The strongest argument an experienced director can make against buying energy assets at the bottom of the cycle, and where it leaves me

The best case against buying at the bottom of the cycle was made to me by a director who had done it twice and regretted it once, and I want to give it in something like his own words before I answer it, because the slogan on the other side has had all the airtime.

His case runs like this. You do not know it is the bottom. Nobody does, and the people who say they do are the ones who were wrong the last time and have forgotten. What you know is that the price has fallen and the assets are cheap relative to last year, and cheap relative to last year is a comparison with a number that no longer exists. Second, the assets that are for sale at the bottom are for sale for a reason, and the reason is usually that the seller has to sell, which means the diligence is rushed, the records are a mess and the people who knew the business have already left. Third, the buyer at the bottom is buying with money raised in the good years, from investors who expected it to be spent in the good years, and every dollar spent at the bottom is a dollar that cannot be spent at the lower bottom that may follow. Fourth, and this is the one he cared about most, a company that buys at the bottom has to run what it bought through the rest of the bottom, and the rest of the bottom can be three years long. The cheap asset is a cheap asset with a payroll, a yard lease and a customer list that is shrinking, and the buyer has taken on all of that on the day the market stopped paying for it.

That is a serious argument, and I have watched it come true. The company that bought the rival’s equipment in the second year of a downturn, at a fraction of replacement cost, and then paid to store it and insure it and keep it certified for two more years while nobody called. The acquisition that closed in the fourth month of a decline, on financials that were accurate for the prior year and fiction for the current one. The fund that spent its dry powder in year one of the downturn and had nothing left in year two, when the prices were lower and the sellers more desperate. None of those were foolish people. They had all read the slogan.

What is right in the case

The director is right that the bottom is unknowable, and any argument for buying that depends on knowing it should be discarded. He is right that distressed sellers deliver distressed information, and that the ordinary diligence process, which assumes a cooperative seller with a functioning back office, does not work on them. And he is right that the cost of carrying an asset through a long trough is real and is almost always underestimated by a buyer who has just been told the price.

I would add one thing to his case that he did not say. A buyer at the bottom is often buying from someone he knows, in an industry where everyone knows everyone, and the price he pays is a price the seller will remember. Cheap is expensive in a small industry if it costs you the next deal with the same family.

What survives it

What survives is narrower than the slogan and, I think, still worth holding. The case against buying at the bottom is really a case against buying because it is the bottom, which is a different thing. The purchases I have seen work in a downturn were not made on the price. They were made on a specific fact about the asset that was true at any price: a customer contract with years to run, a crew that had stayed together, a yard in the one basin where activity had not stopped, a piece of equipment that the buyer’s own customers were already asking for. The downturn did not create the reason to buy. It created the opportunity to buy for that reason at a price that made the reason sufficient. A buyer who can state the reason in one sentence without mentioning the cycle is a buyer I would back. A buyer who says the assets are cheap is a buyer I would ask to come back with the sentence.

The second thing that survives is about time rather than price. The director’s fourth point, that the buyer has to run the asset through the rest of the bottom, is an argument for buying only what the buyer can carry without the market’s help. That is a constraint on the size of the purchase, not a prohibition. A company that buys a rival’s best crew and one customer contract can carry that through three bad years on its own cash. A company that buys the whole rival cannot. The mistake in the cases I described above was scale, and the slogan encourages scale because a bigger purchase at a bigger discount looks like a bigger win.

Here is where I part from the director, and it is the position he would still argue with. He concluded that a private company should hold its cash through the trough and buy on the way up, when the information is better and the sellers are calmer. I think that waits too long. The information is better on the way up because the sellers no longer have to sell, and the price reflects that. The window in which a specific, nameable reason to buy is available at a price that makes it sufficient is the window in which the seller is under pressure, and that window is at the bottom, or near it, and it closes fast. The discipline is in the reason, not in the timing, and a buyer who has the reason should act on it even when nobody can tell him where the bottom is.

Where my position breaks is that I cannot tell you in advance which reasons are real. A customer contract with years to run can be terminated for convenience in a clause on page nine. A crew that stayed together can leave the week after closing. I have bought on a reason that turned out to be a hope, and the director’s case was correct about that purchase in every particular. The narrowed position does not protect against being wrong about the reason. It only protects against buying without one.

So I will not buy because it is cheap, and I will not wait for the recovery to prove it is safe. I will buy when I can write the reason on one line, and carry what I bought without asking the market for help, and I will accept that some of those lines will turn out to have been written in the wrong ink.