28 Jan 2012 by Jim Fickett.

On Friday the BEA reported a first estimate for 2011 Q4 GDP.

Real gross domestic product – the output of goods and services produced by labor and property located in the United States – increased at an annual rate of 2.8 percent in the fourth quarter of 2011 (that is, from the third quarter to the fourth quarter), according to the “advance” estimate released by the Bureau of Economic Analysis. …

During 2011 (that is, measured from the fourth quarter of 2010 to the fourth quarter of 2011), real GDP increased 1.6 percent.

James Hamilton at Econbrowser points out the most important consequence of relatively slow growth:

A key reason to be concerned about continuing below-average GDP growth is Okun's Law, which originally held that to get the unemployment rate to decline by 1 percentage point, we'd need a year of GDP growth 3% above average. Okun based that estimate on data for the U.S. economy prior to 1960, but it has held up pretty well in the half century since then, with 2.5% above-average GDP growth a better summary of the requirement based on the full sample of data now available. …

if real GDP grows by less than 3.3% over a year, the unemployment rate is more likely to rise than fall. The fact that the unemployment rate fell by 0.9 percentage points in 2011 despite GDP growth of only 1.6% for the year is thus a little surprising, and attributable in part to a declining labor force participation rate. If we want to see real progress in 2012, we have to hope for better GDP numbers than we had for the fourth quarter.

27 Jan 2012 by Jim Fickett.

In an earlier post I mentioned that the Vestas stock price was down about 90%, while orders were rising, and wondered whether this might be an important bargain opportunity (Vestas, beaten down, may be a bargain). The answer is that it might indeed be an opportunity, but it is hard to build a case for a margin of safety.

Here is the cash flow and income data from the last 8 years, from annual and quarterly reports on the company website (for 2011, results are scaled from the first three quarters; all numbers are millions of euros):

Free cash flow over this period is not, on the face of it, very encouraging, but there are mitigating factors. First, as I mentioned in the earlier post, capital expenditures have been very high in the last four years due to a change in strategy, where factories in Europe are being closed and new factories built closer to the point of delivery and, in the case of Asia, where labor is much cheaper.

In looking up these data, I was hoping to find that operating cash flow was consistently strong, and the cost of capital expenditures was making a temporary peak. The latter may well be the case, however cash flow from operations has been very inconsistent. The 2009 annual report explains the miserable performance that year so:

At the end of 2009, the Group's net working capital amounted to EUR 1,235m, which corresponds to 19 per cent of revenue, against 5 per cent in 2008. The large increase is due to lower prepayments caused by the delayed order intake.

Net working capital is subtracted from income in calculating cash from operating activities. Apparently what happened in 2009 is that customers, having a bad year, delayed delivery, which delayed cash payments. The orders stood, and revenue was recognized, resulting in high income, but the cash did not come.

So, between high capital expenditures, on what is probably a very sensible strategy, and a hit to operating cash flow, from the poor economic conditions following the financial crisis, there is very reasonable story to tell about poor cash flow in the past few years, and also about likely improvements to come. However it must also be said that there is a great deal of guess work involved in trying to come up with projected future cash flows. And that, in turn, means it is difficult to show persuasively that the current stock price is a bargain.

My best guess is that Vestas is a good buy right now, and the stock price will rise once they get past the current bulge in capital costs. But, at least so far, I do not see how to build a solid, quantitative case.

26 Jan 2012 by Jim Fickett.

If you are interested in climate change (and every long-term investor should be), the blog Early Warning is quite useful. Stuart Staniford is a physicist who follows climate science in his spare time, and regularly summarizes technical papers for the layman.

In a post today entitled Another terrifying drought paper, he summarizes joint work from National Oceanic and Atmospheric Administration, the Lawrence Berkeley Laboratory, and the Lawrence Livermore Laboratory.

The research had two main parts. First the scientists fit past rainfall and temperature data (widely available) to a drought model (drought data is not widely available), and summarized the result in a standardized drought index. Then they averaged the results of 19 climate models to predict the drought index over North America in the future. The discouraging conclusion was that drought as bad as the dustbowl 1930s could become the norm by the middle of this century, over most of the US.

There is, of course, a great deal of uncertainty about all climate modeling. This is, nevertheless, a sobering result. In particular, one should probably try to understand these results more thoroughly before jumping on the farmland investment bandwagon.

26 Jan 2012 by Jim Fickett.

There is a new Investment post. Access requires free registration.

25 Jan 2012 by Jim Fickett.

In this post I look at the worst scenario I can think of for Encana, examine it in some detail, and conclude that it is very unlikely to occur. Incidentally, the Encana stock price is up 17% in the last few days.

When I'm waxing poetic about a possible investment, my partner likes to ask me, “OK, so what's the nightmare scenario?” It's a good question. In this post I'll try to give a realistic appraisal of the worst scenario I can think of for Encana. In short, the nightmare scenario goes something like this:

• Many gas companies shift to drilling “wetter” wells, with a higher proportion of natural gas liquids (NGLs), and make enough money from the liquids that they can afford to make no money on the gas.
• These wetter wells still produce a lot of gas and, as a result, the gas price stays low for several more years
• Encana, having just split off its oil assets into a new company, has a harder time than some companies in rescuing themselves by producing more liquids, and simply cannot make money

A number of people are taking the first two points quite seriously. I haven't seen any serious quantitative analysis, but there is at least one case in which well-informed people, with access to excellent data, take this view. This is the Energy Information Administration, in their preview of the Annual Energy Outlook, which I mentioned in a previous post.

They project that US shale gas production will keep growing very strongly:

And, at the same time, prices will stay quite low for at least 10 years:

With increased production, average annual wellhead prices for natural gas remain below $5 per thousand cubic feet (2010 dollars) through 2023 in the AEO2012 Reference case. The projected prices reflect continued industry success in tapping the Nation’s extensive shale gas resource. The resilience of drilling levels, despite low natural gas prices, is in part a result of high crude oil prices, which significantly improve the economics of natural gas plays that have high concentrations of crude oil, condensates, or natural gas liquids.

The EIA also project that, despite the low price, the share of natural gas in the overall US energy picture will remain constant, at 25%, over the next 25 years.

The overall EIA projection is implausible in two important ways.

First, it is hard to believe that no matter how much effort is shifted to looking for and producing oil and NGLs, the volume of gas produced will continue to grow all the same. They provide no supporting analysis, so it is impossible to tell whether this is based on hard data, models, or currently fashionable opinion. One prominent example suggests that this idea is wrong.

While Encana only decided in the last few months to concentrate more on liquids, Chesapeake Energy already made a clear strategic commitment to finding and producing more liquids in early 2010. This change in strategy took a while to implement, but it is in full swing now. For the first three quarters of 2011 the year-over-year increase in quarterly liquids production was, Q1: 54%, Q2: 64%, and Q3: 93%. And with all the increased spending on liquids production, what happened to gas? The year-over-year changes in natural gas production were Q1: 16%, Q2: 3%, Q3: 1%. So if Chesapeake is in any way typical, we can expect the growth in gas production to slow drastically as emphasis switches to liquids. (In addition, Chesapeake just announced that it will actually cut gas production 8%.)

The second aspect of the EIA projection that I find quite implausible is that, even though gas prices are predicted to remain very low, the share of gas in the overall energy picture is projected to remain unchanged. Here is a graph from a recent Encana presentation, showing an historical comparison between the cost of a unit of heat from oil and the cost of the same unit from coal or natural gas. The dashed lines are predicted costs based on the futures market, which is giving a reading very similar to the EIA projections.

Is it really likely that the cost of heating and electrical power from gas will remain much cheaper than it has been relative to other fuels, and at the same time homeowners, manufacturers and power generators will not migrate to gas? Come now.

Keep in mind that projections like these are always heavily based on continuation of current trends and belief in current estimates. Don't forget that only a few years ago the consensus was that natural gas shortages would persist for decades.

But back to Encana. Based on the above, I don't believe gas production is going to keep increasing while the gas remains unprofitable, even if liquids help. And I don't believe the price will stay so low, since that low price continues to drive demand growth. But how bad would it be for Encana if indeed the price did only slowly rise from the current $3 or so to the EIA and futures market estimate of $5 or so?

The first thing to note is that a $5 price would be fine for Encana – they claim they can make a decent internal rate of return at a price of about $4. Second, although it is true that they divested the assets that were primarily oil, the gas assets that remain include a fair proportion of liquids. According to the 2010 annual report, their proved reserves, as of Dec 2010, were split evenly between natural gas and associated liquids. So they will likely have no trouble in following the now popular strategy of producing more liquids to survive until the gas price rises.

All in all, the case is very strong for a rising gas price and, even if the price stays low for several more years, Encana will manage all right until more realistic prices return.

24 Jan 2012 by Jim Fickett.

The latest estimates from the Energy Information Agency revise down US gas resources substantially.

The US Energy Information Administration puts out an Annual Energy Outlook. The latest one will be completed in April, but they published a preview yesterday.

They have revised down their estimate of natural gas in the Marcellus shale by two thirds, and their estimate of overall US gas resources (unproved, technically recoverable resources) by 42%.

In the AEO2012 Reference case, the estimated unproved technically recoverable resource (TRR) of shale gas for the United States is 482 trillion cubic feet, substantially below the estimate of 827 trillion cubic feet in AEO2011. The decline largely reflects a decrease in the estimate for the Marcellus shale, from 410 trillion cubic feet to 141 trillion cubic feet. Both EIA and USGS have recently made significant revisions to their TRR estimates for the Marcellus shale. Drilling in the Marcellus accelerated rapidly in 2010 and 2011, so that there is far more information available today than a year ago.

If we add their estimate of unproved resources (482 tcf) to BP's latest estimate of proved reserves (272 tcf), and divide by current demand (22 tcf; for the latter two numbers see US natural gas reserves), we get that the US might have (in round numbers) about 35 years worth of gas at current consumption rates.

Don't expect any reporters to notice, or to stop saying that the US has 100 years worth of gas.

24 Jan 2012 by Jim Fickett.

The VIX volatility index on the S&P 500 is near the low end of its range for the past few years. That means that options on the S&P are lower-priced than usual. If you have been thinking about adding some protection against the possibility of a market fall stemming from a global recession, this would be a good time.