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Diversifying against your "natural" capital

Posted: Mon Mar 04, 2019 5:41 pm
by Greenman72
OK. Here's the scoop:
First - a little about me - I'm a CPA in a tax practice and also have a fledgling financial advisory practice. It does integrated wealth management, including advice on estate planning, intergenerational wealth transfers, recordkeeping & payroll, insurance (of all types), etc.

I also happen to live in West Texas, where there are a whole lot of very wealthy people. (As evidenced by this WSJ article. https://www.wsj.com/articles/in-this-oi ... 1551436210) And there are a lot of people making a lot of money on oil and gas--especially now that we are 15 years into a prolonged oil boom.

The problem is--we live in a largely undiversified economy. As oil prices (and mineral interest prices) go, so goes the economy of West Texas. There is no other industry. There is no other buffer or ballast. Oil and gas is all that a lot of people know or understand. And everybody who is rich out here made their fortunes in oil and gas.

Case in point--I met with a kid the other day who just turned 30. He made over $3m last year by trading mineral interests. This year, it looks like he's going to make that again. When I saw that, I discussed some things with him--including estate tax and maybe some ways to move that money out of his estate now, when some of those mineral interests have (relatively) little value.

During our meeting, I tried to impress upon him that he should take some of the gains that he is realizing and diversify into other investments. (You know, like, "Don't put all your eggs in one basket" and all that jazz.) He politely told me that he wasn't interested in that. As soon as he realizes the money, he puts in right back into another mineral property. He doesn't see any risks at all of holding 100% of his wealth in oil and gas properties.

And he's not alone. I get a lot of that out here. People say "what goes down must come up" and "it'll come back. It always does." I had a person the other day who scoffed at somebody who sold their mineral interests in 2009 for a LOT of money (nine figures). He said, "If they had just waited until 2017, they could have doubled the amount of money they made." I retorted with, "Well, had they invested it in an S&P 500 fund, they could have tripled that money." He laughed and told me (in not so many words) that I didn't understand what I was doing, and that the only way to make serious money was in oil and gas.

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I guess my question to the BH community is this--am I off my rocker for telling people to diversify their holdings? I'm not telling them to immediately sell the entire family business and invest the money immediately. But rather, as time goes by, we should try to divest ourselves of it slowly but surely, being selective about the assets we sell and appropriately investing them, mainly as insurance against a drop in oil prices.

Or is it quite possible that I'm giving good advice which will just never be well received? Or am I saying it in the wrong way? Just curious to hear your thoughts.

Re: Diversifying against your "natural" capital

Posted: Mon Mar 04, 2019 5:49 pm
by Greenman72
A couple more things that came to mind:

Yes, I realize how self-serving this is. "Sell your oil & gas that I can't monetize, and invest in in a way that I will get paid on it." That notwithstanding, I still believe that it's good advice.

Also, most people out here don't realize exactly how much they have invested in oil and gas. If the industry goes south, they are forfeiting their current income (in the form of lower production AND lower prices), but they're also foregoing any future capital appreciation. Additionally, any non oil & gas assets that are based in West Texas will certainly plummet (real estate, privately-held businesses, etc.) Not only that, but the entirety of their intellectual capital will be worthless. (Nobody will pay a petroleum engineer when there's no petroleum to be engineered.)

Again, just wanted to hear the thoughts from the community.

Re: Diversifying against your "natural" capital

Posted: Mon Mar 04, 2019 5:54 pm
by alex_686
Greenman72 wrote:
Mon Mar 04, 2019 5:41 pm
I guess my question to the BH community is this--am I off my rocker for telling people to diversify their holdings?
You are not. You are offering sound advice.

First, you might want to read up on behavioral economics and its impact on personal investing. What you are describing is common. Second, consider that you clients may actually have some special skill they they can exploit. I would never recommend that somebody become a professional poker player, but there are people with the skill out there to succeed and that they need to have some of their own capital in the game. The same is true of your local dentist - just a less extreme risk profile. Between that you should be able to find a starting point.

I am sure there is professional guidance to inform, educate, or - worst case situation - help minimize the impacts. I worked in wealth management and we have stuff like this. Unfortunately most of the specific stuff that I know of is restricted for general distribution.

Ultimately, your job is to advise - and your clients are free to ignore your advice.

Re: Diversifying against your "natural" capital

Posted: Mon Mar 04, 2019 5:55 pm
by z3r0c00l
Yes of course, if I were lucky enough to earn millions a year, I would make sure that most if not all of it was in a safe place including cash/bonds/stocks/and a home. Since 3 million is nearly enough to live on for the rest of his life, it just makes sense to have that security in place. Then he can gamble with the rest.

Re: Diversifying against your "natural" capital

Posted: Mon Mar 04, 2019 7:23 pm
by megabad
This seems to be normal human nature. People have a tendency to invest in what they believe they know. This tendency illustrates itself through people investing in their own companies stock in retirement plans (very common). Also is rampant in the casual real estate investor community (where sometimes nearly 100% of NW is in a few individual real estate properties).

The problem is that you are generally assuming you know more than the market and that you will continue to know more in perpetuity. This is quite an ambitious (risky) position to take, but the rewards may be high if it holds true. I am not willing to stake my livelihood for 30-40 years of retirement and that of my family on gambling that I will always know better than the market. These folks are. Sometimes I think lessons like these are best learned through experience. Unfortunately, I have learned over time that I am not able to consistently predict the long term performance of the oil market, the real estate market, or the stock market.

Re: Diversifying against your "natural" capital

Posted: Mon Mar 04, 2019 7:59 pm
by Raymond
Perhaps you could mention the diversification as similar to that necessary for a professional athlete - several years of very high income, but the possibility of that income stopping due to injuries, etc.

The analogy here being the possibility of oil and gas prices tanking for long periods of time - if your clients have other funds, then they can weather those drops.

Keep on recommending diversification, and document that you did, so no one comes back saying, "But you never told me to do that!" :annoyed

Re: Diversifying against your "natural" capital

Posted: Mon Mar 04, 2019 8:10 pm
by delamer
You are giving good advice, but your audience isn’t likely to accept it.

It is like going to a cattle ranchers meeting and tell them that people need to eat more vegetables. Any objective observer is going to agree with you, but no one at the meeting wants to hear it.

Also, certain personalities are attracted to boom-or-bust industries and that works against someone like you preaching diversification.

Good luck.

Re: Diversifying against your "natural" capital

Posted: Mon Mar 04, 2019 10:52 pm
by Afty
"It is difficult to get a man to understand something, when his salary depends upon his not understanding it.”

Re: Diversifying against your "natural" capital

Posted: Tue Mar 05, 2019 7:16 am
by riverguy
If oil and gas are tanking, the stock market is going to follow. It's pretty clear that demand for oil is directly related to economic activity. Stock market vs oil and gas is not as much of a diversification as you think it is. There's no near term replacement for oil and gas. It's not going anywhere anytime soon.

Perhaps you have a little jealousy of these people and their success?

Re: Diversifying against your "natural" capital

Posted: Tue Mar 05, 2019 9:23 am
by Greenman72
riverguy wrote:
Tue Mar 05, 2019 7:16 am
Perhaps you have a little jealousy of these people and their success?
Oh, there's no doubt about that. I did a tax return for an O&G partnership last week. Guy moved to West Texas from NYC in 1962 and started buying mineral interests. Those mineral interests started producing minerals, and some 57 years later, they made $15m in net revenue between the 25 partners. (Great-grandkids and what not.) So these people are cashing checks of anywhere between $200k and $1.4m, and they did absolutely nothing to earn that money--they just picked their great-grandpa wisely. (Believe it or not--this is fairly common out here.) But that's neither here nor there.

I'm curious about your first paragraph. Why do you think a standard 60/40 portfolio would not be a good diversifier? And what makes you think that oil & gas has long-term viability? I believe that there are too many social, political, and economic forces moving against petroleum to make it a good long-term investment. I think that 30 years from now, it will be a fraction of what it is today.

Re: Diversifying against your "natural" capital

Posted: Tue Mar 05, 2019 11:50 am
by megabad
riverguy wrote:
Tue Mar 05, 2019 7:16 am
If oil and gas are tanking, the stock market is going to follow. It's pretty clear that demand for oil is directly related to economic activity. Stock market vs oil and gas is not as much of a diversification as you think it is. There's no near term replacement for oil and gas. It's not going anywhere anytime soon.

Perhaps you have a little jealousy of these people and their success?
Like OP, though I am jealous of their success (in the same manner that I am jealous of Powerball winners or folks born with a silver spoon), I would refer you to history if you believe that oil and gas prices are directly linked to stock market performance. I can refer you to specific periods in the 80s and more recently just a few years ago where crude and NG valuations were almost exactly inversely correlated with the stock market. Owning a broad stock market index is academically unquestionably more diverse than owning individual mineral rights. Whether its performance will be better or worse is not clear.

Re: Diversifying against your "natural" capital

Posted: Wed Mar 06, 2019 1:20 pm
by Greenman72
^It occurred to me that you may be mistaking "publicly traded oil and gas stocks" for "privately owned oil and gas royalties and mineral rights".

While I don't have any idea how to value mineral interests and royalties, I imagine that their return would be vastly different from the S&P 500 (or whatever other market index you want to use).