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).

We continue to like using a short Euro position in combination with risky assets. In our Fixed Income Strategy we’re invested in senior loans through closed end funds such as BlackRock Defined Opportunity Credit Trust (BHL) and ING Prime Rate (PPR). They’re both at a modest discount to NAV of around 5%, and yield over 6%. Their portfolios of leveraged loans to non-investment grade borrowers will no doubt go down if equities sell off, but holding this position in combination with a short Euro (we’re long EUO) protects against the tail risk associated with Euro sovereign debt problems or Middle East conflict (such as an Israeli attack on Iran). The US has a 3% GDP differential over the Eurozone so over time this should favor the US$ anyway. Short Euro is akin to owning put options on the market – you just need to own something in addition that will generate a return.

There were a couple of interesting articles about energy over the past 24 hours. The WSJ noted that natural gas is eating into demand for coal. Over the past three years natural gas has gone from producing 21.4% of U.S. electricity to 24.4% (coal has dropped from 48.2% to 42.8%). It’s a slow process and don’t expect near month natural gas to trade at $4 anytime soon. But it does illustrate market forces at work. In another article, Bloomberg notes that the U.S. is on its way to achieving energy independence . By way of illustration, they report that Methanex, the world’s biggest producer of methanol, is dismantling a factory in Chile and moving it to Louisiana to take advantage of cheap natural gas. We continue to own Comstock Resources (CRK), which reported earnings yesterday and expects production to be 20% oil by the end of 2012. They have minimal debt, low operating costs and while today’s low natural gas prices don’t help the company does control its own destiny and trades at a healthy discount to book value (even after taking a reserve writedown in 4Q11).

Finally, Bill Gross wrote an interesting piece on the problem with low interest rates in yesterday’s FT. He suggests that QE2 and Operation Twist are keeping long term rates so low that banks don’t see much upside in lending there. This slows down the recapitalization of the banking system that a steeper yield curve would provide. Whether he’s right that this is slowing growth or not, he’s certainly right that long term rates provide little incentive to lend. Long term high grade and government bonds are a safe way to lose purchasing power. An obscure but interesting trade can be found in the eurodollar futures curve. The spread between Sept 2013 and Sept 2014 is 35 or so basis points. The market is pricing for an increase in three month Libor of only 35 bps between 2013 (when a majority of FOMC members expect short term rates to be unchanged) and 2014 (when a majority expects them to be rising). This spread is unlikely to narrow much beyond 25-30 under those circumstances, and an upside surprise in GDP growth (perhaps led by housing?) could cause a substantial steepening in this part of the curve, straddling as it does the point at which the Fed has indicated it will start raising rates. We think it’s an interesting trade, there’s probably no need to rush into it though.

Disclosure: Author is Long PPR, BHL, CRK, EUO

This looks on the surface to be good news across the board. Private payrolls up almost 100K greater than consensus; increased hourly workweek, and a drop in the Unemployment rate in spite of an increase in the labor force. Not a 4% GDP type of number, but good enough to reassure that the 2-2.5% type GDP growth trajectory we’re on is sustainable.

It supports the case for equities over bonds. The Equity Risk Premium is wide but this type of data will cause it to narrow somewhat, as stocks rise and bonds fall. In addition, the utility of holding a short Euro position in combination with long stocks is highlighted. The U.S. economy is likely to grow 3% faster than the Eurozone this year. The $ can draw support just from the relatively better prospects here, as well as providing tail risk insurance against an economic or geopolitical surprise. Leon Panetta probably isn’t using the Washington Post to communicate policy, but the article draws attention to the closing window Israel has to set Iran’s nuclear plans back several years. While the more likely outcome is that EU-led sanctions will be allowed more time to play out, an Israeli attack on Iran is just the type of event that could derail the recovery. The US$ would undoubtedly offer some protection in that type of environment.

We continue to like Microsoft (MSFT) which has quietly broken above $30 following a solid earnings report in January. Corrections Corp (CXW) is also attractively priced – California’s state budget included no cuts in funding for private prisons which has helped the stock price of the largest private prison operator. We’ve added to a couple of natural gas E&P names lately – most notably Comstock Resources (CRK) which has $1.5BN in reserves based on its PV-10 (albeit using early 2011 natural gas prices), net debt of $700MM and is valued at $560BN. They recently announced reduced 2012 capex and expect revenues will be 20% oil by year-end. We expect them to be acquired if valuation doesn’t improve soon.

Discclosure: Author is Long SPY, MSFT, CXW, CRK, EUO

It’s hard to watch JC Penney’s CEO, Ron Johnson, give his presentation yesterday without feeling a tinge of excitement that we’re at the beginning of something new in retailing. His absorbing performance promises a new paradigm in retailing. Turning around JCP won’t just be a question of spending ad dollars more wisely or weaning customers off perennial discounts, but will ultimately transform the shopping experience. When Ron Johnson joined JCP he spent $50 million on 7.5 year warrants ($29.92 strike price, 7.3 million shares) that he’s not allowed to hedge for six years and received $50 million in restricted JCP stock, as well as walking away from around $70 million in stock in AAPL, his previous employer. Much of his prior team has joined him on this new quest. It’s exciting stuff.

We own JCP in our Deep Value Strategy. Reading through prior investor presentations, after Ron Johnson joined but before he’d begun to communicate his vision, was underwhelming. Buying JCP back then represented an act of faith that the man who led AAPL’s retail strategy, hand-picked by Bill Ackman, could perform some magic on a dowdy retailer. Looking like the late Steve Jobs without his trademark black jeans, Ron Johnson provided plenty of reasons to get excited about owning JCP.

Transforming the company will take several quarters to even begin to show financial results. No doubt there are enormous differences between selling AAPL’s proprietary products, and changing retailing while your competitors watch and quickly emulate your best ideas. But in the meantime, the bear case will have to survive without the benefit of disappointing financial results to shake out the bulls. And it’s not hard to imagine hope and a little reflected stardust from Ron Johnson’s prior employer adding some rocket fuel. Our JCP holding is an investment, and the upside is sufficient that we’ll likely hold it for a long time to see how the story plays out. Although JCP’s earnings multiple is high, it trades at 0.5 X next year’s consensus revenues compared with 0.55 for Macy’s (M) and 0.64 for Kohl’s (KSS). There seems little point in being short JCP at anything less than industry revenue multiples. Nordstrom (JWN) trades at 0.97X. As of Dec 30,  20% of the float was short, and those must be weaker hands than many of the longs. For now, the bulls are in charge at JCP.

Disclosure: Author is long JCP

Bloomberg TV invited me back on this morning – the sorry results of hedge fund investors are just too incredible to be believed and so they asked to produce a chart illustrating how fees have been split. It turns out that if you calculate how much money hedge funds generated BEFORE fees from 1998-2010, and then deduct hedge fund fees (and fund of fund fees) from the gross profits (that is, in excess of treasury bills since those are the only measure of returns that are worth anything) , the clients were left with 2%. Hedge funds have been highly profitable, but unfortunately the profits haven’t made it to the investors. Anybody can do this calculation – the methodology is simple, is explained in my book (The Hedge Fund Mirage) and has not been seriously challenged by anybody.

The industry kept 98%. Bloomberg presented a version of this chart on TV this morning. Hopefully the message is getting across. It’s not that there aren’t some great hedge fund managers out there – of course there are. But investors need to do a far better job of negotiating terms that allow them to share in that success.

To make any money in natural gas E&P stocks you need to look carefully at balance sheets and production costs. Natural gas prices have been collapsing because of oversupply and a mild winter. The success of shale drilling is hurting many natural gas E&P companies whose activities have led to an abundance of cheap gas.

We’ve never owned Chesapeake Energy (CHK) because we’ve always felt that Aubrey McClendon has a bigger risk appetite than we do. But he’s shown some financial discipline in today’s decision to curtail natural gas production. The old saw that the cure for low prices is low prices is in action.

While we don’t own CHK, we have recently been adding to other E&P names that we like. Range Resources (RRC) is among those. If natural gas is being sold at prices that make continued production uneconomic for the industry, only those with the lowest production costs can be expected to benefit. Below is a slide from RRC’s recent presentation (originally created by Gooldman Sachs) which reveals which companies have the lowest costs of production. The Marcellus Shale in SW Pennsylvania has the lowest costs in America, and the slide indicates that even natural gas at $2.50 can still be profitable for those that drill there. RRC is the purest bet on that region. The financial discipline shown by CHK is good for their shareholders but great for companies who can afford to maintain current levels of output.

The Euro has been a good hedge on a portfolio of long stock recently. Equities are attractively valued for a long-term investment; the equity risk premium remains high. But who can think about investing in stocks for the long run and shunning bonds when the Euro sovereign debt crisis rolls on. For us, the solution was to short the Euro as a hedge against long equity positions. The correlation between the two rose during 4Q11, not surprisingly since Europe was driving short-term market moves.

But the ECB’s Long Term Repo Operation committed them to support the banks and, by extension the Euro sovereign governments (barring possibly Greece, which is heading down its own path). Since Europe’s banks are the biggest holders of European sovereign debt, the ECB has in effect become a lender of last resort to its governments. The removal of the Sword of Damocles hanging over markets has been replaced with a more plausible path to a lower Euro. Europe is in recession, the GDP differential between it and the U.S. is likely to exceed 3% this year, and the next move in rates from the ECB is likely down. Meanwhile, the U.S. economy continues to produce steady if unspectacular growth.

It’s still worth holding a short Euro with a long equities position. The tail risk, an unforeseen crisis in Europe, still makes it a worthwhile hedge even while the day-to-day relationship has become slightly more subdued. But they could just both be good investments in their own right. Equities are attractively priced and the threat of a European crisis is receding. The Euro area is in for a period of no-growth while banks recapitalize and governments impose austerity. Long equities and short Euro is not the pairs trade it was, but both look like attractive investments.

Disclosure: Author is Long SPY and Short FXE

Today’s interview on Canada’s Business News Network.

Natural Gas prices have been declining for years. The shale gas boom has been great for servicers and consumers, but drillers have been producing so much natural gas that they’re almost giving it away. The Wall Street Journal has an article highlighting the steady increase in domestic production (up around 50% since 2005) and the sliding price. Spot Natural Gas dropped to $2.71 yesterday and there are forecasts that the price may drop as low as $2.

The stocks have reacted predictably, with Comstock Resources (CRK) and Southwestern Energy (SWN) both falling sharply. To be sure there is no end in sight for the weak pricing environment. Natural gas is starting to replace coal as the fuel of choice for new electricity generation, and low prices will create their own demand. But this all takes time, and for traders who rely on pictures, the charts certainly look ugly for these and other names.

However, it’s worth remembering the recent M&A activity that’s been taking place. Sinopec, a large Chinese oil company, invested $2.2BN in a joint venture with Devon Energy (DVN) in oil and gas fields it’s developing. Access to cheap, secure U.S. energy resources is attractive to China. France’s Total invested $2.3BN alongside Chesapeake Energy (CHK) and Spain’s Repsol put in $1BN to partner in a field alongside Sand Hill Energy. This week, Bloomberg highlighted the record prices shale acreage is receiving from international buyers.  Last Summer BHP Billiton acquired Petrohawk at a 60% premium to the then current price. Floyd Wilson, Petrohawk’s CEO, no doubt had sublime timing. But there’s little doubt that the major E&P companies recognize the long term role natural gas will play in U.S. energy consumption. Exxon Mobil (XOM) publishes “The Outlook for Energy: A View to 2040” which provides some insight into their thinking. It’s worth reading. They expect gas and electricity (which is increasingly produced by using natural gas) to meet a growing share of total energy demand. Natural gas is far cleaner than coal, far cheaper than oil and provides energy security in the U.S. While in the near term it is supplanting coal as a source of electricity, it’s likely to make some inroads to transportation. And those northeasterners who burn oil for heat will see the economics of shifting to natural gas.

None of this makes for a trade. But natural gas E&P names with low debt and production costs provide the staying power to hold as an investment while M&A activity continues and demand reacts to low prices. And there’s always the potential upside from instability in the Middle East. We continue to own DVN, whose proved reserves alone are worth around $60 per share. We like CRK, which owns assets similar to those Petrohawk sold at a high price last year and is steadily adding higher-margin natural gas liquids and oil to its output. Yesterday we bought back into Range Resources (RRC) which represents a concentrated bet on the Marcellus Shale but has very low production costs and in our opinion solid management. Although its proved reserves put a floor value far below the current stock price, we think the company is highly confident about its ability to de-risk much of its acreage but FASB rules require that proved reserves be extracted within five years and RRC need not start the clock ticking on everything. We had exited RRC in the Fall as takeover speculation drove the price up. We think at current levels it’s an attractively priced investment. They estimate up to 50 Trillion Cubic Feet (TCFE) of resource potential which, even if it only generated a realized $0.50 per MCF of cashflow would generate $25BN. The company expects to fund all capex from cashflow by next year.

There is a huge divergence in what large long term focused companies are willing to pay for these E&Ps hydrocarbons and what market participants are willing to bid for their stocks today.   In the near term, expect these stocks to be volatile.

Disclosure: Author is Long DVN, RRC, CRK, SWN