WSJ Calls The Bottom In Natural Gas

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One day, probably in the not so distant future, Spencer Jakab of the Wall Street Journal will probably regret suggesting that natural gas prices may go negative, as he did in today’s article “Why Natural-Gas Prices Could Fade to Red”. It’s an attention grabbing headline, but is likely to be better known some time in the future when natural gas has bounced and Mr. Jakab’s piece comes to be remembered as the time when the very last sellers showed up on the scene.

And of course natural gas fundamentals over the near term continue to look extremely poor, with a warm winter reducing the need to restock inventories during the shoulder months. Owning natural gas futures has been a terrible trade for anyone foolish enough to speculate that way, and there’s no near term bounce in sight.

But it’s not clear why anyone would pay to give away natural gas. It can be flared off or simply not produced if prices are unattractive. There’s also growing evidence that its cheap price is drawing utility demand for electricity generation while at the same time depressing demand for coal. In fact, the long term outlook is revealed by Kinder Morgan’s strategy (KMP). Their acquisition of El Paso (EP), expected to close in 2Q12, adds an extensive network of natural gas pipelines to KMP’s existing network as can be seen in the presentation they published when the acquisition was announced. Kinder Morgan expects increased movement of natural gas.

And KMP is expecting increased exports of coal as domestic demand wanes.

Meanwhile, investing in companies drilling for natural gas hasn’t been nearly as painful as being long the commodity itself. Range Resources (RRC) for example, over the past twelve months has matched the return on the S&P500 (although it’s been more volatile). In round numbers, 5 TCFE (Trillion Cubic Feet Equivalent) of proved reserves provides a solid base for its $9BN market cap (if they earn $1 per MCF that’s worth $5BN) and they have ten times that in potential reserves. Their manageable debt (less than $2BN net of cash, or 45% of their total balance sheet capitalization) and low production costs means that the equity holders are unlikely to lose the company to the debt holders. Their increased production of NGLs (natural gas liquids) generates cashflow from an area with more buoyant demand. Owning operating assets, or equity in operating companies such s RRC is far better than going long the futures.

So remember today’s WSJ story – although Mr. Jakab does point out that in the long run low natural gas prices will create their own demand and likely selfr-correct, the article’s headline will almost assuredly be worth revisiting at some point in the future.

Why Gold and Silver Miners are Attractive Today

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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

Optimizing Shareholder Value – A Lesson from Devon Energy’s Management

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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.

Pre-plan (YE2009) Post-plan (YE 2011)
Shares Outstanding 447MM 404MM
Proved Core Reserves 2641MMBoe 3005 MMBoe
Proved Divested Reserves 200 MMBoe 0 MMBoe
Total Proved Reserves 2841 MMBoe 3005 MMBoe
Net Debt $6.6B $2.7B
Average repurchase price $71 $71
Proved reserves/share 6.4Boe/share 7.4Boe/share
Net Debt/share $14.76 $6.68
Cash Margin per Boe* $19.37 $19.37
Value/share debt adjusted $109.21 $136.66

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

How Shale Gas Is Leading To Energy Independence

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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

Chesapeake Takes One For the Team

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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

6% Yields In Senior Loans With A Cheap Market Hedge

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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

Today's Unemployment Report is all Good

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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

The Case for JC Penney

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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

Chesapeake Responds to Market Forces

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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.

Looking Beyond $2.71 Natural Gas

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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

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