Opportunity in oil spill

There has been a lot of talk of the opportunity in the energy sector as a result in the sell off of the Gulf of Mexico (GOM) producers, drillers, platform operators...etc. Most of these names have been halved in price; BP is offering 10% dividend yield, which is an amazing return by itself.

The question presenting itself, is the disaster an opportunity for stock pickers? Some think it is.

The disaster is a game changer. No one can argue that in a couple of years, and into the distant future, GOM operators will operate in the same manner as they did few years back. I do not think so. Costs are going to go up materially.

Insurance, security bonds, royalties, clean up funds, taxes...etc will be on the rise as a result of this disaster. Some suggest that platform operators like SeaHawk (HAWK), which I reviewed their spin-off and did not like, is a good value proposition as it is selling below liquidating value. However it was selling below liquidation value a year ago as well.

I think the smaller the player the more disadvantaged operationally and financially in the new and expected environment. Weak balance sheets will find it harder probably to comply with bond and clean up funds requirements and will be forced out by the bigger players, who ironically caused the disaster in the first place.

If I wanted to buy, I like McDermott International (MDR), which will spin off it is off-shore construction and management business. The company operates three businesses:

• off shore drilling project management,
• government operation: nuclear submarine building, and
• fossil fuel power construction

MDR will operate the off shore construction business and the spin-off will own the other two.

My idea is to buy on the spin off date MDR as it will be more than likely added to the several energy sector ETF and mutual funds. Those funds did not own it due to the complexities of the other two units and was not pure play energy equity.

1. MDR will be less complicated than the other unit from accounting, regulation and business is easier to understand,
2. growth potential in offshore drilling around the world; its Arabian Gulf operations is growing at a fast clip and will offset any weakness from GOM operations,
3. demand from energy index and sector ETFs as the company will become pure play energy service company. MDR is held in mid cap portfolios but not in sector specific ETF like energy funds; ishares Energy Service, Holders (OIH)...etc. Will the spinoff induce sector specific funds to buy the oil and gas segment to be part of energy ETF/ funds? A very high possibility.
4. The backlog of the company alone should provide good support for earnings growth.

To capitalize on the energy sell off, I will require more odds in my favour and I think MDR might do it.

What is wrong with this picture?

Natural gas producers have rallied and continue to do so although the underlying commodity is suffering. Natural gas producers represented by index for natural gas producers have returned some 45% on YTD basis while the underlying commodity has declined by 62% on YTD basis.

Normally that relationship have a high correlation. Natural gas producers price returns go the way of the commodity. However the relationship seem to have been broken since March of this year.

Is buying in this market indiscriminate? May be, but this is a question that can not be answered with full certainty. You can only attempt to guess as one would never have complete information to ascertain the validity of a claim.

Cloud Peak Energy...not so Peak Value

Rio Tinto IPO of Cloud Peak Energy (CLD), sort of a spin off, came with no great fan fare. The IPO has gone down some 10% so far. There are good reasons why the stock is down. Some are due to industry dynamics and other, in my opinion, is due to the corporate structure of the mines.

Industry Dynamic

Demand

Coal demand is growing. There is no secret that coal is under pressure from environmentalists and regulators due to global warming issues. CLD mines thermal coal used by utilities for electricity generation. The US generated 50% of its electricity from coal. So there is no escaping coal no matter what politicians say or do. Coal will be still be used during my lifetime and even during my sons lifetime. Coal demand will grow as long as we use electricity.

Supply

There is a glut of supply right now evident by increasing stock piles at utilities, but I reckon that will be short lived:

• Miners are cutting coal production in 2010 due to decrease in demand that will stabilize pricing
• Mountain top mining in the states is in jeopardy as a source of cheap thermal coal due to environmental issues.
• Mountaintop mining in West Virginia, Kentucky, Virginia, Tennessee and parts of Pennsylvania and Ohio accounts for 6 percent of U.S. coal production.
• The end of mountaintop mining in Appalachia would remove about 70 million tons a year from the market, increasing demand for coal from Colorado, Montana and Wyoming.
• EPA has been holding mining permits with more frequency under new president.Natural gas pricing, is it firms up then utilities that switched to nat gas will switch back to the cheaper fuel, coal.

On balance the downturn in coal is cyclical rather than permanent. So when a distressed seller like Rio Tinto, it needs cash to repair it over leveraged balance sheet, off load its coal business at these levels, it piqued my interest.

Transaction Specific Issues

My issue is with how the split off is structured. There are many issues that makes me hesitate pursuing this business.

• Rio Tinto still owns some 49% of the mines. However its ownership is at the limited partnership level rather than the holding company CLD. The public owns 100% of the holding company which in turn owns 51% of the limited partnership. That will make for conflict of interest between the public holders of CLD and Rio.
• Pretty much CLD is controlled by Rio as its board of directors is made of RIO executives. Moreover, CLD is governed by agreements that needs Rio's consent.
• Funds from operation will go to Rio and the holding company, CLD, but not to shareholders. I would rather see RIO and the public holders get the same treatment makes for better alignment of interest.
• Tax reimbursement agreement where CLD pays Rio any tax savings due to higher assets base level making depreciation and amortization higher thereby reducing taxes on income.
• Debt that got loaded onto CLD'd balance sheet to pay Rio for the assets is a bit high and will saddle the CLD with interest payments for some time to come.Most of the proceeds of the IPO goes to Rio.

So as you can see the deck is stacked in favour of Rio at the expense of CLD holders. However, there are some good qualities for CLD being low cost producer, cheap, and good reserves.

In conclusion, I will wait for a better entry point or when Rio floats the reset of its ownership in these mines.

Exit from Peyto

I sold out of Peyto Energy @ $12.26 (35% return) due to changes in competitive structure of gas supply. Pipelines are raising significantly their fees to carry natural gas. This will spell increased operating costs for gas producers and will lower asset values.

Demand for natural gas occurs in the north eastern of this continent and supply, typically, comes from western provinces like Alberta. So transportation costs is big chunk. TransCanada pipeline will raise fees by some 50% next year, which will make western Canada gas uncompetitive compared to closer sources. In the past there was not many sources close to the northeastern market but now they are abundant. There is two new sources that can supply that market maybe at lower costs with transportation costs are rising signifiacntly:

1. New shale gas basins that are coming online are much closer to northeastern states like natural gas from the mega Marcellus shale play that extends to west virginia, is likely to grow to 1.0 Bcf/d.
2. LNG gas coming from overseas as Europe does not need as much gas as previous years due to economic slow down.

The reduced operating profits at gas producers as Peyto will lead to lower credit as bankers set credit lines based on estimates of their NAV or reserves in the ground. Those estimates are facing a double whammy: lower gas prices and higher operating costs. Many will see their credit lines reduces in March 2010 and will scramble for liquidity.

I will come back to Peyto as it is my favourite in the space once something changes in the fundamentals.

Value idea: Peyto Energy Trust

Natural gas is at extreme lows as it should; there is tremendous supply in the system. Storage is almost full. There will be no where to put extra production. The reason is the vast discoveries of shale gas. North America is abundant with natural gas contrary to what was believed of North America peak gas. Even with a harsh winter I do not think the supply picture will improve.

However I believe that goods or assets can't sustain prices below its average production cost over the long term. Sure there will be some divergence in some periods but it should return to equilibrium eventually. The question is when. I am not going to speculate on that as it is going to be a crap chute at best.

However a good position if I can find a way to participate in the price recovery of natural gas, while I get some downside protection and a margin of safety. I think Peyto Energy Trust (Pey.un) gives me this proposition. Peyto is :

Canada-based energy trust. The Trust’s principal business activity is the exploration for, development and production of petroleum and natural gas in Western Canada. As of December 31, 2008, the total proved plus probable reserves were 998.3 billion cubic feet equivalent (166.4 million barrels of oil equivalent) with a reserve life of 23 years. Production is weighted approximately 85% natural gas and 15% natural gas liquids and oil.

I like Peyto for the following:

• hedge book for half of their production of the next 12 months at an average price of $7.5 per mcf
• low debt to capitalization and good coverage of debt service and dividends
• low cost producer of natural gas. currently their operating costs per BOE is $2.56 as of their latest quarter
• long life reserves
• the cost structure for the most part is variable and gets reduced with lower revenues.
• cheap valuation where its Entp. Value to NPV is .57, a measure to value the company to its discounted cash flow from reserves in the ground.
• The current dividend yield is Distribution is 15.5%. The coverage of the distribution is good but if gas prices continue its decline it will be halved.
• I get good odds betting on natural gas plays. The upside is potentially large while the downside is limited. We are already at a decade low of natural gas price. Most Natural gas producer did not participate fully in the recent rally and lag the indices by a wide margin.
• And a very good management, extremely good management.
• My catalyst will be the revision to mean in natural gas prices as most likely it can't keep going down. We are in a period of supply and demand imbalance and there should be an equilibrium found in the next 12 months.

What can go wrong:

• Payout ratio is trending higher, which is understandable given the weak revenue figure. Peyto has already cut its distribution and it could a further cut is probable.
• Natural gas is the "widow maker" and can be very volatile. There is no reason it can't go to low $2s per mcf.
• Their operating lines can be shut or reduced if credit environment deteriorates further. Producers rely on operating lines to fund operations and exploration.
• Royalties are influx in the government of Alberta and can be very fickle to factor in analysing operations. Couple years ago royalties has been hiked on gas producers but once the bust has set in it was reconsidered.
• The conversion to corporate entity issue. Trusts will be subject to regular corporate taxes in 2011 so this is issue is hanging on Peyto and all trusts alike.

A note: This is a Canadian trust equivalent to master limited partnership in the US so it will have personal tax consequences that will have to be taken into consideration when purchasing

Value Idea: Pride's Spin off

Forced Sellers:

I think this will be dumped by investors because they will want Pride high margin business in the deep water drilling and not the shallow-water low margin and limited growth business. But the $64,000 question is are they forced sellers due to non economic reasons or are they justified in their actions?

Industry Fundamentals:

lower utilization rates and pressure on daily rates. Oil finds moving to deeper waters, which seahawk fleet is not capable of operating under. Their biggest customer are requiring more depth capable rigs, which prices them out of more business.

The disparity between the US Gulf of Mexico Shelf and deepwater rig markets continues to widen. Earlier this year, the jackup market reached its lowest level in 33 years, according to ODS-Petrodata figures, and slid downward from that point. Drilling contractors continued their exodus from the Gulf whenever possible, moving jackups to more lucrative areas. Despite a slowdown in some jackup markets, eight rigs will have mobilized from the Gulf by the end of July. As far as the deepwater Gulf, most people consider it a growth market. As many as 17 new-build deepwater rigs are scheduled to enter the region by the end of 2010. More deepwater rigs could mobilize there for a few wells, then mobilize back to other markets during this period. As a result the utilization rates have been coming down steadily over the last few quarters.

Rig Type	Current		Month Ago		6 Months Ago		1 Year Ago
Drill Barge	90.0%	(9/10)	90.0%	(9/10)	90.0%	(9/10)	90.0%	(9/10)
Drillship	90.5%	(38/42)	92.7%	(38/41)	79.5%	(31/39)	78.4%	(29/37)
Jackup	74.9%	(275/367)	74.9%	(274/366)	82.5%	(296/359)	91.0%	(312/343)
Semisub	80.2%	(134/167)	82.5%	(137/166)	82.7%	(134/162)	83.9%	(130/155)
Submersible	50.0%	(1/2)	50.0%	(1/2)	100.0%	(2/2)	100.0%	(2/2)
Tender	80.8%	(21/26)	76.9%	(20/26)	92.3%	(24/26)	88.5%	(23/26)

Natural gas prices are weak and depressed. There is plenty of supply and surplus inventory to keep the pressure on prices for awhile. I do not want to try to forecast or predict the direction of natural gas because what if my baseline forecast did not materialize. Natural Gas prices are called the "widow maker" for a reason, they are very hard to call.

Overcapacity in the sector. There are several deliveries to take place for shallow water rigs. During the past several years, the supply of available jackup and semisubmersible rigs has been unable to meet the increasing demand of oil and gas companies on a global basis. As a result of this global supply and demand imbalance, various industry participants ordered the construction of over 180 new jackup and semisubmersible rigs, over 60 of which were delivered during the last three years. Approximately 60 additional jackup and semisubmersible rigs are scheduled for delivery in 2009.

The new rig deliveries scheduled for 2009 include over 30 jackup rigs, the majority of which are not contracted for work upon delivery from the shipyard. These new drilling rigs will increase supply and likely reduce utilization and day rates as rigs are absorbed into the active fleet, especially in light of the recent decline in oil and natural gas prices and jackup rig demand. However, the current supply of jackup rigs is limited and it is time consuming to move offshore rigs between markets. Accordingly, as demand changes in a particular market, the supply of rigs may not adjust quickly. Utilization and day rates in specific markets could fluctuate significantly while utilization and day rates in other markets may be relatively unaffected. Additionally, several rig construction cancellations have been recently announced and the tightening credit market has created substantial uncertainty as to whether construction of other rigs will be completed.

Ok, you would say that weak industry fundamentals are cyclical and should adjust. Then seahawk would give you great risk/ reward proposition, assuming its price will fall to below liquidation value of its assets, which more likely it will. In this case company fundamentals has to be flawless to get me interested.

Company Fundamentals:

• Potential of fines regarding bribery charges and accounting irregularities, however there is limit to the fines paid to $1 million, any excess pride will take care of it.
• Mexico Oil company account for 60% of SeaHawk gross revenue. One customer dominate their business. This was not a problem when the company was a division of Pride but on a stand alone basis is very risky.
• accounting is a bit aggressive:
• changes to depreciation expenses by extending the useful lives of rigs, which means a boost to their earnings as depreciation expense get smaller. This annoys me to no end when companies change their depreciation policies or assumptions. It makes comparisons difficult and obviously management motives to boost earnings by hook or trick.
• already there is investigation for accounting irregularities by pride into Seahawk division.

• no debt and clean balance sheet, which a very good in this environment.

• SeaHawk Jackup rigs are shallow in the 200-250 feet range which does not work in the current industry dynamics. Their biggest customer are requesting deeper and deeper rigs, which prices Seahawk out.
• very capital intensive business. in order to expand more capex need to spent to buy new rigs. most free cash flow will go to acquisition of new PPE.
• most of its rigs are idle they have 40% utilization rate.
• most rigs are old so it may require some capex going further
• no unique competitive advantage that is very apparent that will distinguish their operations from others.

Management

SeaHawk's president and CEO was CEO of Hercules offshore, similar business to seahawk. He left the company in June 2008 and the company took a big impairment expenses due to large acquisition done on his watch, $2.3 Billion in cash and stock. As a result of the acquisition, Hero balance sheet is over leveraged and impairment charges mounted when the turn in the economy came.

Investment returns over his tenure were not overly outstanding.

	2004	2005	2006	2007	2008
ROE	11.35%	19.13%	38.98%	11.35%	(73.37%)

He spent $660.1 million in capex, not including the merger deal, cumulative over the 2004-2008, and generated $618.9 millions in cash from operations during the same period. During the same period cumulative earning were partly at $291.2 million, and if you include 2008 results it would be a significant loss.

Management Compensation Plan

This is a bright spot, somewhat, as the good chunk of compensation is in form of equity. I say somewhat because not all long term incentive compensation is equity. The better alternative is to have 100% of their long term compensation in restricted stock. From their filing:

The beginning value of the initial equity award is $4,800,000 for Mr. Stilley, $1,000,000 for Mr. Manz, $690,000 for Mr. Cestero and $575,000 for Mr. German. ....50% of the equity compensation will be in the form of restricted stock.

Competitive Position

The company is second lowest cost operators in the GOM region. Hero operates better cost structure than Seahawk. According to my analysis the operating the costs per available day is

Business	Notes	OE per avail Day
Seahawk	only GOM locations	$49,634
Hercules Off shore	very similar business to Hawk but diversified geographically	~$28,000
Ensco International Incorporated	shallow water but more specialized assets/ fleet. their GOM fleet water depth is 250-400 ft	$50,175
Rowan Companies	shallow water but more specialized assets/ fleet water depth 250-500
DO	deep water rigs- not very applicable
Nobel	deep water rigs- not very applicable	~$63,000
RIG	deep water rigs- not very applicable (55 standard jackups with depth from 250-400)

Conclusion:

There are so many strikes against the spin off and not too many positives even if valuation are ridiculously cheap, which I did not need to perform. This is a leveraged play on the prices of natural gas, which is very hard to call: will it stay depressed or take off? Weak sector fundamentals and potential liability and fines all are external to the company and can be manageable by good management team. However, I have my doubts about the new CEO hi track record in Hero is not encouraging. If there is any contrarian play on this name, I do not see it. I will pass on this spin off.

Spin-off Idea: Pride International

Not a lot of spin offs came to the market lately. But I think that is about to change as companies will reorganize themselves and cut businesses that no one want to buy. There is two opportunities right now: Pride International Spin off of Seahawk Drilling and CableVision spin off of the Madison Square Garden business. I will introduce the Pride spin off and talk some other time about Cablevision.

Pride International (PDE) is spinning off its Gulf of Mexico operations to shareholders. Pride International is an offshore drilling company that leases rigs and vessels to producers. The company recently made strategic effort to focus on deep water and other high-specification drilling solutions. As a result the decision to spin-off its shallow water business. Jack-up revenues has been declining in over the last few quarters. Management thinks this GOM drilling is slow growth business and that's why they want to divest out of it.

The shallow water business or the leasing of jack-up rigs is concentrated in the Gulf of Mexico (GOM) only with no other international operations. The shallow waters of the GOM is a mature region that oil production has peaked some time ago. companies are moving deeper and deeper for new finds. Pride management is justified in dumping this low growth business to focus on the deep water. However, the questions is can an independent Seahawk make earnings grow on their own without the constraints of Pride management of investing in deep water segment?

The offshore and land drillers have been trading at very low valuation. The sector PE is around 10. some notable high margin and specialized businesses like DO, RIG and NE are selling at PE between 5-9. These businesses have very specialized field and very much have solid backlogs, unlike Seahawk, for years to come so the valuation seems puzzling?

The service companies are leveraged play on the price of oil and gas, particularly natural gas in the Gulf of Mexico. Currently Natural gas is at very low pricing levels that make some field uneconomical to operate. Most will making a call on the price of gas to invest in these GOM drillers. I want to avoid making such a call. I am not in the forecasting business but in the investing business.

This is an interesting proposition. The spin off will be completely debt free with management that is properly incentivized with restricted equity and options but the company operate in poor sector until Natural gas increase in value. The price of the commodity does not concern me a lot at the moment and will play a secondary factor in the decision making. I will look for more important things on the company level:

• management compensation plan
• management track record and prior accomplishments
• accounting practices and policies
• valuation once it is traded
• competitive position in the industry
• what are my risks
• Will there be forced sellers?

Not every spin off is an automatic investment; the economics of the company must make sense as well. I will work on my analysis to see if this is worth establishing a position in.

Teck Resources faces Perfect Storm

I have taken a position in Teck Resources (TCK) @$4.65 betting that the company will be able to meet its debt obligations or at least restructure them. Investors have written off Teck after its ill timed acquisition of Fording Coal, which was financed mainly with short term debt. Then Teck faced the perfect storm:
1. collapse in commodity prices, and
2. a credit crunch that left most companies with short term debt maturities crushed, Teck is one of them.

As a result , Teck shares have gone from high of $48 per share to low of $2 per share.

Teck Resources assets are impressive and valuable. Teck is

....engaged in the exploration for and development
and production of natural resources. The Company’s principal products
are copper, metallurgical coal, zinc and gold. Lead, molybdenum,
various specialty and other metals, chemicals and fertilizers are
by-products produced at its operations. It also sells electrical power
that is surplus to its requirements at the Trail metallurgical
operations.

After it consolidated its ownership of Elk Valley by acquiring its Fording Coal, Teck has become a major producer of met coal. Also, Teck owns significant oil sands reserves in the Fort Hills project among other oil projects co-owned with UTS energy in Alberta.

The market has priced a strong possibility of Teck liquidation or bankruptcy. So all bad news is priced in which creates for good risk reward proposition, if Teck manages to restructure its debt. And I think it can for the following reasons:

1. Asset sales that can cover some of its obligations. Its assets base is impressive and the value is there. The industry still sees real value in this company's assets, just not at the prices it paid. The company has already sold some none core assets and looking for more sales.
   
2. operational cash flow in 2009 will cover some its debt as some commodities price have increased from the bottom observed in Q4 2008.
   
3. Possible short term debt restructuring. I can't see any lender forcing Teck to liquidate. Teck as going concern can cover its obligation but it may need additional time. I am betting that banks will give it that time.

Teck still faces a daunting task of repaying short term debt of $7.7 Billion (CDN). I have calculated that from already announced assets sales, tax refunds and free cash flow, Teck will be able to repay $3.6 Billion, see table. This will leave the company with a balance of $4 billion to refinance or repay through further assets sales.

Teck still has multiple options to generate funds from asset sales. It can sell its partnership with UTS to Total, which has an offer outstanding to UTS shareholders. this can amount to $500-800 million. It can sell partial interest in its coal operations for $4 billion and take an impairment charge, as it will less than what it paid for Fording.

This is a speculative extreme outcome situation. If it recovers then the payout can be good but the downside is 100% loss of principal, however given the caliper of the company I think it will pull through.