Skip to content

Posts from the ‘Midway Energy (MEL)’ Category

Week 29: Conviction and Humility, Investigating PHH, Don’t forget about Atna, Buying Midway

Portfolio Performance

Portfolio Composition:

On Conviction and Humility

I find that investing in stocks is a constant antithesis/synthesis (to use a couple of terms from philosphy) between conviction and humility.  Never is this more evident than when things aren’t going your way.

While the market has been up the last couple of weeks, and my portfolio has been up somewhat as well, it is not doing as well as I would like, not as good as the market even, and that makes me want to reevaluate.

Part of me wants to just get out and start all over again.  Right now there are things of  which I am wrong.   Wrong about some of the gold stocks I own (while Atna continues to do well, Aurizon is not doing well, Lydian is not doing well, and a couple of my more recent purchases, Esperenza and Canaco, have stalled out).  Wrong about some of the oils I own (I probably should have sold out of Reliable Energy at 30 cents)  that aren’t doing much of anything.  Certainly wrong about my big bad bailout bank short bet, which went quite far south last week.

The other part of me, pushing just as strongly, wants to stay the course and, more exactly, to ignore what the market might be telling me because the market is wrong and I am right and in time I will be vindicated.

It goes without saying that this last attraction is a dangerous one.  Surely we all have listened to the expert that held his conviction against all evidence to the point where his credibility was lost forever.

The truth between these two extremes lies, of course, somewhere in the middle.  The difficulty is figuring out exactly where that is.

The basic long term investment theses on which I am currently holding stocks (and shorts) are as follows:

  1. Europe is on an inevitable course to dissolution, with a collapse in Japan not far behind
  2. Gold is the only asset that is no one’s liability and it will gain respect as a store of value as these events unfold
  3. The US, while troubled, is muddling through, and the US housing market has likely had, as Kyle Bass has put it, the pig go through the python
  4. Oil is harder to find and harder to get out of the ground then most people appreciate, and its price will prove sticky to the upside
  5. The hz-multifrac is a revolutionary technology and so you want to own oil companies that can take advantage of that technology

I think its helpful to review these basic points on occasion, particularly when things are not going my way.  If I can still stand by these tenants then the rest is just a matter of evaluating if the individual stocks themselves are decent businesses (or perhaps more importantly good stories) in their own right.

And, having thought about it over the weeked, I wouldn’t stand away from any of the above.

Two weeks of a market moving up with many of my stocks doing nothing can seem like an eternity.  Sitting with as much cash as I currently have (though I have reduced that cash level somewhat, mostly in response to specific opportunities and a recogntion that the deterioration of Europe no longer seems imminent) while the market rises, can be tough to bare.  But I can’t just abandon what makes sense because of a few tough weeks.  If the facts change, certainly I have to change with them.  No doubt about that.  But when the main fact that has changed is that the market is not going down any more, I think it is wise to respect that fact (no sense doubling down and some sense in lightening up with what doesn’t work) but not so wise to change course entirely.  Better to move as a big ship might, slowly inching it way towards a new course, ever on the lookout for signs on the horizon that might make the destination more clear.

Wading into the Mortgage Market

On Tuesday this week a 13-G was issued that Hayman Investments (the hedge fund run by Kyle Bass) had purchased over 7% (4,448,751 shares) of PHH Corp.  I got a google alert  on the news almost immediately.  It still wasn’t soon enough.  The stock was up 10% within minutes and closed up 12% on the day.

I sat down on Tuesday night with the intent of understanding what Bass what was up to.

I don’t think this is just Bass buying a cheap company (which they are) and hoping for the best.  I think there is more to this story, as I will explain below.  But first, lets talk a bit about where I think we are in the housing cycle.

First of all, I am no blind optimist here.  I don’t think for a second that housing is about to make a robust 180 with rising prices and robust new builds.  That’s not happening for a long time yet.

But that does not mean that all housing company’s should be left in the trash bin.  No I think that those that rely more on volume then price may find themselves doing better this year, and may be ripe for a move.

Why?  Because I think prices have fallen enough in many markets.   Most of the damage in terms of declines appears to have been done.  There was a great graph provided by Core Logic a couple weeks ago that showed prices both including and excluding foreclosures.

Illuminating!  If you ignore foreclosures, prices nationwide are on the verge of going positive.  If you look at the regional data, prices are actually up in many locales.  And while some areas are still bogged down in foreclosures, many have worked through the worst of it.  Those are going to be the areas where we start to see a turn.

So it makes sense to look for companies that stand to gain from these first signs of stabilization.

And with that, onto PHH…

PHH is in the business of mortgage origination. They are in the business of mortgage servicing rights.  Tthey are also in the business of commercial vehicle fleet management but I don’t think that’s the story here so I’m not going to dwell on that.  Lets talk for a minute about the two former businesses.

Mortgage Origination

Mortgage origination basically consists of finding a person that needs a loan to buy a home, showing that person a list of mortgage options of how they could finance that loan, qualifying the borrower for loan guarantees such as those from the GSE’s, and then processing the loan through (doing all the paperwork) and passing it through to the eventual lender institution (usually to Fannie, Freddie or a bank that will either keep it on their books or sell it to another investor).  PHH takes a cut in the process, or an origination fee, that is typically between 1/2% and 1%.  In the third quarter the company said that their “pricing margin also expanded by more than 47 basis points as compared to the second quarter.”

Mortgage Servicing

Mortgage servicing happens after the loan is made. The servicer is responsible for calculating how much the borrower owes and collecting that amount.  If a loan is not being paid then the servicer takes on additional responsibilities such negotiating a workout upon default, looking after the foreclosed property and such.

PHH refers to these businesses as a natural hedge of each other.  Why?  Because they are inversely correlated with respect to interest rates.

Let’s say interest rates fall.  What happens?  People with mortgages at higher rates refinance those mortgages.  That’s great for the origination business.  They are writing up refi’s and taking in the fees.

Not so great for the servicing business. Those refi’s mean that the mortgages that PHH has the rights to service no longer exist.  Now ideally PHH originates the refi and thus takes on the servicing rights for that refi so the old mortgage servicing right (MSR) is replaced with a new one.  But there’s no guarantee of that.

Rates go up and the opposite situation occurs.  Origination suffers, no one is refinancing at the higher rates, but that also means the MSR’s are not being lost either.

As it is, PHH has proven to be pretty good at holding on to more MSR’s then it loses.  Forthe 9 months ending in the 3rd quarter the company had a replenishment rate on MSR’s of 167%.

Ok, back to Bass.  There are a number of things happening in the mortgage business right now from which PHH stands to benefit.  Let’s go through them one by one starting with Harp II.

HARP II

Harp stands for the Home Affordability Refinance Program.  Harp II is the name that has been coined for the new version of HARP.  It supersedes the original Harp.  Harp I was a total failure.

The HARP program has helped far fewer borrowers than its proponents estimated — roughly 894,000 borrowers since Aug. 31, 2011. — and many less than the estimated 11 million U.S. homeowners who owe more than their homes are worth.

Why was it a total failure?  A few reasons:

1. Put back risk: Basically when a bank participated in the original program they were worried that they would get stuck with the original mortgage.  I think what happens here is that to rewrite the original loan to new terms, the loan is going to be scrutinized.  The banks and other underwriters know that the quality of many of those original documents are sketchy at best and they would rather not have to pull out the skeletons.

2. LTV Limits: This is probablythe biggest problem.  The original HARP program dealt with current loans with LTV’s of 80-105.  That was expanded to 125 in 2009, but that still wasn’t enough.  I was surprised by that until I read this:

This should have a big impact in certain parts of Nevada, Arizona, and Florida where many borrowers owe more than 125% of the value of their homes. In Nevada, for example, two thirds of all loans backed by Fannie Mae are underwater, and half of all loans are above the 125% loan-to-value cut-off.

3. Appraisal costs: the borrower had to have an appraisal done to qualify for the original program.  That appraisal could cost $400.  Borrowers were reluctant to take this cost on when there was no guarantee they would be accepted by the program

HARP II aims to correct these mistakes.  The LTV limit is gone.  Appraisals are no longer required.  And banks are protected against the put backs.Says Brian Ye, analyst at J.P Morgan Chase & Co:

“We are of the opinion that there are enough changes to the program that bank servicers could really change their behavior, and this could be one of the first times that the administration has under-promised and over-delivered,”

The two tiers of HARP II

There is one particular element of the new program that helps out PHH is that servicers get a head start over third party originators.   I confess I don’t know just what of impact this is going to have, but it is interesting and potentially significant, so I think its worth mentioning.  Servicers like PHH have been writing borrowers up for the program since the beginning of the year.   A third party originator cannot submit any documents to Fannie or Freddie until March.   This was done to entice the banks into the program, but the corrollary is that a company like PHH can capture business up front without the competition.

There is more interesting information on the new HARP program here.

What’s it going to mean?

This is, of course, the big question. The program is aimed to attract two million borrowers by the end of 2013.  This would be a little more than twice what the original program attracted.

However if the program works, and if JP Morgan turns out to be right and the administration “under-promised”, there is certainly a lot of room for upside.  According to CoreLogic:

10.9 million, or 22.5 percent, of all residential properties with a mortgage were in negative equity at the end of the second quarter of 2011.  Eight million borrowers with negative equity, or nearly 75 percent of all underwater borrowers, have above market rates. The disparity is even greater for those with severe negative equity. More than 40 percent of borrowers with 125 percent or higher loan-to-value (LTV) ratios have mortgages with rates at 6 percent or above, compared to only 17 percent for borrowers with positive equity.

Apart from the obvious fact that these numbers show just how staggeringly bad housing has become, if you prefer to see the glass half full those numbers also suggest that there are a lot of borrowers out that could benefit from a program like this.

I was listening to this week’s Lykken on Lending and they were talking about Harp II.  Lykken said that listeners (brokers and third party originators) needed to gear up for the “mother of all refinancing booms”.  In another segment a couple of weeks earlier Lykken and his guests spoke quite excitedly about the impact of no LTV limits. The one guest talked about how common it is to have to turn away borrowers because they are too far under on their home.  HARP II should help with that.

BOA and correspondent lending – another tailwind

So first of all, what is a correspondent lender?

Consider a broker who develops significant business volume, has earned the confidence of wholesale lenders who will authorize him to approve their loans, and has accumulated some capital. He can now obtain a credit line from a bank that can be drawn against to fund loans, repaying the loans when they are sold to wholesale lenders. Under the law, the broker has morphed into a “lender” – the type called a “correspondent lender”.

This has been a business the big banks have taken a large piece of.   Until now.  In August BoA reported that they were exiting correspondent lending.

This isn’t small potatoes.  It accounted for”47 percent of Bank of America’s mortgage originations, or $27.4 billion, in the first quarter of 2011, the Wall Street Journal said citing Inside Mortgage Finance.”

There are rumors others are leaving the business.  Its a low margin, highly competitive business but it could become less so with some of the big players moving on.

In comparison, for PHH total mortgage closing volumes for 2011 so far were $36.3 billion of which approximately 70% were retail and 30% were wholesale/correspondent.  Here is what management said on the Q3 conference call:

Yes I’m going let – yes the answer to the question is yes, we think there are better opportunities but once again we’re really pretty opportunistic in that channel. So we pay close attention to margins in that channel. As you know it’s probably the most cost competitive channel, it is the most cost competitive channel that we operate in and we’ve seen some really strange behavior in that market in terms of where margins are being priced. Some of our competitors are in the market, when they are in the market they’re very aggressive in terms of their pricing and then they back off and they’re out of market and that’s why we stay really opportunistic in that market. Luke, do you want to add anything?

The company made a total of $95M off of mortgage production, meaning off of fees for new originations of that $36.3B of loans they processed.  The company doesn’t break down the margins between the retail and the wholesale/correspondent.    Total revenue from the segment was $264M, which suggests that the fees on average are around 0.7% of total loan value.

Tailwind 3: Signing up new partners

The last tailwind for PHH is that they are having success signing up some big partners for their origination business.  From the Q3 CC:

We also made significant progress in growing our nationwide sourcing footprint over the past two quarters signing five new private label accounts. The new relationships include Barclays which we mentioned on last quarter’s call and today we’re pleased to announce that we’ve added Ameriprise and Morgan Stanley Private Bank along with two other financial institutions all as new PLS partners.

They also lost one significant client in Charles Schwab but over all the company expects to gain significant production:

We expect the five new PLS accounts in the aggregate based on their 2011 production and taking into account ramp up time and anticipated launch schedules to produce about 7 billion in closing volume in 2012, about double what we predicted for Schwab.

Twisting in the (tail)Wind

The Donald Coxe conference call this week was very good, and it produced one particularly enlightening graph.

Long term rates, both treasury and mortgage, are at all time lows.  When the Fed embarked on operation twist, it was with the intent of bringing down the long end of the curve, and by doing so, propping up and ideally pushing ahead, the housing market.

I would say this was a success.

When you add to the fact of HARP II that interest rates are at all time lows and really, given the decline in house prices in many markets, are basically creating the conditions where you would be crazy not to buy a house, you just have to think that this is going to help origination activity in 2012.  I think the point that is sometimes forgotten is that the downard spiral of housing is really caused by the foreclosure mess.  Its the lynchpin.  If you could create the conditions to stem that flow, I think the situation would right itself a lot faster than is appreciated.

When core earnings matter

A lot of the time when a company is reporting some sort of non-GAAP earnings, its in order to hide something.  A good example of this is Salesforce.com.  They report non-GAAP earnings that exclude certain costs (particularly stock options) that they would rather ignore.

PHH reports a core earnings number every quarter but for a very good reason.  Core earnings is a far better representation of the company’s profitability than is the GAAP number.

The problem with the GAAP number is that it is obscured by changes in the mark to market value of the MSR portfolio. PHH has to write up and down their mortgage servicing rights with changes in interest rates and to a lessor degree credit quality.  When rates go down they have to write down the value of the rights and when rates go up they have to write up the rights.

The fluctuations on the income statement caused by these mark to market moves are huge.  Up to $400M in some quarters.  If you look at quarterly GAAP earnings over the past couple years they look like a scatter chart.

The reality of the MSR’s is that as long as the company is replenishing the existing pool with more rights from new originations then its losing to payoffs of its existing pool, its all good.  As I already noted, PHH is doing that.

The core earnings number takes out that effect. And if you look at that core earnings number you see a pretty cheap looking company.

All that, and discount to book…

The last point I would like to make about PHH is the discount relative to book value.   You can get the shares at a pretty substantial discount, even after the post-Bass run up:

What’s even more interesting is that this discount exists even after the valuation of the MSR portfolio has been clobbered by falling interest rates.  It is not impossible to imagine a scenario where the MSR’s add book worth $500M plus, or another $10 per share.

So what does Bass see?

To sum it up, with PHH you are getting a cheap company that has earned decent money of late and that should benefit from the tailwinds of HARP II, weary competitors and a rebounding housing market.

The negative with PHH is the debt they have coming due, and whether they will have the cash to pay it off.  That debt is an issue I believe is worthy of a post in itself, and I will try to get around to that next week.

Europe is still a problem

…it just doesn’t seem like it right now.

I have a few other things I was hoping to talk about this week but I’m running out of time and this letter is getting quite long already.  But I do want to talk a bit about some of the reading I have done on Europe the past week.

It seems what with the stock market rising every day that Europe is old news now.  Yet I think that to ignore the risk of Europe right now, to go all in, is still at best a gamble.  It may turn out, you could do it and cash out big in 6 months.  But to say you knew it would turn out that way would be kidding yourself.  We could just as easily wake up tomorrow in crisis mode again as in the happy-happy-risk mode that we’ve been in the last couple weeks.

Europe  hasn’t gone away.

The S&P downgrade of a number of European countries been widely reported already so I’m not going to dwell on it, but I do want to point out that the language used.  In particular:

We also believe that the agreement is predicated on only a partial recognition of the source of the crisis: that the current financial turmoil stems primarily from fiscal profligacy at the periphery of the eurozone. In our view, however, the financial problems facing the eurozone are as much a consequence of rising external imbalances and divergences in competitiveness between the EMU’s core and the so-called “periphery”.

This strikes at the basic point that I have made in past posts.  Austerity measures are not going to fix the problem with Europe because the problem is not a one time spending binge that just has to be paid off.  The problem is much deeper, relates to inherent inequities in the productive abilities of the economies, and is quite possibly not solvable without a break up.

As John Maudlin said in his piece “End of Europe”:

For most of the past two years, European leaders have tried to deal with the problems as though they were short-term liquidity problems: “If we just find the money to buy some more Greek bonds, then Greece can figure out how to solve its problems and then pay us back. Given enough time, the problem can get solved.”

They have now arrived at the understanding that it this not a short-term problem. Rather, it’s a solvency problem of the various governments, which of course creates a solvency problem for their banks. They are now addressing the problem of solvency and providing capital until such time as certain countries can get their budgets under control and the bond market sees fit to provide the capital they need.

But they are completely ignoring the third and largest problem, and that is massive trade imbalances. Germany exports products to the peripheral European countries, which run trade deficits. As I have shown in several letters, a country cannot reduce private-sector leverage, reduce public-sector leverage and deficits (balance its budget), and run a trade deficit all at the same time. That is simple, unavoidable math, based on 400 years of accounting understanding. Ultimately, there must be a trade surplus if leverage and debt are to be reduced.

There is a great model that Maudlin creates in the post that summarizes the situation of Greece, Portugal et al to a tee.  I would recommend reading the piece in its entirety.  One last point from the piece:

Prior to the euro, the imbalances would be handled by currency exchange rates. The value of the drachma would go down relative to the value of the deutschmark. Things would balance over time. Now, all of the eurozone countries are effectively on a gold standard, with the euro standing in for gold this time. Britain, the US, and Japan print their own currencies. Their currencies can rise or fall over long periods of time, based on national accounts and the desires of foreigners to buy goods or invest in their countries.

He is retreading the old Jane Jacobs idea that I brought up a couple weeks ago:

What Europe has embarked on with the Euro is the exact opposite of what is needed.  Currency regimes need to evolve to produce better feedback, not worse.  The Euro currency feedback mechanism is skewed by the strength of the German economy (actually more exactly the economy of its one or two prime export replacing cities, Berlin and Frankfurt).  Peripheral countries like Italy, Greece, Spain and Portugal are doomed to receive faulty feedback rather than the natural “export subsidy” that would occur if those countries had (lower value) currencies of their own.

To think that all is well is to mistake the calm eye of the storm for the end of it.

Meanwhile, I’ll end my Europe talk with this: There seems to be a growing recognition that Greece needs to exit the Euro.  The chief executive of Germany’s natural gas firm Linde’s chief executive Wolfgang Reitzle was quoted as saying the following in Reuters:

“In the medium term Greece needs to exit. And the writedowns on Greek debt will not be between 50 to 70 percent, but in the end will be written down by 100 percent,” Reitzle said.

Asking Germans to pay more than 50 percent taxes to help fund other euro zone countries will erode the will of the German electorate to support rescue measures, Reitzle said.

Although this scenario is not desirable, he felt that German industry would survive working in a new currency.

Atna’s jump in reserves (and share price)

I haven’t spent as much time as I should writing about Atna.  I tend to ignore the stocks that I am right about.  This is perhaps not the best way to self-promote, but since I’m not really in that ballgame anyways, who cares.  I learn more from my mistakes.

But don’t take that for disinterest.  I watch Atna like a hawk every day. As I pointed out a month ago, I think that if Pinson works out the stock is worth somewhere between $3 and $6.  I know that there is some skepticism around Pinson, that there may be rock stability issues, but I’m of the mind that the current stock price is more than pricing in that risk.

It feels to me like a stock being accumulated before a break-out.  Perhaps we got a taste of things to come this week when the stock popped over $1 and up to as high as $1.05.

On the news front, Atna released an updated resource at Briggs on Thursday.

There is not too much to get too excited about, though it is nice to see that they managed to move about 50,000oz to measured and indicated, basically replacing production.  Overall they showed a slight increase of about 14,000 oz all in.  At the current production rate (45,000 oz), Briggs is good for another 10 years. That alone is probably good for the current share price.

Buying Midway Energy (Again)

The other move I made this week was to reinitiate a position in Midway Energy.  I decided to pull the trigger here because the other Swan Hill players showed signs of moving up towards the end of the week.

I already own positions in Second Wave and Arcan (though the Second Wave position didn’t get taken in the practice account due to an unfortunate glitch in the order fill).  I did not own Midway and it had not moved higher and it seems a reasonable presumption that it will follow suit eventually.

Letter 25: Tax Loss Buying

I am on vacation with limited computer access so this is going to be a short letter.

There was some good news for the oil stocks in my portfolio this week.

News that should help Equal

Equal Energy has not performed very well lately.  I don’t expect much from the stock until something is announced with the companies Mississippian lands in Oklahoma.  While we wait, Sandridge, the biggest landholder in the Mississippian, jv’d 363,000 acres of their land to Repsol this week for $1B.   That works out to $2,754/acre.

SandRidge will sell an approximate 25% non-operated working interest, or 250,000 net acres, in the Extension Mississippian play located in Western Kansas and an approximate 16% non-operated working interest, or 113,636 net acres, in its Original Mississippian play. The 363,636 net acres in total will be sold to Repsol for an aggregate transaction value of $1 Billion. Repsol will pay $250 million in cash at closing and the remainder in the form of a drilling carry. In addition to paying for its working interest share of development costs, Repsol will pay an amount equal to 200% of its working interest to fund a portion of SandRidge’s cost of development until the additional $750 million drilling carry obligation is satisfied.

Admittedly, this is a little on the low side compared to some of the earlier deals.  That is because this deal included 250,000 acres of the second Mississippian play that Sandridge is involved in.  The second play is newer and riskier.

The fact that Sandridge was able to get $2,750 per acre while only including 113,000 acres of the prime land (in Oklahoma the heart of the Mississippian is Grant, Alfalfa and Woods) provides another positive data point for Equal.

Equal has 20,000 acres of land in the heart of the Mississippian.  This is another deal that suggests that the land is worth around $70M.   At $4.50, the stock trades at an enterprise value of $300M and with a market capitalization of $150M.  It is clear that that the Mississippian land is not priced into the stock.

I bought some more Equal on Thursday at $4.50.  I believe the recent decline in the share price is simply tax loss selling.  I believe that the stock would be undervalued at $7/share.  At $4.50, its a little ridiculous.

Coastal Energy News

Coastal Energy has been the best performing stock for me over the last few months.  They have hit on well after well after well.  The string of success continued with the B-09 well news released on Tuesday.

“The Bua Ban North B-09 well encountered the largest pay zone we have seen to date in this field. We are particularly excited that we have encountered oil across five Miocene zones. This confirms the lateral extent of the deeper pay zones below our main producing reservoir. Following this successful result in the deeper zones, we plan to drill further appraisal wells to continue testing the 63.0 mmbbl of prospective resources defined in the RPS report ofNovember 15, 2011, which are incremental to the 67.0 mmbbl of 2P volumes defined in the report.”

What is most important about the result is that it begins to prove up the lower miocene sands.  First Energy noted the following:

The Bua Ban North B-09 well discovered 3-4 mmbbl in deeper Micocene sands which could open a new play for Coastal with an overall prize of 63 mmbbl prospective resources.

The Miocene sands that Coastal is drilling into are actually a number of layered sands as shown in the illustration below.  Up until the B-09 well, Coastal had been focusing on the upper two layers.  The B-09 explored the lower layers.  The RPS report distinguished between reserves and prospective resource in the Miocene.  While the news release did not say so specifically the above snippit implies that most if not all of the prospective resource is in the deeper sands.

There is an excellent summary of the Micoene sands that Coastal is drilling into that was posted by Oiljack on the Investorsvillage Coastal board.

Midway gets us Excited and then…

The moment I noticed that Midway Energy was halted I went out and bought shares in Second Wave.  I thought for sure that the halt was due to a takeover bid and that there would be a subsequent boost to the other Swan Hills players (Arcan and Second Wave).  Unfortunately, while a takeover bid may indeed be in the works, the clarification by Midway left the waters muddied.

Midway Energy Ltd. (“Midway” or the “Company”) announced today that it has become aware that information may have entered the market with respect to certain potential transactions. The Company has not entered into any definitive agreement with respect to these transactions and will issue a press release when and if a successful transaction has been negotiated.

Nothing like clarity.  Nevertheless the stock popped when it opened and Second Wave popped along with it.

I think I will hold onto Second Wave for a while; their latest update was mildly disappointing with a few of the recent wells producing at far less than the earlier more prolific Crescent Point JV wells.  However according to an Acumen Capital report, the lower production rates can be attributed to a failure of the packer equipment during the frac operations, while the 100% WI well drilled to the south (08-23-062-10W5) was limited to 100bbl/d by the surface pumping equipment.  I’m not sure I understand that second one entirely, I mean why would the company install insufficient surface pumping, but nevertheless I hold out some hope that the going forward results for SCS will improve on these numbers.  Meanwhile SCS does not appear to be as encumbered with infrastructure requirements as Arcan is in the short term, so  capital is going to be spent drilling wells.

Unfortunately, as seems to happen from time to time, the practice account I post here had my SCS order rejected because of a lack of margin, something that clearly isn’t the case (I don’t think RBC spends much time updating and debugging the practice accounts functionality).   I am reluctant to try to re-buy the stock now after the pop so for the moment I will not have my SCS position reflected unless it falls back to the $2.45 range that I bought it at in my actual accounts.

Gold Stocks

I am not sure if it was a smart thing to do but I added positions in a couple of gold stocks this week.  These should not be considered long term positions; they are simply me trying to take advantage of what I see as the severe underperformance of the stocks when compared to the bullion.  I added a position in Semafo at $6.40.  Semafo is a mid-tier producer that has generally held up well in the market but that got taken down to new lows of late.  I also added a position in Canaco.  Canaco has had a rather spectacular decline from over $5 a share to a low of a $1.  That is where I bought it.  The company has what looks to be a decent deposit in Tanzania.  Moreover, at $1 they have a market capitalization of $200M and with cash on hand of $115M.

Portfolio

Week 21: Getting Worried Again

(current positions shown at end of post)

The benchmarks that I compare my portfolio performance to have begun to trend ominously down.  I am a little concerned about what the market will do next week now that Thanksgiving is over and investors are looking more soberly at a pictrue of Europe that really should perhaps not be viewed without a good bottle of scotch.  Of course the rumor making the rounds tonight is that the IMF is going to set up a massive bailout fund for Italy and that has the market soaring.  Count me a skeptic here.  Morgan Stanley put out the following note on the subject:

The Italian newspaper La Stampa reported over the weekend that the IMF is preparing a €400-600bn loan at a 4-5% interest rate for Italy. We would view this report skeptically, as even a credit line amounting to the lower end of the reported range would eat up the entirety of the IMF’s available $385bn (as of Sept ’11) forward commitment capacity. The only workaround would involve substantial IMF quota increases, a measure that would require the support of the US Congress.

The bottomline is that while stocks may be rising on the news, yields in Italy have hardly fallen this morning, an German yields are actually up.  There simply is no easy Sunday night fix for this crisis.

Europe Still Dictates my Decisions

What worries me is that in the end it is the ECB that has to step up and fill the void and there is more than a little evidence out there that the ECB has no intention of coming to the rescue of profligate governments.  There is a very good article in the NYT this weekend called As Crisis Mounts, Europe’s Central Bank Stands Back.  The article explains the ECB position.  Printing money to buy the bonds of countries facing funding problems does not solve the underlying issue. And the ECB is not necessarily going to step in.  Witness the following:

“I think markets are going up a blind alley thinking there’s going to be a common euro bond or thinking that the E.C.B. is going to act as a lender of last resort,” Norman Lamont, the former British finance minister, told Bloomberg on Friday. “I think Germany would rather leave the euro than see the E.C.B.’s integrity affected.”

Instead, the E.C.B. insists, euro area governments must amend their errant ways. “Governments need to ensure, under any circumstances, the achievement of announced fiscal targets and deliver the envisaged institutional and structural reform programs,” Mr. González-Páramo said in London on Friday.

This is true.  However what printing money does do is it avoids a full scale banking crisis and the commiserate deflationary recession brought on by the insolvency of Italy or Spain that results from the funding problems.

If the ECB chooses not to engage in significant bond buying, and to stand aside as Italian and Spanish yields march higher, markets will rightly conclude that a deflationary recession must be priced in.  And this isn’t going to be goo for any asset, save perhaps US treasury bonds.  It isn’t even going to be good for gold.

It is with that line of reasoning that I remain 50% cash, and while I am not allowed to short in my online portfolio, I am 50% hedged with shorts against my long positions.  My long positions remain significantly skewed towards the gold stocks.

Portfolio Moves:

I didn’t buy or sell any stocks this last week in my online portfolio. This was not entirely the case however for my actual portfolio.   In particular, I sold some Arcan early in the week this week.  My overall exposure to Arcan in my online portfolio  is about 5%.  In my actual portfolio it is now only 2%.  In addition to Arcan, I have a small position in Midway (about 1%) that is not represented here.  Let’s talk for  a second about the problem with these stocks.

Why you should be Wary the Oil Juniors:

Both Midway and Arcan are junior oil producers.  Arcan has a large (96,000 acre) position in the heart of Swan Hills.  I have written extensively on the company here.  Midway has a fairly large (33,000 acre) position in the Garrington Cardium and a reasonably sized position (23,000 acres) on the fringes of Swan Hills.

Both Arcan and Midway show strong growth in production, as witnessed below:

       

Based on their growth both companies look like great investments.  And they are… in the right environment.  The problem comes with the particular environment we find ourselves in.  We live in a credit constrained world.  Based on events of the last few months, most notably of late the escalating problem that even the Germans are having trying to raise money, and one has to wonder how well companies that are not self-financing are going to do.

The downfall of Arcan and Midway is that they are anything but self-financing.

With European banks teetering on the brink it just doesn’t seem like a great time to be taking much of a chance on companies that need cash.  I have reduced my exposure to Arcan and have decided to leave my exposure to Midway at its current level unless we see some sort of resolution across the ocean (as if).  I likely will wish that I had done the same steps here online.   Unfortunately Arcan fell rather substantially last week and I am reluctant to reduce the position now at below $5/share.

New Short Position in Deutsche Bank:

The other move that I made that is not expressed in the online portfolio is that I add a short position to Deutsche Bank.  I have been trying to add a short position in this stock for months.  Its hard to get the shares to short with.  I finally had some luck and shorted it at $34.  I have been reading about the company regularly in FT.  This is one leveraged bank.  The tangible assets to equity ratio is 60:1.  To compare, when researching the regionals, I wouldn’t look twice at a regional bank that had a ratio above 10:1, and many of the one’s I found most attractive (Home Federal Bank of Louisiana for one) had ratios of less than 5:1. This makes DB the most underfunded bank in the EU.

Secondly, DB relies on wholesale funding for short-term liquidity to a greater degree than most. Below is how Deutsche Bank stands in comparison to other EU banks with regard to the Net Stable Funding Ratio (NSFR), which is often used as a proxy for determining a banks reliance on wholesale funding.

It seems to me that the combination of high leverage and reliance on less than stable sources of funding are a recipe for a liquidity squeeze for DB as Europe continues to get worse.

Current Portfolio:

Week 20: Back into Gramercy, Adding to OceanaGold

This week I finally got my order filled for Gramercy Capital at $2.75.   Plan Maestro had another excellent write-up on Gramercy last month.  CDO-2005 did relapse and fail its over-collateralization test.  This may have something do to with the weakness in the stock.  Still, the stock has a net asset value somewhere north of $5.  And Bloomberg has had two articles in the past two months commenting on the likely sale of the company to private equity.  I feel comfortable holding shares bought at this level and waiting for such a buyout.

While on the subject of US real estate, I began to review some of the regional and community banks this week.  Community Bankers Trust, which released Q3 results last week, appears to be on the upswing.  The stock remains extremely cheap based on tangible book value or earnings potential.  I do not own any regional banks shares at the moment but it may be something worth looking at in the next (inevitable) downdraft.

I added to my position in OceanaGold on Friday.  I have had a standing bid in for OGC.to at $2.21, and it was filled.  This stock seems range bound between about $2.20 and $2.70.  I’m not sure why it cannot break higher.  I posted Sunday about the cash generation capabilities of Aurizon Mines.  I could have just as easily written about OceanaGold.  The only difference between Aurizon and OceanaGold is that Aurizon can continue to generate cash at lower gold prices.  In addition, OceanaGold’s costs get misinterpreted to be higher than they actually are because

  1. so much of them are being expensed right now, as opposed to capitalized.
  2. They are in NZD, which has been perhaps the strongest currency in the world this year

Absent these two factors, the first of which is really just smoke and mirrors, and the stock would be trading substantially higher.  As it is I am picking up a company with growing production, likely lower costs (the NZD is down from 83 to 78 so far this quarter), and doing it at the lower end of the trading range.

The last trade I made did not show up in the practice account but will next week.  On Friday I sold 1/3 of my position in Arcan and planto use the proceeds to buy Midway.   I have nothing negative to say about Arcan.  They appear on-track.  Nevertheless, Midway is a cheaper stock right now, especially after the recent steep drop.  Midway also appears to be a good takeover candidate to me, so I don’t mind being diversified in case of such an event.

Comparing the Oil and Gas Juniors

Earnings season should be upon us shortly for the Oil and Gas junior companies.  To prepare for the onslaught of earnings reports over the next month, I have updated and published below my junior comparison spreadsheet. I’ve added a few new companies to the list of those I follow, with those being Pinecrest and Galleon (now Guide Exploration).

A few things jumped out at me after having reviewe the spreadsheet:

  • We’ve had a big move in Equal Energy from $4 to $6, but even with that move the stock is trading very cheaply on pretty much any metric
  • Skywest really looks cheap compared to its peers.  I used to own Skywest, but I sold it when it looked like they were headed for a cash crunch.  I think it is worth looking at again at these levels.
  • Arcan trades at a premium to its peers.  Just something I like to point out to be aware of.  I believe that it should trade at a premium, but its worth remembering because it suggests that any production hiccup will be severely punished
  • Reliable Energy is starting to look interesting again.  They had some interesting drill results in their last update and are reaching that critical production level (1,000bbl/d) where they will begin to generate the cash flow needed to ramp their production up on a consistent basis

 

Week 17 Portfolio Update: Of Two Minds

My portfolio was up rather substantially last week, along with the rest of the stock market.  To be honest, I would not have expected it to happen that way.

My portfolio is constructed against what I see as an eventual calamity in Europe, and my expectation that as the dominos begin to fall, perhaps extending as far as Japan, that investors will reconsider the grand 40 year experiment with fiat currency , and with that they will reconsider gold.

(I’m really starting to sound like a gold bug, aren’t I?)

The market, on the other hand, looked at the plan (or plan of a plan depending on how exact you want to be with your language) that the EU laid out on thursday and apparently began to wave the all clear flag.

So what happened?  How did gold rally at the same time as the broad markets?  Isn’t this a conflicting signal?

Well it is and it isn’t.  I think you have to look that the situation through two lenses to truly understand the response of gold, of the stock market and of the bond market.

The first lens is reality. This is what the bond market and the gold market are telling you, and it is all about the inadequacy of the bailout.

The WSJ laid out a fact based piece on the front page of the Saturday Journal.  Sometimes the facts are as damning as any commentary.  While the market rallied on Thursday, the bond market hardly budged.  Sometimes a chart is worth a thousand words.

Worse, on Friday Italy held an auction and was forced to issue 10 year bonds at above 6%.

In Friday’s bond auction, Italy was forced to pay more than 6% interest on its new 10-year debt, approaching levels that some analysts said the country can’t afford for long.

Its actually somewhat surprising that the market has so far shrugged this off.  First, it is a pretty scathing critique by bond investors.  One day after the grand plan announcement and Italy is paying higher rates than it was even a few months ago.

Moreover, as the above quote alludes to, this crisis began in August when Italian bonds rose from 5% to 6%.  The reason that this seemingly innocuous move up was met with such fear by the market is because Italy is basically on the precipice of falling off the cliff of solvency and 1% can throw them over the edge.  While Italian government revenues can withstand a 5% interest payment, they cannot withstand 6%.

That is how thin the thread is that Europe hangs to right now.  Italy owes $1.9t of debt.  When you owe that much debt, over the long run (as that debt comes due) whether you are solvent is more a question of perception than anything else.

Right now the perception isn’t so good.

And let’s look at little closer at some of the details of the plan.  First, the EFSF.  Do you really think that the EFSF, which according to the same WSJ article is expected to guarantee only the first 10% of Italian and Spanish debt after default (I thought this was supposed to be 20%?) is going to appease investors at future Italian and Spanish bond auctions who have just watched Greece take a 50%+ haircut?

And do you really think that Greece is going to be able to live up to the forecasts laid out in the plan?  The recap agreed to will lead to a Greek debt load that will peak at 186% in 2013 and that will fall to 120% by 2020.   That alone is worth reading twice.  But it gets better.  This will take place if you presume their growth scenario of 1 1/4% by 2013 and 2 1/4% by 2015. Seriously.

Given the scenes I’ve seen from Greece the last few days I wouldn’t be betting my pennies that the country will be growing at 1.25% in a little over a year.  It looks like a country in collapse mode.  As the WSJ points out in another article on Saturday:

Greece is the canary in the euro zone’s coal mine. The bloc’s prescription for a crisis spurred by overborrowing and overspending is a dose of radical fiscal rectitude, delivered fast. To regain the confidence of skittish investors, countries are being asked to rip up paternalistic policies that provided stability and comfort to legions of citizens but left the state reeling from the bill. The question is, can it be done without igniting society into revolt?

Greece has youth unemployment of 43%.  They have total unemployment of 16% and rising at a pace that is beginning to look parabolic.  And they haven’t even begun to fire the civil servants that they need to in order to meet the austerity measures they have agreed to.  The country is being ripped up at the roots and it is supposed to grow again in a year?

Moreover, the one mechanism that could make Greece competitive is off limits.  They are stuck with the Euro, which means they are stuck playing on a level currency field with Germany even when they are clearly world’s apart.

On final point.  The bailout, and future bailouts, are all going to have to be be paid for by someone.  Those someones are Germany and France.  Neither of these countries are a fortress of debt virtue.  Both have debt to GDP ratios of around 80%.  This point seems to get forgotten.  The bailout-ers are really not in that much better shape then the bailout-ees.

I could go on.  But you get the point.  This is not over by a long shot.

But, having given my critique, I did say that I was of two minds right now.   What is the other?

Well I was re-reading The Big Short this weekend for perspective.  By the summer of 2007, when the two Bear Sterns hedge funds collapsed, pretty much everybody that mattered knew that sub-prime was a big problem.  By February 2008, when Bear Stearns collapsed, you would have had to be in a bubble to manage money and still not know anything about subprime mortgages.  Yet the market plodded along, rallying at times, until the fall of 2008.  And it wasn’t until after the shit hit the fan, after Lehmans went belly up and credit essentially ceased to flow, that the stock market actually began to plummet.

I think that what has to be remembered is that most money managers investing in the stock market are not really being paid to quantify the scenarios in Europe.  Its out of scope to have to account for that sort of risk.  They probably just want it to go away so that they can return to what they are paid for and go home when they are supposed to.

This deal appears to give them the out, for a while, that lets them do that.  What this deal has done is stave off the final denouement for another few months.  Enough time that the market can perhaps gleefully rally and pretend again that all is well.

And who am I to argue with that logic?  I’m certainly not going to go out and buy bank stocks based on it, but if the market is going to tread water for a while longer, there are a number of stocks out there that could benefit.

With that in mind, I bought some stock this week.  The first is I bought back some Equal Energy on the news of their property disposition.  As I have already written this is a good deal because it is a deleveraging one.  And Equal remains extremely cheap by any metric.  There was a very good post on IV that pointed out that Equal’s Mississippian land in Oklahoma is worth $60M to $75M alone at the going rate of recent transactions.

I also opened a new position in Midway Energy.  Again pointing to a post on IV, Midway is trading very cheaply based on its current production and cashflow.  As teh excerpt below points out, you aren’t even fully paying for the Garrington assets, let alone the potential in the Beaverhill Lake.

With the stock only trading at $3.61/share we believe the stock is not even fully reflecting the value of the Garrington Cardium assets let alone any value for the Swan Hills Beaverhill Lake play. Our base valuation reflecting the 2012 cash flow is $3.00 and the Garrington upside potential adds another $2.50. We therefore believe that investors are getting a free ride on the 40 net sections of Beaverhill Lake rights at Swan Hills with their investment in MEL.

As well I have sold down the extra shares I bought of Jaguar when it got into the low $4 range, and replaced them with shares of Aurizon Mines in the mid $5 range.  Jaguar, which was up 35% this week, is an enigma.  There was no reason for it to fall as much as it did two weeks ago, and there is no reason it rose last week.  I think its pure manipulation.  I decided to lighten up before the manipulators changed their stripe.

Finally, one stock that I have not yet bought (back), but that I plan to is Gramercy Capital.  The company is cheap, and it probably is going to sell itself sooner or later.  I will be buying on any significant correction downward.