Blessed by the Potato

I don’t know what to say about the disaster striking Japan. The size of the earthquake (now being reported as a 9.0) was tremendous, one of the largest earthquakes ever, and the following tsunami overwhelmed even one the countries best prepared for tsunamis.

The focus now is on the nuclear plants that are in partial meltdown. There is a lot of fear out there, and some of the coverage has been hyperbolic. The situation is still unstable, and it could of course get a lot worse from here.

As someone who supports nuclear power, who is a scientist, and who has been trained in radiological disaster management, I have to ask myself if these events would change my views, and I would have to say so far, no. I do think there could have been more done at the plants for saftey backups (e.g., the ability to run a backup turbine off the decay heat to power the cooling pumps), and that a safer (in my non-specialist and Canadian opinion) CANDU design probably should have been used in a seismically active country like Japan. But, nuclear power is one of the few options to meet the power requirements of the world, and especially countries like Japan, with high population densities and few hydroelectric options.

Plus, I think it’s important to keep in mind the scope of the problem so far. First off, this is not a separate nuclear power problem, this is a result and an extension of the one of the worst earthquakes and tsunamis ever. This is the worst-case scenario for these reactors, and these are old reactors. The death toll from the earthquake and tsunami are still being tallied, but are in the several thousand range. There are workers in the plants that will likely have health effects from radiation exposure (unclear how many at this point), but most of the general public near the plant was evacuated days ago. Radiation has been released into the environment, with the highest numbers I’ve seen peaking at 12 mSv/hr close to the plant, but generally much lower than that. A typical background dose is in the range of a few mSv per year, and a CT scan might be several mSv. The Canadian occupational limits are 20 mSv/year. So even close to the plant, a person could take their sweet time evacuating and still have no health effects.

What the ultimate outcome will be is still an open question, and it will take several days until the decay heat from the cores is gone and any further fire/explosion/breach risk dissipates. However, the actual impact of the nuclear disaster looks like it will pale in comparison to the impact of the tsunami and earthquake natural part of the disaster. Yet, already the fear is enough to compromise the development of nuclear plants around the world.

I know there must be burning questions out there, ask away and I’ll try to answer them!

On the topic of BP and the environment: I meant to focus more on the horrible nature of the situation in my last post, on the Chernobyl-like precedent this tragedy might have in the public mind. How things like the deepwater drilling ban might spur us to say, tax oil a bit more to reflect the costs, or encourage better, faster implementation of crude alternatives in our power and transportation systems.

But I got on the investment thinking train, and that seemed to prove popular, so let me just continue briefly here.

First up, I’ve been trying to pay more attention to the story in the media lately. I was a little surprised to see a guest on BNN the day after I put my last post up saying almost word-for-word what I said about this disaster not killing BP outright, so at some point there must be value in the stock. He followed up by advising people to not catch the falling knife though, which is advice I have a particularly tough time following, so it’s good to hear again.

BP has now successfully cut off the top of the riser pipe down there, making for a cleaner hole. That makes it possible for them to siphon some of the oil off of the gusher and up to a surface ship. It also unfortunately allowed more oil in total to be released, which will be really bad if say a hurricane starts to form and the surface ships have to skedaddle. I thought that net-net, it was a positive move, but that may be a close thing, depending on how close to the upper end of the range we were at for the size of the gusher: if they’re collecting ~15k barrels/day, and the cut in the pipe allowed 20% more oil to escape, then that’s a losing move if the size of the leak was over 75 k barrels/day. I actually expected BP’s stock to jump on that news, but it had another horrible day today (down almost 16%). It’s now under $30, which has me making “Om Nom Nom” noises.

One thing their collection operation proves though is that the early estimates of oil flow were way, way too low. The most-reported estimates of the size of the spill are still climbing day by day in the media, but now seem to be plateauing in the lower range of what the image analysis guys were saying (i.e., in the neighbourhood of 50k barrels/day). Not all of that is making it to the surface, and there’s no way to tell yet whether or not that’s a good thing. Obviously it’s harder to skim/clean oil that for whatever reason is remaining dispersed beneath the surface, but maybe we’ll get lucky and it won’t need to be cleaned. OTOH, it may poison marine life for decades to come. No way to say just yet, I think.

Alongside the climbing volume estimates comes the climbing cost estimates, which are now closing in on my back-of-the-envelope $50B figure. At that point, I still have to think that BP is value-priced now at < $30. Some articles today raised the spectre of bankruptcy for BP, which I think is highly unlikely given the facts on the ground right now — as I said before, BP is a very profitable company, and can afford to make good on even large payments if given time (and litigation will likely give them that time). Even a $100B final price tag wouldn’t kill them if they had 5-10 years to pay out, though it would mean that the stock would have more shit left in it to get kicked out. Despite the fact that I’ve been pretty pessimistic on the scale and cost of this disaster so far, I think $100B is probably the upper-end of the range.

That is, assuming that the relief wells being drilled right now are able to stop the leak before the end of August. A 3rd-party drilling expert was interviewed on BNN the other day, and he gave me hope that this would work. Specifically he said that these kill wells have a greater than 90% chance of success, and are very good at being able to find the borehole underground. With two drills going, there’s a very good chance this will stop before the fall.

In the scenario that the kill wells fail (or to compound a tragedy, one of them blows out) then there is unfortunately no salvation for BP. If this thing leaks for the better part of a year like Ixtoc, then the Clean Water Act penalties and other settlement costs could conceivably bankrupt them. I can’t say that it won’t happen for sure, but I discount it as a very remote possibility.

On the matter of the dividend there has been a good deal of commentary. It’s a tough call. On the one hand, they do have enough cash on hand and cashflow being generated to pay for the ongoing costs of the cleanup at the moment, so a dividend cut isn’t strictly necessary. Plus, it’s a “widows and orphan” stock, especially in Britain, so there’s some pressure to continue to pay a dividend (even if a reduced one). On the other, there are the optics, which can cut both ways. They may seem callous to the situation by paying out cash to shareholders in the midst of the crisis (and powerful politicians are calling for them to cut it). To a lawyer in front of a jury though, a cut and the buildup of a reserve fund may just be a target — however much they build up, a court may reason that they should award more in damages to make the award truly punitive. Giving the cash to their limited-liability shareholders may help keep the court awards/settlements down. The dividend is pretty rich, but I’m not sure that eliminating it for a few years should really affect the investment thesis all that much — the uncertainty in the cleanup costs is much higher than that, so I don’t get the news reports saying that the stock declined on rumours of a cut. I think that they can keep it up, but will probably cut (not necessarily to zero though — probably down to 25-50% of what it was), however either way I don’t think it’s a significant enough factor to affect my value price.

So after looking at it a little closer, my back-of-the-envelope calculation doesn’t seem all that far off to me: BP is likely getting into the buy range now (under $30 for the NYSE ADR), and it might just be a matter of waiting for it to stop being sold in a panic to get in as a long-term value/recovery play. That said, it’s definitely getting detached from the fundamental issues here and trading on emotion in my opinion. It could go nowhere until the relief well connects and kills the leak; it might stay low until a decade from now when the settlement payouts stop and people see the EPS clearly again. It might spring back 15% tomorrow on no news. Some big-name analyst might pan it and it could go no-bid until the vultures start picking it up for pennies. Just no way to say in the short term. That said, the bonds may also be well worth looking at: I haven’t bothered to log into the fixed income side of my broker’s website, but the paper today said that their debt was now yielding 8% — and that was just a 3-year bond! — which plays even better into the “they won’t go bankrupt” thesis (especially if you conclude with “at least not in the next 3 years”).

Another side to the catastrophe that I haven’t seen mentioned yet is the fact that a large portion of the release appears to be methane. As we know from the snickering over cow farts, methane is a very potent greenhouse gas, and here we have a rather substantial release of the stuff going on. I have to wonder if it’s going to be enough to affect the climate records for the next 10-20 years, though I suppose that’s a problem to worry about after the spill is stopped.

One final note on government malfeasance. Some have speculated that the US will simply confiscate BP (or it’s american assets), or create legislation to penalize them post hoc. That is expressly forbidden in the US constitution. However, the US government’s actions during the financial crisis (seizing banks that were not necessarily demonstrably insolvent; arbitrarily making bondholders whole and wiping out common and preferred shareholders without the benefit of a release of their calculation arriving at such a split or orderly liquidation; their continued efforts to keep the GSE’s down with ridiculous interest payments on money that they are forcing them to borrow, which the GSE’s don’t really need — what use capital requirements when possessed and guaranteed by the government?) do not inspire continued faith in the concept of due process.

PS: note that when I say “today”, I mean June 9th (I composed this the evening of June 9th, but held off until June 10th to hit publish).

You’d have to have been in a hole the last month to have not heard about the disaster in the Gulf of Mexico leading to huge amounts of oil streaming out of a well after an accident at the rig. The oil under the ocean floor is under a great deal of pressure, so it’s pouring out through the hole, and has been for a month now. And every day, more comes streaming out. The slick on the surface is huge, affecting a large number of fishery operations, and coming ashore now.

This is a massive disaster, and it’s not over yet. It could be another month or two before the gusher is finally brought under control, and then a long time after that mopping up the coastlines.

For some perspective I did a quick bit of reading on the Exxon Valdez spill. The oil was thicker on the coast there, in large part because the tanker grounded fairly close to land (esp. relative to the BP drill site).

As this plays out there may be more realization in the public mind of what the externalities of an oil-based economy are, and we may finally get more of a drive towards alternative energy, public transit, hybrids, etc. Plus of course, stricter regulations on environmental protection for drillers (though like with financial reform, closing the barn doors after the horse has run out).

From an investing point of view, people are looking at the massive decreases in BP’s stock over the last month — 30% over the last month, 15% today alone! — and are wondering whether this is now becoming a value play. I doubt very much that this disaster will lead to BP going bankrupt and the common shares becoming worthless. Thus at some point, there must be value in the stock. However, determining what that point would be is very difficult at this point since there is so very much uncertainty at the moment. To be sure, uncertainty and volatility can present opportunities, and there’s a good discussion about that possibility at CMF right now.

So, a quick back-of-the-envelope calculation: the ultimate costs to BP are probably the largest unknown factor, but also the most important here at trying to guess at the bottom. The Exxon Valdez spill ended up costing Exxon in the neighbourhood of $5B. This is likely going to be about 10X worse (BP has reportedly already spent $1B in the first month on cleanup and well capping attempts — and the litigation hasn’t even started). So I’d start with a guess of about $50B to clean things up. That figure makes me more pessimistic than most of the reporters and analysts I’ve seen in the news, but there’s so much uncertainty here that I think it could end up being more. At the very least, I’d be looking for a margin of safety on top of that before I start bottom-fishing. As big as that number is though, it’s not a killer for BP: it’s a huge company with profitable oil operations all over the world, and it can probably pay out the costs of the cleanup out of operating profits over the next few years (as they’re required for cleanups, or as litigations complete).

Let’s assume that we’re willing to pay a stock price of the sum of the earnings for the next 10 years (i.e. a P/E of 10). Their earnings for 2009 were about $17B, so 10X that gives us a 10-year sum of $170B, or a stock price of about $54, which is where they were trading before the disaster. If we now figure that $50B comes off that 10-year sum, we’re left with earnings of $120B, which would be a stock price (US ADR) of about $38 (which as of today it’s below). On top of that, we want a margin-of-safety of at least 20% (though I think given the uncertainty, a higher margin of safety would not be out of the question). That brings me to a price of about $30-31 before it starts to look interesting to me. I haven’t done a whole lot of research since I’m busy with my real life, but if BP does start getting down into that range, I might give up a Saturday afternoon to sit on the porch and read up.

All that said, the bloody thing dropped 15% in a day. I’m not going to touch it for at least a few more days. Plus there’s the ethical investing issue: even if it is bargain-priced, do I want to own a fractional share of a company that was responsible for such a massive environmental disaster?

TD announced today a “green mortgage” for installing solar panels (or other projects). There’s no rate discount for going variable (and I’m pretty sure you can get more than 1% off the posted 5-year fixed just by asking), and if you’re just installing solar panels, the 1.5% rebate is not huge, but it’s nothing to sneeze at, either…

The Ontario incentives for putting solar panels on your home/cottage are quite lucrative — they’ll buy your power at 80.2 cents/kWh, about 10 times higher than what you pay to buy power from Ontario Hydro. Even with the fairly high cost of buying and installing panels at retail prices (and without squeezing some of the extra efficiency from having setups like sun trackers) you can probably expect to make money by installing panels, and those prices are contracted for 20 years out.

It’s hard to find solid information on what exactly the costs are — the installers I Googled wanted my address and contact information to get back to me with a quote, rather than having a ballpark figure. I started with a back-of-the-envelope calculation, figuring that the solar panel manufacturers are close to $1/W for their costs, so the panels probably retail around $2/W, plus installation is probably the same as panel costs (i.e., $2/W), so that would put a 2 kW roof system at around $8k. More Google searching indicates I hit the order of magnitude, but am a little too optimistic: one site said ~$15k (Arise says anywhere$12-32k), several others said the payback would be ~8-10 years. So, working backwards: southern Ontario gets ~13 MJ/m² averagedthrough the year, with a 2 kW system taking up something like 7 m² — so that would be 13 MJ/m² * 7 m² * 0.15 efficiency *365 days = 4982 MJ generated in a year, or roughly 1384 kWh. At 80 cents per, that’s a yearly revenue of $1110, so if the talking head on TV is right and it pays back in 9 years we’re talking a ballpark cost of $10k.

So the gross yield is somewhere between 4 and 12% — a pretty big range of uncertainty, but without having a roof of my own to get an estimate on, it’s tough to be more accurate. 10% with next to no risk sounds fantastic, but remember that it’s not like a bond: you don’t get your capital back at the end of the panel’s life. Taking a straight-line depreciation of the 10% case (out 20 years), we still get a 5% net yield — little low to make a good case with 100% financing, but not too shabby for a home improvement.

Since the revenue is guaranteed for 20 years, the only real risks are weather (amount of sunlight you actually receive), trees (could your neighbour’s shrub grow to shadow your roof in 20 year’s time), and financing (you can lock in your interest rate for 5-years, but after that…). There’s also the issue of selling your house: if you move, the contract transfers to the new owner of the house. In that case there’s the risk of not realizing good value for the panels when you sell before the end of their lifetime. After the 20 years, even if the panels die, you’ll probably be happy with the investment; if they don’t (and their lifetime should be more like 30+ years) then even without the subsidy you’ll probably enjoy reduced electricity costs or even self-sufficiency (important as you’ll likely be in retirement by then!).

Considering that the risk is low, it’s a fairly attractive investment, actually. There are also some other factors to consider, such as improving the cooling of your home in the summer (this is hard to quantify, but a few days ago someone on TV said that Wal-mart found nearly as much benefit from reduced cooling loads after putting solar cells on the roofs of some of its stores as from the electricity the panels generated in the first place — sorry, can’t find the source). And, of course, that warm green feeling of being all sustainable and helping promote the technology of the future.

From a practical standpoint, you also need to have a suitable roof space: facing south ideally, without trees (or recently-built condo towers) blocking your sun. There are some negatives: some people don’t like the look of the panels (who looks at their roof, anyway?), and there is some effort on your part needed to get permits, quotes from builders, etc., that you don’t get from a hands-off investment like a bond or stock with similar yields. And there’s the question of how good your inverters are. Solar cells output DC power, which has to be converted to 60 Hz A/C to join the grid or be used in your house. Those inverters (especially the cheap ones) produce “dirty” 60 Hz, which you may-or-may not care about.

John Hempton just put up a post about why he is short First Solar. I got out of FSLR just a month after getting in, in large part because it had a nice little rally that brought it closer to the upper end of my value range, and also in part because I realized that I have very little idea of their competitor’s economics, and could have been too optimistic in my initial estimates.

His preamble on why technology stocks can flounder in the long term is great. I’ve been looking on and off at RIM: on the one hand, even if they lose market share over time to Apple and Google for smartphones, more and more people are getting smartphones (I might even get one soon!), so it’s a declining share of a market that’s growing rapidly, so absolute growth should still be there. On the other hand, 4 years ago I got my Motorola Razr, and they seemed to be near the top of the cell phone game at the time, yet now are floundering (and similarly, their stock price is down ~50% in that time). Sentiment (especially consumer tastes) can change quickly. Right now people want to surf the net and level their pool tables with their phones, but if the next generation of voice devices is the size of a bluetooth earpiece now, the trend may revert to tiny and voice-only.

As for the specifics to First Solar, I’m kind of neutral on it now, but lean long, so I have some thinking to do on JH’s post. Questions that come to my mind though:

Silicon prices, are they temporarily low, or will First Solar’s edge in pricing disappear? If the low silicon prices are a temporary nadir due to the recession (and many raw material prices crashed last year), then their competitive edge may return. Unfortunately, a quick Google search suggests that the crash in prices was due to the supply-side expanding extremely rapidly and overshooting demand… so low prices will probably stay for a while.

Political risk has always hovered over this company — it (indeed, any solar company) depends pretty heavily on subsidies to make the economics work. However, on the short side, if the US gets serious about greening its grid and starts to introduce subsidies, that could delay declines for a while longer. I had hoped that would be the case when I was long, but still haven’t heard anything about that. Up here in the great white north, our federal rebates are over, and the provincial power purchase subsidies are due to expire shortly, and there hasn’t been word of renewing them.

However, his insight into the new technologies that allow less silicon to be used for wafers (further reducing the cost of the technically superior crystalline panels) may be the killer. The question then is what is the volume capacity in that world, and how long will it take for the crystalline competitors to catch up to take over First Solar’s market?