Introducing Numbers, not Narratives.
First in a series of posts introducing my risk management process for energy cycles, driven by data.
Engineering to Investing
First, a brief introduction to my background. I am an engineer by education (petroleum engineering) and an investor (private equity) by training. I have been fortunate to work with some of the smartest people in the energy industry on both the operations and finance side of the business. Those interactions have helped shape my investment process into what it is today. At the heart of that process is data. I love numbers and am fondly referred to as a “data junkie” in our office. Every investment or capital allocation decision I make is anchored in what the data is saying. Narratives without data are often constructed as reasons to make an investment, or capital allocation decision. I have found that “process” to be ineffective at best, and counter productive at worst. This first post will focus on high level background information for my investing process, and what I expect to achieve with this newsletter.
Rule 1: Don’t Lose Money
My goal with this newsletter is to provide a new way to risk manage cycles within the energy markets through the lens of data and probabilities. Risk management is most apparent for protecting capital at a portfolio and corporate level, but is just as critical at a personal level with respect to one’s career and livelihood. The most important lesson I have learned in investing is from the Oracle of Omaha:
“Rule No. 1: Never lose money. Rule No. 2: Never forget rule No.1” - Warren Buffett
My content is intended for anyone interested in the energy industry, from field personnel and C-level management teams, to investors looking to put capital to work in the space.
Energy fuels world
I use the term energy, because I will cover the entire energy sector (including, but not limited to) crude oil, natural gas, refined products, renewable energy and associated auxiliary services within each of those areas. Content will be broken into three categories:
1) Fundamental analysis - everything in the the supply/demand equation for energy, such as crude oil and natural gas production/consumption, mobility, GDP, inflation, commodity storage, and many more data points.
2) Market analysis - data points impacting commodity and equity prices, such as rates (2YR/10YR treasury yields), currencies (US Dollar, Euro, Yen, Franc, etc.), equity volumes, positioning and volatility.
3) Equity analysis - equity analysis for publicly traded companies in the energy sector relying on the fundamental/market setups.
Data Driven Process
Investing is a long-term game, and the down cycles in energy can make the long-term picture very difficult to see at times. Flashback to mid-2020 when the world was never going to use oil again, or late 2000’s when we would run out of oil. Enter my data driven process. I combine fundamental, market and company analytics to minimize drawdowns and maximize risk adjusted returns. This applies to both investing for public equities, and capital allocation decisions for C-level management. In its simplest form, my process is multi-factor, multi-duration with Bayesian Inference at the core.
Fundamental Cycles
The fundamental cycles are driven by commodity supply/demand dynamics, and economic cycles (U.S. and Global). This is where I start when building an investment idea, or capital allocation decision. Over the long-term, fundamental data drives markets. One of the main tools I utilize to understand where we are in these cycles is the rate of change of the underlying data. Newton long ago showed us that we can predict where an object is going if we know its initial position and initial velocity. While this is incredibly difficult to apply directly to everchanging fundamental data, the concept provides a framework to probabilistically determine where the cycle is going. Additionally, like in the physical world, momentum can also be observed in fundamental data and is a concept I incorporate into the process.
Markets
The next steps is to understand what the market is “saying” about the current economic, or commodity cycle. Volatility is a key input in this analysis, and one I will cover repeatedly. My reliance on market data is where I start to deviate from traditional fundamental analysis in energy markets. The market is an incredible discounting mechanism, and often presages moves in the fundamental data. These moves can be head-fakes, and is why I utilize market data as a part of the whole process (not in a vacuum!). Dislocations in markets relative to fundamentals should be seen as opportunities to generate incremental returns, while others wait for fundamental data to prove/disprove their view. This is a very detailed/robust piece of my process, and one I will spend significant time covering.
Equities
After I have built a data driven view on the fundamental cycle and market regime, I turn to equity analysis to determine the best way to express those views. For investors, this is where the rubber meets the road (long/short equity ideas and commodities exposures). For companies, this is where capital allocation decisions are made (balance sheet management, capex budgets, hedging decisions, etc.). Over the course of my career, I have helped build numerous businesses from the ground up in the energy industry. This “inside view” has provided me a unique perspective that can take an entire career for traditional equity analysts to develop. It has also led to a significant network of professionals in the industry, who are much smarter than me in their respective areas.
Transparency and Accountability
My process is continually evolving, and I will change my views when the data changes. This is a difficult concept for those who take a more dogmatic approach to investing and capital allocation decisions. I will always admit when I am wrong, and work as diligently and expeditiously as possible to determine the best path forward. One thing I pride myself on is never deleting any tweets. I have found this adds an element of accountability that enhances my overall process.
Onward and Upward
This is the first post in a series that will cover my overall process. The remaining posts will be uploaded over the course of the next two weeks. Those are primarily to familiarize new subscribers with my process. The rest of my content is a real-time look at the various components of my process and how I am making investment/capital allocation decisions. I frequently post on twitter and am always open for a discussion.
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Disclaimer: This is not investment advice. All of the views are my own, and not representative of Donovan Ventures, LLC or Energy Founders Fund, L.P.
Great! Numbers drive the Process and Process drives the Results.