There’s an old scam where an enterprising prognosticator sends out many thousands of his newsletters unsolicited. Being a friendly chap, our prognosticating protagonist personalizes his newsletters. Choosing a binary event, perhaps a football game, or the direction of a particular stock index that week, he predicts for half of his recipients one outcome. Ever eager to please, for the remaining half, he predicts the opposite outcome, guaranteeing a customer satisfaction rate of 50%, on par with cable companies and far exceeding that of the President.
Our entrepeneur, not one to be deterred by a 50% churn rate, dashes on, dropping his disgruntled readers and sending out an additional set of personalized missives to the gruntled ones. After repeating this several more times, the intrepid CEO of our fledgling enterprise becomes alarmed by his dwindled customer base and embarks on a restructuring plan. Those customers who remain are asked to send substantial remuneration in order to consider receiving these money-making predictions. Having received an improbably long series of correct predictions many are happy to oblige. All is well until subscribers realize that performance has suddenly worsened. Ideally, by the time this happens, our visionary has retired and is comfortably ensconced in his well-appointed mansion.
This came to mind when I heard about the dramatic and sudden reversal of fortune at Amaranth Advisors. The Greenwich, Connecticut-based hedge fund reported to investors this week that its fund had fallen 50% since August as a result of a highly leveraged long position in natural gas. After spiking to $7.50 in August on fears of a Gulf hurricane cutting production, natural gas has steadily fallen to yesterday’s close of $4.88, near 2-year lows.
There are 9000 hedge funds out there, and most of them are run by people who have had good track records- but how many of these track records reflect skill(and are reproducible), and how many reflect luck(which will run out)? Hedge fund managers are self-selected from those who have had success, but I suspect that many of them aren’t any more prescient than our scammer. They’re the coin flippers who’ve gotten 10 heads in a row, and given the huge amounts of leverage in use, I think we will continue to see additional falls from grace.
If you’re going to fail anyway, you might as well fail spectacularly. Amaranth didn’t quite fail in spectacular fashion, but only because the bar was set so high by the 1998 collpase of Long Term Capital Management. Anytime the Fed begs banks to bail you out because your failure may trigger a collapse of the global financial system, you’ve definitely failed spectacularly(and if you haven’t already read it, When Genius Failed, Roger Lowenstein’s account of LTCM, is a must-read for every investor).
While perhaps not spectacular, the failure has had a major impact on the market. The sheer volume of positions Amaranth has been forced to unwind have exacerbated the problem, pushing down natural gas even further. Amaranth continues to liquidate positions, and as it does so, natural gas will continue to drop.
Natural gas will stop its fall when Amaranth’s liquidity crisis ends. This will happen in one of several ways. Amaranth will liquidate everything and close up shop, sell enough to restore solvency, or sell distressed assets to a buyer with greater liquidity. Bloomberg reports that another hedge fund, Citadel Investment Group, is in talks with Amaranth to take over open energy trades. Were this to happen, Citadel would be in a position to sit on trades and close the book over time, removing downward pressure from the market.
Natural gas prices would appear to be near a bottom and should rise somewhat once this situation is resolved. In order to take advantage of this, there are several stocks with a natural gas focus in North America that are good buys, but my favorite is Cimarex(XEC).
Cimarex is an oil and gas exploration company with all of its activity in the United States. The product mix is 70% natural gas and 30% oil. Cimarex has historically not hedged but announced in August that it had begun hedging natural gas, locking in about 15% of production above $7. At yesterday’s close of $35.02(within $1 of the 52-week low and well off the high of $47.80), the company has a P/E of 7 against last year’s earnings. With oil and gas prices down it’s likely that profits will decline as well, but even at 2004’s level of $3.59 per share, the P/E is below 10. Of course, this is offset somewhat by higher production levels than last year given the mild Gulf hurricane season.
Cimarex has been very successful in developing new wells. In 2005, the company drilled 382 wells with a remarkable 88% success rate, resulting in the replacement of 183% of production. The company has announced that it will be spending $1 billion on exploration and development this year up 50% from last year’s number. So far the company has continued its high success rate(134 wells with an 89% success rate in Q2). 60% of the company’s acreage is undeveloped so there are plenty of remaining opportunities for growing the already impressive proved reserves 1.4 trillion cubic feet equivalent.
Cimarex is poised to perform well even with oil and gas prices below current levels. The company recently instituted a dividend, has been buying back stock and paying down debt. Would I bet the house on it? No, Amaranth shows the danger of that. But if you can buy at these levels and have the wherewithal to wait out(and perhaps buy on) any further drops, I believe you will be amply rewarded.
Update:
According to CNBC, Amaranth has transferred its entire energy portfolio to Citadel and JP Morgan Chase(JPM). There’s still a lot of volume to unwind, but now that we’re out of crisis mode, the natural gas market should settle down.
Disclosure: I own XEC