Blessed by the Potato

The market looks to have gone a bit crazy lately, which I guess shouldn’t be unexpected given the turmoil all over the world. The world is a mess, and I just need to rule it which should (eventually) lead to opportunities presenting themselves. Oil was down a fair bit recently, which I found a bit surprising given the headlines, but I suppose some pullback was due. Oil stocks seemed to follow with gusto, which lead to me looking again at the sector for another value name to stick in there.

I should note that I have a bullish bias on oil long-term. Approx 12% of my active portfolio is in the energy sector (plus whatever’s in the TSX in my indexed portfolio), and that’s not including pipelines (which do have some exposure to energy prices; they make up 11%), or other companies that have some exposure (e.g., part of Canadian Helicopters’ business is servicing the oil & gas industry). That seems high to me, but it’s actually considerably less than the TSX (which is 27% energy). Most of my exposure is through the ETF on the sector, XEG. My thinking’s a bit torn on that. On the one hand, it’s a great, low-cost way to just pick a sector if one has a strong feeling about it, without having to pick individual companies. My ability analyze an oil company is admittedly weak (how to value reserves? what is land in one “play” worth vs. another?), so that works out for me, and gives a good amount of diversification. On the other hand, I could go even further and index more of my portfolio, and just get energy exposure through the TSX. Which I suppose comes back to my schizophrenic view on passive investing in general, which may be worth a post of its own in the future. The short version: I think it’s great, most people should do it (and it’s the only thing I recommend to others), as it’s hard-but-not-impossible to beat the index… but for 3 years running, I have. Which is terrible, because as they say, one of the worst things that can happen to a novice investor is to get lucky early on. So I try to stay grounded, and I do engage in passive investing (indeed, that’s largely where new savings go). Anyway, that brings me back around to wondering if, on the active/value side, I can do better than just say “I like oil” and buy the ETF.

I have to acknowledge my weaknesses: I can read a balance sheet, and look at cash flows, make back of the envelope calculations, and reason. But, even though I’m a scientist, I’m not a geologist, so I have no clue about formations and different plays, and have no idea how to even begin to value a company that isn’t at the production stage. So I don’t look at junior/exploration players (though that’s a high-reward, high-risk area that may serve a properly trained active investor well… that is definitely not me). Even with producers, I have to admit that I’m new at trying to examine them, and this next part is basically going to be me thinking out loud (unlike the rest of the blog). I would definitely welcome feedback on my thought processes and how to analyze these companies.

Example: Petrobakken (PBN). PBN is a little interesting: it has just tanked this year as its growth has slowed. It is an oil-weighted company (~85% oil, ~15% natural gas) with lots of land in Saskatchewan and Alberta (the Bakken and Cardium areas — it’s mostly focused in the Bakken, hence the name). The issue that seems to have brought down the share price is that the wells in the Bakken have been tailing off very quickly. Now there is normally a “decline curve” for oil wells: lots of oil can be pumped per day when the well is new, but as the pressure tails off (and, I’m sure, a host of other factors), less oil per day comes out as the well ages. But for Petrobakken, the decay has been very quick. The biggest declines have been in the namesake Bakken area, with new drilling not able to keep up with declines: the rock formation is “tight” and has to be fractured (“fracced”) to open channels for the oil to flow from the pockets it lives in to the well. The Cardium region has been making up the gap.

There are a few ways to try to put a price tag on an oil company, and I’m sure I’ll screw them all up.

The first is the way I look at many companies: discounted cash flow valuation. PBN reported cash flow per share of $3.51/share. If I assume that their production levels have roughly stabilized (tough to say, as they had a lot of growth, then some pull-backs, but many of the analysts say they’ve stabilized or will grow) and that oil prices (i.e.: cash flows) go up 4%/year, then I can plug all that into a discounted cash flow spreadsheet and get a valuation. Note that to be conservative, I’m using a 12% discount rate, assigning a -$9/share book value/starting value. That’s because they have about that much debt, and the assets (capitalized drilling costs, reserves, etc.) are not subtracted from cash flows, so if I counted them towards book value, they’d be counted twice (at least, I think so — if I’ve screwed up my accounting, let me know!). I’m not sure that I’ve fully accounted for the cost of drilling in this (because I’m not sure that their statement of cash flows discounts drilling costs), but hopefully I’ve been conservative enough in the other aspects that it’ll all come out in the wash. This quickie valuation gives me $23/share as my target price — indicating that the current price of $19 represents a substantial discount.

Another way is to try to multiply out the value of the oil they have in the ground. I could approach that in a number of ways, which will hopefully get me to the same ballpark. One is to take the total reserves (2P*) of 170 MBoe, and multiply that by a dollar value per BOE. That’s a little subjective: I pulled $35 out of my butt, partly by discounting their reported netback per barrel, and assuming that natural gas (15%) would be just break-even. TD suggests that the average valuation right now is $27/2PBOE, but $33 for oil-weighted companies, so I guess that gets me close. Multiplying out gives $6B value. Subtract the debt of $1.8B, and that’s $4.2B, or $22.50/share. This is a method prone to errors, for example, I wouldn’t want to pay $33 for a barrel of oil today, expecting to sell it for $33 in the future: I’d want a discount for the time invested. I would assume though that that premium would come from the price of oil increasing (I am bullish on oil), and also from growth in the reserves as more drilling and exploration is done (and their replacement ratio — the finding of new oil to replace what they drill — is above 1).

A similar method might be to try to multiply out by well instead of by reserve: it looks like their wells return something like 100 kboe in their life (with ~200 bbl/day initially, which rapidly decays). I’m getting conflicting readings on how much it costs to drill each well. They budget for $800M in capex, and plan to drill 200 wells this year, which to me translates to $4M per well, but the reports have figures all over the place, down around $2M. It looks like $4M might be a good conservative estimate, so I’ll use that. They have 2200 total well sites planned out (with, I’m sure, the potential for more as reserves are explored and firmed up). I’m not sure what figure to use for the amount they can sell the oil for: their “net back” is around $43, but that includes a cost for operations, and I don’t know if that includes the drilling, or just the ongoing costs. If I assume it includes the drilling, then I don’t need to subtract the drill cost, and I get a value of ~$9B (from which the debt should be subtracted). If I do have to subtract the drilling costs, that’s much less attractive: a value below $1B comes out in the end. So I don’t think I’m approaching this method right.

So mathy stuff aside, there are some concerns with PBN. The biggest one to my mind is the fact that they pay a nice dividend, but that they have been over-paying, racking up debt in order to finance the dividend. The debt is at least cheap, but still, I’d prefer they cancel the dividend to pursue the growth, and keep the leverage down. A close second concern is part of what caused the slowdown in the growth rate: they halted fracing in some areas because of “fracing out of zone”, which is when the rock structure is fractured beyond where the oil pool is, and they get water coming into the well. It’s a technical challenge, and it sounds like they have some solutions to improve the oil flow rate. What concerns me though is the potential liability if this fracing out of zone, into a water pool, means that they’ve contaminated groundwater in the area. I honestly don’t know if that’s a material concern or not, but it has me worried. Divestor has an article up on whether PBN is a value trap, and unfortunately, I can’t really refute his concerns, and I don’t have much confidence in my ability to put a value on the company here (again, any help appreciated!).

I’m primarily a “value investor” in my active portfolio (my passive portfolio is, naturally, passive, and designed to protect me from being too clever by half), and I don’t tend to pay too much attention to my asset allocation: instead I look for opportunities in individual stocks. Nonetheless, despite my statement about being bullish on oil long-term, I don’t have a huge exposure to oil (especially after selling BP). And, thanks to a great run in Canexus and Chemtrade, I find myself with a bizarrely high allocation to sodium chlorate producers — not normally a sector of much significance. I still think they’re both pretty attractive, so I’m hesitant to trim them down, but I think that’s probably where I’ll be getting the cash for an oil company (or more XEG) like PBN above.

* – 2P: Proved and probable (or possible). To put it simply: there are usually 3 levels of reserves reported, proved (1P) being oil in the ground that the company has a very high certainty (usually 90%) is there and can extract using current technology. Probable is oil that’s likely there (to some confidence, say 50%) and can likely be extracted using current technology.

Disclosures: don’t listen to me, I’m just a blogger, blah, blah, blah, long XEG, HSE, DAY, CHL.A, CHE.UN, CUS.UN, no position in other companies mentioned.

There was a recent CBC Marketplace episode on homeopathy, in particular, the bizarre decision by the Ontario government to regulate some homeopathic preparations. I have to agree with the hosts of the show that this is a dangerous move by the government, as it may lend credibility to a practice that is void of any evidence of efficacy. For those unaware of what homeopathy is, it’s an old belief that if an agent does something (e.g.: arsenic is a poison that can lead to gastrointestinal and liver issues), then a dilute solution of that something does the opposite (e.g.: a homeopathic preparation of diluted arsenic is given for gastrointestinal issues). However, homeopathy has never been shown to do anything, and the theory and dilutions were developed before key advances in our understanding of molecular chemistry: many homeopathic tinctures are diluted so much they contain zero molecules of the supposed original substance. I had long heard about British evidence-based medicine, skeptics, and science advocates in general battling against homeopaths in the UK, but this Marketplace episode was the first time I found out that there was any homeopathic activity here in Canada. I found that surprising, as unlike other controversial alternative therapies (e.g.: herbal/”natural”, high-dose vitamins, chiropractic), homeopathy is a whole new level of nonsense. There’s literally no there there. It’s not that the evidence is weak, it’s that there’s no evidence, and no rational theory suggesting any efficacy. Homeopathy is completely, utterly, without merit.

I wrote to my MPP & Minister of Health and Long-Term Care Deb Matthews with one simple question: is this a program that is a cost centre for the government, or does it generate revenue by charging fees to the homeopaths? This is a relevant question, as we must control health care costs in our province, and we can not afford to waste money “regulating” sugar water.

I hope that the government is at least making money off the attempt, because I do believe that certifying in any way a homeopathic preparation does, in the eyes of the lay public, lend an air of credibility to the woo-woo. It’s been over a month, and I haven’t heard back on that yet. I got a response from one of her staffers that I would hear back later, but after several weeks with no response I re-sent my question. It’s been another few weeks and still no response.

“Dr. Joshua Tepper: People are choosing health care, people are voting with their feet, if you will.”

You know what else people are voting with their feet for? Marijuana. People who know me know that I am not a user. I despise the weed, and don’t think really it should be legalized (though to be fair, cigarettes should be criminalized). But you know what? I bet that there are way more users of pot than there are of homeopathy in Ontario. And there is much better evidence that pot might actually help a few medical conditions! So I don’t see any reason for this kind of “voting with their feet” logic for homeopathy but not for marijuana.

Something else millions of Ontarians are voting with their feet for is vision and dental care. The government’s never paid for dental care, and cut regular eye check-ups out of OHIP coverage years ago, yet somehow has the money and energy to worry itself about homeopathy?

Ugh.

It’s been a tumultuous year so far, and the snow hasn’t even melted yet! The big news story has been the Japanese earthquake and tsunami, which has killed thousands of people and caused billions in dollars of damage. Oh, it also put some nuclear reactors into partial meltdown which added salt to the wounds by possibly making a few hundred more people sick, and releasing radiation into an area around the plants. But since it’s the ongoing story which will take weeks to fully play out, since people are afraid of the very word nuclear, and since fear-mongering sells papers, it’s been the headline story all week. Not that I am free of blame — I’ve re-read my radiation safety training materials and spent a lot of time brushing up on nuclear power generation this week, and have been soaking up the Fukushima stories.

While I do want to help everyone who’s going out of their minds keep perspective, I also don’t want to minimize the tragedy: the workers are being very brave while facing a terrifying situation, and are making personal sacrifices to try to minimize the damage to the rest of Japan. There have been fires, explosions, and meltdowns, leading to some radiation release (though whether the panicked mobs in Tokyo have anything to fear is an open question)…

Oh yeah, and there’s a civil war in Libya, demonstrations in Saudi Arabia, and crackdowns in Bahrain.

Joe Kelly over at Nerd Boys has a few posts on UBB up. He even tabulates the UBB fees by various ISPs.

Michael James reports that AT&T in the US has introduced UBB, which has sparked some outrage… at 1/10th the price of Canadian UBB.

Something I haven’t really drawn enough attention to is the very framework the CRTC laid out for making its decisions. They state that when congestion occurs, it should be corrected first by network infrastructure upgrades, then by economic incentives (i.e.: UBB), then by throttling and other traffic control measures. The thing is, there’s no structure to those guiding principles, leading to perverse incentives with UBB: an ISP can make more money by encouraging congestion, then charging UBB than it can by upgrading the network to stay ahead of traffic growth. Anyway, it was back in my 5-page submission if you read that, and if not, you probably want to focus on other things now.

Michael Geist, who has been debating Dan McTeague about proposed copyright reform, points out that despite calling for severe penalties for copyright infringers, Dan McTeague himself appears to fit the criteria for a repeat infringer. Zing!

Laser pulse pistol. Yes. The future is here.

On the profiteering side of the Japanese tragedy, Financial Uproar discusses investing in Tepco, which I was actually just talking about today with Netbug. I saw a lot of parallels with the BP situation there. Though there is an ADR, it trades on the pink sheets and is quite illiquid: TD Waterhouse wouldn’t let me put in a bid online, I had to call. I decided to sleep on it, but it’s now up ~20% in Tokyo tonight, so I may have missed my chance.

National Post: Language used to describe Japan’s atomic crisis borders on reckless hyperbole.

An old Scientific American article about how the emissions from coal plants are more radioactive than those from nuclear power plants. However, the mercury, particulate, and greenhouse gas emissions of the coal plants are far bigger concerns, not to mention mining issues.

And finally, I think my favourite link in the round-up: A post showing the deaths per TWh for different power generation methods. There’s lots of room to quibble about an order of magnitude here or there, but the end result is that coal is several orders of magnitude more deadly than nuclear. And coal never provided us with medical advances like radiotherapy or diagnostic nuclear medicine.

There’s Chernobyl, everyone knows that one. Then a handful of other accidents involving nuclear power generation, with the most famous perhaps being Three Mile Island, though the impact of the non-Chernobyl accidents have been pretty minor.

In the early days of research, there were a fair number of accidents, especially with enriched fuel, and a bunch of military accidents.

But after Chernobyl, most of the worst civilian radiological accidents come from the medical side. As much as people rail against nuclear energy, I don’t hear a lot of people trying to ban nuclear medicine.

The biggest cause of accidents seems to be the escape of radiation sources, with the Goiania, Brazil accident being perhaps the best example. There, a medical clinic moved, and left behind a radiotherapy device. These guys came in to the abandoned, half-demolished structure, and stole the Cesium-137 source at the heart of the machine, to sell for scrap. In dismantling the source, they got a large dose of radiation, and then later did sell the core for scrap. The scrap dealer noticed this blue glow in the material, and — I kid you not — decided it was magic.

He invited his friends and family over to check it out, made jewellery and body paint out of it, and spread this stuff all over. People were putting it on their bodies to increase sexual potency, ingesting it, and selling it. It took over two weeks before it was realized that a disaster was unfolding. 4 people died, many others got sick, and something like the equivalent of 100 transport truck containers of contaminated waste were produced.

There are also a number of cases of accidental over-exposure from radiotherapy or imaging, though those seem to be more accepted as there is always some background medical mistake risk.

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!