Saturday, May 12, 2012

Social Mood Theory: Natural Gas Rig Count Hits New 10-Year Low, Prices Begin to Rise, as Most Visible Name in Industry Gets Crushed

"The number of rigs drilling for natural gas in the United States fell this week to the lowest level in 10 years [...], sliding by eight this week to 598, the lowest since April 2002 when there were 591 rigs operating, data from Houston-based oil services firm Baker Hughes showed on Friday. If in coming weeks the count drops to 590 or lower, gas-directed drilling would be at its lowest in 12-1/2 years, or since October 1999."
This is awesome. At the same time, a bunch of journalism majors have ginned up a scare campaign against Chesapeake so that you can buy in at a fraction of net asset value.

This is another example of real world events that are brilliantly predicted by social mood theory. The natural gas storage situation has been improving, as weekly injections are smaller than in past years. Meanwhile, prices have bounced significantly as the June contract has jumped 25% in a month. (It's possible that fundamentals have already turned around, although this is unknowable and a question that doesn't need to be answered, anyway.)

The point is that even as the gas fundamentals were improving we saw an onslaught of negativity about, and selling of, the most visible, aggressive, and controversial name in natural gas. There were days when Reuters, the NYT, and the WSJ each ran multiple stories about dated and relatively inconsequential aspects of CHK corporate governance.

It's classic social mood stuff. Does buying natural gas assets become more or less risky as the share price falls while the price of natural gas goes up? How big of a discount should there be for having a CEO who is a jerk? Isn't that something that activist investing could solve?

How did a compensation scheme that had been consistently disclosed, and which is relatively tax efficient and incentive aligning, become front page news for two weeks? Since when do arcane governance and compensation issues constitute anything but bland articles for p7 of the business section?

Also, the CHKDG has gotten more attractive. On Friday, it was yielding 7.6% and convertible at a share price equivalent to roughly 25. There is still around $10 billion of market capitalization junior to it.


Josh said...

Seems like an attractive conversion / coupon. The main attraction (to me) is that if CHK is acquired the units might trade close to par. Where do you look up more information about the stock? I use Quantum Online but did not find anything there.

When I looked up CHK on Edgar it lists those notes at a conversion price of $38.

(page 134)

CP said...

Right, but you think about convertible instruments in terms of conversion parity. That's the % of par * conversion price.

The instrument you are looking for is called the CERTIFICATE OF DESIGNATION OF 5.00% CUMULATIVE CONVERTIBLE PREFERRED STOCK (SERIES 2005B).

It talks about what happens in the event of a fundamental change. My take is that the preferreds would get par in a takeover, unless the takeover happened at a higher price than the conversion price.

Josh said...

found this link on CHK webiste that is helpful.

CP said...

Yes, that is key.

The way I think about the preferred is that you have a running 7.5% yield until the situation normalizes, at which point there should be a close to 50% capital gain.

I've mentioned before, there is a NYSE listed preferred, the CHKD. It has a lower coupon and higher conversion price but trades at a dollar price about $10 higher. Implies that the CHKDG is very undervalued.

Allan Folz said...

The piece I found interesting was over on Zero hEdge commenting that many producers hedges are soon expiring and some how that was a bad thing.

Um, might all these hedges be the reason the spot price is below the cost of production? If the hedges finally run off, and spot is below the cost of production, well... producers won't pump, storage will get burned off, and soon enough the price will rise to be commiserate with the cost of production. By that logic, now is actually the best time to be without hedges, assuming one can ride out the dry period that is. The just announced financing implies to me CHK can.

Josh said...

I understand your math now. That makes sense. I read the post too quickly and thought... 25 conversion price at par and it is trading at 2/3s par that gets really interesting for an arb (if the terms allow an early exercise).

I like the strategy of buying these preferred especially (hopefully) for the quick capital gain possibility with the idea that 7.5% is nothing to sneeze at if it takes some time.

CP said...

That zero hedge article is pretty stupid. Does he think people don't know whether their natural gas companies are hedged?

Also, he expects "natural gas prices to remain between $1.50 and $2 per MMBtu for the next 12 months."

Uhhh... good luck with that.

The cheapest part of the strip is the front month which is already at $2.50. November gas is already back above $3.

The reserve writedowns he mentions are irrelevant too. No one values natural gas names based on out of date PV-10 estimates.

I am excited about the improving weekly injection numbers.

I think the preferred have a great risk/reward.

Seriously though guys... the point of the post was really the social mood aspect. How did this media onslaught happen? Orchestrated or just classic example of sentiment bottoming after fundamentals?

anony mouse said...

One of the big bear cases is the amount in storage. Last weeks injection was 30 BCF, the 5 year average for last week is 89 BCF. At this pace, we'll be back to "normal" by August, assuming no other output reductions as drilling has fallen off a cliff.

I'm thinking about throwing some money into some UNG calls. I know they're not good long term plays because NG is in contango and you'll eventually get killed on the roll, and but the contract is pretty flat for the summer months, and I think we could see NG run back into the $3 - $3.50 pretty quickly range when the market figures this out.

CP said...

Right, the weekly injections are doing better.

I don't know why you would do UNG, which has a headwind against you, when you could do one of the undervalued producers. Think about how little you are paying for NG reserves by buying CHK. The economics of that have to be better.

anony mouse said...

For the next few months, the headwind is pretty small ( )

The reason (and this is a trade, not a long term buy and hold) is because it's more of a pure play. If NG goes from to 3.50 by July, that's a 40% upside from here. I wouldn't expect CHK or any other producer to rise 40% if NG goes from 2.50 to 3.50.

Small headwind and I don't see a lot of downside in the price @ 2.50..

anony mouse said...

That said, I think CHKDG is pretty tempting around this level, especially after Friday..

Josh said...

I sold CHKDG today. I made 10+ points in a month and half 64 to 74. 125% annualized return.

These are the assumptions I used to make the trades. I used 100 par at a discount rate of 15% and a 3 year time horizon. 100/1.15^3 64.75. At a current price of 74.50 the discount rate moves to 10%.

Normally I use a discount rate of 20% but since the dividend is 5% (at par), I used 15%. Of course you could change my time frame to 2 years from 3 years (I thought about it) but could not get comfortable with it. At the same time, what is to say it isn't 4 years.