Monday, December 30, 2013

Is the U.S. really becoming oil self-sufficient?

Currently the U.S. consumes around 18.5 million barrels a day while the world consumes around 92 million barrels (yes it is still going up – in 2008 we produced and consumed 86 million barrels). 

How much was the U.S. producing in 2008? Barely 5 million barrels; so yes today’s production increase to around 8 million barrels is nothing short of spectacular. To do so the U.S. drilled 43,000 wells in 2013 (nearly three times as many as the Canadian 'Energy Super Power').  Of those 61% were horizontal wells and 75% of the horizontal wells were oil wells or just around 20,000 wells.
Humongous! But does this make the U.S. energy self-sufficient or even a net exporter as the rumours go?

Figure 1 U.S. Oil production 1080-2012 according to the E.I.A.  Click on image to magnify.
Well that may be a bit of pink colored glass dreaming. So I used this typical decline curve for a horizontal well in Canada (in fact a rather good well). The well initially produced around 350 barrels and then declined 80% in the first half of year 1 to 70 barrels per day and to 28 barrels per day during the remainder of year1. In its second year, it declined by another 60% to 17 barrels/day in its first half and down to 12 barrels by the end of year 2. After that well production declined 10% per year until the end of time or until the economic limit of 5 barrels per well.  This single well decline curve typical for a good ‘resource play well’ is shown below.

And don’t forget that such a well easily costs between $1.5 and $3 million dollars. Assuming that oil prices remain high and that net operating profits, i.e. net backs are $70 per barrel then we calculate a modest profit (unrisked). Did you know that U.S. oil companies have a gross profit margin of around 8.5%?  Compare that to 48% for Microsoft – mind you, there is here a bit of an apples and orange comparison!

Figure 2 shows production of the 'type well' declines 80% in the first 6 months, 60% in the remainder of year one, 40% during the first six month of year two and 30 in the second half of year., The 'type well' declines 10% annually there after.. In fact this is still an optimistic decline curve – believe it or not!  Vertical axis measures oil rate in barrels per day.

With the U.S. drilling close to 20,000 oil wells a year and assuming they’re drilling each year 4% more wells, then they will drill 21,218 wells annually 3 years from now - all declining at frightening rates (see graph above) .  That should bring us around a U.S. oil production rate of approximately 9 million barrels a day which was the 1985 production peak shown in figure 1. To keep that production steady, you would need to drill every year there after another 21,218 wells. If you kept that up for another 16 years, you’d drill around 365,695 wells – typically spaced 200 to 300m apart for a 'mere' 549 billion dollars  and an unrisked rate of return of 14.5% assuming your facilities are costing nothing (NOT SO!).  Right now, the entire U.S. petroleum industry spends around $140 billion per year and that includes pipelines and refineries! So spending of 549 billion just on drilling oil wells is… enormous. And… you will need those high oil prices and you need to reduce your operating and capital costs big time to make GOOD money. Hmmm!
 
Yes this is nearly a back-of-the-envelope guess, but I did not use an envelope but rather I wasted a day on a darn EXCEL spreadsheet (hopefully with not too many mistakes). So if the U.S. wants to truly become energy self-sufficient and flip the bird to us dumb Canadians with our tar sands then it will have to drill 41,472 horizontal oil wells per year (i.e. increase drilling 20% annually for the next 3 years) and then keep that up indefinitely!  Total drilling expenditures (not counting infrastructure such as pipelines and refineries): 0.9 TRILLION dollars. Eh, another financial stimulus program – who needs tapering? J  I don’t think such an amount of U.S. oil drilling is very likely over the next 16 years or so!  In the meantime, us dumb Canadians will have gained access to world markets (Enbridge thinks it will start building Gateway by 2017). Guess who will be flipping the you-know- what THEN to whom?

As stated before: Thank you Mr. Obama for dithering on Keystone.


Figure 3 Calculated daily production rates of annual drill cycles counting up to 41,472 horizontal oil wells per year.

Sunday, December 22, 2013

How I write my posts and why you would care?

I like to write my posts on a Saturday or Sunday morning around a nice breakfast and a cup of java. I start with musings about the recent markets and how things affect my own investment practices. The 'musing' often includes watching repeats of BNN, reading investment letters on-line and reviewing my portfolio. The latter especially during a week of rising markets J. Added also to the musings is often an update of my 'Stop-loss' Spreadsheet.

This week my spreadsheet has 5 stocks out of 29 that reached a new high and 3 out of 7 market index funds that reached a new high, On average my list traded 5.83% below its peak value compared to 7.59%  a week ago. The median stock price for my list was 2.79% below peak value  compared to 5.16%  a week ago.

Back to the matter at hand. Sometimes I just get no clear picture of what issues may be important to you or me. Then there is not much to write about. At other times I am full of ideas and write several postings in a short time. And... there are times with just one idea to write about. Sometimes, I follow the idea up by creating a spreadsheet and write out the numbers. I also have times that an idea for a posting has been brewing in my head for several days or even weeks, then during Saturday or Sunday morning coffee it crystallizes and I start writing.

The posts themselves are written and edited for the first time within an hour or two, Often I am excited about sharing the post with you and I publish it right away. Then over the next couple of days, and sometimes even a couple of months later, I review the post and realize how poorly the matter at hand may have been described and I start re-writing it. Sometimes I re-write a post 3 or 4 times. Thus, if you have trouble understanding a post, return to it a day or two later and it may have been written more clearly. Also, if you have trouble understanding or if you know a better way of stating the topic of a post, please, drop a [polite] comment and I'll have another go at it.

I do care about my audience and I would love to have comments from you. I know you are out there and that I am not talking into to the void. As of today this blog had over 45,000 page reviews and the viewing numbers seem to increase exponentially over time.

Thank you for your interest and I truly hope that the ideas spouted on this blog help you to become more successful investors.

Godfried Wasser

Saturday, December 21, 2013

How to protect profits – Selling discipline

  When entering the last stage of a bull market it is important to have the discipline to sell some of your winning holdings to build up cash for the next down turn. Stop losses are the emergency break, but how can you take part in the final market frenzy and still get out with most of your profits intact?

When markets are highest in price then the risk of a crash is highest. Thus we have to be able to take profits incrementally. You own or buy a stock position and you set a profit target. Say you own TD Bank shares which are currently trading around $98.00 per share. We had a great run since 2009, but how much farther can TD go? Another 10% or $9.50? That would be a share price of $107.50!  Ok, let’s assume it goes up gradually over the year by 10% . That would be 10%/4 = 2.5%  over the next quarter (3 months) or a share price of $100.94 by April or so.
A call option is the right to buy a share of a company (say TD) for a fixed price (strike price) over a certain period of time (say 3 months). You can buy the right to buy TD  at a certain strike price (buy a call option) or sell the right to buy TD at that strike price (write a call option). If you sell or write a call option then you assume the obligation to sell a TD share for the strike price within a certain time span (the term of the option). For taking on that obligation you get paid the option premium. The premium price is set using an auction system in the option market.

Options trade in contracts of 100. So you don’t buy/sell 1 option at a time but rather you trade in packages or contracts of 100 options. The option price is reported on a per option basis but the contract price is 100 times the option price (plus or minus commission).

Let's assume that we own 100 TD shares priced at $98.00.  We’re happy with the current profits but maybe we can hold on and get even more. So let’s take on the obligation to sell the shares at 100.94 over the next 3 months. Checking the option market, we find out that we cannot write a call option for exactly $100.94. Rather we find one with a strike price of $100.00 and that option expires on April 19, 2014. The current premium is around $1.50 per option or $150 for a contract. Also, we learned that TD’s upcoming ex-dividend dates are January 02 and April 01, 2014 so if the options expire on April 19 and if they don’t get exercised (i.e. the call option buyer demands to buy the shares from you) you also will receive 2 dividend payments totaling around $1.72 per share. 

If the call option is not exercised because TD didn’t trade above $100 then you keep the extra dividends plus the option premium. Write a new set of call options with a strike price 2.5% above  April's  prevailing market price and repeat until ‘called’. 

If the market crashes and your stop-loss emergency brake is triggered sell your shares and buy back your call options to close that position. This way you will be better off than if you held on to the stock without receiving the option premiums.

In case TD rises to $100 before April 19 then you’re likely to receive another $2 in profits ($100 – 98) plus $1.70  in dividends (if you’re lucky and the option wasn't exercise on or before April 1) plus the option premium of $1.50. In other words, in just 3 months, your $98 dollar TD share will earn you another $5.20 or 5.3% (that is 21.3% annualized) in additional profits before you were 'forced' to sell. Not too shabby!
If the call option gets exercised you have two choices: repurchase the shares in the market for the then prevailing market price and sell another 3 months contract for 2.5% above that market price and repeat the option selling game - NOT recommended. Or, better in my opinion: be happy and add the proceeds to your cash stash.  Now you have forced yourself to cash in your profits along with an attractive bonus.
When the market goes even higher and the risk of a crash escalates, you can start protecting your downside as well by using an option collar. That we’ll discuss in a later post.

You don’t have to be right to be successful

If there is one thing I have learned during my career as a geologist then it is the fact that you don’t have to be right to be successful.  I have seen guys recommend and drill 11 or more dry wells in a row and being promoted.  Peter’s principal certainly comes to mind: "Employees tend to rise to their level of incompetence." Also, it is well known that success is often built on numerous failures.  As a geologist, I do not describe a rock accurately and therefor find oil. No, I only describe rock as good as I can in order to decide how to manage an oil or gas bearing asset as efficiently and profitable as possible.  I determine what ACTION to take next within the guidelines of the company where I happen to be engaged. It is not about being right but about taking action that makes the most sense.

That too is truly the crux of life!  You don’t need to know the truth and the precise future in order to move in ‘the right direction’.  Once you have made your move, just like in an oil or gas industry, you have to re-asses the performance of your action; check whether your action is working and what you may have to adjust. Next, implement your revised action plan. This you have to do over and over again – until the day you have no longer the energy to do so. As mentioned in an earlier post, This'll be the day you die [bye bye Miss American Pie J).
LIFE IS NOT ABOUT BEING RIGHT. IT IS ABOUT KNOWING ENOUGH TO TAKE ACTION IN MORE OR LESS THE RIGHT DIRECTION AND TO ADJUST YOUR ACTIONS WHEN THE RESULTS COME IN. Life is more about the journey than the goals, your Belize. So you better make sure that you enjoy the journey. And… before you reach your goals you should be ready to set new and even more ambitious goals. 

I do geology – something I enjoy tremendously – to describe rocks as good as I can with the goal to design actions that result in the highest hydrocarbon recovery with maximum profits and maximum benefits for society. The same is true for investing, I try to gain sufficient knowledge of an investment to choose the most profitable actions for myself and those around me; continuously adding to my investment knowledge and re-adjusting my actions will lead to ever better results.

In fact, I learn about life in generally not to create the perfect life model but to understand life as well as I can, to take actions based on my understanding; review the results and adjust/improve my actions. This is a world of continuous improvement! We all try to do something like this and that is why overtime our world will get better and better. Why do we want that our children to do better in life than we do? Because we’re failures? Or because we all are traveling  the same journey towards a better world and we better learn to enjoy that journey because once we meet our goals we just move the target even farther out!   I wish you a Merry Christmas and a better universe for all.

Sunday, December 15, 2013

How to protect your profits

With share prices rising higher and higher in this bull market, so does the risk. The higher the market the closer we’re getting to the next melt-down.  Yet, it is also true that profits tend to escalate in these late stage markets. Everyone is on fire; it is hard not to get dragged along in the frenzy; many investors don’t realize that the high profits being made are not normal.

Then comes the crash – when most investors least expect. “I just started to make profits [yeah because you were out of the market many months ago when you should have been buying] and now you tell me that the market will crash?”
Market timing is close to impossible, but with this rising market there are strategies we may want to deploy as protection against the coming crash, while still enjoying the fruits of the market hysteria. In the coming posts I will discuss:
1.       The emergency break: stop-loss selling.
2.       Selling discipline – once you made a decent profit force yourself to sell by using call options.
3.       Collared options – sell calls and buy puts – put a ‘collar’ around your up and down side.
4.       Take profits and build your cash stack.  Build cash for after the crash!
This post will start with a very simple strategy – Your emergency break: Stop-Loss Selling!
Many people consider selling below the market peak as ‘losing money’ regardless of the fact that even 20% below the peak they still may have a profit compared to their purchase price. This form of ‘investor self-entitlement’ is common to most investors, including myself. We tend to consider pricing at the market peak as the value of our investment even if that price is more based on hysteria (irrational exuberance) than on true business value.
So the stock was worth $30.00 at the peak and now it is down to $25. “Oh I lost $5.00!,” the self-entitled cry. “Really? But you bought at $22. However, if you really feel that way, you’d better sell before the stock falls to $18!" The self-entitled investor replies:  “No, I can’t, I have to recoup my ‘losses’… I’ll hold on.” Next thing you know, the market crashes another 30% and then are in a true loss position. Next  Mr. Investor panics and sells because “it may fall even more”. [But we know better – once a market has fallen dramatically, so has risk!]
This chart illustrates how much an investment has to rise in price (recover) percentage-wise after incurring a loss in value in order to break even.  A $100 investment with a price fall of 10% is worth $90. For the investment to recover to  $100 its price needs to rise by 11.1%. 
When the market falls 10% you need to go up 11.1% to get back to the same price you started. When the market drops 20% you need prices to rise  25% to recover. When the market is down 25% you’ll need to go up 33.3% and when you crash 50% the market needs to go up 100% to get back to where you were (see table above).
 That is why 'buy & hold' is so difficult for so many investors, because by the time you are back to the high of the previous bull market, the media starts hooting and hollering about investors who bought at the bottom and 'made nearly 100% !'  The potential 'buy & holder' feels stupid and discouraged comparing himself with those 100% guys who look like geniuses (although those 'geniuses' didn’t talk about the stocks THEY lost on).
We need a strategy to get out in time and to be able to buy back in at lower prices. But when to sell in a bull market? Well, let’s look at it in simple terms: typically the term ‘correction’ is used in a market that has fallen between 10 and 15%. People get nervous during a correction but the market typically recovers within a week or within a month or two after which the market will go up even higher.
 A bear market officially is called after the market has fallen 20% from its peak - the ‘fall’ occurs typically in stages. In October, 1987, the one day 22% market drop was exceptional – it was the steepest drop in history. Not even Peter Lynch saw it coming. Other than in October 1987, there usually is time to react in a falling market.
So if an individual stock or the market falls 25% from its recent peak , we know that we’re in real doodoo! Do no longer hesitate and sell!
The idea is that even when caught off guard, if you sold at 25% below the previous market peak of a stock or of a stock market (index), then you probably got out in one piece (although with some scars). We know bear markets can go easily down yet another 25% from this point onward (a total drop of up to 60% percent below the peak is possible). Selling at 25% below peak is truly your emergency break!  With discount brokerages it is quite affordable in commissions to sell quickly. You can sell 10 positions for $100 in commissions and thus that is quite doable.
The big problem may be the taxes that you may trigger when selling – in particular capital gains. But it is probably better to pay taxes over profits than losing so much money that you can’t fight another day.  So create a spreadsheet of your stock holdings (similar as the one shown below), enter your purchase price or the last high after purchase (whichever is higher). If you want to use a stop loss of 25% then multiply that price by 1-25% (75%) to get your stop loss price. If the stock hits your stop loss price then sell. If you prefer a tighter stop loss, say 15%, then multiply your peak price with 1-15% (85%), and so on.
Example of a spreadsheet with stop-loss price calculations for a portion of a portfolio. Click on figure to magnify. Column 1 is Name of stock; Column 2 is the stock symbol; Column 3 is current share price; Column 4 is either purchase price or most recent high whichever is higher; Column 5 is allowable maximum loss at which point sale is triggered; Column 6 is the corresponding stop-loss share price. Sell Flag triggered at maximum allowable loss from peak. Column 7 flags if current price exceeds last high. Update your sheet periodically, preferably once per week.
 
I like a stop-loss trigger around 25% - research suggests this is a good number. But in the end, it is up to you to decide how much pain you can handle before you want to pull the emergency brake! Above is a table with an example of a stop-loss spreadsheet that you may want to use.
 If you bought stocks of good companies that don’t go under, chances are that the crashed stock will eventually recover and flourish. So, if you can’t sell at your stop-loss price that is OK. You are only trying to build a war chest for when the market has bottomed and stocks are on sale – thus improving your future portfolio performance.  Try to sell your riskiest/shakiest stocks first as they have least chance to recover in subsequent months or years.
Don’t chase the market down because if you sell too low, you may never have a chance to recover (how can you if you no longer own the stock and have no money left to invest?). Once you have built a decent war chest, say you are 30 to 40% cash, you can sit back and wait for clear signs that the market is near a bottom. At or near the bottom you will get hints that the turn-around is not far away. It is not our intent to time the bottom precisely, we’ll be buying once prices are attractive enough and when we think that there is not a lot of down side risk. We’ll discuss some of this in more detail in the future.
Now, please, understand. I don’t think a bear market is imminent. To the contrary (see my outlook for 2014), but I want us to look ahead and be prepared once the next bear market starts.

Saturday, December 7, 2013

The natural gas bull market is now in full swing! Hold on to your economic hat, Albertans!

What!!!! You may shout, I thought natural gas is doing terrible and now you say this! 

My answer: Well, hindsight is 20/20 but yes we’re clearly in a natural gas bull market and it started April 2012. Yes, this blog told you to stay alert about the natural gas market and to ‘nibble and nibble’. Not that I was that sure about it the last year or so. But look gas is now trading over $4.11 per Mcf!
Wasn’t that the reason we’re posting daily oil prices and natural gas at the header of this blog (and Gold at the footer)? So below are today’s Gas Price Charts. The first one shows the market bottom and how gas prices have recovered since. But how far will it go up?  In the past, we suggested that prices should go up to the cost of production plus a bit of profit, i.e. to the $6-$8 dollar range.


So is that price range still in the cards? Considering that most large economies of the world are still in recovery mode, I suspect that gas prices will go higher with improving economic conditions. Besides, the world is an ever increasing energy consumer, in particular it likes gas as it is ‘clean’.  These days, converting gasoline powered cars and trucks to natural gas is a booming business. So is the conversion from coal to natural gas a favorite past time in the electricity generation world. Look at the demand forecast by the EIA for natural gas (below). Meanwhile the multi-frac oil and gas boom is about to peak; in fact gas production has already peaked and the number of rigs drilling for gas is severely depressed. If the oil boom hadn’t produced so much flare-able gas, we could experience a significant gas shortage.
Pipeline construction, so strongly opposed by environmentalists may increase gas supply because it may increase gas transportation capacity along with that of oil and less gas may end-up being flared. But looking at the long term gas price chart below, I think that over the coming two years, well see gas prices in the $3.50 to $5.00 range and thereafter it may go even as high as $8.00 not counting spikes.  Of course, during the natural gas bear market, the natural gas industry has learned to find and produce natural gas more efficiently and cheaper.

 

The big beneficiaries may be Alberta natural gas producers such as Peyto and CNRL; even Encana may become a bit more attractive investment. A revival in Alberta’s natural gas industry will improve prospects for many other companies in the industry as well. Finally Alberta’s petroleum industry may stand once again on two legs – oil and natural gas. If that’s the case, hold on to your economic hat, Albertans!




 

Low P/E – Moderate Dividend Portfolio 2013 performance

I haven’t provided regular updates of this portfolio during the year simply because doing this on a spreadsheet is too tedious a job for me, ‘the lazy investor’.  Then I found the portfolio feature on GlobeInvestorGold and it does it all for me. So here are this year’s results and compared to last year’s they are… Spectacular!  Especially since we had kept $27, 370 of the $109,356.60 investment money intended for BMO and National bank as cash and used options to have positions in both instead. BTW This portfolio is fictional, I may own a similar portfolio, but I won’t reveal its true size (smaller, larger or the same).

The profits for the first 6 months of option trades are not included but were approximately $630.00.  You may ask why only 6 months?  The answer is that by mid-year the market started to act up just like in 2012. Last year, returns on the portfolio were tremendous before May 2012, then the TSX faltered and our final year-end returns were barely on par with the TSX60 (6.3% - XIU). This year I decided to take profits and sell severe underperformer Sherritt while buying TD (for $78) and National Bank (for $70)  outright. The results were even better than that of the low P/E portfolio! ... I think.  You may suspect I would have known better, but after six months the profits in AutoCanada were so good, I took profits; I bought for $15.30 - I sold for $27.27 for an annualized rate of return 255% including dividends. Today AutoCanada is trading at… $42.47 that is close to a 3x the purchase price in one year! So was the 6 months sale premature?
I used GlobeInvestor Gold to track this portfolio
The goal was to test a mechanical method of investing (with minor initial adjustments – yes I can’t keep my dirty little hands entirely off! J). We’re looking at the real performance of the portfolio as show in the figure above (excluding option profits and excluding the profits if BMO and National Bank had be purchased outright at the beginning of the year).

Yes, that is real: a 36% return YTD.  We started out 2 years ago with $100,000 and now the portfolio is worth $135,291. That is a compound annual return of 16.43% compared to Jim O’Shaughnessy’s historical average return of 18.23%.  Jim’s All U.S. stock performance was a respectable 13.26% annual based on 45 years stock market data HIS low P/E and moderate dividend program outperformed the U.S. market by 4%. Now here’s the kicker! We used the low P/E and moderate dividend stocks of the TSX not U.S. stocks and thus we should benchmark to Canadian stock performance over the last 2 year’s (based on iShares XIC = 2.68% per annum and over the last year 3.19%). Now, our portfolio has outperformed the TSX spectacularly.

For 2014, I have created a new Low PE – Moderate dividend portfolio with the shares being re-invested on the first trading day of the year. Rather than augmenting the portfolio with option trades, this year. we’re going to work with stop losses so as not to repeat the mistakes of selling AutoCanada and of selling Sherritt too late (its year-end loss was 40%). 
The idea is that stocks can go up because of momentum way higher than we dare to imagine. So it is better to let profits run and use a 'trailing stop-loss'. Every time the stock price reaches a new 52-week high, the stop loss is set 25% below that price. Thus we can keep the shares as it rockets higher but will sell as soon as we start incurring serious losses (remember a bear market starts at 20% losses from the previous peak). Also, if the portfolio contains an obvious dog, we will this way restrict our downside. Research shows that this stop-loss method can significantly improve our long term returns.  (I learned this year in the real market that stop-loss selling works when I bought and sold Silver Wheaton). I’ll reveal the 2014 Low P/E and Moderate dividend portfolio at the beginning of 2014 once I have built the stock position. Nothing stops you from composing a similar portfolio for yourself, if you can’t wait.