We often write about companies involved in drilling for shale gas in the U.S. Their drilling success has depressed natural gas prices with little near term prospect of a bounce, and consequently we’ve focused on companies with low debt and cheap operating costs. Range Resources (RRC) Southwestern Energy (SWN), Devon Energy (DVN) and Comstock Resources (CRK) are all holdings of ours in this sector.

In the years ahead it seems clear that the growing use of natural gas will require significant investment in infrastructure to transport, refine and distribute what the E&P names above and others extract from the ground. Master Limited Partnerships (MLPs) offer an interesting opportunity to invest in this growth. A great deal of the midstream energy infrastructure currently employed is owned through MLPs. Since they are structured as pass-through entities they are not subject to corporate income tax. The public unitholders are partners owning a proportional share of the assets, and therefore receive K-1s rather than 1099s. This additional tax reporting complexity dissuades many investors from owning MLPs, but their cheaper cost of capital (since they don’t pay corporate income tax) and the tax-deferred nature of most of their distributions make them compelling for most U.S. taxable high net worth investors.

Building the additional infrastructure to process growing volumes of natural gas will over the next ten years result in a bigger MLP industry. JPMorgan recently forecast (using estimates from the  Interstate Natural Gas Association of America, INGAA) that today’s $250BN market cap MLP sector will require an additional $130BN in new capital to fund new natural gas and oil transmission lines, gathering lines and storage facilities.

Plains All American (PAA) is one of the larger MLPs with a market valuation of $12BN and a well regarded management team. In their 2011 10K PAA outlines the growth they expect to see in U.S. oil business and their position as a major owner of energy infrastructure places them in a good spot for natural gas as well. Cheap ethane, often used as a feedstock in the petrochemical industry, is expected to continue attracting investment in the U.S. Some analysts expect Natural Gas Liquids (NGL) supply (including ethane) to increase by as much as 40% by 2016. PAA’s ownership of assets is significant, including storage capacity for 71 million barrels of crude oil and refined products (equivalent to almost 4 days total U.S. demand for crude oil), 9 million barrels of NGL/LPG storage capacity and 90BCF (Billion Cubic Feet) of natural gas storage working capacity and base capacity (around two days’ total U.S. consumption).

The companies that will be able to raise the capital to build additional energy infrastructure will be the ones that have shown they’re capable of managing existing assets efficiently. PAA is likely to be one of those. Sell-side coverage of MLPs is increasing as banks anticipate the fees they can earn from helping raise capital. As an investor, owning shares (or LP units in the case of MLPs) in a company doing a secondary isn’t as exciting as it is for the underwriter, and prices often fall somewhat when the announcement is made. However, MLPs’ capex plans are subject to the discipline of the market, in that new money raised must be deployed at an IRR above the marginal cost of capital. Since MLPs can’t retain much of their earnings they have to make their case to investors every time they wish to finance a new project, and as such the better-run firms invest new money in ways that are ultimately accretive to unitholders.

MLPs have been strong performers of late, but PAA still offers a distribution yield of 5.2% and is expected to grow its Distributable Cash Flow at over 7% this year. PAA is a holding in our MLP Strategy.

We’ve never been big believers in owning gold and silver. Warren Buffett’s comment (most recently in his 2011 letter released on Saturday) that all the gold in the world could be exchanged for “all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils…” with $1 trillion left over is one of the more eloquent ways to describe the value of gold. It is one of those commodities whose value is derived from the expectation that others will pay even more for it; most gold is expensively mined, moved and buried again in a vault somewhere. It seems a wasted effort.

But we take the world as we find it rather than as it should be. Developed country governments are providing more reasons to be suspicious of fiat money, and the notion that the solution to excessive debt is steady currency debasement is not easily dismissed. The New York Times noted on Monday that interest expense on the Federal debt is roughly where it was in 2006 even though the debt outstanding has doubled; the government is setting its own interest rates at levels too low to provide a real return to savers, and as such the budget’s sensitivity to higher interest rates is more acute. If the Federal Reserve does ever raise rates their analysis will need to incorporate the increased fiscal drag of higher interest expense, perhaps resulting in negative real rates for longer than might otherwise be the case. And the latest LTRO operation by the ECB has created another 500BN Euros or so of liquidity. So it’s not difficult to construct a dark,  inflationary outlook.

That’s not our central view, though it is a real possibility. But you don’t need to be an extreme gold bull to find value in mining stocks. Coeur D’Alene (CDE) is a name we’ve owned (in small to modest size depending on valuation) for a couple of years. They are one of the few pure silver miners around, although gold is becoming an increasing percentage of their output. Silver is an interesting metal in that it has highly inelastic supply and demand. Most silver is produced from non-silver mines, so silver supply is driven by the price of nickel, copper or whatever is the primary output of a given mine. Demand is similarly inelastic because silver is a vital but tiny input into many manufacturing processes from consumer electronics to medical products. So the price has to absorb changes in supply and demand, making it very volatile. Around 50% of silver demand is for commercial use.

Gold has less industrial demand and “investment” (i.e. speculation) has been growing. Figures from GFMS (used in some research published by JPMorgan) reveal that gold jewelry demand has still barely rebounded from its 2008 trough of 1,800 tons (2012 estimates are 2,120 tons compared with 2001 demand of 3,000 tons). The big swing factor remains speculation (around a third of 2011 demand). But mining stocks appear quite attractively priced relative to bullion and are an interesting investment even if you’re not bullish on gold/silver. Using CDE’s proved reserves of 51 million silver ounces and 830K in gold ounces and assuming modest decreases in capex from 2012 guidance, 3% annual increases in extraction costs and current prices values the company at $30, around its current price. We think of this as our Downside Case. In the Upside Case,  if all their probable reserves were successfully mined the same analysis results in a $50 price. CDE is cheap to the NPV of its likely production assuming no new discoveries. They also represent a levered way to invest in gold and silver because if precious metal prices rise their operating leverage will result in more quickly increasing profits. They may even start returning cash to shareholders through a dividend at some point, and because CDE never hedges it makes valuing the stock and managing an investor’s risk simpler.

CDE is not unique. Gold and silver miners have generally been lagging precious metals, and the last six months is a case in point. For similar reasons we also think GDX is an attractive investment. Even an investor who’s not totally convinced that governments are about to inflate away our savings can find something to like in precious metal mining stocks.

Disclosure: Author is Long CDE, GDX

Last week Ford (F)  announced plans to shift their pension fund even more heavily towards bonds. At a time when interest rates are ruinously low and equities should appear attractively priced to a long-term investor such as a pension fund this represents quite a radical move. As recently as 2006 the company had targeted an equity allocation of 70%. Generally pension obligations are long-lived and one would expect pension funds to be more tolerant of equity market volatility in their quest for higher long-term returns. However, Ford’s stance probably reflects an acknowledgment of the inherent cyclicality in their own business; if they had a higher equity allocation in their pension fund, it would likely be most under-funded during a weak equity market which would coincide with a tough automobile market, perhaps stretching Ford’s  ability to inject additional cash to meet a projected shortfall. It’s part of a plan to reduce the risk of their overall balance sheet. Nonetheless, the reaching the 7.5% return target (reduced from 8%) on their pension assets appears challenging with 80% of their assets in fixed income, and the company is currently facing a $15.4BN shortfall on such obligations.  Today’s yield curve is a long way short of delivering adequate returns, even with the other 20% of their pension assets invested in “growth assets (primarily alternative investments, which include hedge funds, real estate, private equity, and public equity)”. Naturally I should point out that hedge funds may wind up underperforming even their fixed income allocation if past history is any guide.

But it does illustrate an alternative to the concept of overweighting equites to meet pension obligations. Ford is in effect relying on strong operating results to generate additional cash contributions (which will surely be needed). The decisions they’ve taken are consistent with an analysis showing that their business prospects will generally be tied to those of the overall economy and therefore public equities. So rather than invest directly in diversified equities that will (they assume) correlate with Ford’s own results, they are relying on their own equity-like business prospects to generate needed future cashflows. It’s quite a clever strategy. They reduce their balance sheet risk and the volatility of their pension obligations. The worst scenario is one where Ford’s results are dismal while the economy is doing well, perhaps driving up their ultimate obligations at a time when they’re ill-equipped to contribute more needed cash. But they may have calculated that retiring Ford workers will earn pension tied to their pre-retirement earnings, again mitigating their risk.

Ford’s approach represents an intriguing approach to the pension shortfall common to many S&P500 companies.

In November of last year, Devon (symbol: DVN) completed its $3.5B share repurchase program announced in May of 2010.  Under this program the company repurchased 49.2MM shares, for an average price of $71/share, reducing the share count by 10%!  During the same period, management sold non-core acreage raising the cash to fund the repurchases, pay down debt, and acquire onshore core acreage.  This strategy realizes full asset value for non-core properties, improves Devon’s balance sheet, reduces shares outstanding, and allows management to focus on the highest IRR projects.  As shareholders we love this.  A little bit of arithmetic shows why.

As seen in the table below, the company sells 7% of its proved reserves for $10B.  The after tax proceeds of $8B are used to: reduce shares outstanding by 10% for $3.5B; reduce debt by $1.8B; acquire new core acreage positions for $1.2B; add $500M of cash to the balance sheet.  Furthermore, Devon’s management has excelled at more than optimizing the capital structure as they have demonstrated continued strong operating results increasing proved reserves per share by 17% notwithstanding the divestitures.

Using a simplistic analysis for debt adjusted value per share based on proved reserves illustrates how Devon’s management created $27/share of value for stock holders over the past two years.  While there are other ways to value shares, this way does serve as a useful evaluation of Devon’s value enhancing capital redeployment and highlights the virtuous cycle of share repurchases for undervalued companies.

Data is taken from 10-Ks, earnings releases, and company presentations

*Based on 2011 results as provided in the 2/18/12 company presentation

On Amazon UK’s Investments and Securities List.

In recent years as hedge fund performance has become ever less appealing, the industry has responded in part by changing the way it describes itself (much cheaper than cutting fees or delivering better results). So when Absolute Return outlived its utility, since many funds were unable to deliver positive returns in excess of treasury bills no matter how long they were given,  some managers claimed that their objective was to deliver Relative Returns. That is, while their returns might not be positive they could be relatively better than other asset classes. This was a handy move prior to 2008, because returns were very definitely not positive but were less horrendous (i.e. relatively better) than equities.

More recently, Uncorrelated Returns has gained favor. This was another smart move just in time for 2011’s results, because while returns were definitely not positive (i.e. Absolute Return wouldn’t have been an appropriate moniker) or even relatively good (since they were worse than virtually anything else you could invest in) they were definitely uncorrelated. This could be a good long term choice, because uncorrelated just means they don’t have to look like anything else you own, which could encompass quite wide set of investment outcomes.

I just came across another term though, Smart Beta. This was used (for example) in an article from last year and although there is no photo of the author’s face when he wrote it I believe it is intended to be taken seriously. Perhaps it is meant to evoke Smart Bombs, which unerringly reach their target through computer driven guidance. In fact, bombs is a useful if unfortunate connection to use in this context.

But then everything was cleared up by Zilch Capital, a hedge fund that is evidently moving quickly from relative obscurity to complete oblivion and whose latest marketing letter was kindly reproduced in the Economist. Ah well, the hedge fund industry is a soft target. As Warren Buffet once said, if you don’t kick a man when he’s down when will you kick him? They’ve tried Absolute, Relative and Uncorrelated. Perhaps it should be the Zilch Return industry.

Alistair Blair of Investors Chronicle provides an additional perspective on my book, The Hedge Fund Mirage, in an article out today. Mr. Blair has gone to the trouble of asking The Alternative Investment Management Association  for a response. One of their Core Objectives is, “To provide an interactive and professional forum for our membership and act as a catalyst and promoter of the industry’s global development.” You might imagine that a book noting the enormous imbalance between the results for hedge fund managers compared with their clients would command AIMA’s attention. If it has, the result must have been rather more time spent on internal discussions of damage control and rather less on quantitative analysis, at least based on their response to Mr. Blair.

AIMA’s opportunity now is to acknowledge the embarrassingly poor past economic outcomes for clients of the industry they promote, and to lead the discussion of how hedge fund investors might access the undoubted talents of many managers on far more equal terms than in the past. Will they be up to the challenge?

On August 8, 2011 Andrew Baker, CEO of AIMA, proudly noted on FTfm that, “Far from being disappointing, hedge fund performance has been impressive.” This was in response to an article by Jonathan Davis whom Mr. Baker accused of promoting “hoary old myths about the hedge fund industry.” Jonathan Davis was on to something, and Mr. Baker’s vigorous defence of his industry (albeit at odds with the facts) happily did not deflect Mr. Davis from shining a spotlight where it was sorely needed. Fortunately for investors he followed up a few months later with the pointed, “Do hedge funds offer value for their fees? No.”

Six months after Mr. Baker’s “…performance has been impressive” comment, AIMA is still avoiding a response that includes numbers and now lamely speculates that, “The main problem with Lack’s whole thesis is that no serious investor would tolerate for long a situation in which nearly all the returns were going to the manager and not them.” I think I shall start wearing AIMA’s criticisms as a badge of honor. Somebody ought to be promoting the interests of the clients – there doesn’t seem to be much competition for the job.

Two articles concerning shale gas have caught my attention this morning. “The Death of Coal” reflects the view of some that under current EPA policies coal will continue to lose ground to natural gas as the fuel of choice for electricity generation. Cheap and relatively clean natural gas is eating into the demand for coal and EPA regulations on some of the more harmful pollutants released by burning coal are adding fuel to the fire. Abundant and cheap natural gas has certainly pressured the stock prices of some E&P names recently, but low prices will create their own demand.

Another piece from UBS makes the case that as the U.S. reaches energy independence this will increasingly provide support for the US$. The U.S. has been an importer of crude oil for as long as any of us can remember (currently estimated at $300BN), but that is changing as new domestic discoveries are reducing the need for imports. The revolution in shale gas as well as new discoveries of oil (North Dakota now produces more oil than OPEC member Ecuador). This will eventually reduce the drag on our trade deficit of being an energy importer, and could well be supportive for the US$. Over time it will reduce U.S. reliance on the Middle East, and by reducing global trade imbalances could slow the growth of sovereign wealth funds.

Devon Energy (DVN) is squarely in the middle of this (and incidentally just reported strong earnings this morning). We also continue to like being long US$ versus the Euro. Short the Euro is a nice form of tail risk insurance. While a Greek default is still unlikely, some European finance ministers are reportedly more sanguine at that prospect should Athens fail to sign up to the latest austerity plan. Neither outcome makes the Euro attractive.

Disclosure: Author is Long DVN, EUO

Today’s news that Chesapeake (CHK) is going to sell $12BN in assets in response to continued weak natural gas prices looks like good news. Depending on the buyers, it’s possible that the new owners could have a sufficiently long horizon that they won’t need to drill just to generate near term cashflow to finance debt payments. And it may also demonstrate that there are many buyers for natural gas assets in spite of the lousy current economics caused by excess supply. Natural gas is beginning to supplant coal as the marginal fuel of choice for electricity generation, and companies like Exxon Mobil and BP forecast an increasing share of power generation will come from natural gas.

So the news is mildly positive for some of those with low costs of production, such as Devon Energy (DVN), Southwestern Energy (SWN) and Comstock Resources (CRK). However, CHK is weak, since the prospect of shedding around a third of its assets when natural gas is trading at $2.50 reveals some poor financial planning by Aubrey McClendon and his team. The expectation that CHK may have to sell more liquids-focused properties is further disappointment for owners of CHK. It shows that debt is bad and low production costs vital if you’re going to earn a decent return on investment in this sector. CHK’s actions are helpful for just those types of company, but not for CHK itself.

Disclosure: Author is Long DVN, CRK, SWN

As I’ve watched the ongoing saga in Europe, the discussions of sustainable Debt:GDP and other elements of the “Maastrict Criteria” I’ve often been puzzled at why these figures were so important. The U.S. represents a large single currency union, and although different states have incurred different levels of indebtedness there is no Federal law dictating what those equivalent ratios must be. Most states are required to run balanced budgets, but those laws are passed by the states themselves.

So although many commentators repeat the mantra that too much borrowing by a few profligate countries is endangering the entire Euro-zone, and this sounds as if it makes sense, I’ve never fully comprehended the precise linkage. Why shouldn’t countries in a common currency (or even cities for that matter) be allowed to borrow whatever they wish at prevailing market rates? Municipalities do go bankrupt in the U.S. (though far less frequently than Meredith Whitney once forecast). Orange County defaulted in the 1994 because of speculative interest rate bets gone awry, and nobody questioned the viability of the US$.  In 1975 the Federal government was willing to let New York City go bankrupt (although President Ford did not tell NY to “drop dead“, as is popularly believed). But at no time was there any question about the viability of the US$ or the single currency area.

So I’ve been somewhat uncomfortable with the accepted wisdom that a fiscal union is necessary for a currency union to work. Fiscal transfers do take place in the U.S. on a far greater scale than in Europe, but not in response to local deficits but to growth shocks.

Then I came across an academic paper called “Target Loans, Current Account Balances and Capital Flows: The ECB’s Rescue Facility“. It’s quite technical and I can’t claim to fully grasp its many nuances. However, the main insight is in the following example: an Italian buying a BMW car from Germany writes a check in Euros drawn on an Italian bank. This results in a series of transactions from the Italian bank to the Bank of Italy, ECB, Bundesbank, German bank and BMW. The Italian buyer obtains his car. The Bank of Italy has a liability with the ECB, and the Bundesbank has an asset. The key point is that these balances, while they offset at the ECB, never have to be settled. Italy has been running a growing trade deficit (hence the discussion of improving southern European competitiveness) while Germany has been running a surplus (because it is already an exporting powerhouse).

Germany, through its Bundesbank, has an “asset” or claim with the ECB of 450BN Euros (as of September 2011). All the Eurozone members net out, but the imbalances have soared since the 2008 debt crisis. They are called “Target” balances, and according to the paper are obscurely reported by the ECB, only disclosed in footnotes. Germany’s loan to the ECB is guaranteed by the other Eurozone countries, but if one was to leave (say, Greece) they may default on their pro-rata share. In this way, Germany is already on the hook to its Eurozone partners for 450BN Euros (and presumably growing).

These imbalances are caused by the fiscal deficits southern European countries have been running, which is why the Maastricht Treaty imposed a 3% deficit:GDP limit and a 60% debt:GDP limit. The architects of the Eurozone payments system understood this. But the debt owed Germany by the ECB is substantial, not widely reported, and fundamental to the crisis.

In the U.S., a Texan buying a Caterpillar earth mover from a California factory would trigger the analogous payments sequence through his regional Federal Reserve bank. However, the Dallas Fed would have to settle its deficit with the San Francisco Fed within a year by transferring government securities. This critical “true-up” doesn’t exist in the Eurozone.

It’s a complex topic, but I found  Target Loans, Current Account Balances and Capital Flows: The ECB’s Rescue Facility helpful. It helps show why Germany doesn’t necessarily want Greece to leave the Euro, and how its break-up could uncover some substantial debts. So the risk of a Euro disaster is extremely low, since it’s not in anyone’s interests. But the growth outlook is correspondingly extremely poor, which should cause the Euro to depreciate. We continue to own EUO so as to be short the Euro in combination with being long risky assets such as equities (SPY).