The Dutch Explorer

Baseball, Energy, and the Madness of Men

Curtis van Son

Baseball, Energy, and the Madness of Men

I can still remember sitting in class during the fall semester of 2006 when our finance professor explained efficient market theory to us onlooking youths.  Like a loving parent clarifying that there is no Santa Clause he relished nothing more than justifying why he was there and not in the trenches putting money to work. “The market discounts all information into the price of each security, that is the very nature of markets.” So sure, and yet so wrong.

As described in Investopedia, efficient market hypothesis (EMH) suggests the following:

“that an investor can't outperform the market, and that market anomalies should not exist because they will immediately be arbitraged away. Fama later won the Nobel Prize for his efforts. Investors who agree with this theory tend to buy index funds that track overall market performance and are proponents of passive portfolio management.”

The problem with the theory is in it’s simplicity, at it’s very core is an imperfect understanding of how human behavior impacts market prices.

While markets may prove efficient at times, I can tell you unequivocally that they do not act efficiently where I live, on the tails.  If the good professor was correct, how could my performance in 2020  (64%) and 2021 (149%) be so high, betting on the ugliest parts of the market (oil, natural gas, coal, uranium)? Was it all luck? Why were these returns not already discounted into prices?

My guess (though I’m not certain) is that it worked for the same reason Sir Isaac Newton explained after he lost nearly all his wealth betting on The South Sea Shipping company during its bubble in 1841. 

Or at least so the story goes: 

Following his righteous sale (and earning himself a handsome profit) Isaac saw his friends getting rich and jumped back in with all his chips prior to the eventual collapse. After the experience he penned this stunning quote:

“I can calculate the orbit of the heavenly bodies, but I cannot fathom the madness of men”

Economics of Baseball

 It shouldn’t surprise you (if you read this blog and understand my bias to value investing) that one of my favorite books and subsequent movies is “Money Ball” by Michael Lewis.  In the book, one of Michael’s best euphemisms is when he describes the madness of ballplayer who redesigned his swing, not to be a better ball player but to save himself the embarrassment of striking out.  

“Every change he made was aimed more at preventing embarrassment than at achieving success.  To reduce his strikeouts he shortened his swing, and traded the possibility of hitting a home run for a far greater likelihood of simply putting the ball in play”

Money Managers are similar and there is safety in crowds. Investing where no one else however involves reputation risk that requires courage in one’s own convictions.  For this reason, the tails of the distribution are consistently undervalued or overvalued based on the typical fund client’s perception of the security.

Money managers like to say, “If it walks like a duck, talks like a duck, it’s a duck”. I believe that prevailing philosophy is often confused not in the least because it’s subject to litany of personal biases, the lens through which we perceive the world but even worse used as an excuse to stay in the acceptable lane where the career risk is tame and the AUM safe.  

Not just the book but the movie, “Money Ball” is also a gem. One of my favorite parts is when Jonah Hill’s character tells Brad Pit (who is playing Billy Beane – the A’s GM)  “Billy that is Kevin Youkilis, the Greek god of walks, I wanted to buy him but Shapiro said that he waddles like a duck.”  

I like this analogy a lot because I too like investments that just need to walk to first base. To me that is the act of simply generating excess free cashflows and then have a management team with the wisdom and humility to get my returns home to me in the form of buybacks and dividends.

Africa Oil Corp.

Africa Oil Corp is a Canadian and Swedish listed (US OTC) oil company (headquartered in Canada) with assets in Nigeria, Kenya, Namibia, South Africa, and Guyana.   The company’s only currently producing asset resides in Nigeria and will be the focus for the extent of this post.

If you’re already determined not to invest in this thing based on the pitch so far all I can say is,  “I get it, so has everyone else”.  But those who aren’t investors are missing out on something very special.

 

And that is a world class asset off-shore Nigeria that (unhedged) has the ability to generate the entire company’s market cap in free cash flow. All at extremely low operating costs.

 To paraphrase investor Damian Roy on a recent Twitter Spaces, “The Nigerian asset is a Monster”.

 

But how come it’s so cheap is the obvious questions and for that, pick your narrative:

 -        Because it’s in Africa

-        Because it’s oil and we already at peak consumption

-        Because it’s a cyclical

-        Because it’s market-cap is less than $1Billion (USD and CAD)

-        Because it’s listed in Canada and Sweden (OTC in the US)

-        Because it’s been the investment plaything of a wealthy Swedish family and a gung-ho chief executive for the past decade

-        Because it’s crown jewel, a 50% JV, Nigerian asset called Prime Energy is accounted for via the equity method on the company’s balance sheet. Preventing any of the revenue (other than dividends) from appearing on its income statement

-        Because it’s oil and “oil is bad for humanity” (see prior posts)

-        Because energy has been in a near decade old bear market

-        Because exploring for oil (the company’s prior objective) has been dead for half a decade

-        Because index investing is the only way to invest due to EMH (see above)

-        Because demographics are declining and we don’t need as much oi anymore

Shall I continue?  The reasons are many. Pick a narrative, any narrative, and this thing will likely come up as a pass.

Luckily for us contrarians, I believe only two things need to go right make good money on this trade. Get on base and be brought home.

 Getting on Base

Firstly, it’s important to be sure that the company can continue to generate these cash flows for the foreseeable future.  That requires stability in the region.  In my opinion, this hoop was cleared when the Nigerian government announced the PIA (Petroleum Industry Act) in August which is well over a decade in the making. The updating of the act includes a framework to give investors and government/citizens of Nigeria clarity as to how the industry will operate in the future. I believe this change should give the company the the confidence to wait for the right acquisition instead doing making a rash purchase based on the need to diversity it’s cashflow base.

Prime Energy (50% net to Africa Oil) get’s on base a lot!

Bring ‘em home

Secondly, management have announced to shareholders their intention to cash batters back home by enacting a shareholder return strategy that the CEO has already expressed a desire to complete (pending restrictions) and provide an update on in February.

Excerpt from the December 15, 2021 shareholder letter (Keith Hill)

Wash, Rinse, and Repeat

Summary of Thesis:

-        As expressed in my previous blog posts (prisoner’s dilemma), I continue to be bullish oil (energy generally) due to the structural changes that have occurred to the industry post the 2014 shale bubble. I see structurally higher oil prices in the foreseeable future ($75+) until significant exploration capital is deployed.

-        The company’s net interest in Nigeria (via 50% ownership in Prime Energy) is currently generating significant cash flow (Approx. $500M USD) at a current hedged price of $69 Brent with hedges rolling off in late spring (Brent prices currently trade approx. $90/barrel). Market cap ($750M USD).

-        The producing Nigeria assets have opex costs of $5.2/barrel

-        The Nigerian assets are operated by high quality operators

-        The spudding of the Venus -1 well in Namibia via it’s 30.9% ownership of Impact Oil is currently being drilled by JV partner Total S.A. and the results of the drilling expected in February.

-        The company has net cash at the corporate level with only $250 million net debt at the Prime Energy (Nigeria JV Interest) level. 

-        Fully integrated tax treatment on future dividends to Canadians (assuming a dividend will one day be paid). Preference for tax treatment and returns is buybacks at current company valuation.

The Risks

-        Nigeria can be a volatile place and sabotage to energy infrastructure has been known to happen in particular to onshore pipelines/facilities.  Does this extend to offshore?

-        The assets will decline eventually, and new investment will be necessary. This is not an oilsands project with a 20+ year life.  However, based on my understanding of this type of asset, a remaining life at slowly declining rates is at least six to seven years with minimal reinvestment.

-        CEO Keith Hill has been known to make audacious acquisitions and there is a fear that the free cash flow from Nigeria will be invested into the Kenyan development assets which have been languishing for years instead of returned to shareholders.  At these prices it would be significantly more accretive to simply buyback the stock and simply wait to find out what a normalized oil price is (live through next recession) before investing any more capital into Kenya.

-        Nationalization and government corruption.  Historically Nigeria has been an extremely corrupt state. Several years back an old boss of mine showed me a picture of his friend, an investment banker doing a deal in Nigeria, it included the banker sitting on a mountain of cash presumably being used for bribes.   It’s my understanding that much has changed since then but stories such as there still permeate the investment landscape and the instability that kind of corruption causes could increase the risk of nationalization or other adverse impacts to the Prime’s operations.

Technicals:

Oil has had a significant countertrend move in January so I wouldn’t be surprised to see Africa Oil trade back with the commodity.  That said, the shares haven’t really participated in the recent oil run up to any material degree.  I think this pause is likely due to two reasons, but who really knows.  (1) A huge 81% run-up in the stock since the start of August being digested/profit-taking and (2) Investors waiting on hearing managements capital return strategy and Venus-1 drill results both expected in February.   

Conclusion

I really like Africa Oil Corp. (AOI, AOIFF) here. I have added it as a max position size (cost base of $1.90CAD) along with my other Canadian energy names disclosed in previous posts.  I think it could hit $2.80 sometime in 2022 if management avoids a silly acquisition and also signals a buyback/dividend to bring returns home to Daddy.

As always this is not financial advice and do your own due diligence.

Original sin, the phoenix, and black gold

Curtis van Son

Original sin, the phoenix, and black gold

Phoenix.jpg

The idea of reincarnation presents itself in nearly every culture around the world. It underlies the basis of many religious stories as well: From Greek, and Hindu, to Egyptian and Christian.  So it should be a surprise that a similar story also exists in financial markets, but it’s called something different: mean reversion. Just like the Phoenix rises from the ashes so too can an organization, commodity, currency, or credit.  In many cases these mean reverting features are a forgone conclusion as they are based on human behavior, the more free the society the more likely they are to be reborn.

I find mean revision in commodities to be of particular interest and currently ripe with opportunity. This is due to phenomenon known as price elasticity. Specifically, the fewer the alternatives to a particular use of a commodity, the lower the elasticity of the demand curve is to prices. In other words, you are not going to walk the 5 miles to work each day just because oil prices have risen 10%. The alternative (time) is simply too expensive relative to the additional fuel charge. It’s no surprise that the R-square of GDP per MJ of fossil fuel consumed was greater than 0.9 between 1950 – 2013.

GDP per MJ of fossil fuel consumed.png

But this is not an article about oil. It’s about a different, more pernicious black gold. One that goes back to the very beginning of the industrial revolution.

Let’s talk coal.

If you haven’t noticed, coal is likely the most hated investment in financial markets today. So much so that I’m surprised there still exists publicly listed companies to be traded.  Demonized not just by those that see what they produce as an existential threat to the survival of the world as we know it, it’s also been avoided by investors who have watched these companies get crushed as coal prices have stagnated for more than a decade.

Coal prices.JPG

This brings us to the, why?  Why have coal prices declined so precipitously this past decade?  If I had to simplify it down to just two reasons it would be (1) competition from cheap, abundant associated gas produced from Shale oil wells, and (2) Gas specific drilling in previously untapped shale Appalachia and Pennsylvania.  These two sources of natural gas have provided stiff competition for coal fired power plants around the world, even resulting in an liquified natural gas export boom where historically LNG had been imported into the United States.

Surmised a different way, a combination of low interest rates, new drilling processes/techniques, and antiquated management incentives caused a title wave of low-cost natural-gas.  Let’s just say that for thermo-coal producers, the neo-puritans have not been their sole concern these long years.

Henry Hub natural gas prices

Henry Hub natural gas prices

Picture2.jpg

For the most part, the majority if not all westerners have been okay with this shift from coal to natural gas, as many of those coal mining jobs lost have been subsequently offset in gas. If it wasn’t for Trumps coal proclamation in 2016 most people would have just assumed that the US coal industry might have well just vanished like a fart in the wind.  

The shift was further placated by natural gas having a lower carbon component (at combustion) than coal, resulting in a larger perceived environmental benefit.  Although that narrative is being challenged by those who include the emissions of methane leakage throughout the natural gas production and transportation process which may offset this benefit.  Let’s just say, it’s a little complicated and not just in regard to emissions. But it also strikes at the very core of American religious fervor.

In case you missed it, the narrative surrounding coal isn’t so good. In fact, in the wrong crowd burning coal has become an unimaginable, inhuman cost to spaceship mother. With externalities that fully personify the parasites to which some environmentalists view us humans.   It’s a narrative that sadly many Westerners crave, as it provides a religious dogma in an otherwise secular world. The devil himself is less easy target.

““Let those who are without Carbon Sin cast the first Coal.”
- Terrence H. King”

Regardless, this sentiment has had just as much of an impact (if not more) on the share prices of coal miners as their declining EBITDA.  It’s been a decade long double whammy that has scared away all but the most skeptical of deep value investors.

Which brings us to today; where COVID-19 has accelerated many pre-existing trends to their point of breaking. Those coal producers that have survived this economic winter have been tested to their limit. If they’ve survived this, they are likely to see another commodity super-cycle.  Even if you are skeptical that we are in fact at the beginning of a new commodity super-cycle (which I still am), you must at least agree that a reflation trade exists so far to fill the massive economic gap left by COVID and will be with us for at least the next year or so.   

Well, my friends, if you happened to have overindulged in your Christmas eggnog you may have missed it: but like the phoenix rises from the ashes so to does thermo-coal prices!

API2 prices.JPG

Enter CONSOL Energy Inc.

Operating is western Pennsylvania; CONSOL Energy is a coal producer and exporter. The company is a combination of its western Pennsylvania thermo coal operations called the Pennsylvania mining complex (PAMC) and a Marine coal export terminal (CMT) located in Baltimore, Maryland.

Another interesting fact is that hedge fund manager David Einhorn currently owns 29% of the company either personally, or through the Green Brick Partners entities that he controls.  David is a value investor who has had a long and storied career and his presence should not be taken lightly.

The assets:

The 25 million tons of thermo coal that PMAC produces each year is in the 1st quartile of the production cost curve, at a cash cost of under $30/tonne.  Not bad considering current pricing.  The PAMC complex is a unique North American asset, as the company has invested over $2.1Billion in its development since 2009.

Low cost production.JPG

Furthermore, the company has rail access to its wholly owned facility (CONSOL Marine Terminal) giving it access to world markets. The terminal also accepts tonnage from third parties who pay on a contracted take or pay basis. This outlet is vital to diversifying its market abroad where consumption is still growing. 

Finally, the company has a metallurgical coal project called Itmann which is expected to reach full production in 2022, at an investment cost of $80million.  Even if operating costs are conservatively estimated at $75/tonne, there is still adequate margin to be had.

My Bull economic thesis is rather simple

1)     Economic recovery

Both thermo and met coal prices have seen dramatic improvement in recent months.  As the world continues to get back on its post-Covid track, I expect both thermo and met coal prices to steadily rise.

2)     Commodity super cycle

The last 10 years have been seriously difficult for commodity producers, as over production of commodities to bring China into the world economic mix caused serious excess capacity. That excess capacity has finally been absorbed and any growth will require higher prices.

3)     Shale oil production

As shale oil production in the united states flatlines, so does natural gas (a by-product of shale wells).  The greatest cause of decline in coal prices can be attributed to its number one alternative – Natural Gas.  I expect natural gas prices to stay strong in 2021, as exports will remain robust and associated gas production continues to lag.

Coal use world wide.JPG

Bear risks to my thesis:

1)     Debt, debt, debt

Coal producers are perpetual bankruptcy filers and while CONSOL has fantastic assets it also has significant debt. Though the company has no maturities until 2024, they do need to use future cash flow to deleverage. If the economic recovery stalls, it could become a problem when trying to roll the debt.

2)     Oil Price recovery

Oddly enough, a dramatic rise in oil prices could cause significant downward pressure on both natural-gas and coal as associated gas from shale oil wells would add additional gas supply to the market.

3)     Green new deal

I generally see the new Biden administration as a positive for the reflation trade. However, there is a risk that Biden introduces draconian measures on domestic thermo coal consumption that would put it at a disadvantage to natural gas.  I’m not worried about Nuclear, as that transition is likely at least a decade away.  Well beyond my investment horizon.

Valuation:

Based on a 10-year DCF model assuming current conditions I get to an implied fair value of $32.86/share. This of course is a very conservative estimate given that conditions are likely to improve dramatically over the next few years.

DCF calculation.jpg

Finally, In my opinion, the company has a strategic advantage over its competitors based on its 100% ownership of the CMT Terminal and its super-low cost, low-sulfur tonnage assets.  Moreover, the anticipated 2022 startup of Itman met-coal project in West Virginia adds further upside value not included in the above DCF.  

Conclusion: 

CEIX Chart.png

I’m long CEIX for a reflation trade.  The share price has been rising fast but in my opinion there is still significant upside in the name. There is upside resistance at the June high of $13.35 and then again, the again the December 2019 high of $19.80.  This is not financial advice and please due your own due diligence.

Until later, the Dutch Explorer

2020 Performance and lessons learned

Curtis van Son

2020 Performance and lessons learned

AC-NewYears-960x641.jpg

By all accounts, 2020 was a ridiculous year in markets. We saw a global pandemic trigger the fastest market meltdown since the great depression, followed by a gravity defying moon shot that took us to all-time highs just months later.

That said, given the outlier nature of 2020, I think it’s particularly important to take stock of what we investors did well in 2020 and what we didn’t do so well.   When looking at a year like 2020 -with a bounce off the bottom- it’s easy to attribute good returns to skill when it’s just as likely luck. It’s smart to be critical of our decisions, to improve future judgements. Here is a summary of my 2020 moves:

Total return 2020 – 63.99%

This year I had a few big winners and a couple of big stinkers I am not likely to forget.  

2020 performance.JPG

Win – Granite Oil Corp. - up 56.5%

In December of 2019, a tiny ($23M market-cap/$65M EV) Canadian oil producer by the name of Granite Oil came onto my screens. The company owned some low decline oil assets in southern Alberta and happened to be undergoing a waterflood program.

What made it interesting was it’s low decline assets that gushed cash-flow, even at relatively low oil prices.  Management had seen the pain over the past year and were intent on paying down debt and would be able to do so within a few years. The equity traded at a 44% free cash flow yield at the time. Yes you read that right. Nobody wanted it. When doing the math at the time the NPV10 of producing reserves after debt came to a share price of $2.64. My cost basis was $0.60/share and I was buying it in size. The market for the shares was so thin I had to wait days not hours to sometimes close my limit orders. Then on January 20th, the company announced it was being bought by International Petroleum Corp. (IPCO) for $0.95/share in cash. My intrinsic value calculation below:

Granite Oil price chart.JPG

What I did well:

-I identified an average, low-decline asset that was un-ownable by the big guys, due to its size and waited for things to improve.

What I did wrong:

-Bought too much. Just a month later, the market was in chaos due to Covid and it’s likely that Granite would have gotten crushed like every other E&P.  Certainly got lucky given the timing on this one.

Loss – International Petroleum Corporation (IPCO)– down 33.36%

To be honest, the sale of Granite sort of irked me. While proud of the win, I was still a little pissed that it sold for so little.  My intrinsic value of the company was 6X my purchase price and it only sold for a 56% premium?!? Damn people hate oil.    But after the deal I looked deeper into the buyer IPCO and found that it owned some decent Canadian oil assets and some okay European assets, had conservative management, and a B+ balance sheet. For what I believed at the time was a market bottom, this looked to be a winner.

Furthermore, they were getting Granite for a song and based on my math, IPCO was also trading at a significant discount to fair value. I bought a material position (though less than half the size of my Granite investment).  

Then shit hit the fan and confronted by the unprecedented collapse in oil/gas prices in early March, I was concerned that the assets IPCO owed were okay, but perhaps not good enough in a world where nobody drives to work or flies for business anymore. So there I was in early March already doing tax loss selling. Seriously, what a fucking disaster.  

But that wasn’t the only reason I sold. There was at the time what I believed to be a massive opportunity to upgrade the portfolio.  I used some of the proceeds in the following weeks to buy into my favorite Canadian oil/gas companies including the GOAT, the Canadian Vampire Squid itself: Canadian Natural Resources in the low teens, a price I do not suspect we’ll ever see again.  *Knock on wood*

International Petroleum chart.JPG

What I did right: 

-        I followed my inner Paul Tudor Jones and reduced the size of the position , as price fell.

-        Took advantage of a bad situation to move into a higher quality asset that had fallen nearly as much.

-        Realized a capital loss to off-set taxable gains incurred on Granite sale.

What I did wrong:

-        The downside support in IPCO broke on March 10th. It took me 3 more days to talk myself into selling the last of my position. I estimate that mistake cost me 8% of the total (33%) loss. Damn that was stupid

Win – Tesla, Live Nation, XOP (US E&P ETF) – PUT and PUT spreads - up 50.5%

Just like you want some defenders and a goalie on your hockey team, I’m never full on 100% long in my portfolio.  However, given the cost of maintaining short positions, I generally try to hold deep OTM puts and then tactically short at times where it looks like the market could conjure it’s inner Icarus. Luckily, I had some insurance in preparation for the February down-turn.

My hedge book included a few shorts but mostly some out of the money options on assets I thought would get beaten up by a pandemic triggered market collapse. Something about people being welded into their homes in China made me think twice. I got lucky (while the whole world got crushed) and the proceeds on the contracts allowed me to be an investor in April/May, when others were just trying to recoup losses.

What I did right:

-        I maintained a tactical down-side hedge book and added to downside assets, as events got progressively worse.

-        I closed on many of my positions in mid-March (sold many of my Tesla contracts on March 16th) when volatility nearly top ticked, one contract at a 614% return. Crazy

What I did wrong: 

-        I initiated some PUT spreads in April and May in anticipation of a re-test.   I was too busy listening to the Real Vision guys talk about the world ending and not enough time reading charts.  I held onto these subsequent positions to long and it limited the gains on these trades.

Win – Canadian oil and gas – CNQ/Parex/Whitecap/Tamarack Valley –  up 37%

I’ve grouped these securities together, as they were discussed in past blog posts:

https://thedutchexplorer.ca/blog-2/consolidation-agency-and-a-prisoners-dilemma

https://thedutchexplorer.ca/blog-2/bullies-betas-and-ugly-trees

https://thedutchexplorer.ca/blog-2/alpha-fragility-and-the-vampire-squid

I loaded up on Canadian energy in 2020 and while it has taken some time to get going, it has been nothing but up since the vaccine announcements in November. They are still unbelievably cheap, relative to their historical values. I expect all the ones I own will be able to return capital to shareholders in 2021 (if not already). The real question is whether there is further consolidation, which would continue to help the industry and my bull thesis. Either way, I have not been this bullish on a particular market segment in a long time. These securities are my biggest positions.

XEG Canadian oil golden cross.JPG

What I did right:

-Bought some in March when the world thought oil was never going to be used again.

What I did wrong:  

-Bought more in March.

Loss – Brighthouse Financial Inc. – down 31%

Another one of my Idiosyncratic plays that I worked on pre-covid.  This is a business that trades at an obscene discount to book, let alone market that very few people understand. The problem was, the books are an absolute mess and it’s in a slow growth industry.  The books are so ugly that most analysts that cover it don’t understand the accounting.

Regardless, the entire insurance industry was in trouble in early March when the Fed stated that interest rates would be pinned at zero for the foreseeable future. The problem being that these companies effectively earn money from (1) fees and (2) the interest earned on their float. The value of the fixed income portion of their float was in serious peril and I closed the position at a three-handle loss. Just a nightmare.

BHF chart.JPG

What I did right: 

-        I sold a business that was at risk of permanent loss of capital (see Buffett selling airlines) so I could fight another day.

What I did wrong:

-        The thesis to own it required a turn in declining interest rates that has been persistent since 1981. Low probability.

-        Owning shares in a business that only an accountant can understand is not in alignment with the current zeitgeist.

-        Similar to the IPCO loss, I didn’t cut it soon enough, It broke the 200 day a full 4 days before I closed my last position costing me at least another 5%.

 Win – Uranium – HURA ETF – up 41%

HURA ETF is my core position in how I’m playing the Uranium bull market.  I first initiated a small position in the ETF back in 2018.  At that time, the market was slowly grinding lower, but I wanted to be a tune with the space.  The best way to give yourself an incentive to do more work is to buy a small block of what interests you.  Since the March lows I have been adding steadily. Also own some PDN and NXE.TO.

Similar to Canadian energy, there isn’t much more I need to say about Uranium. See last week’s post for more details: https://thedutchexplorer.ca/blog-2/fear-density-and-yellow-cake

HURA ETF.JPG

What I did right:

-        I waited for the market to give me the breakout signal and fundamental signal (mine closures) that the bear-market was nearly over before getting into a decent position.

What I did wrong: 

-        Traded around my Paladin position which I should have just sat tight as missed a couple of big days in November instead of just sitting tight.

Win - Antero Resources up 96%

When it became apparent that the shale oil companies were going to shut in wells, I initiated positions in several U.S. Midwest natural gas players.

Post the June surge in natural gas companies I dumped the whole basket except Antero Resources which I’ve held through December. Given that it's 100% hedged in natural gas combined with the dramatic rise in the price of propane use, the company has done exceedingly well in this difficult environment. It’s currently generating significant free cash flow at strip and despite a lot of debt (they are terming it out) I remain bullish long-term. In particular, I look forward to winter 2021/2022, when gas inventories have a real chance of becoming very tight.

Antero Resources.JPG

What I did right:

-        Bought a collection of names to take advantage of the bounce and remove some of the idiosyncratic risk in the trade.

What I did wrong:

-        I did not fully comprehend the scale of the propane story (outside heaters are in high demand) until it had already ran-away on me so I didn’t get in as big of a position as I would have hoped to.

While the term-of-the-year might have been “social distancing”, I still think unprecedented is the most apt (if not most overused) word to describe this chaotic year in the markets. That said, when looking back on what I did wrong, many of them seem to relate to better trading vs. investing required in 2021. But it could also just have been the unprecedented times.  Reminder, the above is not investing advice.

Best of luck in 2021!

The Dutch Explorer.

Fear, Density, and Yellow Cake

Curtis van Son

Did you know that of the 140 pounds of Uranium included in the bomb that detonated above Hiroshima, only 1.38% underwent fission?  Yet, that 1.38% was so powerful that it destroyed nearly all buildings within a 1-mile blast radius. A small amount of Uranium is extremely powerful and so is the market for Uranium producers.

Mushroom cloud.jpg

So, when comparing base load power sources, it shouldn’t be a surprise that Uranium’s energy density is much higher than its competitors.

energy density.JPG

While its density makes Uranium an interesting option long-term, I think there are also a number of reasons to be bullish Yellow Cake now.  Here’s why:

Demand:

1)Uranium is the ultimate ESG play

Nuclear power provides reliable, emissions-free, baseload power with the lowest amounts of material inputs.

Nuclear load factor.JPG

Despite these obvious benefits, it is fair to say the political will for adopting Nuclear energy has been lacking (at least in the west). I believe that this is due to the fears held by both, major political parties.   As per Arnold Kling’s idea, Liberals tend to fear oppression, while Conservatives tend to fear loss from change. Nuclear to its detriment occupies a place where historically neither party wanted to be and that’s been a problem.

venn diagram.JPG

The good news is that this looks be changing, as Joe Biden’s green energy platform specifically outlines funding and policy intended to accelerate the development of small module reactors.  Also mentioned is the desire to lower development costs, increase safety, and improve disposal systems.  This certainly has been a positive development that may catalyze the political malaise surrounding Nuclear.  Moreover, Conservative Premiers in Canada have already outlined a goal to support the adoption of small modular reactors.  It appears at least that Nuclear energy is now a bi-partisan issue, slowly gaining mainstream attention.

2)Higher Natural Gas prices

The cost of Nuclear power generation is currently higher than both Gas and Coal (see table below). However, if you include the carbon capture and storage costs it becomes cheaper than coal and within 10% of the cost of natural gas. If we see a structural increase in the price of Gas, I expect costs to come closer into alignment.

LOCE.JPG
Baker Hughes - oil rig count.JPG

3) Reactors under construction

In addition to the other positive developments, there are currently a significant number of new rectors under construction (54) as well as 109 reactors planned and 330 more proposed worldwide.  To boot, there has been further impetus in North America refurbish and extend the operating life of existing reactors which will also encourage future uranium demand.

Nuclear power plant construction and proposed.JPG

Supply:

If you thought the demand side for Uranium was compelling, the real action is on the supply side.

1)COVID-19

Firstly, the global pandemic resulted in Cameco shutting down its Cigar Lake mine not once but twice. In addition, Kazatomprom (the world’s largest producer) lowered resource development in 2020 which is expected to have a material effect on the company’s production in 2021.  Given this loss of production, both began buying spot-price uranium to fulfill their existing supply contracts with utilities.  In what other industry do you see the two largest producers not just limiting production but also eating up supply (??) from the spot market? 

Like COVID did to many trends, it seems to have accelerated the Uranium bull market  by cleansing the market of excess lbs.

2) All in sustaining cost of production

Currently, only half of the worldwide production has an all-in sustaining cost below $31.  Consider a weakening $US dollar and rising input costs and this is likely to continue over time. Furthermore, it does not include the required rate of return that investors will demand to start up each additional project.

Lowest cost producer.JPG

Based on annual demand of approximant 200M lbs. in 2020 – 2030, the price of Uranium must climb dramatically to incent producers to sign long-term supply contracts.  Paladin’s Langer Heinrich incentive price is closer to $45/lb. and the industry will require it plus an additional 60 million pounds to match demand.   

Cost curve #2.JPG

3) Secular bottom

After Fukashima, we saw the price of Uranium collapse after both Germany and Japan took draconian measures to slow the use of Nuclear power. While this is normally a kiss of death for explorations/development companies, it also caused the shuttering of major mines including Cameco’s McArthur River and Paladin’s Langer Heinrich. These mines will not be re-started unless they are able to contract at significantly higher prices than spot implies.

Yellow Cake PCL historical chart of price.JPG

As more and more utilities seek to contract/recontract long term supply agreements with producers, it will become ever more apparent that there will be not enough chairs when the music finally stops.  I think this could cause a price squeeze not seen since 2007. 

Utlity uncovered requirements.JPG

Investing in Uranium

Base on the above you probably guessed that I am very bullish on the Uranium sector.  But similar to prior posts this is not a buy and never sell kind of investment, this is a trade. If that wasn’t already apparent from the chart above.  You should be prepared to exit as the bull-market progresses.  Like most value investors I can only hold something if I believe it has intrinsic value, when all the good news is priced in I will be a seller and I won’t think twice.  

I’m playing this theme by buying a basket of Uranium producers, the main component being the Canadian ETF HURA.TO which effectively tracks the Solactive Global Uranium Index, thus giving me exposure to the two largest pure play producers in the space, Cameco and Kazatomprom (36%), as well as physical Uranium with Uranium Participation Corp. and Yellow Cake PLC (16%). The remainder of the fund is miners in various stages of development including NexGen Energy, Denison Mines, Energy Fuels, Paladin Energy, plus some associated businesses.

I like having broad exposure to the space and I plan to hold it for the next 1-4 years depending on the cycle.  I also have additional exposure to my favorite brownfield project through Paladin Energy (PDN), and favorite greenfield project in NexGen Energy (NXE.TO).  

Technicals

HURA ETF.JPG

As shown above, the Uranium sector has already had a great run from the March lows by breaking out above the August highs of $10.65.  Therefore, I do expect some take-back in the near-term.  Based on its last consolidation zone a 38% retract of the recent move would be around the $12 level.  That said, if the 11% pullback in May is any indication it won’t take much of a move down in price to incentivize buyers to flood back in. 

Disc. I’m long HURA.TO, NXE.TO, PDN.  As always this is not financial advice

Happy New Year!

The Dutch Explorer

Consolidation, Agency, and a Prisoner’s dilemma.

Investing, What I'm Thinking AboutCurtis van Son

In 1952, Princeton mathematician John Forbes Nash Jr. discovered what would later become one of the preeminent fields of study in economics: Game Theory.  Game Theory is defined by the Oxford dictionary as: “The branch of mathematics concerned with the analysis of strategies for dealing with competitive situations where the outcome of a participant's choice of action depends critically on the actions of other participants.”

One of the most applied scenarios in Game Theory is called, ‘The prisoner’s dilemma’.  The scenario is rather simple and goes as follows:  

·        Two prisoners are pitted against each other by authorities to the find out the truth

·        Given their solitary confinement, neither knows if the other will confess or not

·        Both are incentivized with just parole if they are to blame the other to the crime. If this were to occur the other gets life in prison

·        If they both confess, they both receive 20 years

·        If neither confess, they each receive 1 year

Prisoner's 2.gif

If you add up the cost of each cell above, you will find the aggregate cost to the prisoners is lowest (2 years) when they both do not confess.  Then second lowest summation (40 years) occurs if both prisoners confess.  Finally, the highest cost comes if only one prisoner blames the other, leaving the other to spend their remaining life in prison. 

Another example of this idea is depicted in the movie “A Beautiful Mind” which shows a young John Nash and his pals at Princeton scheming to get dates for each man. It’s really a great clip and worth a few minutes of your time: https://www.youtube.com/watch?v=LJS7Igvk6ZM&t=7s

Commodity markets

Over the last number of months, I’ve been thinking about Game Theory and how is applies to the North American energy industry.

In 2009, CIBC chief economist Jeff Rubin wrote a book called “Why your world is about to get a whole lot smaller” which argued that the era of cheap oil prices experienced in the late 90’s and early 2000’s would never be seen again. As these things tend to go, it was a great contrary indicator as prices meandered lower for the next decade, plummeting to an all-time low of negative $40WTI in spring of 2020. It was really quite something.

In addition to Rubin’s book, there were several other more obvious red flags that could have foretold oil’s inevitable decline. This included the high price of oil itself, which encouraged investment, but also new and more efficient drilling and completion techniques, and perhaps worst of all cheap capital.

Fresh off a near 10 year run in increasing oil prices, Investors were thirsty for growth in such a scarce and valuable resource.  Investors and bankers handed the industry money faster than its roughnecks could hammer it into the ground.

Moreover, management teams- spurred on by antiquated short-term-incentive packages that emphasize production growth over returns on investment- presented a major principal-agent problem that influenced further unprofitable production that only further exacerbate the problem. Still Investors brushed off these governance issues, as the shares of many shale companies climbed without abandon.   

This was peak competition, when each executive team trying to out-drill the next to show the highest growth and receive the highest short-term compensation.

History of oil prices.JPG

Consolidation

This intense environment continued up to 2014 when OPEC decided against supporting prices and forced North American shale drillers to cut production the old fashioned-way, maintaining their market share .

While the 2015 crash felt like the heavens opening, the Pandemic has been biblical.   And while the economic outcomes of the pandemic are still coming to the fore, we have witnessed a dramatic wave of consolidation that is extremely positive for the industry. 

As much as this consolidation helps the individual companies become more resilient and efficient, the real benefit is to the industry itself.  Higher quality management in control of larger swaths of assets leaving fewer producers to get drunk on cheap wall-street money. Just like John Nash says in A Beautiful Mind, “The best results come when everyone in the group does what’s best for himself, and for the group” Not just what is in his own best interest.  When it comes to oil and gas this is especially true, just ask OPEC.

It’s been brutal but the pandemic has done the impossible, forced the shale drillers to come to heal bringing us back full circle to a now anti-competitive environment where all investors, bankers, and management are aligned in their focused on free cash flow not production growth.

Technicals:

As I outlined in my last two posts, I’m playing this theme by being long specific Canadian oil and gas names.  Technically speaking, the Canadian energy equities (as represented by XEG.TO) experienced a golden-cross this December when the 50 day moving average crossed the 200 day. This speaks to a longer-term bullish trend, which I believe is confirmed by positive fundamentals coming in H2 2021.

XEG Canadian oil golden cross.JPG

At the time of writing, I am waiting to add to my existing positions until there is a clean break above the $6 level and a re-test of that same level.  As witnessed last week, the $6 level could not be held, though it appears poised to be make another run here again post-holidays.  Disclosure. I’m long TVE.TO, WCP.TO, PXT.TO in the Canadian oil space.  Reminder that this is not investing advice.

I wish you all a Merry Christmas and a happy and healthy 2021!

The Dutch Explorer

Bullies, Beta, and ugly trees.

Curtis van Son

Every kid knows there are two kids that you don’t mess with on the school yard.  The first and most obvious is the Bully (Alpha) who is so much bigger and stronger than the others (Beta) that winning a fight with the Bully is an exceptionally low probability. 

The second and perhaps less obvious is the crazy kid. He is like the rest of the Betas except maybe built a little leaner and a little more volatile.  If set-off under the right conditions he can take the bully. The trick is timing, or the consequences will be once again more of the same.

School yard bully.jpg

This analogy is useful because it gets us thinking in terms of probability.  Generally, with cyclicals and commodity type businesses, you only want to own the Alpha stocks of a given sector (see last week’s blog). The risk of a permanent loss of capital in these industries is so great, you can be taken out of the game easily if the winds were to quickly change. Beta stocks should be treated as trades as at their core they are simply premium free long-dated call options on the underlying.  The lower the quality the company, the less time you have for your underlying thesis to play out.

Lucky for us, this is the current macro position of one industry in particular: Energy. I expect that Beta stocks in this industry have a good chance to outperform in the near-term, just as they did at the bottom of the great financial crisis ending in 2009.

As shown in the chart below, the red line represents the XOP (Beta small caps) vs. XLE (Alpha large caps) U.S. energy names.  The XOP outperformed from 2008 to the cycle top in 2014 and then got crushed from the top to the eventual bottom which I expect to be at the depths of the pandemic in 2020.

Oil and gas producers. Large Cap vs. Small cap.PNG

Enter Tamarack Valley Energy Ltd.

Tamarack is a Canadian Junior oil and gas company with operations in the Cardium and Viking formations. Today they also announced an acquisition to gain access to the high-quality Clearwater area in northern Alberta.  The acquisition will be financed with a non-brokered bought share deal at $1.15/share and a 2% gross overriding royalty, financed by Topaz Energy.  

The company is a small producer of hydrocarbons with approximately 59% of its production in oil and liquids and the rest being natural gas.  Liquids represent 86% of revenues.

An interesting part of the Clearwater asset acquisition is that the purchase will result in increased liquids production: up to 68% by exit 2021. It will also provide the company with an even lower corporate decline rate of between 22 – 24%, down from 25% currently. As production grows in this area, these decline rates should continue to fall.

Moreover, the acquisition took off the table one large concern investors had with Tamarack, in that the company lacked a serious growth driver.  Management’s prudence allowed the company to go into the pandemic with a relatively stoic balance sheet compared with its peers.  The timing of this acquisition could not have been any better, right when the market is starved for capital.   

Tamarack acquisition highlights.PNG

In fact, as shown above, the company believes they will exit Q4 2021 with a net debt of just 1.2X cashflow, which is top tier in the Canadian junior space. Furthermore, expectations are that they can grow production from these assets up to 12,000 boe/d (from 2,000) by 2025.  Looking ahead to 2021 the company estimates $38M in free funds and a 12% growth rate at strip.  Not too shabby..

Picture2.png

Put another way, Tamarack is that crazy kid, recently juiced up on steroids, ready to take advantage of the reflation coming to the economy.  The acquisition gives the company Alpha-like characteristics, making it attractive in the current environment.

Financials:

Ninepoint Partners, a long-only energy fund (so take this with skepticism) released their sensitivity analysis of the company’s metrics post-transaction. In my opinion, if the actual numbers come anywhere close to their 2022 estimate of $168 million free cash flow generation at $60WTI, this is a highly attractive opportunity. Those figures would represent a 47% free cash flow yield at current prices!

Eric Nuttal sensitivty analysis.png

Alternatives:

When buying into a theme like higher energy prices, it’s often a good strategy to take a basket approach, given that companies are individually exposed to other risks (beyond the commodity price).  I have employed this strategy with Tamarack being the greatest weighting in my basket. 

Some other interesting securities for this trade could include some of the following Canadian small caps: Parex, Whitecap, Crescent Point, MEG, or Enerplus.  They are all likely to trade in a relatively tight range over the short-term and only offer idiosyncratic returns over the medium to long-term.  With these types of positions stops one should employ some risk management tools (stops, hedges).

Technicals:

Last week, Tamarack broke-out from the June intra-day high of $1.09 on heavy volume up to $1.39. The move ticked the top of its current ascending channel pattern. I’m awaiting further price confirmation before further action.

TVE technicals.PNG

I expect Tamarack to trade in parallel with WTI in the near term (which could come under some near-term pressure) but as we inch closer to a 2021 re-opening, I believe there is the potential for leveraged returns relative to the commodity.  Disclosure: I’m long Tamarack, Whitecap, and Parex as a reflation trade.

Merry Christmas,

The Dutch Explorer