Natural gas prices getting slaughtered

The “discovery” of economical shale gas mining has done an extraordinary job of depressing natural gas prices since the price shock of 2008:

It is noted that the spread between crude oil and natural gas prices have reached an all-time divergence, but this is likely to be temporary – it will just be a matter of time before the laws of supply and demand force effective conversion between the two commodities. For example, it makes it more economical to use a higher natural gas input to achieve an output of crude given the price spread. Activities such as tar sands mining are very intense on natural gas (to generate steam) and as a result, the market should equalize over time.

One of the worst ways of playing natural gas is by purchasing a Natural Gas ETF (UNG), as it does not actually hold the physical commodity – traders will eat away at the fund when it has to rollover its futures contracts. Even purchasing calling options or the futures directly still exposes you individually to rollover risk. You could buy long-dated futures, but there is very little liquidity in the marketplace and you pay a significant premium, as the market is anticipating future price increases.

The only real way for people to play natural gas on a long-term basis are to purchase producers with considerable reserves. Which producers to pick is a matter of risk tolerance and market pricing. Typically if an investor wishes to be fancy, they would ideally pick a producer that has a marginal cost structure such that the cost to produce natural gas is that of the present market price; such a company will be losing significant amounts of money and will be trading at depressed valuations. Assuming this is the case and assuming the market has significantly marked down the equity in such a money-losing company, it is a very speculative way of playing for a natural gas price increase.

This principle also works with any other commodity on the planet – including crude oil and gold companies. Again, it depends on doing your homework with respect to valuations and knowing what value you are receiving when you put in the order for shares.

A more conservative strategy and one that relies on other market participants to have done their homework to receive a fair price is to purchase shares in EnCana or Canadian Natural Resources, which are the top two natural gas producers in Canada. After the split-up of EnCana and Cenovus, EnCana is a much more “pure play” on natural gas than Canadian Natural Resources. With either company you will not see your money double over the course of a year or two, but it will certainly be there at the end of the day and also provides a bit of comfort with respect to inflation-proofing a portfolio. Despite all of the media and political attention paid to carbon emissions, it is a given that natural gas and crude oil continue to be consumed in massive quantities for the foreseeable future. The only promise is that, over the long run, it will get more expensive.

Canadian Taxes – Waiting for the T3

Anybody invested in income trusts should know that the T3 slip, a statement of income from trusts, is required for applicable trust holders by March 31 of every year. This is usually the last tax form to come in, and it will explain how much income (and what type of income) you received over the year.

The reason why the T3 slip comes so late is to give trusts sufficient time to finalize (and audit) their financial statements for the fiscal year.

Impatient investors that want to get cracking at their personal income taxes, however, can go to CDS Innovations’ website and get a sneak preview of most publicly traded entities’ allocation of income. T3 statements for the 2009 tax year can be found here. Just note, in theory, a trust can change the reported allocation on March 30, 2010 and one should never submit their income tax return using the preliminary data.

Modern Finance – The risking of the risk-free rate

There will be a huge quantum shift coming in the financial markets, and this is mostly inspired by the fiscal mess that countries such as the United Kingdom and the United States will be facing in the medium term future.

It has to do with the concept of the “risk-free rate”. Most formulas in finance reference the US government bond or Eurodollar (essentially an interbank short term interest rate) as the “risk-free rate”, where all other financial securities are referenced from. So if the 5-year US government bond is trading at a 2.5% yield and General Electric issues 5-year debt at 3.2%, typically the financial literature would state that the bonds were sold at 70 basis points over. The spread of yield, rather than the absolute yield itself has typically been the market benchmark in determining how creditworthy a corporate issue is.

This is going to change, mainly because the risks inherent in the reference securities will be significant to the point that it will start to distort the concept of the spread.

It is very unlikely that the US government will default on their debt; instead, the road to their fiscal recovery will lie upon debasing their currency. An investor in General Electric would still face the same inflation risk as an investor in US government securities; however, the big difference in modern finance is that an investor can hedge their currency risk and solely take on the default risk of the security.

As a result, it will increasingly be seen that corporate bonds will be trading at lower yields than their government counterparts under the belief that the market thinks the corporation is more likely to pay off its investors than the government.

Thus, the finance variable of the risk-free rate must not be solely relied upon – just as how Newton’s Laws become unreliable when dealing with objects that are close to the speed of light, the risk-free rate becomes unreliable when sovereign defaults start becoming non-zero possibilities.

Quantitative traders that fail to adjust for this in their models will end up losing a lot of money for their clients.

Paying attention to debt call features

Rogers Sugar Income Fund announced yesterday a bought deal – they were issuing $50M in convertible debt. The salient part of their press release was the following:

The net proceeds of the offering will be used to redeem all of the outstanding $50 million principal amount 6.0% convertible unsecured subordinated debentures of the Fund due June 29, 2012. The redemption is intended to take place on or about June 29, 2010.

The $50M currently outstanding trades as RSI.DB.A. It had a maturity of June 2012, coupon of 6% and a conversion feature at $5.30/unit – before this announcement, the debt was trading very thinly at a price of 103-104. This implies a 4.1-4.5% yield, plus the option premium on conversion. The proper valuation of the debt actually is not a trivial issue considering you have to make some complex calculations with respect to the convertible option – Black Scholes will not cut it in this case.

In any event, Rogers Sugar refinanced the debt. The June 2012 debt also contains a call option, where the company can call the debt, as per the prospectus:

On or after June 29, 2010, the Debentures will be redeemable prior to Maturity in whole or in part from time to time at the option of the Fund on not more than 60 days and not less than 30 days prior notice at a price equal to the principal amount thereof plus accrued and unpaid interest.

So in other words, debt that was trading between 103-104 on March 18, 2010 will be redeemed at a price of 100 by the company on June 29, 2010.

Not surprisingly, the debt now is trading with a bid/ask of 101.75/102.00 and the only reason why this is above 100 is purely due to the value of a three month option with a strike price of $5.30/unit embedded in the debt. Debt purchased at 102 actually has a negative 0.5% yield when you factor in the call that will occur on June 29, 2010.

Investors would be very well to take note of any embedded call features in the debentures they purchase – especially if they are purchasing the debt for over par value.

The new debt issue of Rogers Sugar has a 7 year maturity and is 2.7% above government bond rates (coupon 5.7%; government 7-year benchmark is 2.96%), which is represents a rather cheap medium-term financing for the company. The $6.50/unit call premium is about 35% above market value and thus would minimize any dilution in the unlikely event that Rogers Sugar actually trades that high and thus the coupon cost is lower. I would have preferred that management lower the conversion rate to about $6.00/unit and have a smaller coupon on the debt, however.

Vancouver Real Estate – Cultural Factors

Just reading this post out of the Vancouver Real Estate Anecdote Archive:

Vancouver has the highest percentage of young adults by government definitions (18-30) living at home in Canada. Much of this is cultural, where members in certain communities (Asian, East Indian just like Greeks and Italians in Toronto) do not leave home until they are married as renting is a huge waste of money in their eyes. When you leave at home for a couple years, it is very easy to accumulate a large DP when you have no expenses (someone making 30k living at home is much better off than someone making 60K having to rent). Factor in that 40% of the city is made up of primarily two ethnic minorities, and that people are getting married later, you have a situation where FTBS come to the table with very very large DPS that more than offset the high cost of houses. The do not need massive salaries to afford their homes…

[DP = Down payment, FTB = First Time Buyer]

I referred to the “Cultural Factor” as being a relevant determinant in terms of the expensive Vancouver real estate market.

I don’t think it is the “live at home” factor that accounts for a latent demand factor in Vancouver Real Estate valuations – looking at the demographic bulge would suggest that there are relatively less people of the domestic 18-30 year bracket that would be moving into their own dwellings, compared to the people coming in (immigration factor).

I do think that having a very heavy Chinese ethnic component in the Lower Mainland is a significant cultural demand component – I don’t think any other culture values real estate and education as highly as people having Chinese origins. Combine this with the perception of price stability (compared to the amount of money lost in the stock market) and it creates demand for an asset class that is perceived to be a “sure thing”.

My rational framework (which is not at all supposed to model real life reality) suggests Vancouver real estate is over-valued around 40%. But the famous quote, “the market’s ability to remain irrational longer than your ability to remain solvent” always applies, especially with real estate.

Stocks and Politics – TennIndependent

I am linking to some fellow named TennIndependent, who resides in Brentwood, Tennessee, USA.

He seemingly has a portfolio that has a billion stocks in it, but his writings are strangely both coherent and incoherent at the same time, but I like his scatter-brained logic and how he knows he writes as such (which he equates to his “left brain” and “right brain”).

Most notably is that he is probably one of the few amateurs on the internet that I know of that invests in Trust Preferreds.

First Uranium raises expensive capital

The financial soap opera continues at First Uranium. On Friday morning they announced they have agreed to a private placement of between $125 to $150 million of senior secured notes. There are a bunch of stakeholders that are getting into this offer, including the major shareholder, Simmer and Jack, and also Gold Wheaton, who has a stake in the gold production of First Uranium.

The notes are convertible at $1.30/share and this will represent a substantial amount of dilution for existing equity holders, assuming conversion – about 48% dilution.

I was informed that the notes will have a 7% coupon attached to them.

Also in the announcement is that the CEO, Gordon Miller, will depart and be replaced by another CEO, Deon van der Mescht, who is currently the CEO of Simmer and Jack.

A relevant quotation is the following:

In addition, the Company is relying upon exemptions from the minority approval and valuation requirements of Multilateral Instrument 61-101 – Protection of Minority Security Holders in Special Transactions, on the basis of financial hardship. The Company’s current payables do not, in the Company’s estimation provide comfort to wait for 21 days to begin closing the Offering. As previously announced, the Company’s financial situation has been severely compromised by the termination of discussions regarding certain financing options as a result of the decision to withdraw and subsequently reinstate the Company’s environmental authorization for the new Tailings Storage Facility designed to accommodate future tailings deposition at the Company’s Mine Waste Solutions tailings recovery project.

First Uranium, therefore, is very close to bankruptcy. If this deal falls through, then bankruptcy is guaranteed. There would be a process where creditors (including the debentureholders) will be able to make their claim on the assets in accordance with Canadian law. Simmer and Jack’s investment would have been completely destroyed in the process, which is why they had to take this very unpalatable deal in order to save their interest in the company – which by all means should be able to produce a substantial amount of revenues once the core operation commences.

If you are holding equity in First Uranium, you have virtually lost most of your value over the past couple years. This deal should probably stop most of the blood-letting, but it is at a huge cost to shareholders.

The market, seeing certainty on the horizon, bidded up First Uranium shares 13% to $1.68. This also provides a substantial conversion cushion for the private placement component of the convertible offering to succeed.

The convertible debentures also rose 12% to 77 cents on the dollar with this news. The convertible debentures are a $150M issue, with a 4.25% coupon and maturing on June 2012. I happen to own some of these and am not afraid of dilution – in fact, I prefer dilution.

If this deal succeeds, it is more likely that I will receive payback on my investment, especially since the maturity date of this new deal is later than the existing convertibles. It is not clear, without reading some sort of prospectus statement, whether the secured nature of these new notes would interfere with the payment of the unsecured debentures.

Of note in this press release is no quotations from any officers in question – probably because this deal was entirely organized without the management of First Uranium consenting to it.

Morneau Sobeco Income Trust announces corporate conversion

Morneau Sobeco specializes in outsourcing HR services. They have an annualized distribution of $0.94/unit, but they recently announced a corporate conversion which will take effect in 2011:

“Today, we are announcing our plans to convert to a corporation at the end of 2010,” said Bill Morneau, Executive Chairman of the Fund. “We intend to maintain our current distribution level for 2010 and provide an effective 10.6% after-tax increase in 2011 for unitholders taxable at the highest marginal rate.”

The conversion is being undertaken in response to the legislative changes enacted by the federal government that will apply a tax at the income trust level on unitholder distributions commencing January 1, 2011. The current monthly distribution level of $0.07871 per unit (or $0.94 per unit annualized) is expected to remain unchanged for the balance of 2010. Starting in January 2011, the monthly dividend level is expected to be $0.065 per share (or $0.78 per share annualized) with a sustainable payout ratio of 65% to 80% of cash flow. This dividend policy will facilitate the repayment of debt, while providing investors with an attractive yield. Going forward, the Fund’s intention is to continue to reward its investors with dividends in line with business performance. A special meeting of unitholders will be held in the second half of 2010 to obtain unitholder approval of the conversion.

A 94 cent to 78 cent reduction in distribution is a 17% decrease in distributions, and is somewhat less than what would otherwise be expected on an after-tax basis. It is not surprising that trust units are not trading too far down – about 3% at the time of this writing.

My valuation exercise on the company indicated they are trading at their fair value range, so I have not even bothered to place any orders for the units. The units are trading at $10.19 a pop, which is a 9.22% yield on their current distribution, or 7.65% in 2011. Given the risk involved, this is appropriate.

Toyota Motors Company – Will not touch

Anybody having common shares of Toyota Motors may think they are purchasing to be a “contrarian” with all of the allegations flying around with respect to their accelerator pedal and perceived safety issues of cars. Looking at a 5-year stock chart, one might think they are catching the lows (currently $77/share)…

… but what really is the upside to an investor? I recall during the ramp-up in oil prices and the downfall of GM and Chrysler (2007-2008) that analysts were jumping all over themselves to compliment Toyota and implying the company is destined to greatness.

Auto manufacturing, at least at the low end consumer market, is a very competitive business and margins are very tight. When companies like Toyota have to end up recalling millions of vehicles because of a politically-motivated examination of perceived safety flaws of their vehicles (I am of the opinion that it is far more likely that for most part the company did not design a ‘flawed’ vehicle), it will affect their market capitalization far more than the recent 15% haircut their stock has taken. They are more likely to head down than up.

I have written this without doing a shred of financial analysis on the company – Toyota stock is being psychologically valued at this time by the marketplace, not financially.