Friday, January 21, 2011

Chesapeake Energy's Derivatives Strategy

Aubrey McClendon, Chesapeake Energy's CEO, made news this week for an audacious move to juice Chesapeake's net income.

His bet on natural gas over the last few years turned bad, causing him personal losses on margined positions. Now, with gas prices looking soft for the near term, he's moving the firm into oil drilling. Sensing weakness, activist investor Carl Icahn has bought into Chesapeake.

Meanwhile, McClendon has Chesapeake aggressively hedging natural gas prices forward, with some positions allegedly not expiring until 2020.

Some analysts and fellow traders argue that Chesapeake is playing with fire. The company has already bet on gas prices as far into the future as 2020—a date so far ahead, some skeptics say, that the markets are too tough to pinpoint. CNBC reporter Kate Kelly wrote a piece yesterday which noted,

“I don’t really like the idea of selling out call options on gas prices and oil prices—mostly gas prices for the long-dated options—10 years out so that I can get more revenue today,” says Phil Weiss, a energy analyst who recently downgraded Chesapeake to a sell rating. “It’s just another way the company is mortgaging its future.”

McClendon counters that “90 percent” of Chesapeake’s hedging activity is focused on the “next eighteen months.” The trades dating to 2020, he said, are “basis hedges” intended to mitigate risk events in regional markets.

Other critics argue that Chesapeake’s hedges, while likely to succeed in the immediate future, will be tough to replicate longer-term.

“In 2011 they’re going to have material hedge gains,” said one energy trader whose company policy prevents him from speaking on the record, “but they’re not going to have that luxury going forward. Because if prices go up, they’re in great shape. But if prices stay depressed, they don’t have the flexibility they did in the past.

Chesapeake officials acknowledge that if gas prices rise far above the strike prices of the calls they sold—$5.84 and $6.19 for the next two years respectively—they could lose some money. But in that case, say officials, they’d be happy because produced gas could be sold at a higher price.

McClendon himself takes offense at the notion Chesapeake has become a hedge fund—a label Weiss and some traders have recently slapped on the company. “We don’t gamble. We don’t bet. We’re physically long gas,” McClendon says. “All we’re doing is mitigating risk.”

Unlike other gas and drillers, some of whom employ hundreds of dedicated traders, Chesapeake’s hedging team is a party of three: McClendon, newly-appointed chief financial officer Domenic Dell’Osso, and Jeffrey Mobley, the company’s senior vice president of investor relations. Before the team makes a move, its members say, their decision must be unanimous.”

Regardless of McClendon's remarks, doesn't this basically turn Chesapeake from a natural gas producer to a closed-ended natural gas options fund? Being naturally long due to their ostensibly main business doesn't make Chesapeake not a hedge fund. They could have just as easily bought options on production instead, and be just as long.

I'm not an energy sector analyst, but most pundits appearing on CNBC yesterday seemed to be shocked at McClendon's recent strategy moves.

I don't quite get how, if the firm has sold calls on current production, they can then claim that rising prices benefit them. Unless, of course, they didn't sell calls on much production capacity. It wouldn't seem that they can have it both ways.

From a larger perspective, McClendon can't both be able to profit more in the future if he's smoothing income now through the use of derivatives. Using derivatives either caps profits and/or losses, or is a one-way bet.

As I read McClendon's comments, and those attributed to the firm's executives, it's not clear which Chesapeake has really done. Which ought to give investors pause.

Repercussions of Meredith Whitney's Muni Bond Default Warnings

Only Monday I was writing of Meredith Whitney's warnings on impending muni bond defaults, putting her publicly at odds with PIMCO's Bill Gross. Further, Whitney explicitly called Gross on the motivations behind his rosy view of such fixed income instruments.

Yesterday on CNBC, Doug Dachille provided his usual scintillating and informative remarks on the fixed income market.

For starters, he agreed with both Gross and Whitney that there will probably not any US state defaults. Dachille then launched into a unique analytic description of how state tax-exempt munis play a part in financing vis a vis tax increases and defaults. Specifically, he noted that most holders of a state's bonds are wealthy state residents, because of the tax exemption. Thus, Dachille noted, a default was as good, or bad, as a tax increase, because, either way, it came out of the same pocket. However, he explained, when a state cut services to fund bond payments, that was essentially regressive, as the state's lower-income residents probably got disproportionately hurt, while the wealthier households continued to enjoy their interest payments without tax increases.

Very interesting insights on income redistribution, taxes, budget cutting and public finance bonds.

Then Dachille told a story that reinforces my belief that retail investors should never, ever, directly purchase bonds. He described a NY city waste treatment plant bond which provided for interest payments before the city was paid its operating expenses. Thus, he noted, the bond was doing nicely at 5+% and had a nearly zero chance of default. But, he cautioned, you had to do your homework to know this. Not all bonds are equal.

Exactly. Which is why when friends talk to me of building bond ladders, I cringe. Unless you are talking very plain vanilla corporates or Treasuries, you're playing with fire. Not to mention the brokerage fees hidden in the spreads when buying individual bonds.

Then Dachille pointed out another important feature of bonds, i.e., with rates so low, and nowhere to go but up, a non-defaulting muni has only its total cash flow as its maximal value. Thus, he said, investors have to realize that muni bonds aren't going to be growth instruments yielding 12% return rates, as equities might.

In sum, he painted what I think is an accurate, often missing picture of fixed income investing as much more risky for retail investors than is generally realized. And why well-managed bond funds serve an important function.

Thursday, January 20, 2011

Holman Jenkins On Apple, Goldman & Facebook

Holman Jenkins, Jr.'s editorial in yesterday's Wall Street Journal dealt with the uselessness of the SEC. He approached the topic rather ingeniously, using the recent news concerning Apple and Facebook.

Regarding Apple, Jenkins simply noted that the firm has disclosed what it felt was sufficient regarding the health of its iconic CEO, Steve Jobs. After that, shareholders are free to buy, sell, or hold the stock, as they wish.

For what it's worth, I believe Jenkins is the first major pundit whom I've read that has explicitly stated the same sentiment I share on this topic, i.e., shareholders have the ability to exit their position in a stock, at nominal cost, if they don't like something about the way the firm is managed. Period. Stop whining.

On the matter of Facebook and Goldman Sachs, Jenkins concluded his brief series of pieces which have generally lauded Facebook's management and absolved Goldman of anything other than simply doing their usual job. Since I wrote this post last week, Goldman yanked its Facebook private placement from its domestic clients, ostensibly to avoid potential SEC sanctions, and, instead, turned to its overseas client base. This has reputedly resulted in a lot of angry domestic clients.

Jenkins has written several pieces extolling Facebook's Zuckerberg's right to remain private, maturity in recognizing his own not-yet-ready-for-prime-time management expertise, and the victimless nature of the firm's right to use a private offering rather than an IPO to raise more capital.

I continue to disagree, somewhat, with Jenkins on the matter of public access to such firms only after the big initial gains are locked in for the wealthy few. But I enjoyed reading his clever turn on the SEC, contending that Goldman's sudden reversal makes a mockery of the agency.

Specifically, Jenkins contends that the SEC made noises about the lack of total privacy of the Facebook private placement in part to look aggressive and tough in the wake of its lapses in the Madoff case and the implosion of the major investment banks, under its watch, during the 2007-09 financial crisis.

On both Apple and the SEC, I concur with Jenkins. He's especially astute to point out how the SEC, by its very existence, has ironically resulted in more investor risk, not less, since many believe the SEC has made investing safe.

Obviously, it hasn't, which creates an enormous and expensive unintended consequence. The core benefits of the agency, whatever they would be, could no doubt be achieved for less money and with less interference in market activities.

Wednesday, January 19, 2011

Paul Ingrassia's Success Call On "The Great Auto Restructuring"

Only a week ago, I wrote this post regarding AutoNation's CEO Mike Jackson's shameless, disingenuous cheerleading for auto stocks on CNBC. In the interests of equal time and treatment, I guess I must also discuss my one-time squash partner and friend, Pulitzer Prize-winning writer Paul Ingrassia's recent Wall Street Journal editorial entitled The Great Auto Restructuring Shows Signs of Success.

Rather than rewrite the prior post's highlights, let me quote from it,

"Thus, to hear Jackson's version of history, the only way America's automakers could be saved was by government rescue. And that was necessary to preserve jobs and technology.

Well, as I've written in several prior posts, a conventional Chapter 11 filing by GM and Chrysler would have provided both with the time and opportunity to reorganize, group healthy units together and refloat them independently, or sell them to bidders. Further, neither company had to cease operations to do this.
Why Jackson seems ignorant of this fact is beyond me. I guess he's either not creative or simply not well-versed in the very real and frequent occurrence of business death or dismemberment.
So, to hear Jackson sing the praises of GM and Ford and the coming high volume vehicle unit sales years is to listen to someone tell half of a story. Give any business free government help to an extreme and you'll get the same happy ending. Jackson failed to discuss government-mandated purchases of hybrids and other unholy consequences of the excessive intervention.
The chart above displays the lone US automaker with a continuous price history, Ford, and, for good measure, Jackson's Autonation, along with the S&P500 Index.

If you have a technical inclination, you might notice that both firms' recent rapid price gains don't have long term sustainable precedents. In Ford's case, it's pretty clearly just a function of the rebound from the nadir of the 2008-2009 market bottom. Of the three series, anemic as its last decade has been, the S&P is the least volatile, ending with a much better performance than either company.
Of perhaps more import is how both Ford and Autonation have current share prices below their 1990s-era tops. Autonation peaked a few years before Ford, but both had either a flattening or multi-year decline for most of the past 12+ years. Jackson became CEO of Autonation in 1999, so he owns most of that performance.
What Jackson chooses not to explain, or perhaps genuinely doesn't realize, is that automaking is, for the most part, an unattractive commodity business over the long term. He railed about how China is the real 'Government Motors,' but, if true, this simply proves my point. It's hardly the sort of industry in which you'd invest a billion dollar fortune, if you had one to invest.
When you consider where most of the so-called innovations in vehicles originate, it's typically with vendor-supplied assemblies or devices, e.g., anti-lock brakes, airbags, and, now, so famously touted by Ford's Mulally, all manner of wireless communications devices. Thus, most of the profit for the automakers would seem to be sourced in design, rather than manufacture. Otherwise, the smart, value-adding components are available from sector vendors to any assembler.

Doesn't sound very attractive as an investible sector to me. Rather, it sounds more like a case of advanced Schumpeterian dynamics, wherein the value-added growth has long since left the sector's auto assemblers. The entry of Korean and Chinese automakers, and near-exits of GM and Chrysler fits the description of an industry with low barriers to entry and exit."

Here's some of Paul's glowing prose regarding the alleged success and its meaning for broader American fortunes,

"The good times are beginning to roll again, far faster than anybody expected, at General Motors, Ford and even at the weakest of the Detroit Three, Chrysler. There might be a lesson here. If the Great Restructuring has the potential to resolve the seemingly intractable problems of Detroit, perhaps bold structural overhauls can produce similar results on some broader issues facing America. Sure, that's a lot to hope for—but consider what tough love has done in the Motor City.

In 2005, General Motors lost an astounding $10.6 billion—this in a year when Americans bought nearly 17 million cars and trucks, nearly an all-time record. Last year, industry-wide sales totaled 11.6 million vehicles, historically depressed by any standard, but GM posted net income of $4.8 billion through Sept. 30. The company hasn't reported full-year results for 2010, but earnings will easily top $5 billion.

At Ford, the only Detroit company that didn't go bankrupt, the financial turnaround has been even more dramatic. Ford lost $12.6 billion in 2006 but earned $6.4 billion in the first nine months of last year. It just announced it will hire 7,000 more employees. Chrysler, meanwhile, is operating at break-even, and its cash flow is positive.
The average vehicle on American roads today is 10.2 years old, says R.L. Polk Co., which collects such data. This compares to an average age of 9.4 years five years ago and 8.8 years a decade ago. The point: Cars and trucks are getting older and will have to be replaced.

GM now makes 28 vehicles per year for each employee, calculates Goldman Sachs auto analyst Parick Archambault. That's more than double the company's productivity during the 1990s, he notes, and fully four times as high as in the 1950s, Detroit's glory years. GM's hourly labor costs now amount to just 6% of its revenue in North America. That's down from nearly 30% a few years ago, when the company was paying tens of thousands of workers to sit idle, and paying the full freight for employee health care.
GM's gains, and similar ones at Ford and Chrysler, have occurred because of the Great Restructuring, much of which came at the insistence of President Barack Obama's automotive task force.
The car companies' unlimited health-care obligations to retired workers have been replaced by a trust, funded by company contributions that are capped at a fixed amount. Active workers now pay about 5% of their health-care costs, up from nothing a few years ago.

Of course, 5% is only about one-fifth of what the average American employee contributes out of wages to his own health-care plan. That's one sign Detroit's turnaround remains fragile, threatened by the companies' traditional tendency to confuse comeback with victory. But even in labor relations there's a whiff of fresh air.
When GM's new CEO, Dan Akerson, suggested this week that workers' wages should be tied to corporate performance, the new president of the UAW, Bob King, quickly said he's willing to discuss the idea.
The United States is facing trillion-dollar federal deficits that are patently unsustainable, and the broad debate in Washington is whether tax increases or spending cuts are the proper solution. But neither approach, nor a combination of the two, will work without restructuring the vast federal entitlement programs that are the national equivalent of Detroit's Jobs Bank.

Social Security can't and shouldn't be abolished like the Jobs Bank was. But it can and should be restructured—to encourage later retirements, for example—as part of a broad entitlements reform.
States are burdened with underfunded pension plans for public employees that have destroyed their fiscal probity. It's nutty to raise taxes to plug state budget deficits, as Illinois just did, without restructuring public-employee pensions that allow workers to retire in their fifties, in some cases, with 80% of their pre-retirement incomes. Restructuring public-pension plans into 401(k) programs will spur fierce union resistance, just as key elements of the Great Restructuring did in Detroit. There's no painless way out of this problem. But further delay will only increase the pain, as Detroit's disaster of 2009 proved.
We should learn from success. Tough-love restructuring can produce renewal. With political will, resolve can produce results."

First, let me suggest reading this post from last summer. In it, I discuss Paul's review of another journalist's book about the Detroit automakers. He admits to journalists cheerleading without giving full disclosure,
"Ingrassia's opening sentences say it all,

"Many of the journalists who covered the long decline of General Motors that led to last year's bankruptcy were, in their hearts, rooting for the company. Such reporters- I among them- would seize on the occasional piece of good news about GM to write something upbeat. It would be a journalistic coup, after all, to be the first writer to call the company's turnaround. In any case, no one who grew up during GM's heyday, in the 1950s and 1960s, wanted to see an American icon self-destruct."
Together, Ingrassia's inclusion of these passages tells us a lot about why we should simply not trust most beat reporting on US companies and industries.

Reporters are not sell-side analysts. And, for that matter, we know from the last decade's dot-com bubble that sell-side analysts are, in reality, marketers for the equities which their firms underwrite and in which they make a market.
You'd ordinarily think that a reporter was more objective than an analyst whose firm clearly has conflicts of interest.
Ingrassia's review tells you different. I am not sure Paul meant to open the media kimono quite so widely, but there it is."

Let me reiterate that I like Paul Ingrassia as a person, but, thanks to that review, I can't say that I completely trust his coverage of the auto sector in the public press anymore. His own words make that a reasonable stance.

Next, I won't question Paul's many numbers involving Ford's and GM's costs, volumes, profits, etc. I simply reiterate my contention that the basic entry/exit realities of the sector suggest it's very mature and suspect for investors.

Further, Paul makes quite clear that none of this was possible without egregious government intervention. Give your local dry cleaner or restaurateur the same help, and he will eventually show promise, too. But what about years later, when the free bailouts are finished and these businesses have to prosper on their own?

Don't you think that as soon as GM or Ford book large profits, the unions and government will come screaming at management nest-feathering? Sure, it sounds good that a union official "is willing to discuss" linking wages to profits. Try getting that into a contract. The existing health care cost-sharing remains a glaring inequity for UAW members versus the rest of America.

Now, I don't even agree, based upon my prior posts, including the linked one at the beginning of this post, that Ford and GM have accomplished legitimate, long term, sustainable turnarounds. But whatever improved performances have occurred would not have been so, in GM's case, without the bailout, unless the firm were put into Chapter 11 and allowed to exit the traditional way.

So I find it troubling that Ingrassia gets all googly-eyed about how what worked for Detroit could be a template for America to self-rescue on its federal entitlement programs.

Of course, as all pundits, Paul quickly disavows really scrapping Social Security or public pensions. Instead, he is in the camp of some sort of sensible discussions and negotiations with recipients to rationalize and temper the liabilities.

Well, Paul, there's a bit of a problem with that. First, GM's bailout only happened because the federal government basically printed the money for it. That has caused enough problems already. Some of the backlash by overseas investors was precisely because they watched their loans to the US government be funneled to the UAW.

However, there's nobody to bailout the US.

If anything is an object lesson in the administration's bailout of GM, it's to borrow the template used to illegally stiff legitimate senior creditors. If the US could do that to GM bondholders, why not use such tactics to cram reforms down the throats of Social Security and public pension recipients?

Works for me!

Other than that, there's nothing about the GM bailout that is really transferable to the larger public pension or federal entitlement spending mess. It's not just like a business problem. And that particular UAW benefits problem was 'solved' by our government printing and throwing money at it.

Despite Paul's best hopes, I just don't think that's going to work for the entitlements messes he believes will be resolved in that manner.

Tuesday, January 18, 2011

Steve Jobs' Medical Leave, Cash Levels & Apple Pundits

Since I wrote this morning's post over the weekend, I didn't include the recent news of Steve Jobs' latest medical leave. Nor this morning's Wall Street Journal pieces concerning Apple. One focused on new Android devices, the other on an institutional manager's fury over the tens of billions of cash on the firm's balance sheet.

Of the three developments, I'd say that Jobs' departure will be the most critical. As expected, it knocked some value off of the equity's price this morning, causing a 3.7% drop by 11AM, as I write this post. As a growth equity, it's understandable that uncertainties over Jobs' future at the company will affect the forward-looking component of its price. So even strong quarterly performance reports will probably be overshadowed by these worries.

As to the cash concerns, I continue to be surprised by whining fund managers who can't simply make a buy/sell/hold decision. They keep wanting to push management by complaining in public, whereas simply dumping the equity if they really object to Apple's financing policies would probably have far more effect. Until these managers mount an Ed Lampert-style takeover of Apple, however, they'd be better off just voting with their trades.

As to Android-based smart phones, the back page piece in the Journal's Money & Investing Section didn't really impress me all that much. The major gripe the author had was that, like its laptops, Apple commands a high price premium for its iPhone, making Android devices more attractive to carriers for discounting. But at the very end of the piece, he admits that Apple's apps are triple the current number for Android phones.

Isn't the real issue, however, growth of Apple's iPhone base, not total market share? Apple's share of PCs and laptops hasn't been dominant, but their sales certainly have continued to help fuel the firm's revenue and income growth.

I remain comfortable trusting the management that brought Apple to its path of consistently superior performance. If Steve Jobs becomes unavailable in the long term, that will probably affect the company's share price and, thus, it's implied performance for shareholders. It's a self-fulfilling prophecy that could very well remove Apple from my equity selection process' results. So be it.

But the other concerns seem, to me, pointless. Such second-guessing is akin to trying to influence the same management which has produced the results which drive investors to buy the equity in the first place.

More of James Stewart's Questionable Investing Advice

I have had the occasion to answer some investing questions from friends as the new year begins. Having been professionally involved in equity and options investing for nearly 15 years, and in the financial sector for much longer, my advice is typically simple.

Avoid individual equities unless it's speculative money. If investing for a longish term, stick to dollar-averaging the S&P500 from a low-cost fund complex. Any other sector bets are best made via Vanguard or comparably-priced, passive index fund complexes.

The dirty little secret of investing is that non-professionals should steer clear of individual equity, bond or option trading and, for that matter, trying to chase the, on average, 25% of actively-managed publicly-available funds which manage to beat the S&P500 Index each year, because they are usually a different 25% the next year.

So I found a recent Wall Street Journal column by its official investing guru, James Stewart, particularly disheartening. Stewart spent most of the article's ink fretting about Apple's continued dominance and growth prospects. After much 'analysis,' Stewart confided that he'd sold some options on the firm's equity recently, content with the profits. His other recommendation involved Google and the new Motorola Mobility. About Apple, Stewart concluded,

"I see only one problem: I'm not sure what worlds are left for Apple to conquer."

Then, in classic fence-sitting fashion for a market pundit, he adds,

"I haven't given up on Apple. I still own shares and another set of call options that expire in January 2012. But the market recently hit one of my selling thresholds, and I feel comfortable taking some profits."

Clear on that now? Me neither.

But here's what really stuns me. Stewart holds options expiring a year from now. That means enduring a lot of potential price volatility. And he doesn't mention any sort of time-dimensioned discipline.

The problem with the price-targeting he uses is that it isn't referenced against a market index level. It's just free-floating, as if that's adequate.

My own equity approach holds portfolios for less than a year, but more than a few months. Shorter than that is to be nearly a market-timer, which doesn't work consistently over long time periods. Longer, and you are asking for trouble due to changing company situations. I don't mind holding the same equity for over a year, so long as the decision is made month by month to do so, for the entire planned duration.

With investing technology and institutional money management having evolved as they have in recent years, the notion that you can buy and hold technology issues for the long term is misleading. Even more so when the Journal recently published an article describing how concentrated many large hedge fund holdings are in just a few equities, often in the technology sector.

But I approach this from a professional perspective, and Stewart ostensibly writes market advice columns for a living. His readers, however, presumably have day jobs.

They have no business sinking substantial amounts into individual, volatile equities. Most of his readers are probably best off dollar-averaging their way into ever-increasing S&P500 Index positions, with some diversification into perhaps one or two passive sector funds and a corporate bond fund.

Many years ago, when I was just out of graduate school, I read the chilling, sad Wall Street Journal stories of how so many retail investors lost everything on WPPS bonds. The infamous Washington Public Power Supply debt wasn't actually federally guaranteed, but had been sold as such by unscrupulous brokers.

The moral of the story for me, however, was simply this. For many investors, just keeping their capital over their investing horizon probably puts them far higher in the distribution of retail investor returns than many would care to admit. Chasing tempting returns on individual technology equities merely adds to the risk.

Which is why I think Stewart's column is inappropriate for the Journal. But, as I wrote at the beginning of this post, that's the sector's dirty little secret. Most retail investors have no business even bothering over individual equities or debt issues.

That's what low-cost, passive index fund complexes, staffed by professionals, are for.

Monday, January 17, 2011

Meredith Whitney Speaks Truth To Power a/k/a PIMCO's Bill Gross

For once, someone is speaking honestly regarding PIMCO's bond gorilla Bill Gross. MeredithWhitney accused Gross of having Pollyanna attitudes on US municipal defaults because he holds so many of their bonds.

Yes, at last, some truth about Gross' shameless pumping his own book and positions on CNBC. Whitney was on the network last week as a guest host. I believe that's where she made her comments regarding her differences of opinion with Gross on the default question. It was picked up in a weekend Wall Street Journal piece, as well.

In that latter article, Whitney is quoted as agreeing that we won't see state-level defaults. But she is clear in believing that there will be a fair number of municipal bond defaults.

This isn't the first time Gross has used CNBC to advance his firm's positions. A few years ago, when the Chinese were questioning US backing of Fannie Mae bonds, Gross asserted unequivocally that the bonds were explicitly backed by the US government, despite evidence to the contrary. In the event, the administration buckled and reassured the Chinese, and Gross. But in the interval before that public statement, Gross did his best to talk up the value of the bonds in question.

This time, however, he's up against a well-regarded, objective analyst. Whitney's warnings on credit card policies by banks in light of new regulations was prescient. Her work on municipal bond safety is looking pretty good, as well. And she recently intimated that her firm will initiate muni credit ratings very soon.

It's refreshing to see someone in the financial sector have the courage and ability to challenge Bill Gross' contentions. Especially when he hasn't exactly provided evidence for his views, other than a general knowledge that his firm's book drives his publicly-expressed opinions.