Think the time has come to step off the offensive accelerator and reduce long exposure and increase short exposure; in other words, position more market neutral. The market is up 20% in a month and extended on a short term basis with many economically sensitive names with poor near term prospects and unclear longer term prospects up significantly. The bulls are out in force and shorts are being forced to cover. The move from 666 to 800 was understandable as cataclysm risks faded when the treasury moved on asset purchase programs and committed to save too big to fail banks equity investors by any means necessary.
Moves to effectively force a preferred for equity swap with a signal that the treasury would also push a move up the capital structure and swap debt for equity as necessary to effectively share the capital burdens between debt and equity investors to keep the banks in the private sector put the screws to the shorts as they effectively changed the game. Regulators also moved to ease the balance sheet pressure levied by mark to market rules.
Clearly positives for equity investors in banks and to the extent that they fostered viability (perhaps regardless of solvency), these moves were a positives and understandable improved sentiment and forced short covering. What these moves don’t do however is make all well and good in the world. Credit markets are still under pressure, consumer spending, incomes, wealth, business spending, capex, and corporate earnings are all still under pressure. European macro fundamentals appear to be deteriorating fast. There is no reason that I can see to believe that consumers or businesses will be in a position to spend more anytime soon. And at some point soon, equities will need fundamental support.
For all those reasons, I’ll be stepping up the short exposure today. I recognize the technical momentum at hand so I’ll do it slowly and expect to deal with a little pain in the short run. The fundamentals, earnings and valuations are my shepherd but the volatility and countertrend moves in an uncertain but hope induced market are a killer so I must continue to adjust market exposure accordingly.
I’m still very bearish on natural gas and still bearish on steel. I let a very nice gain in NUE disappear by only covering half on a terribly negative preannouncement and letting the other half go 10 points against me. That always sucks because I thought about covering the whole thing and putting it back on a few points higher. But I didn’t so that’s spilled milk and some pain in the PA as they say and I’m not going to cry about it. That said, I’m going to short more this morning as the fundamentals have turned from incredibly good to disaster yet hope reigns supreme as investors look to NUE as a play on early cycle macro sensitivity as well as global stimulus related infrastructure. That’s optimistic to put it mildly, naive might be a better description. Anyway you cut it I'm still betting that estimates still have to come down more for the balance of the year and next year and think the shares would be under pressure as that happens because they aint cheap.
I continue to think that NUE is clearly the best house in a bad neighborhood that is going to stay bad for many months to come. NUE’s residential and commercial construction, auto, infrastructure end markets are not coming back nearly as fast as bulls hope. Although NUE typically benefits from scrap declining more than end market pricing, as well as lower energy (natural gas) costs, costs can not decline fast enough to stave off severe margin pressure because volumes have plummeted. NUE and most of its competitors are suddenly operating at 40-45% utilization rates. At such levels, companies like NUE simply are overwhelmed by negative operating leverage. Demand and pricing would have to recover significantly to change the revenue and margin pressure dynamics and I don’t see that happening anytime soon. Pricing might stabilize as the industry has done a great job of making regional and product markets less competitive through consolidation and have now move to shut capacity quickly so inventories don’t balloon. However, volumes need demand to recover in a big way and there are too many end markets under severe pressure to expect that to happen soon. That’s my call on I’m sticking to it.
Friday, April 3, 2009
Wednesday, April 1, 2009
The case for being short Natural Gas equities
Oil and Natural Gas equities have rallied on the prospect of an economic recovery, reflation gaining traction and dollar weakness. Although I do understand (and agree) that dollar weakness should act to support all commodities in general, I’m confident that the fundamentals on the whole favor sustained weakness in prices as supply, demand and inventories are all likely to pressure prices both short and long term. If the emerging view that rapidly declining land rig activity signals a speedy return to balance in natural gas supply and demand as inventories get drawn faster than is generally expected is incorrect (as I believe it is); then you have an excellent opportunity to short natural gas levered equities like DVN, XTO, CRK and RRC.
If I’m right, then sustained natural gas price weakness is apt to weigh on profitability, cash flow and multiples. Estimates for 2010 would have to come in considerably and multiples would compress such that shares of most nat gas producers would decline significantly. And I have little doubt that the bulls, which hang their hat on significant rig activity declines leading to meaningful production declines, will be wrong. They'll be wrong because although land rigs are coming offline at a rapid rate, the production decline is likely to be less sensitive than generally believed and has historically been the case. I think production will remain high for several reasons but the most under appreciated in my view has to do with the nature of recent production increases. Its going to take many more rigs coming offline than most think in order to re balance this market and get prices going up meaningfully.
Recent production increases have come from relatively low cost shale plays which have been, in many cases financed with increased debt on balance sheets of companies which, in many cases, bet their balance sheets on sustained high prices. In prior cycles, it had been the case that relatively high cost resources (which required high prices to be profitable) came on line in the late stages of a bull market in energy. Similar to what has happened to oil sands and the like. In the current cycle, unconventional gas plays like the Barnett, Fayetteville, Marcellus and Horn River Basin shale plays have ramped at a higher rate and faster pace and have done so on favorable unit costs and overall superior economics. The Finding and Development costs have surprised to the downside as the initial production has been much better than expected in most cases while improved technology has also led to a lower initial decline rate, as well as, a fatter tail with regard to out year decline rates.
The net net of this is that the recent industry production additions are profitable on lower prices. The important drivers as I see them are all have risks to the bearish side. On the demand side, industrial and residential demand both have risk to the downside in my view. Utility demand might increase slightly but it is likely to happen as utilities let lower prices come to them. And even at $4/mcf, coal is competitive and often hedged more so than other utility raw materials. If you also consider competition from alternative energy sources this cycle, its reasonable to expect sustained price weakness.
On the industrial side, demand related to chemicals, steel, fertilizers and other industrial end markets all have risk to the downside in my opinion. And if that wasn’t enough, there has been a tremendous amount of LNG capacity that has come online in recent months. Huge fields in the middle east, north sea and russia have ramped. Some of the largest fields in the world (in Quatar and Kuwait). The north field in Qatar is huge (probably the largest ever) and it has ramped up, importantly with liquification capacity at a time when worldwide inventories are high and demand in Europe and North America are weakening significantly. With shipping rates down sharply, LNG can be delivered to North America at $1.50/mcf. With nat gas in the high $3s still and demand in Europe and Asia weakening, its quite likely that LNG imports to the U.S. will rise meaningfully, and take share from conventional gas.
Although I do agree that energy markets are self correcting, I think that the market is underestimating the duration of the adjustment phase. By all accounts, supply is likely to continue to surprise on the upside while demand surprises on the downside. There has been billions of dollar of capital invested in capacity expansion whose variable costs are relatively low and the associated debt must be serviced even though all in cost economics suggest such production is better shut in.
So a wash out is in the making and although I do think the market is likely to correct sometime in 2010, there will be a lot of pain in the meantime. First class companies like DVN will struggle to be profitable. Excellent operators like XTO will see their solid 2009 cash flow consumed by debt service and be forced to hedge 2010 production at substantially lower prices than 2009 was hedged at. Many of these companies managed to hedge the bulk of their 2009 production at $9+/mcf. Today, spot remains under pressure and the futures continue to flatten out through 2010. This suggests that bullish promoters like T. Bone Pickens and Aubrey McClendon are crazy to expect a return to $8 or 9/mcf anytime soon. More importantly, persistent price pressure and futures price weakness suggests that all substantially unhedged nat gas producers will have no choice but to eventually hedge 2010 production at prices less than $6/mcf at best. And at such prices, most natural gas companies are barely profitable. If that turns out to be the case, then estimates for 2010 are way too high and most if not all companies are going to guide down and/or miss expectations over the next few quarters. The current stock prices would thus be significantly overvalued.
Full Disclosure: Have been short CRK, for months and just put DVN on friday.
If I’m right, then sustained natural gas price weakness is apt to weigh on profitability, cash flow and multiples. Estimates for 2010 would have to come in considerably and multiples would compress such that shares of most nat gas producers would decline significantly. And I have little doubt that the bulls, which hang their hat on significant rig activity declines leading to meaningful production declines, will be wrong. They'll be wrong because although land rigs are coming offline at a rapid rate, the production decline is likely to be less sensitive than generally believed and has historically been the case. I think production will remain high for several reasons but the most under appreciated in my view has to do with the nature of recent production increases. Its going to take many more rigs coming offline than most think in order to re balance this market and get prices going up meaningfully.
Recent production increases have come from relatively low cost shale plays which have been, in many cases financed with increased debt on balance sheets of companies which, in many cases, bet their balance sheets on sustained high prices. In prior cycles, it had been the case that relatively high cost resources (which required high prices to be profitable) came on line in the late stages of a bull market in energy. Similar to what has happened to oil sands and the like. In the current cycle, unconventional gas plays like the Barnett, Fayetteville, Marcellus and Horn River Basin shale plays have ramped at a higher rate and faster pace and have done so on favorable unit costs and overall superior economics. The Finding and Development costs have surprised to the downside as the initial production has been much better than expected in most cases while improved technology has also led to a lower initial decline rate, as well as, a fatter tail with regard to out year decline rates.
The net net of this is that the recent industry production additions are profitable on lower prices. The important drivers as I see them are all have risks to the bearish side. On the demand side, industrial and residential demand both have risk to the downside in my view. Utility demand might increase slightly but it is likely to happen as utilities let lower prices come to them. And even at $4/mcf, coal is competitive and often hedged more so than other utility raw materials. If you also consider competition from alternative energy sources this cycle, its reasonable to expect sustained price weakness.
On the industrial side, demand related to chemicals, steel, fertilizers and other industrial end markets all have risk to the downside in my opinion. And if that wasn’t enough, there has been a tremendous amount of LNG capacity that has come online in recent months. Huge fields in the middle east, north sea and russia have ramped. Some of the largest fields in the world (in Quatar and Kuwait). The north field in Qatar is huge (probably the largest ever) and it has ramped up, importantly with liquification capacity at a time when worldwide inventories are high and demand in Europe and North America are weakening significantly. With shipping rates down sharply, LNG can be delivered to North America at $1.50/mcf. With nat gas in the high $3s still and demand in Europe and Asia weakening, its quite likely that LNG imports to the U.S. will rise meaningfully, and take share from conventional gas.
Although I do agree that energy markets are self correcting, I think that the market is underestimating the duration of the adjustment phase. By all accounts, supply is likely to continue to surprise on the upside while demand surprises on the downside. There has been billions of dollar of capital invested in capacity expansion whose variable costs are relatively low and the associated debt must be serviced even though all in cost economics suggest such production is better shut in.
So a wash out is in the making and although I do think the market is likely to correct sometime in 2010, there will be a lot of pain in the meantime. First class companies like DVN will struggle to be profitable. Excellent operators like XTO will see their solid 2009 cash flow consumed by debt service and be forced to hedge 2010 production at substantially lower prices than 2009 was hedged at. Many of these companies managed to hedge the bulk of their 2009 production at $9+/mcf. Today, spot remains under pressure and the futures continue to flatten out through 2010. This suggests that bullish promoters like T. Bone Pickens and Aubrey McClendon are crazy to expect a return to $8 or 9/mcf anytime soon. More importantly, persistent price pressure and futures price weakness suggests that all substantially unhedged nat gas producers will have no choice but to eventually hedge 2010 production at prices less than $6/mcf at best. And at such prices, most natural gas companies are barely profitable. If that turns out to be the case, then estimates for 2010 are way too high and most if not all companies are going to guide down and/or miss expectations over the next few quarters. The current stock prices would thus be significantly overvalued.
Full Disclosure: Have been short CRK, for months and just put DVN on friday.
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