Airline CEOs: Hedge Your Fuel Costs Now

We have seen crude oil prices fall 50% from $150 to $75 per barrel. Aside from Southwest Airlines (LUV), my preferred air carrier for many years (for traveling, not investing), the other airlines missed the boat on hedging fuel costs and paid the price as the oil spike wiped away their profits after the last round of bankruptcies. If they were smart, they would begin hedging right now. Given the economic problems we are facing and the fear of a global economic recession, oil is on sale due to temporary factors and global demand is still growing (more on this in coming days).

Sure,oil could get even cheaper in 2009 as the economy weakens, but that would be the time to increase the hedges further as prices fall. Once the economy rebounds we will see $100 oil again and those who hedged will look very smart. Legacy carrier CEOs might not be used to being called smart, but they certainly should give it a try.

If any airline workers are reading this, pass along this advice to your bosses. Airline CEOs: start hedging your fuel costs now and increase them should oil prices continue to fall during the recession. Global oil demand is not going to start falling anytime soon, and falling gas prices today are just going to reaccelerate the demand growth that has fueled the commodity bull market.

Full Disclosure: No position in Southwest Airlines stock at the time of writing, but positions may change at any time. I do, however, have a Southwest Visa card in my wallet.

Don’t Borrow Money to Buy Stocks

Much of the recent market decline has been due to forced sellers like hedge fund and mutual fund managers that have had no choice but to sell stocks they own due to redemption notices from their panicked investors. In many cases, forced selling has also taken the form of margin calls.

Consider the shares of long time Peridot favorite Chesapeake Energy (CHK) which fell 50% in just the last 3 days of last week. The stock movement felt like panic selling and late Friday we learned that the company’s largest shareholder (the co-founder and CEO) was forced to sell most of his 5% stake in the company between Wednesday and Friday. Why? To meet brokerage margin calls that were triggered because he had bought the shares in part with borrowed money.

For the most part, I would never recommend that individual investors borrow money to buy stocks. Every so often there are arbitrage opportunities that can be completely hedged and therefore using margin can pay off if downside risk can be hedged away, but speculating on a stock price’s future movement based on fundamental bullishness (as was the case with CHK) with borrowed money is a recipe for potential disaster.

Aubrey McClendon, Chesapeake’s CEO, has paid the ultimate price by being forced to sell 94% of his stake in his own company in the middle of one of the most panicked weeks the market has ever seen. Don’t make the same mistake he did by speculating with borrowed money. Leverage has crushed the investment banks, but it can get individuals in deep trouble too.

Full Disclosure: Peridot was long shares of CHK at the time of writing, but positions may change at any time

With Oil Down 25%, Is The Bull Market Over?

After seeing the price of crude oil start the year around $100 per barrel, peak at nearly $150, and come nearly all of the way back, where does the oil market go from here? It is interesting to see how many people no longer think we see a range of $150 to $200 anymore. The Goldman Sachs year-end target of $149 is now considered overly bullish by most pundits. Is the bull market in oil over?

The sharpness of the recent decline lends some credence to the belief that much of the 2008 price spike was related to speculative trading activity. After all, the move from the 120’s to the 140’s came with nearly no new information that would lead one to think the supply/demand balance had changed materially. Daily price swings of $5+ became commonplace without significant events accompanying them. Now with oil down about 25% from its high, calls for $70 or $80 oil are easy to find.

Personally, I think it is important to note that the fundamentals of the oil bull market remain intact. Global demand is growing faster than global supply. It is true that we began to see demand destruction once crude passed $140 per barrel, but since that level was merely temporary, a price of $110 or $115 all of the sudden looks reasonable again. Should we expect gasoline demand to continue to drop at the same pace when gas drops from over $4.00 to under $3,50 per gallon? Probably not.

Even if demand growth drops in the United States and China and India see lower GDP growth levels, oil demand should still rise in coming years. Consider 2008 worldwide demand. Despite the price spike we saw this year, daily global consumption is estiamted to rise 1% to 86.3 million barrels per day. That comes on the heals of a 1% increase last year and another 1% increase forecasted for 2009.

In any bull market there are periods of sharp spikes higher and even sharper declines. Looking at the global economy, it is hard to argue that oil demand will not continue to grow. Sure, alternative energy sources can cut that growth rate noticeably, but with each and every price correction brings less pressure to really promote alternatives in a meaningful way.

A price correction moving toward $100 per barrel, without significant fundamental changes in the outlook for crude oil demand and supply and demand, makes me think triple digit oil prices are not going to become a thing of the past any time soon, for an extended period of time anyway.

From an investment perspective, leading oil producers have seen serious price per share declines, which now imply long term oil prices of far less than $100 per barrel (most are between $70 and $80 per barrel). If you think the next three to five years will see triple digit oil, as I do, then the stocks are going to prove to be excellent investments from here.

With Oil Peaked For Now, Contrarians Likely Will Turn To Refiners

There aren’t many energy stocks sitting nearly 60% below their highs, but as the crude oil bull market has continued in 2008, refiners have gotten crushed. The explanation for why refiners fare poorly in the face of rapidly rising crude prices is pretty simple. Refiners buy crude oil, refine it, and resell it to users of gasoline and other refined products like jet fuel. If the price of your core cost component is soaring and end demand for your finished product is falling because of high prices curbing demand, profit margins will contract pretty aggressively.

As a result, shares of refiners such as Valero Energy (VLO) have been pummeled. After earning about $8 per share in both 2006 and 2007, profits for VLO are expected to fall 50% this year, to around $4 per share.

But what happens if crude oil stops going up so fast? Already we have seen per barrel prices top out in the 140’s and trade down to the low 120’s and gasoline prices nationwide are below $4 per gallon again. Frankly, the backdrop for refiners really can’t get much worse that is has been so far this year. As a result, VLO shares have fallen from a high of 78 last year all the way down to the 30’s.

There appears to be some value here if investors are willing to be patient and wait out a turn in refining industry fundamentals. Let’s value VLO stock two different ways and see what we come up with.

1) P/E Ratio Valuation

Let’s assume normalized EPS of $6 per share, up from the current run rate because conditions stand a good chance of improving, but 25% below the levels of 2006 and 2007. Use a 10 P/E and we get $60 per VLO share.

2) Asset Liquidation Valuation

Valero has sold 2 refineries since last year for about $3 billion. Those two refineries produced a total of 250,000 barrels per day. Valero now owns 16 refineries producing 3 million barrels per day. Let’s assume they sold all of their refineries for the same price. That would net them $36 billion, or $66 per share.

As a result of the tremendous value that appears to be embedded in the stock, VLO is being added to the Peridot Blog Model Portfolio today. Refining margins stand a good chance of improving over time, as long as crude oil prices behave better, which would likely positively affect VLO’s earnings per share, earnings multiple, and in turn, the share price.

Full Disclosure: Long shares of VLO at the time of writing

Did Gas Use Really Drop to Five-Year Lows?

This story is a few weeks old, but I came across a Wall Street Journal article dated July10th with the headline “Gas Prices Spur Drivers to Cut Use to Five-Year Low.” I had mixed emotions when I read that. On one hand, lower gas use will ease the upward pressure on prices. On the other hand, as we have seen time after time, when prices go back down consumers ramp up use again, so the problem never gets fixed. Hence, many claim the solution for high gas prices is… even higher gas prices.

After reading that headline I wrongly assumed that U.S. gasoline use had actually fallen to levels not seen since 2003. After all, the article pointed out “gasoline consumption dropped 3.3% from last year to 9.347 million barrels a day.”

The very next sentence, however, gave us the real picture. It reads “For the first week of July, that is the least drivers have used since 2003, when consumption was 9.05 million barrels a day.”

Wait… what? Gasoline demand reached a five year low, but isn’t 9.347 barrels per day a lot more than 9.05 million? In reality, gas demand has risen 3.3% since 2003. What the author was trying to say was that the year-over-year change in demand was the lowest in five years.

I only point this out because many people have quoted this data and would have you believe that Americans are really cutting back on gasoline use. In reality though, even though prices at the pump have more than doubled over the last five years, we are still using 3% more gas today than we did then. Demand destruction is happening this year, just not in any meaningful way if you look at the bigger picture.

Did Wall Street Forget About Chesapeake Energy’s Haynesville Shale Monetization?

Back on March 26th I pointed out that earnings estimates for Chesapeake Energy (CHK) appeared to be too low. At the time the company had just released a bold exploration and production plan for its leaseholds in the Haynesville Shale, but Wall Street was only expecting the company to earn $3.50 in both 2008 and 2009, which seemed way too conservative.

Since then estimates have increased to over $4 per share, which is closer to reality, and CHK stock soared from $47 in late March to north of $70 on July 2nd. Such a large move in the stock was prompted by two events; a sharp move in natural gas prices to above $13, but more importantly, Chesapeake’s announcement on July 1st that it had successfully monetized its Haynesville Shale acreage.

Under a joint venture with Plains Exploration (PXP), Chesapeake will sell a 20% stake in its Haynesville Shale acreage (440,000 acres) for $1.65 billion in cash. Not only that, but PXP has also agreed to pay 50% of the development costs for the remaining 80% of the play (which CHK owns), up to an additional $1.65 billion. As a result, Chesapeake is swapping a 20% economic interest in the Haynesville shale for $3.3 billion, with half of the cash paid upfront, and the other half over the course of several years as the land is developed.

Considering that the Haynesville Shale was not even on investors’ radar screens earlier this year, this deal is pretty astonishing. The Haynesville represents only 3% of CHK’s net acreage, 0.3% of the company’s proved reserves, and 21% of the company’s risked reserves (proved reserves plus risked, unproved reserves), but the Plains joint venture values Chesapeake’s Haynesville acreage at $16.5 billion.

That is especially impressive because even at the all-time high of $74 per share, Chesapeake’s equity market value was only about $40 billion. Not surprisingly, those highs were achieved the day after the PXP joint venture was announced.

Over the last few weeks, however, natural gas prices have fallen from $13 to $10 per mcf. As I have written about many times before, CHK shares track gas prices in the short term despite the fact that the company hedges most of its production, thereby insulating it from the volatility of the near term spot market. As a result, CHK shares have fallen from the July 2nd intraday high of $74 to a closing price of $47 on Wednesday.

Is such a move down warranted, especially given the recent Haynesville announcement? Well, Chesapeake has hedged 81% of their remaining 2008 production and 54% of their 2009 production. I would have to say July 2008 prices really have little impact on CHK’s financial performance. Still, traders will use the stock as one of their main natural gas trading vehicles, so investors need to live with this price action.

For those who are bullish on natural gas and are fans of Chesapeake, but missed getting in on the stock as an investment, short term market fluctuations have once again provided you a chance to purchase shares for 36% less than their level three weeks ago. CHK’s market value is now only $25 billion, versus an implied valuation of more than $16 billion just for the company’s Haynesville Shale acreage. Given that single play represents only a fraction of Chesapeake’s natural gas assets, this recent collapse in stock price appears to be another case of stock market short term irrationality.

Full Disclosure: Long shares of CHK at the time of writing

Illustrating the Bullish Case for Oil

Those of you who follow the oil markets know that a core bullish argument for rising oil prices over the long term is the growth in demand from overseas, most notably China and India. Those two countries alone represent 36% of the world population, so if their demand rises steadily, the logic goes, lower oil prices are a tough accomplishment.

On Monday a very telling statistic mentioned on CNBC caught my eye. I did not catch the source of the data, so we will have to assume it is correct, but take a look at this:

Barrels of Oil Consumed Per Person, Per Year:

United States: (25) Japan: (14) China: (2) India: (1)

Barring huge oil discoveries in coming decades (highly unlikely) or a dramatic shift to alternative fuels (more likely, but by no means assured), imagine where oil would trade if China and India reach 5-10 barrels of oil consumption per person annually.

As for a more short term view, I have been taking some profits in oil-producing stocks lately. The sudden move to the high 130’s per barrel makes me think the risk-reward trade-off is more balanced now. The next $20 move could be in either direction pretty easily (up if we have a bad hurricane season, or down if it is mild and we get a common correction) and the recent leg higher looks a little extended to me (see the chart of the U.S. Oil Fund ETF (USO) below).

I am not getting into the short term energy price prediction game, but I think taking some profits is a good idea after such a big move, as that matches my investing discipline. Long term, it is pretty hard to justify selling large blocks of energy stocks given that we can look at numbers such as those above and see that without dramatic change, the oil bull market remains intact.

Full Disclosure: No position in USO at the time of writing

Would Offshore Drilling Bring Down Gas Prices?

With gasoline prices nationally surpassing $4.00 per gallon, politicians are revisiting the idea of allowing oil companies to drill off the coasts of the continental U.S. as well as the National Wildlife Refuge in Alaska.

Alaska is probably not going to happen for environmental reasons, but what about the idea of allowing the states to decide if they want to allow offshore drilling in their areas or not? I think that plan has some merit, since it takes into consideration the potential negative impact on tourism and other issues in certain areas. States that feel the benefit will be outweighed by the costs can take a pass, but other states can allow it if they see fit. Localized decision making on this issue seems better than a federal mandate.

That said, just how much benefit would be gained from such drilling? Unfortunately, not much.

From the AP:

“The 574 million acres of federal coastal water that are off-limits are believed to hold nearly 18 billion barrels of undiscovered, recoverable oil and 77 trillion cubic feet of natural gas, according to the Interior Department.”

If we assume it will take 5 years to get the first drop of oil out of the ground and into our gas tanks, that the fields discovered have a useful life of 20 or 30 years from that point, and that we will be able to collect every single barrel of oil that is projected to be there (not a certainty by any means), we are looking at an incremental increase in domestic production of ~700 million barrels per year, on average. The U.S. is expected to consumer 7.45 billion barrels of oil in 2008, so 700 million represents about 9% of our consumption.

Given that world demand for oil is rising so much, the offshore oil we may be able to drill out of the ground would have little impact on gas prices because the oil market is a worldwide exchange. If we just had a U.S. oil market, then yes, it would have a decent impact, but that is simply not the case.

As a result, it is hard to see how more offshore drilling would impact gas prices at the pump in any measurable way. Even if world oil consumption was held constant, we could potentially increase global supply by about 2%. An equal drop in price would bring $4.09 gasoline down to $4.00 per gallon. It just does not help solve the real problem.

That said, it would certainly prevent our energy dollars from being shipped to the Middle Eastern oil-rich countries, so we could keep that money here. Of course, that means our oil companies in the U.S. will make even more money than they are right now, and people are already complaining about record profits for the energy industry even without offshore drilling.

Honda Previews Future of Compact Vehicles

It will take time, but this kind of introduction shows we do have the ability to transform our domestic vehicle fleet in order to greatly reduce oil consumption from transportation, which represents the vast majority of our energy use. As 5% of the world’s population using 25% of the world’s oil, even a 10 or 20 percent drop in our consumption would meaningfully impact the global supply and demand picture for crude oil, which is hitting new highs today at nearly $140 per barrel.

From the Associated Press:

Honda rolls out new zero-emission car
Monday June 16

TAKANEZAWA, Japan (AP) — Honda’s new zero-emission, hydrogen fuel cell car rolled off a Japanese production line Monday and is headed to Southern California, where Hollywood is already abuzz over the latest splash in green motoring.

The FCX Clarity, which runs on hydrogen and electricity, emits only water and none of the noxious fumes believed to induce global warming. It is also two times more energy efficient than a gas-electric hybrid and three times that of a standard gasoline-powered car, the company says.

Japan’s third biggest automaker expects to lease out a “few dozen” units this year and about 200 units within three years. In California, a three-year lease will run $600 a month, which includes maintenance and collision coverage.

The fuel cell draws on energy synthesized through a chemical reaction between hydrogen gas and oxygen in the air, and a lithium-ion battery pack provides supplemental power. The FCX Clarity has a range of about 270-miles per tank with hydrogen consumption equivalent to 74 miles per gallon, according to the carmaker.

The 3,600-pound vehicle can reach speeds up to 100 miles per hour.

John Mendel, executive vice president of America Honda Motor Co., said at a morning ceremony it was “an especially significant day for American Honda as we plant firm footsteps toward the mainstreaming of fuel cell cars.”

The biggest obstacles standing in the way of wider adoption of fuel cell vehicles are cost and the dearth of hydrogen fuel stations. For the Clarity’s release in California, Honda said it received 50,000 applications through its website but could only consider those living near stations in Torrance, Santa Monica and Irvine.

Initially, however, the Clarity will go only to a chosen few starting July and then launch in Japan this fall.

Spallino, who currently drives Honda’s older FCX and was also flown in for the ceremony, said he will use the Clarity to drive to and from work and for destinations within the Los Angeles area. The small number of hydrogen fuel stations is the “single limiting factor” for fuel cell vehicles, he said.

“It’s more comfortable, and it handles well,” said Spallino of Redondo Beach. “It’s got everything. You’re not sacrificing anything except range.”


$130 Oil Leads to Irrational Moves at American Airlines

With oil prices surpassing $132 per barrel today for the first time ever, American Airlines (AMR) has reacted by raising prices. Most notably the airline will charge travelers $15 to check a bag. The company calls this a “revenue growth initiative” in their press release, but it is really just silly. When high fuel prices are pressuring an already bloated cost structure and a weak economy is reducing air travel, price increases are not going to help AMR. It simply does not address the problem.

In such a competitive industry, weak players increasing fees will only result in more people going to discount airlines, which are run far better than their larger counterparts. There is a reason Southwest Airlines (LUV) has been taking market share and has never lost money in any year since its founding more than three decades ago and it is not because they started to charge their customers for things like checking baggage. In fact, they have used those boneheaded ideas in their brilliant marketing campaigns:

The problem for AMR and the rest of the airlines that go bankrupt every five or ten years (this time will be no different) is that they rarely directly tackle the problems that are causing them to bleed red ink. Raising prices in a price sensitive industry reduces revenue and does nothing to address bloated costs. The airlines need to get their costs in line with their revenues. It is not rocket science; Southwest and JetBlue (JBLU) have done wonderfully over the years.

The AMR story is not very much different than the management of our federal government lately. Gas prices are crippling lower class Americans? Okay, then we will give them tax rebate checks and tell them to go out and spend that money on $4 gasoline. How does that solve the problem? As Dr. Phil would say, “money problems are not solved with more money.”

All the government is doing is paying us to buy gas when buying gas is exactly what is causing fuel prices to be so high in the first place. We are sending money straight to the oil executives and the nations who export their oil to us. This transfer of wealth, both from poor to rich and from the U.S. to the oil producing nations, doesn’t even begin to address the energy problems we face. As 5% of the world’s population using 25% of the world’s oil, paying our citizens to buy gas is the last thing we need.

As long as these are the things that AMR and the government are doing about sky-high oil prices, the investment strategy is not very difficult to pin down: stay long oil producers, foreign currencies, and the rich and stay short the airlines, the dollar, and the poor.

Full Disclosure: No positions in the companies mentioned at the time of writing