Thursday, 5 February 2009

Investing for Comrades, 101

Joel Bowman, still wandering around Asia's Great Southeast, reports...

"To keep you is no benefit. To destroy you is no loss." – Popular motto of the Khmer Rouge .

You would hardly expect it listening to the nightly economic news, but in some places in the world, communism is still a dirty word. Mostly, it's the countries that have lived through "red eras" that despise the concept the most. Those that fought most vehemently against it are now left to carry the hammer and sickle.

Last week your editor journeyed to the Choung Ek Killing Fields, about a 20 minute tuk-tuk ride outside Cambodia's capital city of Phnom Penh.

Between the years 1975-79, this tiny Southeast Asian country fell under the control of one of the most brutal regimes of the 20th century, the Khmer Rouge. Led by the infamous Pol Pot, the Khmer Rouge is responsible for the death of an estimated 1.5-2 million people. As a percentage of the national population (>20%) Pot's genocide count outranks even Hitler's.

In the center of Choung Ek stands a 17-story glass stupa, which houses 8,000 human skulls exhumed from the surrounding mass graves. They are the remains of anyone suspected of involvement in free-market capitalism, the sworn enemy of the Maoist-leaning Khmer Rouge.

Barely a generation has passed since the horrors of the Khmer Rouge. Even today an estimated one third of the population is under the age of 15.

As the fallout of the global recession hits these shores, the IMF expects economic growth in Cambodia to decline to 4.75% in 2009, the slowest rate in 11 years. The second-poorest nation in the region, Cambodia already relies on foreign aid for about a quarter of its national budget.

Tourism, construction and garment manufacturing make up more than 60% of the total economic output there, and all face serious threats to growth.

Hang Chuon Naron, secretary-general of the Ministry of Economy and Finance, warns the number of foreign visitors may fall by 20% in the coming year as westerners tighten their travel budgets. Construction is also likely to slow and garment exports, 70% of which are bound for U.S. shores, are expected to continue their decline.

But despite the country's precarious economic position, the government has resisted calls from the opposition to implement a $500 million stimulus package, similar to those recently implemented by neighboring Thailand and Viet Nam.

"We cannot distribute cash to the people," Hang Chuon Naron was recently quoted as saying. "What we can do is give targeted tax cuts to garment factories and spend more on infrastructure so we can prepare for economic development in the future."

For one thing, the struggling country just doesn't have the money to bailout shrinking industries, although that's certainly not stopping those in the west from digging into the pockets of future generations to pump up their economies. But more than that, Cambodians are acutely aware of what surrender of their private property represents and of where that slippery slope can lead.

In addition to outlawing all religions and freedoms of expression, the Khmer Rouge also instigated a strict form of national protectionism, abolished the banking and finance sectors, confiscated all privately owned property and destroyed the nation's currency. Once bitten...

For those of us in the west who have yet to learn the very, very hard way, let's take a look at how best to trade the deteriorating situation. Even in the face of ever-expanding government intervention into the markets, there are many opportunities to improve one's own lot. Dan Amoss offers some ideas on what to do next in today's column, below...

Investing for Comrades, 101

By Dan Amoss

As the U.S. government spirals toward Soviet-style economic practices, the American capitalism we once knew and loved is becoming as endangered as a bald eagle…or a GM car dealership. We don't have to like the changes underway, but we do have to respond to them intelligently if we hope to preserve and increase our wealth. The time has come for us "free market" aficionados to dry our tears and try to figure out what to do next.

The federal government's attempts to reshape the U.S. economy will provide numerous profit opportunities. Take, for instance, the inevitable move toward taxing carbon emissions. Attaching a price to carbon dioxide would, obviously, increase utility bills (and the price of anything made with electricity). As a result, consumers of energy would try to avoid this taxation by utilizing cleaner sources of energy.

Right now, many natural gas-fired power plants are brought online only at times of peak demand, while coal is considered a "base load" fuel since it's cheaper. But a carbon tax would raise the price of coal (and the extra carbon it emits) closer to the price of natural gas. So it's seems likely that carbon taxes or any other "climate change" legislation that comes from the Obama Administration will favor natural gas-fired electricity at the expense of coal.

Assuming the political popularity of natural gas will keep growing, and that solar and wind power production cannot increase fast enough to be meaningful (even with heavy subsidies), it makes sense that natural gas-focused exploration and production (E&P) companies and their critical suppliers like National-Oilwell Varco (NYSE: NOV) will enjoy years of attractive growth opportunities. NOV has an attractive business selling brand-new, highly efficient rigs built for shale gas drilling.

At the moment, a glut of natural gas has produced a drop in number of drilling rigs operating in the U.S. This drop was already discounted by the crash in the oil service stocks last fall. But the faster the rig count falls, the faster the gas glut will dissipate as 2009 wears on. If demand for natural gas rebounds later in 2009, while supply is falling, then prices could move much higher in a short period of time. I'm going to keep monitoring the supply situation closely because I think it will yield several good trading opportunities this year. And the best way to get a handle on supply is to follow where and how the smartest companies are investing.

I recently tuned in to several Webcast presentations made at the BMO Capital Markets North American Unconventional Gas Conference. The larger presenters included Talisman Energy, Comstock Resources, Southwestern Energy, Ultra Petroleum, and Range Resources -- several of the visionary early movers into shale gas drilling.

These companies employ cutting-edge technology in the natural gas industry. As a group, they delivered much of the production growth the U.S. has enjoyed in recent years. We can't do without this shale growth. Keep in mind that virtually all new electric power plants brought online in recent years have been gas-fired plants.

Most of the premier shale gas plays (Barnett, Marcellus, Fayetteville, Haynesville, etc.) can be booked into reserves and brought online at cash costs between $2-4 per million cubic feet of gas.

With natural gas prices currently at $5.50, the economics of adding to shale gas reserves and production makes sense. Even if they don't immediately hook up newly drilled wells to gathering pipelines, most of these exploration-and-production companies will still want to drill at a fairly rapid clip to book new proved reserves in 2009.

The E&P industry, like most others, contains the "haves" and "have-nots." The haves tend to be public companies with premium valuations that reflect their huge inventories of low-cost drilling opportunities. The have-nots tend to be private highly leveraged companies that hit the accelerator on any resource that looked economic in the high-price environment. Many of them are releasing low-end rigs and will not survive this downturn.

Ultra Petroleum is certainly at the top of the "haves" list. It controls tons of acreage in the obscenely profitable Jonah and Pinedale fields in Wyoming. Because its acreage is so cheap to develop, it can keep expending production very quickly, and incremental returns on invested capital are enormous.

The same goes for Range Resources. Range is a first mover and considered an expert in developing the Marcellus Shale. It looks to have locked up most of the highest-quality acreage in the Marcellus. The Marcellus is definitely promising, but it has different characteristics across its wide geography. Range has the most profitable gas wells because it has the most experience, expertise, and proprietary seismic data. At the BMO conference, Range estimated that its Marcellus wells have the potential to earn 20% internal rates of return at $4 natural gas.

The good news if you're exposed to E&P or service stocks exposed to shale gas: The stocks have already crashed in anticipation of an ugly environment for natural gas pricing, production, and drilling in 2009 and 2010. If conditions stabilize, rather than continue collapsing, many of the stocks exposed to growth in shale gas drilling -- including NOV -- should regain plenty of lost ground.

The big concern with NOV recently was J.P. Morgan's downgrade. I read J.P. Morgan's report and agree with many of its points. But I disagree with its method of getting to a $31 price target for NOV (I think $31 is much too conservative). It gets to $31 through a discounted cash flow model in which it assumes 2009-2011 returns on invested capital will average 8%. This is down dramatically from the 2005-2008 average of 16% and equal to the 2002-2004 average of 8%. I have two issues with this:

1) Hardly any company was investing in rig equipment during 2002-2004. The upturn in day rates didn't really gain traction until 2004. On the next up cycle, most of the world's drilling fleet will be approaching 30 years of age. So many of the oldest rigs will be scrapped and there could be a shortage of newer, more productive rigs that NOV helps create.

2) J.P. Morgan gives no consideration to NOV's greatly strengthened negotiating position relative to its customers, since it scooped up several competitors. It is a one-stop shop for equipment and consumables for every E&P and drilling company worldwide. It can afford to take advantage of this down cycle with more cheap acquisitions. Such moves won't dilute shareholder value -- thanks to its strong balance sheet and cash flow.

3) J.P. Morgan gives no credit to NOV for its excellent integration of Grant Prideco -- a company with very attractive growth prospects (considering that its product lines are levered to the strongest trends in oil and gas production, including stronger drill bits and better drill pipe).
So J.P. Morgan reflects the bear case on NOV, yet it still gets to a $31 price target.

J.P. Morgan's target implies that NOV should trade at 3 times its estimated 2009 EBITDA, in line with the offshore drillers. In my view, NOV deserves to trade at more than twice the EBITDA multiple of the drillers, since it's a far less capital-intensive business model. NOV will not be generating losses during this downturn, nor will it be forced to spend a lot on maintenance capital expenditures (as drillers must, depending on the age and shape of their fleet).

I expect the market to come around to this view when NOV reports earnings in early February. Sure, the segments of NOV's business that are the most sensitive to the rig count will slow in 2009, but the stock market excessively discounted this slowdown when it hammered the NOV share price from its crash from $92 last July to $18 in November.

At the current quote of $25.62, NOV is a very cheap stock that could easily rebound to the mid-$30s in the coming months. I think the trend for NOV will be up over the next month or two as the market anticipates that 2009 and 2010 earnings will not be as bad as previously expected.

Joel's Note: Here at the Rude Awakening, we're been stressing a cautious approach to investing for the past few months. Instead of trying to call the bottom, we've favored the "toe-dipping" approach. That's why Dan's analysis excites us more than most. As the editor of the hugely successful Strategic Short Report, Dan is better positioned than just about anyone in the game when it comes to sorting the good from the bad and, of course, avoiding at all costs the downright ugly.

At the end of this report, detailing his Ultimate bear Markets Strategy, Dan invites you to join him for the next round of profit taking. To learn how to get on board with our best 2008 trader,
read on here

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