This is the second installment of a three-part series where we review the Insider portfolio, our views on the themes, and ways of expressing those views.
This is a reference where subscribers can quickly gain an understanding on:
- sectors where we have a bullish or bearish view,
- the reasoning behind our views,
- how to apply those views and,
- any changes to the trades in the alerts.
We’ll be reviewing our oil trade alerts in this report.
Yip, just offshore oil, because it is a very big topic and we want to do justice to it. The truth is we began preparing this this report with the intention of covering much more than just oil until we realised that you didn’t want to read War & Peace, and so it’s just going to be focussed on oil.
We’ve tried to keep this review short and straight to the point. We want you, our client, to quickly come away with a clear concise understanding of our views. That way you can make better judgement calls with your own capital and how you manage it.
We want to reiterate to subscribers that these are long-term views (5+ years). It is easily both the toughest thing to do as well as the most sensible we can think of.
There is no way we, you, or anyone without at the very minimum a few hundred million Benjamins can compete with the algos who are extremely concentrated in multiple variations of technical analysis trading, down to split seconds. This dynamic has led to the growth of what is referred to as “passive capital” and an entire fund management industry, which, to this day, steadfastly tries to compete, only to be forced to benchmark and trend follow. It’s not an area we have ANY competitive advantage in, nor is it one we’ve therefore ANY desire to even try.
As a consequence, we’re not concerned with shorter-term volatility, though we note that this is exactly where everyone is focussed. This doesn’t mean we don’t recognise that there is likely to be a lot of volatility in some of these trades.
That is both a consequence of the nature of these deep, out-of-favour sectors and the collapse in volume that tends to accompany most any sector left for dead, as well as the inevitable volatility that occurs when massive pools of capital move from one area to another because algos’ technical levels have either broken some key level beginning a feedback loop, which itself brings on forced selling. If you’re unfamiliar with it, just go read my buddy Kuppy’s explanation on this topic here and the follow up here.
We are constantly asked, “what exposure should I take?”
Now, obviously we can’t manage people’s portfolios for them, but our guidance is that for individual stock trades a maximum of 1% exposure and to sectors up to 5%. Bear in mind this is a rule of thumb and by no means anything but that.
When to take profits?
We haven’t any prescribed profit targets. However, in general, once the theme/sector starts to gain widespread acceptance amongst the investment community, we will be phasing out of the trade.
In essence, we aim to buy in pessimism and sell in optimism. This isn’t to say we’re not cognizant of typical valuations metrics, but it is to say that they come together with the zeitgeist. Take a look at say the valuations of ridiculous companies such as Tesla, WeWork, and Netflix and you’ll understand where we’re coming from.
So… our thinking on offshore oil.
Our trade alerts on oil:
The SPDR S&P Oil & Gas Exploration & Production ETF (XOP) — 5 September 2017
- stock — 19 March 2018
- warrants (July 2023 expiry, 62.28 strike, 1:1 ratio) — 19 March 2018
- warrants (November 2024 expiry, 100 strike) — 19 March 2018 (note these were the old Gulfmark warrants which converted to Tidewater on the merger)
Seacor Marine (SMHI) stock — 19 March 2018
- stock — 13 August 2018
- warrants (February 2023 expiry, 4.02 strike, 3:2 ratio) — 27 August 2018
We most definitely want to keep Tidewater, Seacor, and CGG. However, we want to replace the SPDR S&P Oil & Gas Exploration & Production ETF (XOP) with more specific trades targeting the offshore sector, namely:
- Ensco: offshore drilling
- Subsea 7: offshore engineering
- Helix Energy Solutions: remote operated vehicles (ROVs)
- Saipem: offshore drilling, construction and engineering, offshore pipeline laying
We have talked about these trades enough in the Big Five and now is an opportune time to put our money where our mouth is.
We believe that there is far more upside by focusing on the offshore oil service sector rather than the average oil and gas exploration and production stock. Note that the SPDR S&P Oil & Gas Exploration & Production ETF holds about 40 oil and gas exploration and production stocks with more or less an equal weighting, alongside a number of significant interests in shale oil operations, which we want exposure to in the same way as we want exposure to radiation poisoning — none.
We will talk about these changes towards the end of this report.
Our View on Offshore Oil
A picture of calm serene seas to kick it off.
Or is any one of these more appropriate?
I think the three pictures above are more appropriate because they convey current sentiment towards offshore oil.
It is either going down in flames or slowly drifting away. Either which way. The market is pricing offshore oil as if it won’t be a functioning industry 5 years from now! Not just smaller, less significant but gone. Finished. Over.
This impresses us as pretty darn low on the probability spectrum.
Remember, some 30% of oil consumed globally comes from offshore sources. We believe that this will continue to be the case 5 years from now!
Here is our thinking…
The great 2014 to 2016 bear market in oil pushed prices from $107 to $27 in less than two years. This plummet wreaked havoc on capital investment in the oil and gas industry.
Demand for oil has been rising by over 1 million barrels a day per annum for the past half century, and it is expected that this trend will continue for the next decade at least.
The other thing I’d like to mention, even though I’m sure you’re aware of it, is that oil projects are massive. They take considerable time, resources, and planning. They take permits, hundreds of people across multiple jurisdictions, and truly huge amounts of capital to develop.
Oil doesn’t come from simply turning on the taps. Projects generally take many years to go from an idea to a fully functioning production. Many of the projects online today were the result of planning and investment that occurred well before the 2014 bear market.
Now, here is the big “problem”. There was over $1 trillion worth of investments (for future production) destroyed in the recent bear market (projects that should of happened but were shelved). There were 25% reductions in investments in 2015 and 2016 and increases have been trivial since (a miniscule 6% increase in 2018 despite the bull market).
And the collapse of oil prices late last year is not helping convince companies to pour vital resources into planning for production of say a large offshore project today, certainly not while prices are at below $50 a barrel.
Companies are electing to invest ever smaller amounts of capital into short term/quick turnaround projects instead of large projects (of the offshore variety). What Chevron is doing is typical of many of the big oil majors:
As discussed above, the world needs to add over 1 million barrels per day to meet demand increases. However, it also needs to add 3 to 4 million barrels per day to just to replace the wells that stop producing due to their age each year. This all underscores the importance of investments in the industry to ensure no future supply shortages. And though it’s important, it’s not been taking place.
According to Rystad Energy, the world is currently at its lowest level of oil discoveries since the 1940s and discoveries have fallen every year since 2014 (when oil prices collapsed). Their estimates suggest shortages in less than a decade, and our research indicates that this is conservative.
You could ask the obvious question. Will shale oil ride in on its white horse to save the day?
The world is certainly putting a helluva lot of faith in shale (namely the Permian basin) to make up for any shortfall in conventional oil and gas production:
But as we’ve pointed out many times in the past here at Insider, shale may not be the miracle that everyone perceives it to be.
We have a situation where most companies whose focus is primarily on production from shale oil sources have never made any profits or been cash flow positive. And that is even when oil was north of $50, much less in the $40s. There is a popular narrative that shale is profitable at $50+ WTI. And yet we’ve absolute 100% certainty this is complete nonsense.
In the first half of 2018, when oil was well above $60, less than one third of shale companies had positive free cash flow. Many of these shale companies actually had cash flow issues when oil was over $100.
The US shale industry has survived and increased production on the back of adding immense levels of debt (hello, junk bond market) and from issuing equity, NOT from free cash flow.
This was an approach that depended on low interest rates and high risk appetites, which, as we’ve pointed out here before, was the result of global investors thirst for yield in a yield starved world.
We are willing to bet that this will not end well. And we’re not the only ones who’ve run the numbers and come away scratching our collective heads.
Kallanish Energy Consultants say there is $200 bn in shale debt that matures by 2023. If shale companies have to attempt to roll their debt at higher (perhaps much higher) rates in the next few years, it is easy to imagine a situation developing in the shale industry where not only is this financing market completely shut to them, which is as obvious as mud, but ultimately less production.
In fact, we anticipate a wave of bankruptcies due to the higher cost of servicing debt, coupled with companies that have survived on stupid equity investors willing to pay up for “increased production” even while it’s come at an operating loss.
If you run the math on the production levels and oil prices needed for shale companies to pay back their debts and to roll over their debt loads at higher rates, it is not pretty for the industry, especially when considering the production decline rates facing the industry.
Perhaps we have already seen peak production in US shale? I’m not smart enough to know, but what is clear is that shale oilers are having a battle to get financing now.
Seems like shale oilers will have to live within their means.
If this is so and a significant amount of production was not economic, then perhaps what Harold Hamm has to say isn’t such a wild guess:
Continental Resources’ Harold Hamm said that shale growth could decline by as much as 50% this year compared to 2018, OilPrice reported. Hamm said that a lot of shale E&Ps are trying to keep spending within cash flow. This newfound mantra of capital discipline has been imposed on the shale industry after a decade or so of a debt-fueled drilling frenzy.
“Producers have become more disciplined in their approach to capex,” Hamm said at the Argus Americas Crude Summit in Houston this week. “Several years back growth was a huge consideration. That consideration has been much less. The peak consideration now has been — are you overspending cash flow. Are you living within cash flow?”
So if we’re right that shale production will likely face serious trouble within the next few years, what does that mean for oil overall?
It’s a great question and one we’ve given a lot of thought to here.
The US is now the largest oil producer in the world and shale is more than half of that production. So nearly half of the production in the largest producing nation is cash flow negative for more or less the entire last decade. Think about that.
There is a reason for all this insanity, of course. This was all possible because interest rates have been an inch above 0% for a long time and investors were desperate for yield. Thank you, central bankers. Misallocation of capital is your bedfellow.
Consider that a massive industry of great domestic economic importance as well as global geopolitical consequence has been and continues to survive on the capital of foolish investors while bleeding red.
Oil production has nearly tripled in the US, which has neatly coincided with a decade of low interest rates. Funny that!
Shale has produced a number of large producers who quite simply cannot and do not make money. But that hasn’t stopped them from achieving ever higher market caps.
The question any sane investor must ask themselves is this, what happens to that production if/when rates rise? Probably not too hard to figure out and all indications are we’re at that inflection point now.
Chatter Behind the Scenes
Here are a few “thoughts” that the mainstream isn’t taking too much notice of.
And the Permian Basin, in addition to being rather unsightly, isn’t a region especially blessed with water.
So where is all that water going to come from to produce all the oil that is expected from the Permian?
I’ll be fracked if I know.
In any event, the point is the costs associated with drillers getting their hands on it is not currently being factored into investors equations when investing in the shale industry.
There is, of course, another side to the water coin that needs addressing. Namely the costs associated with disposing of all that toxic water that comes out of the well with the oil, otherwise known as “produced water”.
Produced (toxic sludge) water is already a huge issue for the industry.
Most problems are solvable but rarely at little to no cost.
Obtaining water in the first place and then getting rid of it will add significant costs to each barrel produced in the Permian (and other fields in general).
More often than not booms come to an end for reasons that no one really gave much thought to. Which is simply part of human nature because let’s face, it if we bipeds had thought about it enough in the first instance, there probably wouldn’t have been a boom in the first place!
And what of earthquakes? Poor old Oklahoma!
You may recall from one of our Insider Weekly issues where we highlighted this issue previously and showed what took place in the land where the people are high and the country is low, the Netherlands.
Onshore fracking in the Netherlands was closed down last year due to significant rises in seismic activity.
Now, I like the Dutch very much, and not just because of their relaxed attitude to sex and drugs and overall tolerance, but because when you travel to Europe, the Netherlands, beside being really quite boring to look at, it’s evident that the place is very grown up. It’s as if the folks running the show actually have a brain and so you see policies that actually make logical sense. And so it’s no surprise to me that they canned this project when the land began opening up and swallowing people.
Fracking at the level it’s being done in the US is still relatively new and the unintended consequences may well prove to be a far larger issue than anyone currently is pricing. And bare in mind this is while the industry as a whole bleeds like a gutted boar.
Will the “collateral damage/costs” or unintended consequences be linear or non linear in nature?
We don’t know but what we do know is that this industry is priced to perfection, and none of the issues we’re discussing here have are being looked at by the men in suits who flog this stuff as “investment grade”.
And what about all the “proven reserves”? Investors have been led to believe that Permian Basin has an “endless” supply of shale oil.
Just look at this:
The USGS estimates that over 46 billion barrels of oil, 280 trillion cubic feet of gas, and 20 billion barrels of natural gas liquids are trapped in these low-permeability shale formations. To better understand just how staggering these numbers are, think about this: at the end of 2017, total U.S. proven reserves of crude oil hovered around 40 billion barrels. For natural gas, figures stood around 465 trillion cubic feet (tcf). The new upward revision of Permian resources represents a more than 100% and 65% increase in U.S. oil and gas reserves, respectively, if they can be extracted economically.
“If they can be extracted economically”… and that is the only reference to economics, but it is also the only one that matters.
Apparently there is an isht ton of gold lurking down in the depths of the ocean floor… more than we can imagine. The problem, of course, is that not even Bond in a car invented by Q can get to it, so there it will stay.
This is classic sensationalist journalism that was never vetted by the reality department. Truth be known that these “reserves” have been known for a long time and it will cost some figure well north of $100 barrel just to extract.
This pixyland thinking is what happens during booms. Few stop to question if the popular narrative is on planet reality.
Hmm, something tells me that we should be a little wary of these reserve estimates.
Often what happens during a boom is that estimates of resources get way over exaggerated because no one is forced to take a good hard look at assumptions.
Remember housing in 2005, 2006, and 2007? You could have thrown out the most ridiculous nonsense (and many did) and nobody blinked an eye. Why? Well, because they’d been making money on the gig, just as those invested in shale have. That is, until now.
We doubt that production will be in the region as to what shale oilers are forecasting. Already there are industry warnings for those who are prepared to listen. The CEO of Schlumberger has been quietly sounding warning bells. Some really interesting comments from him from Schlumberger’s fourth quarter earnings call:
Conversely for the North America land E&P operators, higher cost of capital, lower borrowing capacity and investors looking for capital discipline and increased return of capital, suggests that future E&P investments will likely be at levels much closer to what can be covered by free cash flow.
It is likely that the E&P operators would gradually lower drilling activity and instead focus investments on drawing down the large inventory or drilled uncompleted wells. This approach would still drive production growth from U.S. land in 2019, but likely at a substantially lower rate than the 1.9 million barrels per day seen in 2018 and potentially with a further reduction in the growth rate in 2020.
It is also worth noting that with the continued growth in U.S. shale production, an increasing percentage of the new wells drilled are being consumed to offset the steep decline from the existing production base. The third party analysis shows that in 2018, this number was 54% of total CapEx and is expected to increase to 75% in 2021, clearly demonstrating the unavoidable treadmill effect of shale oil production.
Add to this, the emerging challenges of production per well as infield drilling creates interference between parent and child wells, as drilling steadily steps out from the core Tier 1 acreage and as the growth in lateral length and proppant per stage is starting to plateau, we could be facing a more moderate growth in U.S. shale production in the coming years than what the most optimistic views have been suggesting.
Read this again. What Kibsgaard has to say is akin to a “production warning” for the entire shale industry.
This isn’t the first time that Kibsgaard has issued a warning. From their Q3 earnings call:
The North American production base, which makes up the remaining 20% of global supply, has absorbed close to 70% of the demand growth since 2010 initially supported by the Eagle Ford and Bakken and more recently by the Permian basin. However, the well-established market consensus that the Permian can continue to provide 1.5 million barrels per day of annual production growth for the foreseeable future is starting to be called into question. In this respect, we do not believe that the temporary off-day constraints are the main issue as this will largely be addressed within the next 12 to 18 months. Instead, we believe the main challenge in the Permian going forward is more likely to be reservoir and well performance as the rate of infield drilling continues to accelerate.
At present, our industry has yet to understand how reservoir conditions and well productivity change as we continue to pump billions of gallons of water and billions of pounds of sand into the ground each year. However, what is already clear to us is that unit well performance normalized for lateral length and pounds of proppant pumped is dropping in the Eagle Ford as the percentage of child wells continues to increase. Today, the percentage of child wells drilled in the Eagle Ford has already reached 70% and in the 3-year period since this percentage broke the 50% level, we have seen a steady reduction in unit well productivity.
In the Permian, the percentage of child wells in the Midland Wolfcamp basin has just reached 50% and we are already starting to see a similar reduction in unit well productivity to that already seen in the Eagle Ford suggesting that the Permian growth potential could be lower than earlier expected. Therefore, assuming that oil demand will remain robust despite the trade war worries and market concerns around economic weakness in the emerging markets, we believe that the level of E&P investment must increase both internationally and in North America first of all to counter the multiyear drop in investments and second to develop and deploy the new technologies needed to overcome the emerging shale oil production challenges.
Old hand Harold Hamm (of Continental Resources) weighed in with his views not too dissimilar to Kibsgaard:
It seems to us that the fracking industry is sitting on very shaky ground, resting on a whole lot of pixyland assumptions, and is ultimately destined to disappoint over the coming years in terms of production levels.
It’s All Junk
As mentioned before, much of this industry has been financed in the junk bond market. This gig is over. And this goes for more than just the shale industry.
As rates ratchet higher expect this to have serious impact on any levered market sectors, especially those profitless ones (I’m looking at you, Silicon Valley venture capital).
So here is the essence of oil supply:
- Oil and gas exploration and development is down significantly, particularly in conventional produced oil.
- The world is finding far less oil than in the last 50 years or so while demand has a helluva lot higher.
- Shale loses money, and as an industry, shale oil producers have not produced a positive free cash flow.
- The shale oil production boom occurred at the same time that demand for junk bonds boomed allowing for some incredible financing to take place. That era is now over, and what’s more, there are going to be no buyers for this shit. Watch!
- About half of US production is from shale, and the US is the world’s largest producer. Safe and solid, right? Nope.
- We need more oil just to meet growing demand and existing old wells dying, particularly more so now due to shale’s share of US production.
It doesn’t take some wild loony sci-fi fantasy thinking to figure out that oil production has huge issues in the years ahead.
And we’ve not even touched on the potential for the Syrian conflict to cause some major disturbance in supply. If you’ve been paying attention, you’ll note that the parties most heavily involved are Iran, Saudi, Russia, and Turkey (all oil producers you’ll note).
What about demand?
Sure, there is a global move towards renewable energy production. However, research suggests oil production will need to continue to rise in the future to fulfil demand. I know it’ll annoy the beardies and hairy armpit crowd, but the simple truth is that oil still moves our world despite the progress in renewables. The head of Exxon is quoted as saying:
Let’s assume that by 2025 every light vehicle (essentially passenger vehicles/cars) sold will be electric so that by 2040 every light vehicle on the road will be electric, the demand for oil in 2040 will still be about the same as it was in 2013.
Now, to be clear, we think the scenario above is rather extreme. But it does prove a point that few are taking any notice of. We think that’s a mistake and frankly one we’re quite glad exists.
Our thinking here is that the EV revolution has been a big factor in many oilers (big and small) not wanting to invest in big projects that take closer to 10 years to develop. After all, who wants to have invested huge amounts of capital in a project only to find that demand for oil has decreased considerably right when the project is about to start producing? Hence the big reason many oilers have focused on the “shale revolution” over the last 5 years or so.
The problem, as you can see, is that to carry this load the world is relying on shale and alternative energy. And when you simply look at the numbers, that really looks worrisome.
There is something else that needs mentioning. The exploding middle class in the emerging world will create significant demand increases for oil in the coming years. Non-OECD oil demand is now materially in excess of OECD oil demand and yet you’d be hard pressed to find this reported widely in Western media outlets.
We think it quite likely that demand growth from emerging markets hasn’t been adequately accounted for in demand models.
So for us, the oil picture is very clear:
1. Supply is more than likely facing significant constraints caused by:
- Chronic low investment levels in conventional oil.
- Production from shale oil in the US that disappoints as the junk bond market implodes.
2. Demand for oil will be materially higher than what the investment crowd is expecting:
- Decreases in demand due to EV adoption won’t be nearly as much as everyone commonly believes.
- Increases in demand from a rapidly expanding middle class in non-developed economies, namely Asia/Pacific is not being adequately priced in or anticipated.
So in a nutshell, supply of crude oil will likely surprise on the downside and demand will likely supply on the upside. This is a recipe for oil moving materially higher than $100 barrel within the next 5 years.
Hence the reason why we are bullish on offshore oil service stocks and why we will stay a mile away from companies who have a significant exposure to shale oil.
Applying Our View
The view is the “easy” part, applying that view is somewhat more complex.
Before we get into a discussion on how “best” to apply a bullish view on offshore oil, let us remind ourselves as to what Insider is all about.
We want to position ourselves in sectors that ultimately achieve big payoffs. We essentially make sectorial calls rather than focusing on individual stock picks. In saying that, we still do look at individual counters, namely from a financial health perspective.
We’re usually investing in sectors that are down and out/left for dead/priced for bankruptcy. Given the high level of financial stress within these sectors there will be a number of companies which enter bankruptcy where stockholders get wiped out. We don’t want to be caught in these stocks. Accordingly, a significant part of our focus will be on ensuring we are only invested in stocks that have a high probability of making it through to the “other side”.
We also want to cover the broad sector rather than selecting one or two sub-sectors. We want to be right on the broad sector and not to have picked a subsector that underperforms.
Our picks for the offshore oil and gas sector.
As discussed above:
- stock — 19 March 2018
- warrants (July 2023 expiry, 62.28 strike, 1:1 ratio) — 19 March 2018
- warrants (November 2024 expiry, 100 strike) — 19 March 2018 (note these were the old Gulfmark warrants which converted to Tidewater on the merger)
Seacor Marine (SMHI:NASDAQ) stock — 19 March 2018
Both Tidewater and Seacor Marine operate offshore service vessels (OSVs).
- stock — 13 August 2018
- warrants (February 2023 expiry, 4.02 strike, 3:2 ratio) — 27 August 2018
CGG specializes in undersea floor mapping otherwise known as geophysics.
Ensco (ESV:NYSE): offshore drilling
Subsea 7 (SUBC:NO): offshore subsea engineering, construction and services
Saipem (SPM:BIT): offshore drilling, subsea engineering construction and services
Helix Energy Solutions (HLX:NYSE): wellhead intervention and remote controlled vehicles (ROVs)
We have talked about Ensco enough times before but it was never an official alert.
Of the four new stocks in this alert Ensco is probably the most risky but it has potentially the biggest payoff.
It trades on a P/Book of 0.24x. Clearly the market is pricing this stock as if bankruptcy within the next 2 years is inevitable. Yet the company has enough liquidity to get it through the next two years (if nothing changes on the earnings front). Its first big debt repayment isn’t until 2024. So debts coming due won’t be an issue, rather it will be Ensco’s ability to service its interest expense.
Once again, this is the most risky of the recommendations here. But with the leverage on the balance sheet, when this sector turns and the world wakes up to the problems brought on by a severe lack of investment, it has the potential to scream higher.
We believe that Ensco has enough liquidity to get it through another two years at least. This is probably all theoretical because of the impending merger with Rowan.
Ensco will benefit from the liquidity of Rowan, which should give the new entity another couple of years breathing space for debt repayments. You could buy it here and now or take an initial position and stagger into it. We don’t see anything on the horizon that would make us feel we had to rush into it.
Once drillers like Ensco have finished “drilling the holes” Subsea 7 takes over and completes everything necessary to bring the oil to shore or surface.
Subsea 7 is regarded as one of the premier companies involved in all things subsea and is probably the least risky way to gain exposure to offshore oil. Virtually no debt, lots of liquidity, even with all the dramas that offshore oil has had to endure over the last 5 years, Subsea 7 is profitable and it trades at a 30% discount to book value. We love it!
Saipem is perhaps the most diverse of the four new trades. Saipem does most of what Subsea 7 does but is also engaged in drilling and some onshore oil and gas construction and engineering. The company has plenty of liquidity and its first debts aren’t due until 2021.
Helix performs wellhead intervention and robotics services for the offshore sector. The company is profitable and well capitalized with almost as much cash on its balance sheet as debt and trades for a 35% discount to book value.
These above mentioned trades round out our exposure to the offshore oil sector. We are using a measured “risk vs return” exposure.
Sure, we could have gone for bigger payoff trades, but then we run the risk of picking stocks that may eventually end up in bankruptcy with equity holders getting wiped out again and the way that we’ve managed to perform well over the years has been by addressing risk up front, having the balls to buy what nobody believes is worth buying and hold for the course. Realise this when buying here.
There have already been a considerable number of bankruptcies in the offshore oil and gas space but we quite expect there will be more. Brace yourself!
As per our standard thinking, 1% exposure to each position. As far as overall weighting goes to the offshore sector, we think that up to a 10% weighting to this sector would not be unreasonable.
As always, thanks for reading and being part of Insider.
Founder & Editor In Chief, Capitalist Exploits Independent Investment Research
Founder & Managing Partner, Glenorchy Capital
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