neural net sees money losing its value right in front of it. For example, take lawn mowing. Before covid, you could pay someone $100 to get it done. Now, you get multiple bids over $600, and then folks ask for more after they start the work. Subway prices are about double at least at some locations. I don't pay attention to prices month-to-month, but when I notice a change in prices pre-covid and post-covid, it changes my behavior going forward. How do you change people's psychology to not ask for more, and to not be willing to pay more? Labor supply has to exceed demand by a lot, and that will take a recession. In 1980s, we had someone like Paul Volcker who was willing to cause a recession. Listen to Powell's words - he wants to just close the gap in vacancies and people. I don't think Powell and either party wants to cause a recession this time. In 1970s also, I presume both parties were trying to avoid severe recession, and then we got lucky to get someone like Volcker. This time, don't know how long it would take to get someone like Volcker. I'm not saying for sure that inflation will continue, but I think we will be too naive to ignore the probability that inflation continues.

@bizaro86, I understand this won't apply to you, but hypothetically, between the following two options, my guess is you would pick (b), right? (a) 100% cashflow from owned treasuries, where treasury won't even try to track inflation and (b) 100% cash flow generated from sale of oil from owned long-term oil reserves, where OPEC will at least try to have oil price not lose out big time to inflation for its member-countries

I think case could be made for investing in oil companies to manage your risks, depending on your situation at both extremes, and in between the two extremes: #1. Folks with 0% of their savings in oil companies, and living on fixed income: One of their biggest worries might be whether they will be able to sustain their livelihood with inflation over a long time, especially if high inflation expectations were to get baked in society's psyche, or more money printing were to happen in the future as a result of calamities, e.g. wars, etc. It might make rational sense for them to consider hiring OPEC for free to manage that risk by keeping their cashflow somewhat in line with inflation because OPEC has to do that anyway for its member countries. #2. Folks with 100% savings in oil companies: They would indeed want to worry about the risk of crude going below $50, and try to figure out ways to mitigate that. This is what OPEC is trying to do for OPEC countries with close to 100% of cashflow coming from oil for some countries. By investing in oil companies you get to hire OPEC for free with the understanding that OPEC might not be able to deliver at some moments, but that over long long times, OPEC has been getting better at delivering. If you could pick only one extreme option out of the above two extremes, which extreme option would you pick?

This is what happens when we don’t think in terms of probability ranges and percentages . How about the following so-called conclusions a century ago . “If you wish to improve the environment, you need economic growth (Kuznets curve). For economic growth, you need energy. Today, that means whale oil. It's a bad thing to curtail that.” “If you wish to improve the environment, you need economic growth (Kuznets curve). For economic growth, you need transportation. Today, that means horses and buggies. It's a bad thing to curtail that.”

Reminder of a quote from Buffett in 1979 letter: "One friendly but sharp-eyed commentator on Berkshire has pointed out that our book value at the end of 1964 would have bought about one-half ounce of gold and, fifteen years later, after we have plowed back all earnings along with much blood, sweat and tears, the book value produced will buy about the same half ounce. A similar comparison could be drawn with Middle Eastern oil. The rub has been that government has been exceptionally able in printing money and creating promises, but is unable to ... create oil." Source: https://www.berkshirehathaway.com/letters/1979.html

Unless you invest in an oil company that has long lasting reserves and doesn’t have to spend on exploration

The other thing to keep in mind regarding refineries alone is very significant PP&E replacement in times of inflation. Refineries in the distant past have been better than oil in some years due to stability of refinery earnings, but going forward with inflation, you have to worry about inflated replacement capex with refineries eating up FCF and not have it available for shareholders. That said, case could be made for vertical integration of both oil and refineries to mitigate risks with each, i.e. mitigate risk of oil volatility that comes with oil alone, and mitigate risk of inflated replacement capex that comes with refineries alone.

One framework to think about it would be to pay the price that will give you your required rate of return, say 15%, assuming you could buy the whole company while market is shutdown forever. With the new reality post Buffett and Ajit, assume float has risk of becoming positive cost, float continues to carry risk of regulators/courts rewriting contracts in event of a big calamity that Ajit already admitted to in the last meeting, and that investment returns won't go far. Assume other operating businesses continue to hum along. Even though they will consume FCF to replace big amounts of PP&E, assume that eventually inflation will go down, and FCF will start being available to shareholders. In such a case, FCF yield of 10% could be fairly valued, i.e. on $40B operating FCF, market cap of $400B. Cheaper than that would help you absorb risk of rewriting of insurance contracts, etc. Splitting between 10% and 15%, at FCF yield of 12.5% on $40B FCF, market cap would be $320B. So, you don't want to be paying $613B at today's price knowing that upon Buffett's and Ajit's passing, you probably won't make your required return if you pay today's price.

Right, a lot of the subs are probably on cruise control. So, Sokol’s opinion might be biased because of his viewpoint. Indeed, the big question marks will be the equity portfolio upon Buffet’s passing and the negative float upon Ajit’s passing. Not many insurance companies have both negative float and great investment results without a leader who is great at risk management. So, BRK would be worth less with both of their passings.

Looks like very high certainty that event will likely be happening within the next 5-10 years. How many days/months do we think it will take to reach bottom after that event? What will be the signal then that it has reached bottom at the time? It would be good to get all that thinking done now to be ready.

In case some folks might have missed the news on following. So sharing: https://www.apple.com/newsroom/2022/02/apple-unveils-contactless-payments-via-tap-to-pay-on-iphone/ https://developer.apple.com/documentation/applepaywebmerchantregistrationapi

Visa/Mastercard maybe used underneath currently. The customer is paying by “Apple Pay”. The underlying network can be swapped out or commoditized out after some scale easily.

I have noticed this too. This reminds me of one of the marketing successes of American Express that Buffett has recalled in the past, where AmEx came up with a card with a higher annual fee than the entrenched competitor and it was a success because of human desire for status. Similarly, I wonder which company will help humans achieve signaling status by their payment method. Wonder how that company would do compared to AmEx in signaling status? The business success here is not only from extra price you can charge customers but also from having a relationship with those higher-tier customers who can also be profitable for other services.

If due to inflation, BRK float doubles from $148B over the next 7-10 years, that will be an additional $148B to invest. If BRK can conservatively earn 8% on that money on average, that is an additional $12B in annual earnings. Now, BRK also has about $177B of PP&E that will need replacement, primarily due to railroad and utility businesses. Let's assume that can be funded out of cashflows from railroad and utility businesses. However, overall, that will mean some decrease in free cashflow coming of railroad and utility businesses offset by increase in earnings from insurance float investments. However, all of this assumes (1) float stays negative cost (for which Ajit probably needs to be around), and that (2) money can indeed be invested well (for which Buffett likely needs to be around). So, I think folks also have to be think about potentially having to exit this investment after Buffett, Munger & Ajit are not around, and pay taxes at that time. There might be a drop in price also due to many people trying to exit at the same time. Isn't this about 99% probability event in the next 7-10 years? So, the right price here will need to make your required investment return after taking that taxable event into account.

Thanks @gfp for highlighting. Have you or anyone else done rough math on how BRK’s past returns would be split among (1) Float growth, (2) leverage using float, and (3) returns on underlying businesses/stocks? In times of high inflation in the past, I wonder if #1 contributed a lot on the order of 5-10% but then stopped contributing when inflation went down? I’m asking because float comes with some risk with courts and regulators rewriting insurance contracts in case of a calamity that Ajit alluded to in the last annual meeting, and knowing how much value #1 and #2 add lets us investors decide whether to hold some great businesses (that Buffett has called out to be better than BRK itself) directly or through BRK especially if one doesn’t want to sell and pay taxes on nominal inflation-based growth years after Buffett and Munger are not here.

Did you mean about 10% not 15%?

Thanks @Ulti for sharing the link. Really appreciate it. Please keep sharing. All your links add to my learning as well and in my case, I find that they add to my learning even more if I listen to them critically, and try to poke holes in what they are saying. I just felt at that some moments in the talk, Currie was stating or implying some logical leaps that I didn't agree with even though he was saying them with so much passion.

Is it only me, or does Jeff Currie sound like a snake oil salesman at some points in the talk to anyone else also? How would the futures indexes make you more money if oil price doesn't move much vs. getting cashflow from selling oil even if oil price doesn't move?