The Rational Walk
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Implications of Cheap Natural Gas on Public Policy and Investing March 5, 2011

There are few prices in America that are more visible than the cost of gasoline at the pump which has recently been on a rapid upward march reminiscent of mid-2008.  At that time, price spikes brought the cost of gasoline to well over $4 per gallon in most of the country.  The causes of oil price spikes vary over time but we can be sure that any hint of turmoil in the Middle East will have this effect.  Although there is vigorous debate among economists regarding the specific price point at which oil will threaten the nascent economic recovery, there is no doubt that consumer confidence and spending would be adversely impacted if prices continue to rise at the current pace.

Historical Context

Investors like to examine pricing anomalies, particularly related to commodities that could be viewed as substitutes but trade at radically different prices.  One barrel of crude oil has approximately six times the energy content of one thousand cubic feet (mcf) of natural gas.  One mcf of natural gas is approximately equivalent to one million BTUs (MBTU).

Despite the energy equivalence, for a variety of reasons, the pricing relationship between oil and natural gas is almost never exactly six to one. Typically, a ratio of 10 to 1 has been more common in recent years, although the ratio varies widely as we discussed in an October 2009 article describing the issue in more detail.  More recently, we revisited the oil/gas pricing situation in December 2010.

Pricing Anomalies at  Extreme Levels

With the recent spike in oil prices due to political turmoil in North Africa and the Middle East, the ratio has approached extreme levels of approximately 25 as the chart below plotting the ratio of one barrel of WTI oil to 1 MBU of natural gas illustrates:

The following chart visually represents how extreme the current pricing situation is.  We are using WTI crude prices in the exhibit as a good proxy for domestic crude prices but the ratio would be even more extreme if Brent crude were used:

From a pure energy equivalence perspective, it costs in excess of four times as much to purchase crude oil compared to natural gas.  While oil has steadily increased in price over the past two years, the price of natural gas has continued to struggle to rally due to higher supply produced by shale plays in the United States. The oversupply of natural gas has caused some companies to switch their focus to shale oil plays, but this may not have more than a marginal impact in the short run.

Investing Implications

Natural gas appears to be cheap compared to oil and has been cheap for some time.  Speculating in commodities is a risky endeavor since pricing anomalies can persist for very long periods of time.  In addition, important fundamental factors related to supply help to explain at least part of the cheapness of natural gas relative to oil.  Here is what Warren Buffett had to say about natural gas in a recent CNBC interview:

JOE KERNAN: You haven’t really bought natural gas or oil in the ground or–typically, right?

BUFFETT : Not very often, no. And, you know, it–I don’t know–the oil picture five years from now will be to, you know, may be much more dependent on politics than whether I can pick the best geologist in the United States. And, you know, I know we’ll be using more natural gas, I know it’s got all kinds of advantages and it’s cheap on a BTU equivalent to oil and it’s cleaner and all kinds of things. But in the end the price depends on supply and demand. And even though demand will go up some, I don’t know whether supply’s going to go up even faster than that. And so far it’s been–the last few years I should say that, you know, natural gas has been pretty disappointing. It hasn’t been disappointing in terms of finding it, hasn’t been disappointing in terms of its performance, it’s just been–there’s been too much of it around. And I don’t know–I’m not good at figuring out, you know, whether that will change a year from now, or five years from now, and I’m not in that game.

We have written about Contango Oil & Gas company in the past and believe it has a low cost advantage over other producers and could benefit from increasing natural gas prices over time.  However, as Mr. Buffett says, the supply and demand dynamics could keep a lid on natural gas prices for many years even if demand increases but supply increases more quickly.  In this type of environment, the low cost producer should benefit, particularly if Contango CEO Ken Peak is correct regarding the need for $6 natural gas for shale plays to earn a 5 to 10 percent return.

Public Policy Implications

At a time when the price of oil is dictated largely by developments outside the United States, it appears almost self evident that sources of domestic energy should be considered for economic and national security reasons.  The argument for domestic energy is even stronger when one considers how much cheaper natural gas is compared to oil on an energy equivalent basis.  An added bonus is the fact that natural gas is a cleaner burning fuel compared to both coal and crude oil.

T. Boone Pickens, among others, have advocated wider use of natural gas.  Mr. Pickens believes that the 18-wheeler truck fleet could be converted to use natural gas rather than diesel:

About 70% of the oil we import is used as fuel for America’s 250 million cars and light trucks and 6.5 million heavy trucks. Nearly half of the oil used for transportation is used as diesel fuel to power 18-wheelers. Natural gas is the only alternative. It is not only more abundant; it costs half as much and emits almost 30% less carbon dioxide.

If, in the normal course of replacements, we exchanged those 6.5 million heavy trucks running on largely imported diesel for new ones running on domestic natural gas, we could reduce our imports by 2.5 million barrels per day. We would be able to reduce our dependence on oil from the Middle East by half in only seven years.

Public policy currently places a heavy emphasis on alternative energy sources including wind power and solar.  In addition, the United States has counterproductive policies that heavily subsidize the use of ethanol as a motor fuel, a practice that Berkshire Hathaway Vice Chairman Charlie Munger has called “monstrously stupid” due to the impact on food prices.  However, ethanol has a formidable lobby in Washington and enjoys bipartisan support.

Ultimately, if given the choice between spending $100 on a barrel of oil versus $23 on the equivalent energy provided by natural gas, a rational individual would favor natural gas purely based on the economics of the situation.  When one adds in the fact that natural gas is a cleaner burning fuel and is available in abundance from domestic sources, it is surprising that broader political support does not exist for wider use.

Data Sources:

EIA:  Cushing OK WTI Spot Prices
EIA:  Natural Gas NYMEX Spot and Futures Prices

Disclosure:  Long Contango Oil & Gas.

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Retailers ‘Stuck in the Middle’ May Soon Face Extinction December 16, 2010

Much of what we do as investors involves studying businesses and critically evaluating the returns that are likely based on management’s competitive strategy.  The elusive search for true “moats” is often frustrated by quick technological change which can make yesterday’s incumbent firm today’s dinosaur.  Investors who pay a rich valuation for a business with a moat must be confident that the advantages leading to high returns today are not destroyed by new types of competition in the near term.

Competition has always been a threat to retailers and numerous strategies have been employed to achieve acceptable returns on investment.  Most investors are familiar with Michael Porter’s work on competitive strategy and the three “generic strategies” firms can successfully employ.  In his well known book, Competitive Strategy, Mr. Porter describes the three generic strategies:  Overall Cost Leadership, Differentiation, and Focus.  This can be translated into a retail context by observing the strategies used to appeal to mass markets, elite shoppers, and niche markets.  A business that fails to develop competitive advantages supporting one of the generic strategies is said to be “stuck in the middle”:

The firm stuck in the middle is almost guaranteed low profitability.  It either loses the high-volume customers who demand low prices or must bid away its profits to get this business away from low-cost firms.  Yet it also loses high-margin businesses — the cream — to the firms who are focused on high-margin targets or have achieved differentiation overall.  The firm stuck in the middle also probably suffers from a blurred corporate culture and a conflicting set of organizational arrangements and motivation system.  Competitive Strategy, p. 41-42

It is not particularly difficult to think of companies that are neither cost leaders nor differentiators.  Usually such companies produce sub-par returns on invested capital but many have historically muddled along for years with incoherent strategies.

The days of muddling along without a clear strategy may be numbered for retailers in the age of the smart phone.  As The Wall Street Journal observed today in a front page article, shoppers are increasingly equipped with mobile phones that not only provide internet access but also often allow instant price comparisons by scanning bar codes on merchandise.  This is surely the nightmare of middling retailers that have long relied on confusion or ignorance to move uncompetitive merchandise.

Earlier this year, Nielsen projected that the smart phone market would exceed fifty percent of mobile phones in the United States by the end of 2011 as the chart below illustrates:

If it is possible to browse through the selection at Best Buy and immediately check prices at Amazon.com or Wal-Mart, pricing pressure is eventually going to drive most business to the lowest cost provider.  Even worse for “brick and mortar” retailers, most online retailers benefit from not being required to collect sales tax in jurisdictions where they lack a physical presence.  Customers who are reluctant to buy products “sight unseen” can then use the infrastructure provided by physical retailers to get comfortable with their purchase and then immediately scan the product’s bar code and order from the lowest cost online provider.

Best Buy recently reported disappointing results and the CEO made comments during the conference call related to competitive pressures.  Shares plummeted in the wake of the results as investors reconsidered the company’s strategic position and competitive strengths.  Retailers such as Best Buy have long competed for business by keeping a wide variety of merchandise in stock and promoting select products in order to bring customers into the stores and allow for cross selling higher margin merchandise.  This strategy may no longer be viable as smart phones begin to dominate consumer behavior in ways that would have been unthinkable just a few years ago.

Physical retailers will not become extinct but they will increasingly be forced to choose a coherent strategy based on a broad offering of very low prices or true differentiation.  While the threat of internet commerce has been a consideration for investors for much of the past fifteen years, the threat has become much larger with new smart phone technology.

Disclosures:  None.

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Guest Article: Meir Statman on Value Investing in Inefficient Markets November 30, 2010

Note to Readers:  We are pleased to publish a guest article by Meir Statman, the author of What Investors Really Want.  Professor Statman is a pioneer in the field of behavioral finance and his book should be required reading for anyone involved in financial markets.  Whether an investor is “seeking alpha” or satisfied with the low cost approach of index funds, investing without a keen appreciation for the behavioral pitfalls that impact nearly all of us can be a costly mistake.

Value Investing in Inefficient Markets

By Meir Statman

Value investors often describe themselves as following the teachings of Warren Buffett who refined the lessons of Ben Graham. They look at the crazy behavior of the market, observe that it is inefficient, and conclude that they can easily beat it. But this is not what Buffett teaches. The market might be inefficient, even crazy, but a crazy market does not turn us into psychiatrists. Investors can do themselves great harm if they believe that they can read Barron’s for a couple of hours on Saturday and then invest like Warren Buffett on Monday.

The puzzle of the beat-the-market game is the market efficiency puzzle. There are two main definitions of efficient markets, one ambitious and the other modest. The ambitious definition is better called rational markets. Rational markets are markets where investments with returns higher than risks do not exist. More modest is the definition of “efficient markets” as unbeatable markets. Unbeatable markets are markets where investments with returns higher than risks exist, but most investors are unable find them.

Warren Buffett illustrated the distinction between rational markets and unbeatable markets and the confusion that arises when they are lumped together. Buffett was considering buying bonds of Citizens Insurance, established by the state of Florida to cover hurricane damage and backed by state taxes. Berkshire Hathaway, his company, received offers from three sellers of these bonds at three different prices, one at a price that would yield Berkshire Hathaway a 11.33 percent return, one at 9.87 percent and one at 6.0 percent. “It’s the same bond, the same time, the same dealer. And a big issue,” said Buffett. “This is not some little anomaly, as they like to say in academic circles every time they find something that disagrees with their [efficient market] theory.”

Buffett used the term “‘efficient market”’ where the term “‘rational market”’ would have been more precise. The story of the Citizens Insurance bonds is, as Buffett noted, an anomaly, contradicting the claim that the market for these bonds is rational. If investors in the 6.0 percent bond are receiving returns equal to risks then investors in the 9.87 percent and 11.33 percent bonds receive returns higher than risks. Yet Buffett cautioned investors not to jump too fast from evidence that markets are not rational to a conclusion that they are easily beatable. When asked for advice Buffett said: “Well, if they’re not going to be an active [beat-the-market] investor—and very few should try that—then they should just stay with index funds. Any low-cost index fund. . . . They’re not going to be able to pick the right price and the right time.”

We know from Buffett’s bond story and much other evidence that markets are not rational; investments with returns higher than risks do exist. Moreover, we know that markets are not unbeatable for insiders and skillful investors such as Buffett. But we should not jump from the conclusion that markets are beatable by some to the conclusion that they are beatable by all.

Indeed, markets are beatable by some because they are not beatable by all. The extra returns of Buffett and his brethren over the returns of index fund investors come from diminished returns of beat-the-market investors who find themselves on the other side of the net from Buffett and his brethren.

Buffett followed his words with deeds. On January 1, 2008, Buffett placed roughly $320,000 on a bet that the S&P 500 Index would outperform a portfolio of hedge funds over the following ten-year period. On the other side is Protege Partners, LLC, a hedge fund company, whose people placed an identical amount on a bet that the hedge funds they have chosen would beat the S&P 500 Index. All the money is now in a zero-coupon bond that would grow to $1 million by December 31, 2017, and go to charity, to Absolute Returns for Kids if Protege wins, and to Girls Inc. if Buffett does.

Protege argued that “Funds of [hedge] funds with the ability to sort the wheat from the chaff will earn returns that amply compensate for the extra layer of fees their clients pay,” and noted that Paulson & Co. hedge fund is among its investments. John Paulson made billions in profits by selling short investments linked to subprime mortgages. But Buffett said, “A lot of very smart people set out to do better than average in investment markets. Call them active [beat-the-market] investors. Their opposites, passive [index] investors, will by definition do about average.” But investors in hedge funds are unlikely to overcome their costs. “Investors, on average and over time,” concluded Buffett, “will do better with a low-cost index fund than with a group of fund of [hedge] funds.”

Are you sure that you are one of the very few of should try to beat the market? Are you sure that your returns would not be higher if you invested in a widely diversified value index fund? Are you sure that Buffett is not the seller of the shares you buy? I’m not sure that I’m one of the few, so I invest in index funds. I think that Buffett approves.

Meir Statman is the Glenn Klimek Professor of Finance at the Leavey School of Business, Santa Clara University, and Visiting Professor at Tilburg University in the Netherlands and the author of What Investors Really Want (McGraw-Hill). His research on behavioral finance has been supported by the National Science Foundation, CFA Institute, and Investment Management Consultants Association (IMCA) and has been published in the Journal of Finance, Financial Analysts Journal, Journal of Portfolio Management, and many other publications. A recipient of two IMCA Journal Awards, the Moskowitz Prize for Best Paper on Socially Responsible Investing, and three Graham and Dodd Awards, Statman consults with many investment companies and presents his work to academics and professionals in the U.S. and abroad. Visit his blog: http://whatinvestorswant.wordpress.com/

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Bernanke Persists in ‘Pushing on a String’ With QE2 November 3, 2010

The mid-term election results appear to match what market participants expected in the days leading up to voting yesterday.  We will refrain from political commentary other than to make the observation that there is a difference between “benign gridlock” when the country’s course is essentially sound and gridlock when our fiscal situation is heading for disaster — which to us seems more like a suicide pact than a political strategy.  Meanwhile, the Federal Reserve is set to announce the details of its second round of quantitative easing later today.  QE2 is essentially a euphemism for printing money, which in our modern economy takes the form of the Federal Reserve buying treasury bonds of intermediate to long term maturities.

Bill Gross has referred to QE2 as a ponzi scheme and this criticism does not seem out of place.  An excellent critique of QE2 appeared in Greenlight Capital’s third quarter letter (pdf) to partners which was published on November 1.  Greenlight points out that the Fed’s initiative is much more likely to cause adverse consequences than to achieve any meaningful improvement in economic growth or employment.

Uncertainty or Lack of Liquidity?

Unlike the situation that prevailed prior to the Fed’s first experiment with quantitative easing, it is not obvious that today’s problems are due to liquidity constraints given the much improved financial condition of the banking sector and corporate cash hoards that have grown rapidly during the recovery.  The economy is facing massive short term uncertainty related to the implementation of health care reform and the fact that tax policy has yet to be finalized for 2011.  Additionally, the long term fiscal condition of the United States is not one that is likely to improve in a highly divided and partisan environment that will persist through the 2012 election cycle. In this environment, it is only prudent to proceed very carefully when it comes to investing or hiring.

As Greenlight’s letter also points out, the Fed’s actions are intended to manipulate interest rates in a manner that encourages two specific behaviors that have ponzi-like attributes.  First, speculators are buying long term government bonds not with the idea of holding the securities to maturity but with the goal of selling these bonds to the Fed or to other speculators at higher prices once QE2 goes into effect.  This is essentially the “greater fool” theory of investing and is bound to end in tears for those who get caught holding the securities when the music stops.  Second, the Fed is explicitly hoping that lower interest rates will increase prices of other financial assets that are commonly valued using models dependent on prevailing interest rates.

When The Music Stops …

At some point, the Fed will have to unwind the QE2 experiment to avoid generating much higher inflation.  At that point, the music will stop and we will find out how much current Fed policy resembles a ponzi scheme.  With Ben Bernanke securely in his position as Fed Chairman until January 2014, it would be refreshing to see him take a longer term view of the situation given that political figures in Washington are unlikely to have a time horizon longer than the 734 days that remain between now and the 2012 election.

Disclosures:  None.

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Google’s Inflation Measure May Keep Government Statistics Honest October 12, 2010

There are no perfect solutions when it comes to protecting assets from the ravages of inflation.  While the United States Federal Reserve does not have an official inflation target, government officials are known to favor an inflation rate of at least 2 percent and define such a level as “price stability”.  As a result, the minimum realistic assumption for inflation causes a doubling of the price level over thirty-five years.  The reality could be far worse given the desire of the Fed to flood the system with liquidity through additional quantitative easing which, stripped of technical jargon, basically involves printing currency to purchase government bonds and other securities.

Financial instruments such as I-Bonds and Treasury Inflation Protected Securities (TIPS) are intended to provide inflation protection but the government is in charge of coming up with the official Consumer Price Index (CPI) that supposedly measures the overall price level.  Many skeptics note that governments that allow high rates of inflation often manipulate official measures of inflation.  However, the amount of data available today may make it more difficult for the government to manipulate statistics in the future.

According to the Financial Times, Google is planning to construct a price index that could eventually serve as an alternative to official government statistics.  While the Google Price Index (GPI) is still a work in progress and only tracks web-traded goods, the potential for expansion into other sectors of the economy could provide a more complete picture of inflation in the future.  As the range of goods sold over the internet expands over time to better mirror the overall economy, the GPI should more closely track to the actual inflation experienced by consumers.

For now, the GPI is showing a “very clear deflationary trend” for web traded goods this year and most economists do not see any widespread inflation on the immediate horizon.   However, with Japan as a notable exception, there are few cases where a government in charge of a fiat currency wishes to create inflation and is unable to deliver.

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