The science and art of turnarounds: a personal view

Turnarounds seldom turn – Warren Buffett

Do not kid yourself, all turnarounds are risky. And that risk is seldom bounded because any margin of safety based on liquidation value can quickly erode in the process. Turnarounds are the ultimate value trap. Peter Lynch, who had a history of successful turnaround investments, said it best:

Turnaround candidates have been battered, depressed, and often can barely drag themselves into Chapter 11. These aren’t slow growers, these are no growers. These aren’t cyclicals that rebound; these are potential fatalities – Peter Lynch, One Up on Wall Street

So why even take a look at turnarounds. Well, they have also some positive characteristics which can help to balance a portfolio and, if you are good at it, give it an extra kick:

• Performance is less related to the general market: specially interesting after a 50%+ bull run
• They have asymmetric returns, so when successful they can make up lost ground very quickly

The clue is to have a process to filter a thousand frogs to get to a prince. It has some echoes of venture capital investing.

Even Warren Buffett has invested in them. Always the riddle, while he makes clear cut statements about the dangers of turnarounds he is more pragmatic when opportunity arrives. The GEICO purchase in 1975, a period where good alternatives abounded, was undoubtedly a turnaround and a complicated one to boot.

I looked again at GEICO and was startled by what I saw after a few rule-of-thumb calculations about loss reserves. It was clear in a sixty-second examination that the company was far underreserved and the situation was getting worse –Warren Buffet, The Snowball

If you know anything about insurance, you know this a complex situation, even for a motor insurer with short tail risk. Buffett’s decision seems with traces of uncharacteristic sentimentalism. Hey, this was “the security I like best”. At the same time, GEICO was one of Buffett’s most successful investments and of course it was more than just sentimentalism:

This is risky. It could go completely out of business. But in insurance it’s very hard to get an edge, and they have an edge. If they got the right person in to run it, I think he could turn it around – Warren Buffett, The Snowball

In that simple paragraph Buffett narrows down the key issues on turnaround investing:

• The Science: We are not looking for survivors that recover somewhat out of a recession only to fall again in the next one. We are looking for outstanding winners like IBM in 1992, not unrepentant alcoholics like GM in 1982, or 1992, or 2002 or 2008.
• The Art: surviving depends on leadership, a good plan, momentum and luck. If you feel you lack the ability to read management and its progress you should probably avoid turnarounds.

I have read a lot of books about value investing. Not many of them even touch the issue of turnarounds. Probably because it is not considered really value investing.

On several postsI will try to give my personal view on this issue. I am not even sure what their content will be but I felt it was time to put some personal unstructured ideas in writing. And if in the process I can get feedback on particular investment ideas even better.

Valuation of oil and gas reserves Part 3 ($CFW)

Multiples and comparables are good for ballpark estimates. However, in the oil and gas industry, as in most commodities, the cost structure is crucial. It gives protection in these cyclical industries and is usually the only possible competitive advantage. One way of adjusting for this factor is to calculate the cost per BOE and make a qualitative assessment. However, in the Cano case it distorts the issue given that most of the investments and costs are upfront so its marginal costs are very high and decrease precipitously over time.

An alternative method, and the most used, is the standardized measure that is an estimate of the discounted after-tax net cash flows of proved oil and gas reserves discounted at 10%. That measure can be compared to the Enterprise Value to get an estimate of the margin of safety. The PV-10 is the same measure pre-tax and you must be careful because management usually emphasizes it in their presentations over the standardized measure since it makes them look better.

Where do I find these metrics? They are calculated once a year and reported in the 10-K right next to reported reserves and is required for all public E&Ps.

The standardized measure is still controversial since it requires future cash inflows to be calculated by applying year-end oil and gas prices no matter how atypical they may be. That raises two issues

• It assumes continuation of existing economic conditions, specifically prices, that can severely misevaluate reserves when faced with steep backwardization or contango or (i.e. natural gas)
• When comparing companies is critical to review price assumptions given that they could report in different periods (oil assumptions in June 2008 were approximately $140 per barrel and in December 2008 was closer to $40)

Sometimes the companies disclose the flows per year so you can adjust it, but that is not always the case.

So how this all applies to our case Cano Petroleum –CFW? Let’s run the numbers and comparing them against Parallel Petroleum’s –PLLL- that received recently a $483M buyout offer from Apollo Management with support of management.

PLLL was facing a borrowing redetermination given that it was highly leveraged and decided to look for support in a financially strong partner. Apollo had tried to buy Legacy –LGCY- a couple of months ago but Legacy’s management decided to do a 180 degrees after oil prices recovered this year.

Even though Parallel closed its fiscal year in December, they made a standardized measure update for the quarter ending in June. Both Cano and Parallel therefore used the same price assumptions: $69.89/bbl and $3.71/mcf that also seems reasonable as an estimate going forward.

We can also see that Cano is priced well below their standardized measure and that its distressed peer was bought at a premium to that same metric. The issue is how fast Cano is going to convert those PUDs from the Panhandle to PDPs. Today Cano announced yearly results and the waterflooding of Cockrell Ranch is still not responding. The current price should provide sufficient margin of safety for waiting.

In the next part we will analyze a case in the natural gas industry to see how steep contango can affect the estimates of the standardized measure.

Disclosure: Long CFW

Key Success Factors – Follow up ($TA)

Do you remember those posts about Travelcenters of America from some weeks ago? One of the tough parts about investing is that is part creative thinking and part disciplined execution. And it is very difficult to find both character traits in the same person. I know I lack discipline sometimes.

Travelcenters is still in my radar screen even after I sold it last week; 2x returns in less than three weeks do not come so often and there were alternatives. One of the advantages of using key success factors, is that you can rapidly pick the story where you left it and see how it is developing. In this case, August was another good month for the trucking industry so I will keep TA in my watchlist looking for a good re-entry price.

ATA Chief Economist Bob Costello said that the latest increase was another positive sign for the industry. “The gains in tonnage during July and August reflect a growing economy and less of an overhang in inventories,” Costello noted. He is hopeful that the overall trend in truck tonnage during the months ahead will be upward; however, he acknowledged that the pace of increase will likely moderate from the cumulative 4.3 percent gain over the last two months. “While I am optimistic that the worst is behind us, most economic indicators, including industrial output and household spending, suggest freight tonnage will exhibit moderate, and probably inconsistent, growth in the months ahead,” Costello said.

via Truckline.com Article.

Alpha Magazine Hall of Fame – The Builders

This is the third and last part of excerpts from interviews with some famous hedge fund managers from Alpha Magazine Hall of Fame 2008. We already cover the fundamental investors and macro traders. Now is time to check the quants and the multi strategy houses (Steve Cohen, Kenneth Griffin, Leon Levy, Jack Nash and James Simons). Here we are not talking about individuals, we are talking about large firms that even more than systematizing a strategy they have created organization where culture and technology are at the core:

• For the individual investor there is not much to learn about them. Algorithms are too valuable to share and disclosing marketing advantages is like a magician showing his tricks
• Very few mentions of risks or advantages of the process of research or leverage or shorting or risk management or anything specific to investing
• The investing process is not the core of what they do, they are better at building marketing franchises and providing the best resources for above average investors or excellent scientist.
• Brilliant traders and investors are almost impossible to keep within an organization, however scientists, algorithms, brands, culture and processes are sticky
• Not sure this emphasis on building empires is all good. Steinhardt’s remarks in the previous part on the excessive emphasis on asset gathering and relative performance in the industry ring true

Institutional Investor’s Alpha Magazine – June 2008

The Industry

• There’s more overlap among quant investors that I might guessed. So we may think – and we have some reason to think- that we’re the best at what we do, but that doesn’t mean that everything we do is completely different from what everybody else is doing –Simons
• We saw firms that grew to fast. They took money just because it was available but didn’t have the resources to properly manage or administer it. We were very careful to avoid that –Nash

Culture

• The best science is done in a open exchange of ideas. So when a new researcher comes in here, we want him to learn everything about the system –Simons
• Bad ideas is good. Good ideas is better. No ideas is terrible –Simons
• I think that our willingness to be open, to change direction if necessary and to make decisions differentiated us. That included cutting losses when the time came –Nash
• I try to keep this firm well diversified, so when and if people leave, the firm just keeps going, which I think is the mark of an institution as opposed to just a one-hit wonder –Cohen
• I’m not out there buying and selling assets on a day-to-day basis. The guys who work for me are much better at doing that. But I’m certainly involved in asking, Where is the portfolio today? Where do we want to take the portfolio? What are the key risk we are taking? Are we being well compensated for those risks? –Griffin

Hiring

• We had a very rigorous process for deciding who we would hire. It included psychological testing, which looked for flexibility, open-mindedness and decisiveness -Nash
• “I didn’t know how to build a business based on traders. I didn’t know how to judge them. If a guy was extremely good, it would take a while to prove that, and by the time he’d prove it, he would probably be too rich for me to hire. But I did know how to hire scientists and mathematicians” – Simmons
• We wanted people that could act well under pressure – in both good times and bad. How they handled the good times was perhaps more indicative of their character than how they handled the bad –Nash

Technology

• And I do believe that our technology gives us a substantial competitive advantage in the marketplace. How many firms can handle a million transactions a day? –Griffin
• Some 20 to 25 percent of all options contracts in America will come through our four walls –Griffin
• If there’s some event that looks like it indicates more volatility in the markets that the computer could have guessed we’ll override the system –Simons

Alpha Magazine Hall of Fame – The Traders

This is the second part of excerpts from Alpha Magazine Hall of Fame 2008 from interviews with some famous hedge fund managers. In the first part we review the more familiar fundamental investors. Now we go to the more esoteric stuff: macro traders (Louis Bacon, Bruce Kovner, George Soros, Michael Steinhardt and Paul Tudor Jones). I would emphasize a couple of things.

• There is a lot of hogwash in the macro traders’ camp, but these managers are the best and if we learned something the last few years is the need to understand bubbles and how to ride them
• I was very surprised with the few mentions of leverage or shorting or risk management. Is it part of the fabric already?
• Paul Tudor Jones seems like a lot fun and reasonable. Not sure if I want to be a slave of the tape the rest of my life though.

Institutional Investor’s Alpha Magazine – June 200

The Industry

• The crowded nature of the hedge fund community has changed the character of trading so that you can see waves of risk-taking and derisking coming from the hedge funds themselves – Kovner
• But a hedge fund is a superior way of running money -or it has been. But as the industry gets bigger and bigger and takes up a larger and larger segment of the market, it renders it more difficult to outperform and to justify the fees – Soros
• They go for size and are less interested in absolute performance. They are more interested in relative performance – Steinhardt
• I was very sensitive throughout my career to the idea that the bigger you are, the bigger your risk is – Steinhardt

Volatility

• Fundamentals might be good for the first third or first 50 or 60 percent of a move, but the last third of a great bull market is typically a blow-off, whereas the mania runs wild and prices go parabolic – Tudor Jones
• Many of the successful macro guys today, they’re all kind of in my age range. They came from that period of crazy volatility of the late 70s and early 80s, when the amount of fundamental information available on assets was so limited and the volatility so extreme that one had to be a technician – Tudor Jones
• I lost my stakes a couple of times which taught me risk control and risk management. Losing those stakes in my early 20s gave me a healthy dose of fear and respect for Mr. Market and hardwired me for some great management tools. Oh, incidentally and by necessity, I became a pretty good fundraiser – Tudor Jones
• The macro space will be great. I think we’re going into one of those slow or zero-growth periods in the US, which will give us a lot of volatility. – Tudor Jones
• While I’m a staunch advocate of higher education, there is no training –classroom or otherwise- that can prepare for trading the last third of a move, whether it’s the end of a bull market or the end of a bear market. There’s typically no logic to it; irrationality reigns supreme, and no class can teach what during that brief volatile reign. The only way to learn how to trade during that last, exquisite third of a move is to do it, or, more precisely, live it – a sort of baptism by fire – Tudor Jones

Mindset

• He gave me an ongoing tutorial in disassociating oneself from the results of the trade, yet still have passion about it. – Bacon on Tudor Jones mentorship
• The prevailing paradigm underestimates or disregards the element of uncertainty. I consider myself an insecurity analyst, not a security analyst – Soros
• I see the younger generation hampered by the need to understand and rationalize why something should go up or down. Usually, by the time that becomes self-evident, the move is already over – Tudor Jones
• Being a hedge fund manager is particularly suitable for the pursuit of truth – Soros
• When I got into the business, there was so little information on fundamentals, and what little information one could get was largely imperfect. We learned just to go with the chart. Why work when Mr. Market can do it for you? – Tudor Jones
• When I was investing, I measured it one way – which was raw performance – Steinhardt

Strategy

• The view I started with and embodied in Caxton’s fund was that business cycles were very important and that they occurred all over the world, and it was useful to observe them and to advantage of the opportunities across four different asset classes (equities, fixed income, commodities and currencies) – Kovner
• When it comes to trading macro, you cannot rely solely on fundamentals; you have to be a tape reader, which is something of a lost art form –Tudor Jones
• While I spend a significant amount of my time on analytics and collecting fundamental information, at the end of the day, I am a slave to the tape and proud of it. – Tudor Jones
• One of the most important skills you need is to constantly reinvent where you put resources. Commodities markets were quiet for years, Now they’re very strong – Kovner
• We feel that we are versatile enough that we can move into a number of different strategies, and if doing that means that we’re global macro, then we’re not going to argue with that label – Bacon
• The lesson was that picking the right investment will trump any lousy trading around it – Bacon
• We tend to make top-down, interest-rate-driven investments. We’ve been pretty U.S. and European –centric throughout most of Moore’s history, and we have been pretty closely focused on what happens with the interest rate cycle and the reactions that it drives around the world – Bacon

Alpha Magazine Hall of Fame – The Fundamentals

This is the Alpha Magazine Hall of Fame 2008 that includes interviews with some of the usual suspects in the hedge fund industry. I will start with some quotes of my heroes, the fundamentals (Seth Klarman, Julian Robertson, David Swensen and Alfred Winslow Jones) and leave macro traders for a later post.

Institutional Investor’s Alpha Magazine – June 2008

The Industry

• He had two powerful ideas. One was that you didn’t need the traditional allocation of bonds and cash and all that – you can go 99% stocks, you’ll get a bigger return. Two was that you stay in there, you hang in there because you’re hedged. Those were his two things: always being in the market and having a big percentage of assets in stock – Robert Burch on Jones
• Not having other sensible home for these non-S&P-like strategies, we decided that we would create an asset class and call it ‘absolute return’”- Swensen
• Their clients are pressuring them for short-term results, or they think their clients want short-term results. That’s probably the biggest problem for professional managers. It makes it very, very hard for an investor to hold a stock that’s going down, to take a contrarian viewpoint – Klarman
• The consultant’s numbers are substantially inflated by survivorship bias. When managers exit for bad performance, their records disappear – Swensen

Research

• Every manager should be able to answer the question, what’s your edge? – Klarman
• Max Heine was great at not looking at what something was called, what its label was. He looked at what it actually was – Klarman
• Michael Price was fabulous at pulling threads. he would notice something, and then he would get curious and ask questions” – Klarman
• When I got so many talented analysts, I realized it was better to go for more expensive growth stocks because the analysts could project earning well into the future – Robertson
• I think I wised up a bit and realized it wasn’t just price that created value. If you can buy a stock at 25 times earnings that you are sure will grow at 20 percent for a long period of time, it is better value than a stock trading at seven times earnings that is going to grow at 3 to 5 percent – Robertson
• One, dig, dig and dig deeper… Two, the value of a world-class information network … The third thing was the importance of management. Bad management with good assets can fritter value away – Touradji on Robertson
• At Yale the most important shift in vetting hedge fund managers over the past 15 to 20 years has been in increasing focus on the character and quality of the investment principals –Swenssen
• Human nature makes it hard for the markets to be efficient… so the questions is not, Are people smart, are people sophisticated, do they have clever ways of looking at things, are they looking in the right areas? The question is, Are there periods when none of that matters because their human natures get the best of them?

Leverage and Shorting

• We don’t even think of ourselves as a hedge fund. We see ourselves as basically long-only investors. Unlike hedge funds, we don’t leverage the portfolio- never a nickel of portfolio leverage. We have a minimal amount of shorts currently less than 1 percent of the total assets – Klarman
• The first thing Alfred would say about hedge fund managers today is that they are not hedged. The word is being abominated. Anybody leveraged 30 to one is not hedged – they are just using the word to get the 20 percent performance fee – Robert Burch on Jones
• I also think leverage is a great risk. If you look at hedge fund failures, virtually all of them were on the back of excess leverage – Klarman
• Another illusion is that short-selling is somehow more dangerous than buying a stock for a rise in price. A stock can theorically go up to infinity and down only to zero… and in both cases there is no danger that cannot be provided for by adequate diversification – Jones
• The ability to short was where you separated the wheat from the chaff – Robert Burch on Jones

Alpha Magazine Hall of Fame – The Fundamentals

This is the Alpha Magazine Hall of Fame of 2008 that includes interviews with some of the usual suspects in the hedge fund industry. I will start with some quotes of my heroes, the fundamentals (Seth Klarman, Julian Robertson, David Swensen and Alfred Winslow Jones)

Institutional Investor’s Alpha Magazine – June 2008 – (40).

http://www.nxtbook.com/nxtbooks/ii/alpha0608/index.php?startid=40

The Industry

He had two powerful ideas. One was that you didn’t need the traditional allocation of bonds and cash and all that – you can go 99% stocks, you’ll get a bigger return. Two was that you stay in there, you hang in there because you’re hedged. Those were his two things: always being in the market and having a big percentage of assets in stock – Robert Burch on Jones

Not having other sensible home for these non-S&P-like strategies, we decided that we would create an asset class and call it ‘absolute return’”- Swensen

Their clients are pressuring them for short-term results, or they think their clients want short-term results. That’s probably the biggest problem for professional managers. It makes it very, very hard for an investor to hold a stock that’s going down, to take a contrarian viewpoint – Klarman

The consultant’s numbers are substantially inflated by survivorship bias. When managers exit for bad performance, their records disappear – Swensen

Research

Every manager should be able to answer the question, what’s your edge? – Klarman

Max Heine was great at not looking at what something was called, what its label was. He looked at what it actually was – Klarman

Michael Price was fabulous at pulling threads. he would notice something, and then he would get curious and ask questions” – Klarman

When I got so many talented analysts, I realized it was better to go for more expensive growth stocks because the analysts could project earning well into the future – Robertson

I think I wised up a bit and realized it wasn’t just price that created value. If you can buy a stock at 25 times earnings that you are sure will grow at 20 percent for a long period of time, it is better value than a stock trading at seven times earnings that is going to grow at 3 to 5 percent – Robertson

One, dig, did and dig deeper… Two, the value of a world-class information network … The third thing was the importance of management. Bad management with good assets can fritter value away – Touradji on Robertson

At Yale the most important shift in vetting hedge fund managers over the past 15 to 20 years has been in increasing focus on the character and quality of the investment principals –Swenssen

Human nature makes it hard for the markets to be efficient… so the questions is not, Are people smart, are people sophisticated, do they have clever ways of looking at things, are they looking in the right areas? The question is, Are there periods when none of that matters because their human natures get the best of them?

Leverage and Shorting

We don’t even think of ourselves as a hedge fund. We see ourselves as basically long-only investors. Unlike hedge funds, we don’t leverage the portfolio- never a nickel of portfolio leverage. We have a minimal amount of shorts currently less than 1 percent of the total assets – Klarman

The first thing Alfred would say about hedge fund managers today is that they are not hedged. The word is being abominated. Anybody leveraged 30 to one is not hedged – they are just using the word to get the 20 percent performance fee – Robert Burch on Jones

I also think leverage is a great risk. If you look at hedge fund failures, virtually all of them were on the back of excess leverage – Klarman

Another illusion is that short-selling is somehow more dangerous than buying a stock for a rise in price. A stock can theorically go up to infinity and down only to zero… and in both cases there is no danger that cannot be provided for by adequate diversification – Jones

The ability to short was where you separated the wheat from the chaff – Robert Burch on Jones

Valuation of Oil and Gas Reserves Part 2 ($CFW)

Now the fun part, how do we go about valuing the reserves. A good place to start is with an estimate of the Enterprise Value (EV) valuing all securities at market. That way we get to compare on an equal level companies with different capital structures.

In this case, we will consider the debt and preferred at par, given that this is not a distressed company. There is no excess cash but there are hedges that are liquid investment that can be sold at market so we will subtract them from the calculation

• Debt: $43.7 million
• Preferred Stock: $25.1 million
• Common Equity: $50.2 million
• Hedges: $14.6 million
• Enterprise Value: $104.4 million

Multiples

A first approximation to valuing CFW is to use multiples of Enterprise Value. The usual rule of thumb is the 1/3 rule: on average a barrel of undeveloped oil reserve is worth around 33% of the current oil spot price. At current prices that would be $22/BOE. There have been some transactions at close to $20/BOE but let’s be conservative and use $10/BOE.

• Proved Reserves: 49.1 MBOE
• Value of Proved Reserves: $490 million

That is almost five times the enterprise value. But hey, we are talking about waterflooding, a capricious process where we have uncertainty on its timing and its results. So let’s be conservative again and value only the proved developed

• Proved Developed Reserves: 10.1 MBOE
• Value of Proved Developed Reserves: $101 million

Interesting result, it indicates that at current prices we can buy Cano for just the value of their proved developed reserves. So anything, and I mean anything, that the Panhandle undeveloped waterflooding decides to give us is free. At this price Cano is a free option on the success of the proved undeveloped, probable, and possible reserves.

Comparables

Another way of looking at this is to compare its enterprise value per proved reserves versus other companies. As an example I will compare it to Breitburn Energy Partners -BBEP, a company notorious for Seth Klarman’s investment, with a substantial proportion of gas reserves that are worth less than oil reserves, and currently undervalued against its MLP peers

Cano Petroleum

• EV/Proved: $2.1 /BOE
• EV/Proved Developed: $10.3 /BOE

Breitburn Energy Partners

• EV/Proved: $9.8 /BOE

I have run these numbers against other companies and Cano Petroleum still looks cheap. Have also found other undervalued prospects but will leave them for another occasion.

I suppose my discounted cash flow friends are complaining that these methods are meaningless, since they do not take into account prices, costs and value of time. For you we are going to go through a third method in the next post, the most popular, the standardized measure and PV-10,

Disclosure: Long CFW

Canta y no Llores Cantarell

If you are an oil investor and you are not following the dramatic news coming from Mexico, I recommend you to wake up, get out of bed and get a new news source. Just look at this dramatic chart:

via The Oil Drum | If We Can’t Get Oil from Mexico . . ..

What is Cantarell? Hey you really need a new news source. This is from the Financial Times in 2007

In 1976, the future of Pemex, Mexico’s state-owned oil monopoly, looked as bright as it ever had. The discovery of Cantarell, a huge oil complex located in the Gulf of Mexico, assured abundant supplies of crude for the foreseeable future and cemented the country’s place as one of the world’s most formidable oil exporters.

For the best part of three decades oil from Cantarell flowed fast and furious – so furious, in fact, that by 2004 its average daily volume of just over 2.1m barrels ranked it the world’s second-fastest-producing oil complex after the Ghawar field in Saudi Arabia.

via FT.com / Reports – Mexico: ‘Delicious dream’ in decline.

The decline is very important and not only for Mexico, well the Economist explained it all also in 2007

CANTARELL, in the Gulf of Mexico, was once the world’s biggest offshore oilfield, holding over 35 billion barrels of the black stuff. Now, after nearly three decades, it is running out. At its peak in 2004 it produced 2.1m barrels of oil per day (b/d), making up 60% of Mexico’s total output. That figure has already fallen by more than 500,000 b/d and could fall by another 200,000 b/d by the spring.

This is a worry for both Mexico and the world. Although Mexico contains less than 1% of the world’s proven oil reserves, it is the sixth-largest producer. Its output of 3.1m b/d is well above that of Venezuela or Kuwait. And although oil no longer dominates the Mexican economy—even at recent high prices it provided 16% of exports in 2006, down from 68% in 1982—it lubricates the public finances, contributing nearly 40% of federal revenues.

via Mexico | Running just to stand still | Economist.com.

The prospects for the Mexican Oil industry and Pemex in particular do not look very bright. The New York Times shows that every once in a while it can still do great reporting:

Government interference is only part of the story. Pemex has been hamstrung by years of short-sighted management aimed at extracting the most cash for the government treasury — Mexico’s president and Congress must approve the company’s budget, its output, investments and exports each year. By law, Pemex is closed to any outside investment, shutting it off from private capital and expertise.In addition, Pemex has not reinvested enough for decades and, because it faces no competition at home, has lagged behind many of the industry’s technical advances. Its labor union has locked it into rigid work rules and siphoned off hundreds of millions of dollars for unexplained benefits. And that does not even touch on the widespread corruption and waste.

via Output Falling in Oil-Rich Mexico, and Politics Gets the Blame – New York Times.

Another wasted opportunity for Mexico and I only hope that Lula reads history. Who was that Mexican president that said something like that the challenge for Mexico was to “administrar la abundancia” of Cantarell?

Valuation of Oil and Gas Reserves Part 1 ($CFW)

Inflation fears and surprising China activity has injected new dynamism on energy E&P stocks. Exploration and production (E&P) is all about finding and exploiting oil and gas reserves. Exploration is a risky hit or miss activity, like internet or biotech startups, and most big oil exploration efforts have been value destroying for their shareholders. At the same time, there are some good track records like Contango Oil and Gas and ATP Oil and Gas, that I hope to discuss in the future, and shale natural gas exploration had its share of successes too.

I will focus instead my attention in the production part of the equation and its main asset: reserves. Oil and gas reserves are a measure of the probability of future production using current technology and oil and gas prices. I will use Cano Petroleum a 79% oil E&P as an example. I own CFW but this is not a buy recommendation I am using it to illustrate the valuation process.

The first step is to collect the total reserves from the last 10K (yearly results), 10Q (quarterly results), corporate presentation, or in this case a recent 8K (material event). The booking of reserves is done according to a set of rules developed by the Society of Petroleum Engineers –SPE. The three categories of reserves generally used are proven, probable, and possible reserves:

• 1P proven reserves : reasonably certain to be producible using current technology at current prices in a reasonable time frame (5 years). That reasonably certain definition is tricky, from what I could find the estimate should be close to 90% of being produced.
• 2P probable reserves : reasonably probable of being produced. In oil and gas lingo, close to 50% probability.
• 3P possible reserves : having a chance of being developed under favorable circumstances having a 10% certainty of being produced.

In the case of CFW, the study was done by a third party Miller & Lents, a known reserve engineering firm, and I could only find details on the proved reserves. Proved reserves are also qualified as developed producing -PDP, proved developed non-producing -PDNP, and proved undeveloped -PUD.

You are probably asking where is the disclosure of CFW’s probable and possible reserves. Any public company listed in the USA has to state its reserves with the SEC; the SEC in turn prohibits mentioning probable or possible reserves in their fillings. The oil and gas industry is not immune to disclosure abuses and we can not discount them in the future. However, several companies mention them in company presentations. The following is an example of Harvard Natural Resources –HNR- on its probable and possible:

CFW uses waterflooding, a secondary recovery technique, and a large part of its reserves are proved but undeveloped. During primary production the average oil field produces only 30 percent of the oil in the reservoir, a waterflood is often tried later. Some of the characteristics of this technique:

• Capricious results and time consuming.
• Investment upfront
• Costs decrease over time

Reserve engineers assigned proved undeveloped PUD reserves based on recoverables of 8-9% for the Panhandle and the Cato fields. That is low if you look at some of the analogue field results like the East Schaeffer waterflood that recovered 15% and initiated back in 1966 with obsolete technology and tactics. We can see the Cato reserves are responding, moving reserves from PUD to PDP and increasing production

Crude oil production was up 6% as compared to the third quarter and 21% compared to the prior year fourth quarter due to increased production from the Cato Field.

The Panhandle, the firm’s largest operating area, is not. When CFW began flooding the Panhandle field it picked Cockrell Ranch that is surrounded by successfully flooded acreages. Management was too bold last year about how the Cockrell Ranch flood would perform and, besides the stock tanking, they have been sued.

But the third party engineering firm confirmed the reserves one month ago did it not? Is this a variant perception opportunity? It could be if the valuation provides some margin of safety and the risks are under control. In part 2 we will run some multiples and provide valuation sensibilities based on Cockrell Ranch potential results .

Disclosure: Long CFW

Munger on personal honesty

The ethos of not fooling yourself is one of the best ethoses you could possibly have. It’s powerful because it’s so rare