Wednesday, January 12, 2011
The Plaza Club
One Shell Plaza
Energy Stocks:
The Re-Education of the CFA Society of Houston
John E. Olson, CFA
Managing Partner
Houston Energy Partners
713-220-5151
Your Speaker
• 43 years on Wall Street
• 35 years as an Analyst, 8 years as Fund Manager
• On Institutional Investor All Star Team for coverage
of Oil & Gas Companies
• Worked for Smith Barney, Drexel Burnham, First Boston,
Goldman Sachs, Merrill Lynch, Et Al.
• Running an Energy Hedge Fund in Houston
• Married for 40 years
• Two Children and a dog
2
One Analyst’s Identity Crisis
• “Looks Like A Bassett Hound With a 25 Watt Personality”
- N.Y. Times, January, 2002
• “Looks Like a Scholarly Ichabod Crane.”
- Washington Post, November, 2002
• “Looks Like Mr. Rogers”
- Assistant’s Children
3
One Analyst’s Performance Review
• “Works Well When Under Constant Supervision and Cornered
Like a Rat in a Trap”
• “A Gross Ignoramus --- 144 Times Worse Than an Ordinary Ignoramus.”
• “He Brings A Lot of Joy Whenever He Leaves The Room.”
• “If He Were Any More Stupid, He’d Have to Be Watered Twice A Week.”
• “The Wheel Is Turning, But The Hamster is Dead.”
4
“Ain’t only three things. Knowin’ the 60-40 end of
a proposition, money management, and knowin’
yourself. Any donkey knows that.”
The Keys to Success
Puggy Pearson
Winner, World Series of Poker
5
6
Propositions For The Day
• “Value” investing is the foundation for debt and equity valuations
• This has come under massive attack on Wall Street via momentum
trading and, more recently, Quant trading.
• Ground Zero has been the energy arena (15% of the market)
owing to vast equity and commodity trading liquidity.
• Given The Rise of Prop Trading and the fall of value investing,
expect ever more volatility, velocity and zero sum games.
Defining Deviancy Down
―To Describe How Society Lowers The Threshold
of Acceptable Behavior Rather Than Face Up To
Troublesome Moral Declines.‖
Senator Daniel Patrick Moynihan
(New York)
7
The Energy Sectors: Oil, Gas & CoalAverage Annual Total Returns: 2004-2010
Simple (Unweighted) Stock Prices & Dividends
8
AATRs
2007 2008 2009 2010 2004-2010
S&P 500 5.5% -36.6% 26.1% 15.0% 4.4%
Crude Prices 57.2% -53.5% 77.9% 15.1% 13.6%
Natural Gas Prices 18.7% -24.3% -2.3% -20.1% 5.0%
Gold (ETF) 4.9% 28.1% 24.8% 17.5% 12.6%
The Energy Sectors: Oil, Gas & CoalAverage Annual Total Returns: 2004-2010
Simple (Unweighted) Stock Prices & Dividends
9
AATRs
2007 2008 2009 2010 2004-2010
Major Oils 33.2% -31.2% 13.3% 13.4% 16.5%
Large Producers 48.1% -29.4% 32.2% 6.2% 30.7%
Integrated Natural Gas 18.9% -45.5% 46.9% 13.3% 17.3%
Coal 53.5% -54.3% 141.7% 40.2% 25.9%
MLPs 9.8% -22.0% 50.1% 30.3% 18.4%
S&P 500 5.5% -36.6% 26.1% 15.0% 4.4%
Crude Prices 57.2% -53.5% 77.9% 15.1% 13.6%
The Energy Sectors: Oil, Gas & CoalAverage Annual Total Returns: 2004-2010
Simple (Unweighted) Stock Prices & Dividends
10
AATRs
2007 2008 2009 2010 2004-2010
Large Oil Service 51.7% -59.8% 62.7% 35.4% 27.7%
Offshore Drillers 56.9% -59.9% 82.3% -1.8% 26.2%
Subsea Completion 69.3% -58.8% 130.7% 34.6% 46.4%
S&P 500 5.5% -36.6% 26.1% 15.0% 4.4%
Crude Prices 57.2% -53.5% 77.9% 15.1% 13.6%
Natural Gas Prices 18.7% -24.3% -2.3% -20.1% 5.0%
Domestic Global Total Taxable Muni Total Grand
$ Billions Equity Equity Equity Hybrid Bond Bond Bonds Totals
2007 -48 139 91 24 98 11 133 224
2008 -152 -83 -234 -18 20 8 9 -225
2009 -40 26 -14 23 307 69 399 385
2010 -81 57 -30 25 240 12 280 249
Cumulative Net Flows -320 139 -187 54 664 100 821 633
Incremental Flows -51% 22% -30% 8% 105% 16% 129% 100%
Investment Company InstituteAnnual Net Flows of Mutual Funds Data
2007-2010
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Value Investing 101
What Kind of P/E Buys What Kind Of:
(1) Earnings Growth
(2) Profitability (Return on Equity and Related Capital Structure)
(3) Income (Yield & Payout Ratio)
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Value Investing 101
Standard & Poor’s 500
13
2010E 2011E 2012E 2013E 2014E
Current Price 1218 1218 1218 1218 1218
Consensus Estimates 85.02 93.00 99.00 105.00 110.00
Dividends 24.48 29.76 33.00 35.00 37.00
Price Earnings Ratio 14.3X 13.1X 12.3X 11.6X 11.1X
AAGR (%) 36.7% 9.4% 6.5% 6.1% 4.8%
Returns On Equity (%) 16.9% 16.5% 15.7% 15.0% 14.3%
Net Leverage (% Capital) 48.4% 47.0% 46.0% 45.0% 44.0%
Dividend Yield (%) 2.0% 2.4% 2.7% 2.9% 3.0%
Payout Ratio (%) 29% 32% 33% 33% 34%
Investing Parameters
Investing Credentials
“If You Ever Sit Down in a Poker Game
and After Fifteen Minutes
You Haven't Figured Out
Who The Pigeon is, You’re the Pigeon.”
Warren Buffett
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Crude vs. SPX
15
Crude vs. SPX
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Crude vs. Natural Gas
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Crude vs. Euro
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Crude vs. OXY
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Crude vs. OXY
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Crude vs. APA
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Crude vs. SLB
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Crude vs. SLB
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SWN vs. Natural Gas
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SWN vs. Natural Gas
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Crude vs. MMR
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Crude vs. MMR
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Elites help create mythologies and rituals that
bring people together under a common set of
beliefs and, more to the point, under the authority
of those elites.
“Invented Tradition”
Eric Hobsbawm
Market Historian
THE
INVESTMENT BANKING
BUSINESS
IS A CRUEL AND SHALLOW
MONEY TRENCH, A LONG
PLASTIC HALLWAY WHERE
THIEVES AND PIMPS RUN FREE
AND GOOD MEN DIE
LIKE DOGS.
THERE’S ALSO A NEGATIVE SIDE.
29
―The Accounting Community Produces Financial
Statements Almost Completely Irrelevant to Financial
Analysis as Currently Conducted.‖
―The Analyst Community Does Workarounds Based on
Numbers That Have Very Little to do With The Financial
Statements. Net Income is a Virtually Useless Number.‖
J. Michael Cook
Chairman, CEO (Emeritus)
Deloitte & Touche, LLP
Source: CFO, September, 2006 (Page 56)
— Wall Street 101 —
• “If you torture the data long enough, the numbers will
confess to anything.”.
31
Valuation Gamesmanship
Earnings EBITDA
Adjusted Earnings Open EBITDA
Adjusted EBITDA
Cash Flow (CFFO) Enterprise Value
Adjusted Cash Flow - Plain
Debt Adjusted Cash Flow - Prior Year Reserve Values
- Mid cycle EV/EBITDA
Free CFFO Yield
Growth Adjusted Free CFFO Yield Tax Adjusted Distributable CFFO
Capital Asset Pricing Model (CAPM)
Break up Values=Sum of parts Discounted Cash Flow
Proved Net Asset Value Adjusted Risk Premiums
Prospective Net Asset Values
Pre Tax Asset Values DCF-Based NAV: Five Years to Blow-Down
Theoretical Fair Value
32
Asset/Cash Flow Valuations
• Either borrow value from future or involve returns of
(your own) capital.
• Cannot easily be compared with other companies or
sectors.
• Give no good readings on profitability (return on equity
or related capital structure).
• Treat equity investors as if they are equal to debt
investors.
• Create opportunities for ever more subjective valuation
judgments.
33
Valuation Methodology and Risks
―We value E&P stocks based on growth-adjusted free
cash flow yield and set price targets according to
prospective NAV estimates based on price-adjusted
PV-10 values for proved reserves plus risked P2 and
P3 reserves values net debt.‖
Deutsche Bank Analyst
34
Current $5.00 $5.00 $5.00 $5.00 $5.00 $5.00
Breakup Valuations Price $60.00 $75.00 $90.00 $60.00 $75.00 $90.00
Anadarko Petroleum 75 18 26 34 416% 288% 220%
Apache 125 78 90 103 160% 139% 121%
Chesapeake Energy 27 13 14 15 207% 193% 180%
Devon Energy 78 47 54 62 167% 145% 126%
EOG Resources 95 30 37 44 317% 257% 216%
Occidental Petroleum 96 52 64 75 184% 150% 128%
Southwestern Energy 38 5 5 5 762% 762% 762%
Average 76 35 42 48 192% 161% 138%
What Is A Large Producer Worth?
1P Valuation Price /1P Valuation
35
Current $5.00 $5.00 $5.00 $5.00 $5.00 $5.00
Breakup Valuations Price $60.00 $75.00 $90.00 $60.00 $75.00 $90.00
Anadarko Petroleum 75 41 57 73 183% 131% 103%
Apache 125 91 104 117 137% 120% 107%
Chesapeake Energy 27 23 26 29 117% 104% 93%
Devon Energy 78 61 75 91 128% 104% 86%
EOG Resources 95 44 70 89 216% 136% 107%
Occidental Petroleum 96 70 87 106 137% 110% 90%
Southwestern Energy 38 29 29 29 131% 131% 131%
Average 76 51 64 76 130% 105% 87%
What Is A Large Producer Worth?
3P Valuation Price / 3P Valuation
36
Research Recommendations?
Stock
Symbol
WTI • Drill to the right, drill to the left, drill up the middle.
Drill ―Till you can’t drill any more.‖
ESV • ―Keep holding on!‖
ATPG • ―Rip off the rear view mirror and chuck it out the
window. ATP’s still a buy.‖
RIG • ―Nothing can stop the Deepwater!‖
RIG • ― Sell off overdone. Table pounding buy!‖
37
Defining Deviancy Down
Hercules Offshore Inc ($3.66)
― We are reducing our 11E-12E EPS to ($0.34) and
($0.44)‖…
―On an Adjusted EV/DACF…Hero trades at…
A blended 32% discount to the group‖…
―HERO has significant upside potential vs. the current
share price (because) HERO is unlikely to violate its
Debt covenants in the next two years.‖
Regional Securities Firm
38
39
How to Blow Yourself Up!
• Derivatives
• Off Balance Sheet Entities
• Mark to Market Accounting
Enron and its Offspring
Enron Corp. Valuation Considerations
$57Wholesale
$6 – T&D
Per Share
$23Retail
$40Broadband
Proven Business Model Will Enable
Additional Business to Generate
Greater Value for Shareholders
$126
40
Enron Corp
And
Creative Accounting
Year 2000
Earnings
($MM)
CFFO
($MM)
Debt
($B)
Reported 979 3,000 $10.2
Actual 42 (154) $22.1
41
“A Kind of Quantomania Prevails in the
Assessment of Technologies. What Cannot
be Counted Simply Doesn’t Count, and So
We Systematically Ignore Large and
Important Areas of Concern.”
Dr. Ida Hoos, 1979
Technical Forecasting and Social Change
42
The New Investing Hegemony
• Value Investors
• Momentum Traders
• The Quants
• The Dominant Strategy – High Frequency Trading (HFT)
• 50-70% of all trading on all exchanges.
• 10,000 Trades/second – 99% DKs – Naked Access @ 300 Microseconds
• Phony Volumes/NASDAQ
• Getting worse: Global Expansion
43
―A situation in which each influential actor does only
what makes perfect sense from an individual
perspective, but the combined effect of everyone’s
acting in this way leads to outcomes that make sense
for no one‖.
Rational Irrationality
John Cassidy
How Markets Fail:
The Logic of Economic Calamities
The Proprietary Trading Shops
Inside The Trojan Horse
• Algorithmic Traders – prop shop packages
• Stat Arbs
• Matrix Traders
• High Vol Traders: 11 Seconds!
Technology, Volatility, Complexity
• Trading Price Points: Hub to Hub
• Commoditizing Stocks: Profit Goal: 10 Basis Points (0.1 cent) Per Share
• Potential Wipeout for Value Investing
• Goodbye Stock Options? IRAs? Pension Investing?
Prop Shops are not your friends
• Compete with their own clients
• Use ―Dark Pools‖ to trade through
• Inviting a growing backlash
45
High Frequency Trading
(Consolidated Tape)
46
%
Volume
2004 21
2005 26
2007 35
2008 52
2009 61
2010 56
Sources: JP Morgan, Tabb Group
HFT Profitability
($ Millions)
47
Citadel
(Est)
Industry
2004 4 —
2005 75 —
2007 892 —
2008 1,152 8,000
2009 NA 7,200
Bloomberg Algorithms
• ―Hide and Sweep‖ — Silent But Always on Alert
• ―Hide and Fire‖ — Stealth strategy sweeping market or nibbles at it without posting your price and size
• ―Arrival Price‖ — Buys and sells stocks aggressively whileattempting to minimize market impact.
48
How is This All Affecting Market Valuations?
• Quant Hardwiring to Crude
• Correlations of Oil & Gas Stocks
• 50% - 60% to Crude Oil
• 20% - 25% to Natural Gas
• Valuations Trumped by ROBOT Programs.
49
Takeaways
Where Do We Fit?
• SEC has created a trading monster.
• Investing fundamentals count for very little.
• How to compete against machines (Trading Algos)?
• First – Look at extent of ―Hardwiring‖ (Indexing).
• Second – Have view on crude oil prices.
• Third – Go where Algos Don’t Tread.MLP’s – High Yield Stocks – Low Volumes
• Fourth – Always use limit orders
50
“Markets Can Remain Irrational
Longer Than You Can Remain Solvent.”
John Maynard Keynes
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