This note was originally published at 8am on December 19, 2014 for Hedgeye subscribers.
“From the elevation of retrospect we can see it all coming together more clearly and sooner than those who were there and running.” - Norman Maclean, Young Men and Fire
On August 5, 1949 fifteen young men parachuted out of a C-47 transport plane to fight a wildfire in the remote forests of central Montana.
It was the dead of summer in the middle of an extreme heat wave. On the day of the jump it was 97 degrees, then the hottest day on record in Helena, Montana. The fire danger rating was 74 out of 100, which meant “explosive potential.” It was so windy that the turbulence onboard the plane caused one of the men not to jump, return to the base, and immediately resign. The men that did jump landed on a steep slope in Mann Gulch that was covered in dry, knee-high grass…
Within two hours of landing all but three of the “smokejumpers” were dead.
What happened in Mann Gulch that day was one of the greatest disasters in US forest-fire fighting history. The lessons learned from the tragedy had a significant effect on how the US Forest Service fought wildfires for years to come.
I think of wildfires a lot like I do investment research, in that the identification and understanding of an unstable system is the primary goal. A wildfire occurs because existing conditions allow it to: the forest is dry, it’s hot, it’s windy, and there hasn’t been a fire in a long time. As conditions become more extreme, the probability of fire increases. So, as a fundamental analyst, I try to figure out where the hot, dry forests are before everyone else does, and before they go up in flames.
The instantaneous cause of the wildfire – the “catalyst” – is a secondary concern, and often, unpredictable. If the forest is dry and hot enough, any small spark can set it ablaze, at any moment. Will it be an irresponsible campfire? A bolt of lightning to a dead tree? A cigarette butt thrown from a car window? It doesn’t really matter because the result is the same, the forest burns down.
Didier Sornette, an expert on financial crises, summarizes the point:
“...a crash occurs because the market has entered an unstable phase and any small disturbance or process may have triggered the instability. The collapse is fundamentally due to the unstable position; the instantaneous cause of the collapse is secondary. Essentially, anything would work once the system is ripe… a crash has fundamentally endogenous, or internal origin.”
I don’t spend a lot of time trying to forecast what I’m ill-equipped to forecast with a high degree of confidence. I don’t know when lightning will strike. But I can put forth investment ideas that are based on sound data and reasoning, and are likely to work under various assumptions and scenarios. And when the spark is set, I am prepared and well-positioned.
I’ve written about no company more than LINN Energy (LINE, LNCO) over the past two years because I thought that the system was extremely unstable. The basic story has always been the same – the company makes no real profit, but dividends out $1 billion per year, which it pays for via serial debt and equity issuance. As I saw it, it was highly likely to end disastrously. The pushback was consistent, “There’s no catalyst.” This was not a good idea, I was told, because there wasn’t a lightning storm in sight…
…And then the price of crude oil tumbled from $100 to $55 per barrel, prompting more investors to doubt the sustainability of LINN’s business model, and sell. The prices of LINN’s stocks and bonds plummeted quickly; in just three months LINE and LNCO fell 60%, and the unsecured bonds lost 25 points. The “catalyst” is now clear, as it always is in retrospect. It was the oil price collapse, though it easily could have been something else: a failed acquisition, an SEC enforcement action, a rise in interest rates, another leg down in the natural gas price, or something else I never even considered.… It doesn’t matter – we were well positioned for any small disturbance to trigger the instability.
Our latest energy investment idea is an unstable situation of a different kind – and this one we like on the long side. Natural gas pipeline MLP Boardwalk Pipeline Partners LP (BWP) trades at a 50% discount to its peer group because it doesn’t dividend out all of its cash flows. Investors are still sour from the February 2014 distribution cut – which we called for in advance – and have not recognized the positive turn that BWP’s business took this year. In our view, this is an unstable system waiting for a trigger to re-rate the stock higher... (Ping us if you’re interested in learning more about our work on BWP.)
What else in the financial world is at risk of going up in flames? Like the Mann Gulch disaster of 1949, it’s not always easy to recognize an unstable system for what it is… Are you prepared and well positioned for the lightning strikes and errant campfires that will invariably come?
Our immediate-term Global Macro Risk Ranges are now:
UST 10yr Yield 2.03-2.23%
Oil (WTI) 52.02-58.32