Is Warren Buffett wrong about oil stocks?

April 6, 2015 10:10 AM

To achieve success in this sector, you have to buy oil and gas stocks when they are out of favor and the price of oil or gas is at a multi-year low. In 2009, the price of ConocoPhillips reached a low of $35 a share, and in 2014, it reached a high of $80 a share. If Warren had purchased ConocoPhillips in 2009, and not 2008, it would have been one of his greatest investments ever. 

Buffett's most successful oil investment was his railroad company Burlington Northern Railroad. This is considered an oil investment, because this rail road company transported oil from the Bakken to its refiners. Since 2009, Berkshire has collected more than $15 billion in dividends from Burlington Northern Railroad, while its annual revenues have increased by 57%, and its earnings have more than doubled. 

The main reason his investment in Burlington Northern Railroad was successful, was due to the fact that he made this investment during the 2008 crisis, when prices were low. This Buffett quote explains the success of this investment perfectly, "Be greedy when others are fearful and fearful when others are greedy." This company also fits the Buffett investing mantra of buying stable, boring, and predictable businesses, with steady cash flows.  

Other notable oil investments include Suncor and Phillips 66, which he has recently added to his already existing positions. 

As you can see based on past history, Buffett's success in the resource sector has been a mixed bag. To understand why his success has been a mixed bag, you have to first fully understand Buffet's investing philosophy, and then fully understand the resource sector as well. 

In order for Buffett to buy a stock, the company has to pass this set of criteria: high margins with a low amount of debt (it doesn't take a genius to run them); strong franchises and freedom to price, with predictable earnings. This set of criteria sounds great when investing in a consumer goods business, but when investing in the resource sector, it's almost impossible to achieve. Look at this chart below. 



The energy industry has higher capital spending requirements than other industries. To be successful in the resource industry, you have to readjust your investing strategy so you're able to succeed in a high capital spending environment. This also means you have to be comfortable with companies possessing higher amounts of debt and lower margins than what you are normally accustomed to.  

Another Buffet criterion that won't be fulfilled when investing in the resource sector is buying franchises that have the freedom to price. When it comes to oil and gas, this commodity is traded on exchanges all over the world. Exchanges, which speculate on world production and consumption, are the only things that influence the price of oil and gas. 

Lastly, when trying to fulfill his criterion of "not needing to be a genius to run it", this is impossible when trying to grow, or maintain oil production. Running an oil and gas company, requires numerous amounts of geoscientists, chemical engineers, mechanical engineers, and petroleum engineers to maintain or grow the business. 

Buffet's successes in the resource sector demonstrate that you should buy when prices are low, the sector is out of favor, company cash flows are still stable, and companies are selling for less than its book value. 

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About the Author

John Manfreda, http://oilprice.com