It was like farting in church, during the silent prayer. I told the audience at Doug Casey's conference in Vegas last weekend, "If you're long natural gas, you ought to have your head examined." The audience looked back at me like I'd insulted their mother. Rick Rule made a bet with me about natural gas prices on the spot.
I didn't really get a chance to explain my thinking... And I was a little concerned that if I said anything more about it, Rick would be tempted to examine my head right then and there. He's a very, very big guy. But now I've had a few days to gather my facts...
First, natural gas prices – like oil prices – are notoriously cyclical. When you have a big boom, you know, sooner or later, you're going to have a big bust. Last September, there were over 1,600 working natural gas rigs in the U.S., a record amount by a wide margin. That number is now down 47%. But even with the decrease in working rigs, gas in storage in the U.S. is up almost 30% over last year and 20% above the five-year average for this time of year.
Even with half of the rigs on the shelf, gas reserves are still way above normal. A large amount of natural gas in storage at this time of year (at the end of the winter heating season) suggests prices are going to fall a lot over the summer.
Now, remember... natural gas and oil have always been boom and bust markets. Always. But over the last half-dozen years, a very powerful new idea – "peak oil" – led some market participants to believe the era of oil busts was gone forever. Don't laugh. Lots of otherwise very smart people bought into this nonsense.
According to these theorists, onshore energy production in the United States peaked in 1974 and energy production globally was going to peak in 2005-2010, depending on whom you asked. Thus, prices for natural gas and oil could only go higher in the future. Make a note: There's nothing more dangerous to investors than any theory which claims to know, with certainty, prices will always move in one direction or another.
What happened, in fact, is that the market worked just like a free market theorist would have expected. Higher prices led to vastly more drilling and more exploration. Huge new natural gas fields were discovered, improved, and exploited. And guess what? By 2008, the U.S. was producing 26 trillion cubic feet of natural gas per year, the most in the recorded 72-year history of natural gas production. So much for peak oil.
So... by the end of 2008, the U.S. was producing more natural gas than ever before, with more active rigs working than ever before, with more natural gas in storage than ever before, at the tail end of the largest price increase to natural gas, ever. Given these facts, I think you ought to have your head examined if you believe the price of natural gas is going up.
I am well aware that monetary inflation may drive the price up, if only because the price of everything is likely to increase. But if you're looking to hedge your exposure to the dollar, buying just about anything else is a much better bet than natural gas. Here's why...
We've discovered huge new reservoirs of natural gas, which are much cheaper and easier to drill than oil reserves. Proven reserves of natural gas grew by 12% in 2007 – the ninth straight year our proven gas reserves increased. (The data isn't available yet for 2008... but it's certain that reserves grew again, probably by double digits.) Over the last nine years, our proven natural gas reserves have increased by 45% – the steepest gain since 1944 to 1953.
It is hard to exaggerate how massive the gains in proven natural gas resources have been over the last few years. Just consider these numbers from one of the new sources, the Barnett Shale. In 1999, proven reserves in the Barnett Shale region totaled 2.4 trillion cubic feet. They now total 17.4 trillion cubic feet. And that's small potatoes compared to the Marcellus Shale in Pennsylvania. In 2002, estimates of the Marcellus gas reserve were around 1 trillion cubic feet. Now it's believed there are 500 trillion cubic feet of gas in this one shale formation. Even if only 10% of this gas is produced, that would increase our total current reserves by 20%.
I bet Rick Rule natural gas prices would fall to below $3. He shook my hand, made the bet, and then adjusted it. "Let's make it $3.25," he told me. "I like you... I don't want to take your money so easily." It usually doesn't pay to bet against Rick Rule when it comes to resources. But I like my chances on this one. We'll see what happens.
Knowing how bearish I am on natural gas prices, you will undoubtedly be puzzled to learn I've been making a killing for my readers by going long natural gas drilling stocks. We're not buying the producers. We're buying the companies that own the drilling rigs.
Why would we invest in drilling rig companies now? Simple: That's when it's cheapest to buy them. You buy straw hats in the winter, not in the summer. Says our oil and gas analyst, Matt Badiali: Oil service stocks are the cheapest they've been in 20 years. You can buy drillers for less than half of book value because investors see them as having no earnings potential. Meanwhile, at the top of the market, they will trade for four or five times book value.
Matt points out Rowan (RDC), which has had six cycles in the last 20 years. If you bought when the stock was cheap compared to its book value and sold when it was high, you at least doubled your money every time. On the best run, Rowan went from $6 to $40 per share.
You'll find the same kind of cycles in all the onshore drilling stocks. We bought our first one, Patterson, in my Investment Advisory back in January and sold a call against it, earning about 30% upfront. As long as the stock is above $10 by the end of the year, we keep the entire premium. We bought our second driller, Rowan, by selling a $12.50 put against the stock in early February, in Put Strategy Report. So far, we're up 50% on our margin. And we recommended buying Bronco Drilling outright in Inside Strategist in March. We're already up 43%.
We warned you: The MGM Mirage bankruptcy is imminent... The casino giant has a $220 million debt payment due today. And CityCenter, the $8.6 billion Vegas development owned by MGM and Dubai World, hired Dewey & LeBoeuf to prepare for a possible bankruptcy filing. To make things worse, Dubai World sued MGM for breach of contract and said it will not make its half of the $220 million payment. If MGM covered the entire payment, it would nearly deplete its $250 million in cash, leaving the company vulnerable to the additional $1 billion in debt it has coming due later this year.
The homebuilding stocks have rallied strongly because investors believe home sales are rising. (They're not... but that's what the papers keep telling people.)
From WSJ: "Sales of new homes rose in February for the first time in seven months, the Commerce Department reported Wednesday, another sign that the housing market is thawing." From Bloomberg: "Purchases of new homes in the U.S. unexpectedly rose in February from a record low as plummeting prices and cheaper mortgage rates lured some buyers. Sales increased 4.7 percent to an annual pace of 337,000."
We don't mean to pick on Bloomberg or WSJ – which normally do an admirable job. Almost every mainstream media source reported this story about rising home sales yesterday. Meanwhile, the actual data, presented by the Census Bureau tells a different story.
Says the actual report: "Sales of new one-family houses in February 2009 were at a seasonally adjusted annual rate of 337,000, according to estimates released jointly today by the U.S. Census Bureau and the Department of Housing and Urban Development. This is 4.7 percent above the revised January rate of 322,000, but is 41.1 percent below the February 2008 estimate of 572,000.
So over the last year, new home sales have actually fallen by 41%. (Thanks to Barry Ritholz for pointing this out.)
News highs: none.
In the mailbag... We get asked a lot why we never report on our trades that go bad. Au contraire... If you read our letters, you know we spend a lot of time commenting on the recommendations that don't work out. And we even publish our Hall of Shame from time to time. The truth is, we remember our bad trades far longer than our good trades. And we learn more from them, too. Today I'll dissect a short that went against me – my recent Continental Airlines recommendation. I'll do so by responding to a Continental bondholder who objected to my research. Send your "what the hell happened" questions here: feedback@stansberryresearch.com.
Porter comment: What follows isn't a typical mailbag. We received a long and detailed letter from a subscriber regarding my research on Continental Airlines. I've broken up his letter into a series of bullets, so that I could reply to it in sections. I hope that will make it easier for you to understand both of our points.
"Porter, I bought some of the Continental 2011 notes for $720 and $700. I was kind of surprised to see them fall to $570 lately and wondered why. Then I saw your latest PSIA and realized that was the likely cause. I will now buy more on the cheap and for that I thank you. You have written such great pieces on Fannie, Freddie, MGM, and GM going broke that I had to check out and refute what you stated about CAL. I told myself not to fall to the narrative fallacy and was more than willing to sell my notes at a loss if I was wrong, but there were way too many mistakes in your piece...
Porter comment: Your 2011 notes are declining in value because Continental will almost surely experience a cascading debt default by the end of the second quarter. And if not by then, certainly by the end of the year. Debt and operating covenants will trigger this default. The airline agreed to keep $2 billion of unrestricted cash on its balance sheet in order to satisfy its credit-card marketing partners, Chase Bank and American Express (frequent flyer miles). If cash falls below that level, Continental must post increasing amounts of collateral, up to $926 million. Doing so will trigger another default on its revolving debt, which will then trigger so-called cross defaults on its entire $5.9 billion debt complex. As the company explains in a recent SEC filing:
[P]osting of significant amount of cash collateral could cause our unrestricted cash, cash equivalents and short-term investments balance to fall below the minimum of $1.0 billion required under our $350 million secured term loan facility, resulting in a default under the facility. The posting of such additional collateral under these circumstances and/or the acceleration of amounts borrowed under our secured term loan facility would likely have a material adverse effect on our financial condition.Continental is now down to $2.6 billion in unrestricted cash. It has been losing around $400 million per quarter on its operations. It faces a huge oil-derivative loss (more than $400 million) under a contract that will expire this year. It also faces large capital obligations ($5.6 billion) relating to a contract to purchase 87 new jets from Boeing between now and 2016. This year's obligation relating to the Boeing contract comes to $495 million. Finally, Continental owes $832 million of long-term debt principal this year. Looking at the numbers – $2.6 billion in cash, $400 million per quarter in losses, $400 million in derivatives losses, negative $500 million relating to the Boeing contract, and $832 million in debt principal coming due – I concluded the obvious: Continental is overwhelmingly likely to require more capital this year than it can acquire without defaulting on its existing debt.
Assuming the bondholders demand to be paid, there is no doubt Continental will go bankrupt this year. As far as buying more of the notes as they continue to fall in price, I'm quite sure you'll get your chance. These notes are probably worth less than $0.20 in bankruptcy, which is where they're headed.
Porter comment: My analysis doesn't consider any other airline – only Continental. Whether the other airlines are making money or not is completely irrelevant to my analysis of Continental's solvency.
Porter comment: No, I don't. Big brokerage firms (that publish "research") get paid to help Continental sell equity and debt. They have a permanent and fundamental bias. If you take their "research" seriously, you're making a huge mistake. And if we spent our time reading and criticizing investment bank reports, we wouldn't have time to do anything else. Nor would anyone care about our work: Everyone knows investment banks only publish their own book.
"And I have to question if you even looked into what these hedges were. 3% of the hedges require CAL to buy fuel at the equivalent of $1.33 a gallon. 6% are at $2.54. This is hardly scary stuff. True, the final hedge is brutal. It requires CAL to buy 14% of its fuel for the equivalent of $3.40 a gallon. But how much is this really going to cost CAL? From the 10k, 'At December 31, 2008, our fuel derivatives, including contracts with Lehman Brothers, were in a net loss position of $415 million resulting from the recent substantial decline in crude oil prices.' And the closing price on Dec. 31, 2008 for WTI oil was $44.60. From the 10k, 'We estimate that a 10% decrease in the price of crude oil and heating oil at December 31, 2008 would increase our obligation related to the fuel derivatives outstanding at that date by approximately $118 million.' But as of today, oil is 20% higher than it was on 12-31-08. If a 10% increase costs $118 million, doesn't a 20% increase mean a gain of $236 million? If so, that would mean the loss on the fuel hedges has gone from $450 million to $214 million. CAL has already set aside $170 million, so the fuel hedge burden per my cocktail napkin calculations amounts to a meager $44 million in added costs if oil stays at these levels."
Porter comment: The structure of the various fuel hedges is largely irrelevant to my analysis, which is based on the total exposure. According to Continental, it owed $415 million on these contracts at the end of 2008. And these contracts don't expire until the end of 2009. If oil goes up, Continental may end up paying less. If oil goes down, Continental will end up owing more. That's one of the unknowns. But even if Continental ends up owing nothing on these contracts, it should still be forced into bankruptcy this year.
Porter comment: I don't pay any attention to other people's estimates. I know why such things are published... and it's not to help me make money. I pay even less attention to "earnings" which are based on some accountant's estimate of profits, not actual cash earnings.
I do pay a lot of attention to stats like revenue per seat-mile. These are real facts, and they suggest Continental's most important product – business-class fares – is doing even worse this year than last year. I'm assuming Continental will continue to lose $300 million to $400 million in cash during the first quarter of 2009. Given its revenue-per-seat-mile stats, I don't see how I could possibly be wrong about this figure.
Porter comment: Good luck following Standard & Poor's advice. I don't know why it would rate the stock a buy. But these are the same wunderkinds who rated subprime mortgages "triple-A."
"Then of course, there is the problem with the amount of the debt. You are not marking it to market. If the market value of said debt is 47 cents on the dollar (and the 2012 notes as of today are 57 cents), then CAL's cash and debt are roughly equivalent. 'The remaining $244 million obligation will be due at year-end. Also due before year-end are $832 million in long-term debt and $551 million in aircraft-purchase obligations. That's at least $1.6 billion in nonoperating obligations due this year. There's simply no money left to pay them.' There is ample money thanks to the nearly $3 billion savings in fuel costs.
Porter comment: If what you say is so – that Continental will make so much money thanks to cheaper jet fuel than it will earn enough to pay its debts – I could very well end up being wrong in my analysis. But if you're right, Continental should suffer even bigger losses on its oil derivatives. And if you're right, Continental should have made money on its operations in the fourth quarter of 2008. It didn't. It lost more than $300 million in cash.
Porter comment: Demand for jet fuel is down because far less people are flying. That reduces pricing and the number of seats filled for Continental. If you did a correlation between jet fuel prices and Continental's earnings, you'd discover Continental does better when jet fuel prices are firm, not when they're falling.
Porter comment: Right or wrong, my research was certainly rational. What seems irrational to me is to buy a bond from an airline. Especially when you don't even understand the terms of the debt covenants or have any real way of knowing what the company's derivative exposure will be by the end of the year. Furthermore, in the entire history of the airline business, the industry as a whole hasn't made enough money to pay for its planes. Airlines stocks are always burning matches. It's only a matter of time before they go bust. And when they go bust, you don't want to be holding their stock or their bonds.
Ironically... shares of Continental recently rallied past our stop loss ($9.07). So regardless of my analysis, we will end up taking a loss here. Stocks have rallied tremendously over the past three weeks. The Dow is up 21% – the biggest, fastest rally since 1938. A rally that big is going to cause a lot of folks to cover their short positions, resulting in moves like we've seen in these stocks. That doesn't mean my analysis is wrong. So... why cover? Because the market can be irrational for longer than you can remain solvent. We made a killing on our short positions during 2008. Now we're paying a bit for them. And that's OK. You should remember that at the same time we put on our short of Continental, we recommended buying shares of Calpine – and they're up 34% as of today. So on a net basis, you should be up around 10% in just a month. That's a great performance. And that's how we play the game. Our long-term goal is merely to break even on our short positions. This gives us free insurance against a broad decline in stocks – like the decline we saw last year. If this approach doesn't make sense to you, no problem. Feel free to ignore our short selling advice.
Regards,
Porter Stansberry
Baltimore, Maryland
March 27, 2009