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Beware Oil

It's a truism that prosperity breeds bad management, and that extended prosperity breeds exceedingly bad management. Example A: Bethlehem Steel (Ticker: PAWS.UP). The legendary CEO of the company used to send people ahead each morning to make sure he wouldn't have to share an elevator. Eventually, the elevators stopped running altogether. Finally, when USX faced bankruptcy, a bunch of mini-mills in the South figured it out and started delivering high-quality, low-cost steel again. A couple of years ago, the leader of the rebellion, Nucor, itself ran into some management problems, opening the door for dozens of others.

It's hard to imagine a set of American companies more victimized by their own success than oil. The automakers learned this less in the late 70s and early 80s, and today's problems are more failures of imaginarion than anything else. But the oil companies, small and large, have a history of making terrible mistakes and then getting rescued by some international crisis or large expanding economy.

Historically, the worst of those mistakes has been over-investing at the peak of the cycle. Anyone from Colorado or Wyoming can tell you about boom-and-bust, and it's a mentality that oil and gas has never seemed to get under control. Right now, they seem to be making the same mistake yet again. I'm not talking about the strike in the Gulf. That kind of exploration has a life cycle of decades. I'm talking about the smaller companies that are now running cash flow deficits because they're looking at the forest and seeing

It's not exploration, which would make sense. It's actual free cash deficits in the face of rising returns, which happen because a company is spending more on its capital investment than its getting from ongoing operations. It's the sign of an expanding supply to meet demand, but it's also risky to plow this money in at the top of the curve time after time. Many of these wells are only profitable at high prices, and when oil prices drop - as they seem to be doing now - a lot of these smaller companies are going to be left with expensive, unprofitable, and idle equipment.

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