Bubbles in Natural Gas or Energy Drinks?
SPECULATION ON WALL STREET is still alive and well. Much to the surprise of many veteran market observers, the recent market downturn doesn’t appear to have scared investors out of highly speculative stocks. Modest signs of a “flight to quality” are popping up, with pharmaceutical and consumer staples benefiting from defensive portfolio rotations. But by and large, it has not been a stampede. In a full-fledged flight to quality, the most expensive stocks would be getting hammered, while cheaper stocks with reliable sales and earnings would be bucking a downtrending market.
We can gain insight into the speculative appetite of the market by comparing the valuations and movements over the past six weeks in speculative darling Hansen Natural (HANS) with valuations in Kerr-McGee (KMG) and Western Gas Resources (WGR), the two just-announced acquisition targets of Anadarko Petroleum. Anadarko will likely receive criticism from most mainstream analysts for paying a high premium for these two companies. But I believe that Anadarko’s acquisition will ultimately prove to be very insightful and speculators trading in Hansen Natural will ultimately be taken to the cleaners.
What distinguishes a bubble from a bull market? From a psychological perspective, a bubble is an upward-trending market that is cheered on by everyone involved, whereas a bull market is an upward-trending market that is constantly doubted. From a valuation perspective, a bubble leaves behind any sort of connection with the stream of future cash flow that the asset can ultimately deliver to its owners. A bull market chugs along with the growth of the underlying cash flows supporting the asset’s price.
Natural Gas Stocks Are Not in a Bubble
Many great investors argue that commodities are in a bubble and cannot trade above their marginal cost of production for long. This has proven to be true, but it downplays the crucial consideration of where the marginal cost of production will head in the future as well. By acquiring Kerr-McGee for $18 billion and Western Gas for $5.3 billion (including assumption of debt), Anadarko management is assuming that both prices and the marginal cost to produce natural gas will continue trending upward over time. These acquisitions provide the added benefit of including gas wells in the same basins where Anadarko already operates. Anadarko’s presentation includes this map showing where the company’s wells overlap with Kerr-McGee’s wells in the Gulf of Mexico:
Anadarko’s Rocky Mountain acreage also overlaps with Western Gas Resources’ acreage. This area is home of the most promising natural gas basins in the country, and Western’s proved reserves consist of 97% natural gas. In the press release announcing the acquisitions, Anadarko estimates that it will ultimately cost them $2.07 per mcf equivalent to extract Kerr-McGee’s oil and natural gas reserves, and $1.67 per mcf to extract Western Gas Resources’ natural gas reserves. These costs are estimates of full-cycle E&P costs and will turn out to be highly profitable if natural gas continues to trade in the $6-15-per-mcf range it has traded in over the past year.
These cost estimates are not made without significant due diligence, and prices are likely to stay at high levels in the future. Furthermore, Anadarko is paying 6.4 times trailing cash flow for Kerr-McGee and 9.7 times trailing cash flow for Western Gas. Western should command this premium because it owns valuable “midstream” gas gathering, processing, and transportation facilities and has a reserve life of 15 years with a heavy concentration in coal bed methane, a key future “unconventional” gas resource.
This deal is important because it confirms that Wall Street is still myopically focused on short-term energy inventories and prices. Secondly, the deal confirms that paying up for proved reserves is still a more attractive alternative than growing reserves organically by undertaking risky exploration. “Peak Gas” may become a concern in the near future, as most of the high-flow gas wells within associated oil basins have long been exploited. There may be plenty of gas reserves, but they are not likely to produce at the high rate demanded by future markets. For more detail on this Peak Gas phenomenon, I asked Whiskey & Gunpowder editor and resident geologist Byron King for his input on the domestic natural gas reserve situation. Here is his response:
Byron King on Domestic Natural Gas Reserves
“Most natural gas is what is called ‘associated gas,’ i.e., associated with oil production. It is located either in the gas cap on top of the oil column or dissolved within the oil at high-pressure temperature and it ‘exsolves’ from the oil as the oil comes to the surface. Much of this kind of ‘production gas’ is re-injected (e.g., at the North Slope, or Ghawar) to keep up reservoir pressures. In the olden days, a lot of this gas was flared (i.e., burned off), which was a colossal waste and helped to damage the producing formation.
“Sometimes, you get essentially ‘dry gas’ or gas with minimal oil associated with it. Examples include some significant gas fields in West Texas, the Hugoton Embayment of Oklahoma, or a field called Malampaya, in the Philippines, with an immense gas deposit and a much smaller ‘oil rim’ at the edges of production. You can produce this gas almost direct to the pipeline, with some allowance for separating the ‘natural gas liquids’ and other fractions.
“As I have mentioned in other articles on Peak Oil (and it is also applicable to Peak Gas), once you find the ‘big fields,’ it is harder to find the smaller ones. Discovery requires more drilling. But even then, you have issues with lower-quality prospects, meaning smaller fields, deeper depths, and ‘sour’ fluids (i.e., containing hydrogen sulfide).
“Matthew Simmons has argued that Peak Gas can be worse than Peak Oil, because when pressure equalizes in the well, production rates fall off a cliff. Simmons is restating a rather universal engineering concept. With oil production, you can inject water or CO2 and enhance a ‘pressure front’ that will move the residual oil to the well bore. You cannot do that with natural gas. When the pressure falls, it falls, and you cannot ‘re-pressurize’ a natural gas reservoir. This matters a lot when you are looking at macro-trends in production across a continental production base such as what we have in the U.S.
“The U.S. is now producing quite a bit of natural gas from tight shales and coal bed methane, rock formations with low permeability. But although there may be quite a bit of this type of gas booked as reserves, it tends to be produced at a slow rate (the permeability issue), and not fast enough to offset production declines from older, much larger fields.
“Because of the lower permeability of rock formations like tight shale and coal bed methane, the drillers have to ‘frac’ the formation. That is, they ‘fracture’ the rock by pressurizing it with a blast pulse of nitrogen or some other compressible fluid, or they ‘acidize’ the formation by dissolving some of the rock matrix with acid. This is technically challenging and tends to be expensive.
“Fracturing and acidizing the rock breaks and splits up the rock formation surrounding the well bore. This in turn increases surface area of exposed rock face and assists the permeability process, because the fluids in the formation have less distance to travel before they find a channel to the well bore. But your depletion rates are vastly more rapid than in the good old days of drilling up nice homogeneous sandstone with lots of porosity and permeability. This is much of the background to Peak Gas.
“The bottom line in all of this is that the U.S. is drilled up. The remaining rock formations do not, in all likelihood, hold vast reserves of easily accessible natural gas. Good natural gas acreage and related land position is at a premium. There are profound manpower (and womanpower) shortages across the fields of geology and engineering, particularly among the age group 25-45 or so. So brainpower, and the ability to generate drilling prospects, comes with a premium price.
“If you are a stockholder in Kerr McGee or Western Gas, all of this technical detail might be more than you want to know. The bottom line is that this is a good deal, so take the money and run. Good luck, everybody. See you on the other side of Hubbert’s Peak.
Byron makes some great points that you are not going to hear in the mainstream media reports about this merger. The geologists and engineers at Anadarko undoubtedly recognized the domestic natural gas supply situation and acted with foresight by aggressively bidding for two companies with strong footholds in domestic gas. Investors can expect this increased merger and activity trend to remain in place and look for smaller domestic producers as attractive acquisition targets. If you are looking for a bubble, the example of Hansen Natural provides more interesting fodder.
There’s an Energy Drink Party Going On
Hansen Natural Corp. is a beverage company that specializes in developing and marketing a broad range of juices, natural sodas, and, most importantly, energy drinks. These energy drinks retail for about $2 per 16-ounce can and include carbonation, natural or artificial sweeteners, vitamins, and a proprietary “energy blend” that includes about as much caffeine as a cup of coffee. These drinks, marketed under the “Monster” brand name, target the key 13-29-year-old demographic.
Excitement about the continuing growth prospects of energy drinks has led investors to bid up the price of Hansen stock to 56 times earnings. When any stock reaches this level of valuation, investors are assuming everything on the cost side will be rosy and that growth expectations will not disappoint.
Costs are less of a concern with Hansen; a company that enjoys 60% gross margins in the key energy drink segment can absorb a great deal of cost pressure. But cost pressures should not be a surprise, because this summer’s new ethanol mandate should greatly increase the price of all sweeteners, aluminum should continue increasing in price, and the fuel involved in packaging and delivering the product will remain high.
The real concern among Hansen stockholders should be the company’ lack of control over its distribution network. Independent distributors may start receiving far more incentives from Coke and Pepsi to push their competing offerings. Combine this with the sense of urgency among Coke and Pepsi management to make a second assault in this white-hot segment of the beverage industry and you’re left with a company that could easily fall short of top-line expectations over the next few quarters. Such disappointments normally cut 56 P/E stocks in half quickly.
Do You “Rent” Stocks or Own Them?
The average holding period of Hansen stockholders is eight days. You read that correctly: eight days. The share float of 15 million divided by average daily volume of 1.8 million shares provides this number. Some hold onto their stock for six months and some hold on for six minutes. But an average of eight days is extremely low. This indicates that there is a war going on between short sellers and day traders, and the short sellers have been getting slaughtered. But they are likely to have their day in the sun, as it was with those who watched the short squeeze drama in stun gun manufacturer TASER Intl. (TASR) unfold into a meltdown of that stock:
A Stock Split Is a Bookkeeping Entry
Much to the delight of day traders, Hansen recently announced an imminent 4-1 stock split. This will bring the price per share from the $170 range down to the $42 range and quadruple the amount of shares outstanding. To the surprise of many speculators trading in this stock, this does not make it cheaper. It is a bookkeeping function to enhance liquidity for smaller investors, nothing more.
A 4-1 stock split can be thought of as slicing a pie into four times as many pieces; more pieces should not be confused with more pie. The primary reason behind Warren Buffett not splitting Berkshire Hathaway “A” shares was to make them prohibitively expensive for speculators. But in the case of Hansen, the company clearly does not want to disappoint the “renters” of its stock.
To continue with the pie analogy, what really dilutes the interests of existing shareholders is a secondary stock offering. Secondary offerings represent an enticing way for young, growing companies to raise capital for expansion. It’s how many of the dot-bomb software companies ended up with cash hoards that have provided years of life support. After their stocks skyrocketed from the launch pads of their IPO prices, these tech companies sold more stock in the open market to wild-eyed speculators who were itching to part ways with their money in exchange for exponentially growing Internet riches.
A Secondary Offering in a Bubble Can Create a Zombie
Looking for a real-world example of a misallocation of capital resulting from a bubble? Look no further than the history of Aether Systems (AETH:NASDAQ). In the heyday of the Internet bubble, this company was in the business of providing real-time data to wireless handheld devices. After its October 1999 IPO, the stock increased by a multiple of 6 to peak at $345 intraday on March 10, 2000, in true bubble mania fashion:
Recognizing a great opportunity to raise a ton of cheap capital, management made the decision to sell 5.4 million shares to the “dumb money” in the secondary market at $205 per share. Voila! $1 billion in fresh capital for expansion in exchange for only diluting existing shareholders’ claims by about 20% (Aether had 27.2 million shares outstanding at year-end 1999). If they had been 10 days earlier, maybe they could have raised $1.5 billion by selling at $300 per share!
The chart tells the story of what happened next. Investors slid down the slope of hope while management had years to burn through the cash they raised in the IPO and secondary offering. But wait, there’s another chapter. Recognizing that they were on a path to insolvency, and that they had built a valuable deferred tax asset through years of net operating losses, they decided to dump the technology business and become a publicly traded hedge fund.
Aether “Holdings” is now involved in the mortgage-backed securities (MBS) carry trade. MBS are like bonds, only they are pools of mortgages with similar characteristics and risk profiles. Monthly mortgage payments flow from the homeowner to the bank (or whoever is servicing the mortgage) and the payment is passed along to the MBS that has ownership of the mortgage. Aether’s assets now consist of mortgage pools, and its liabilities are short-term floating rate debt. The deferred tax asset enters the equation by shielding a good portion of future operating income and capital gains from taxes. So the pile of money extracted from “greater fools” in the secondary offering six years ago is now being put to work fueling the latest bubble: home mortgages.
This carry trade strategy seems to have backfired in the first quarter of 2006 as the Fed rate hikes have squeezed Aether’s cost of carry up to an unprofitable level. Aether sold off over half of its MBS portfolio when the rate on its floating-interest debt rose to a higher level than the MBS yield. It appears that it is waiting for the Fed to embark on another rate-slashing campaign before tacking on the leverage again. If not, what’s next? Will Aether chase higher yields by taking a flyer on junk bonds?
Hansen May Be Tempted to Issue a Secondary Stock Offering
As the example of Aether reveals, a soaring stock price often serves as a flashing neon sign to raise cheap capital through a secondary offering. The research reports recently published by a few major investment banks have glowing things to say about Hansen. These reports include price objectives north of $200 using discounted cash flow models. It’s true that Hansen has a great business model and perhaps several more years of high growth. But isn’t that already discounted in the current price of the stock — a stock trading at 56 times trailing earnings?
These reports look suspiciously similar to the ones that were published in 2000 when companies like Aether were looking to do secondary offerings. If so, then these reports are hardly more than auditions for investment banking business. The “Chinese Wall” between sell-side research and investment banking may be firmly in place in the eyes of regulators. But it never hurts an investment bank to have a positive opinion on a company it is courting for investment banking business. Don’t be surprised to see these large firms as co-lead managers of a potential future Hansen secondary stock offering.
One might argue that because Hansen outsources most of its distribution, warehousing, and R&D, it has minimal capital requirements that can be funded out of operating profits. This would take away the need for Hansen to raise fresh capital in a secondary stock offering. However, the company remains dangerously exposed to the Monster Energy Drink brand as a high percentage of sales, and management undoubtedly recognizes this. It may be time to make significant investments in brand diversification and purchase a stronger presence in the distribution chain, rather than rely entirely on independent distributors.
Coke’s and Pepsi’s entries into the energy drink market have failed to make a dent in Monster thus far, but that will not deter these juggernauts from improving their products and the marketing behind them. The energy drink category represents too attractive a market to leave to a small fry. “Renters” of HANS at $170 per share should take heed of this fact.
Bubbles Are Ultimately Corrected in Free Markets
The participants in HANS, KMG, and WGR over the past six weeks suggest that speculation, not investment, is still on the minds of small traders. Kerr-McGee and Western Gas — great long-term values in hindsight — have both been weak since their May 10-11 highs, while Hansen has not declined nearly as much as one would expect.
Who do you think has a better understanding of intrinsic value when buying these three stocks: Jim Hackett, chairman and CEO of Anadarko Petroleum, or traders flipping speculative stocks like Hansen Natural? My answer would be Mr. Hackett, given his long, successful experience in oil and gas merger and acquisition activity.
Moreover, what’s more important to the U.S. economy over the long term? Comparative advantages in energy drink research and development or investment in further expanding and developing reliable domestic natural gas supplies?
We report that the free market ultimately decides.
Dan Amoss, CFA
June 26, 2006