Sunday, May 20, 2012

The Natural Gas/Oil BTU Spread In An Indeterminate World

These are Blake Masters' notes from the Peter Thiel CS183: Startup class.

"In a determinate world, there are lots of things that people can do. There are thus many things to invest in. You get a high investment rate. In an indeterminate world, the investment rate is much lower. It’s not clear where people should put their money, so they don’t invest. We have a very low rate of investment in U.S. [...]

Can things work out when no one is thinking of substantive things to do or adding new ideas into the system? The era of indefinite optimism is arguably coming to an end. Look at government bonds, which are essentially the purest version of money. Yields keep going down. People keep holding because they don’t know what else to do. Today you can earn 1.8% on a government bond. But expected inflation is 2.1%. The expected return over the next decade is -0.3%. You get negative returns when people run out of ideas."
I can think of some support for this view. If you think that natural gas is going to remain cheap forever, build a natural gas-to-liquids (GTL) plant. If you think that natural gas will converge with the BTU equivalent value of oil and go back to $10ish, buy Chesapeake. But those are the only two possible scenarios and each implies a very particular course of action.

In fact, you could buy Chesapeake, build your own GTL plants, and sell the liquids output forward to lock in the huge spread. Meanwhile, there were $22 billion of Facebook shares traded on the first day. Why do people watch CNBC and get excited about companies hanging paper on them when there are actually high ROI projects out there to be done. Something else worthwhile from the notes:
"Any company with a good secret plan will always be undervalued in a world where nobody believes in secrets and nobody believes in plans. The ability to execute against long-term secret plan is thus incredibly powerful and important."
This also makes me think about Chesapeake. See these comments from Aubrey during the third quarter conference call last year.
"Chesapeake single-handedly has generated almost half of the entire industry's growth in natural gas production. Said another way, a 2% gas market share company in 2000, which was us, grew its production 472% over the past decade, while the other 98% of the industry, 49x bigger than us and represented by more than 10,000 other companies, only grew its collective production 12% during the past decade.

As incredible as that is, it's even more incredible how most natural gas market observers fail to understand the impact of these numbers on future supply demand trends, because for the next 5 years, Chesapeake is planning to keep its gas production essentially flat. Please see Slide 18, which shows our projected annual 10% production increases coming almost entirely from liquids production growth from 2012 through 2015.

Said in the simplest way that I can, natural gas markets during the past 5 years were basically changed single-handedly by the efforts of 1 company. And now I'm telling you, during the next 5 years, it will be very different from now. And the futures curve is currently pricing natural gas, we believe, incorrectly because the same company that helped bring you the gas oversupply is now dedicated to increasing its liquids production, and its gas production will not increase much from here."
The parallel I see with the Thiel quote is that no one believes in the CHK plan. The company has an incredible track record of hedging gains, which implies an information edge on hydrocarbon prices. The natural gas futures are already rallying. It's strange that the market for NG producers is lagging so much.

It's also strange that people are giving Aubrey such a hard time regarding arcane governance and compensation issues. There are essentially two explanations for the negative publicity onslaught: the social mood explanation or a conspiratorial explanation. Either way, what fundamental concerns there are don't justify the public hand-wringing that took place for several weeks straight.

4 comments:

portland_allan said...

RE: Aubrey & CHK, I think there is legitimate concern that he is a prima-donna. CEO prima-donnas have a bad habit of betting and losing the company in some overly complex, often off-balance sheet, financial shenanigan. AIGFP, Enron, and LTCM are three that come immediately to mind. I'd probably be able to bust out a half dozen more given a minute's pause.

Hopefully Aubrey isn't the next Fastow, but who can be sure?

CP said...

What's the evidence that he is "a Fastow"?

Wasn't Steve Jobs a "CEO prima-donna"?

Doesn't it take some aggression and balls to lease up all the new gas plays in the U.S.?

Does having $1 in natural gas assets owned by a company with a "CEO prima-donna" (who could easily be fired) mean that they are only worth 45 cents?

portland_allan said...

Obviously there is no direct evidence he is a Fastow. Things like that usually come out in retrospect after the criminal indictments have been handed out. However, the way he used the company to bail him out of his margin calls in '08 were certainly unseemly and suggestive of where on the totem pole shareholders sit. I don't believe the assets themselves should trade at a discount because the CEO is a prima-donna, but I think there is a legitimate question as to whether there are any off-balance sheet skeletons lurking in the closet.

I am long both the common and the preferreds, but I am not as long as I would be because I have no way of being certain all the debits are fully accounted for.

Maybe you're right. Maybe it's all dis-information being used by big-money to vacuum up shares on the cheap and create pressure for Aubrey to lose some control now that the hard work of building from scratch is done and all that's left is pumping gas and selling off assets. I certainly hope so.

CP said...

I appreciate your thoughtful reply.

Isn't it telling that they are under a media spotlight and the worst anybody can come up with is pretty middling?

Speaking of CEOs, would you rather buy FB at this valuation and knowing that no one can ever get rid of "the Zuck"?

I actually think your last para. is a great restatement of the conspiratorial hypothesis. I'll make it a new post.