Exxon (XOM) and XTO: A Bold Vote for… the Status Quo
Exxon Mobil’s (XOM) blockbuster $40+ billion acquisition deal to buy natural gas producer XTO Energy (XTO) immediately raised questions about whether it was a signal nat gas is the future primary energy source for America. Exxon’s management team made it clear that the XTO deal was done with a long-term time horizon and is not meant to be judged on the basis of 2010 earnings accretion or dilution. This perspective is helpful because nat gas producers have many near-term earnings headwinds as their production hedges roll off in 2010; a nearly $2/mcf difference exists between spot prices and where XTO has, on average, hedged half of their scheduled 2010 production. When faced with the reality that future realized prices could be much lower (say, $5.50/mcf vs. $7.50/mcf from lucky hedges), producers needing to show earnings growth will have to produce much greater amounts of nat gas, leading to excess supply and lower prices – a situation that’s tough to break out of.
The sheer size of the transaction lends some weight to the idea that Exxon sees domestic nat gas sources as a valuable transition fuel, perhaps a decade out, but that does not lead to the conclusion that nat gas prices are going to soar. Whatever major sources of energy America uses as a country have always been cheap and readily accessible – something I call “Say’s Law of Natural Gas.” Say’s Law, the idea that supply creates its own demand, means that the over-supply of natural gas at present is keeping prices low, but it will eventually lead to incremental new demand for the fuel, and the friction costs of switching fuel sources will lead to future price inelastic demand for nat gas.
The better comparison than oil vs. nat gas could be the implications for the integrated major business model. Exxon Mobil is proverbially doubling down on that concept with this acquisition, while a company like ConocoPhillips (COP) has stated that the former advantages of the integrated major model are no longer attractive, and it will slowly be shrinking in size. By investing in new reserves rather than buying back its own, Exxon is casting its lot that the status quo – fossil fuels being essential to American energy consumption – will persist for some time.
Other potential nat gas-producing acquisition targets have been fairly well hashed out – Chesapeke (CHK), Devon (DVN), Anadarko (APC), EnCana (ECA), Range Resources (RRC), Petrohawk (HK), Ultra (UPL), and Southwestern (SWN). Funds I co-manage own UPL, as well as XOM.
Dubai, Risk Assets, and the Liquidity Illusion Redux
Is there a way to make money, on the long or short side, from the quasi-sovereign debt issues in Dubai? Because the situation has already broken and isn’t generally accessible to individual investors, there’s a more worthwhile path to consider than trying to short a bank with UAE exposure (which tends to be relatively small in concentration for global banks) – and that’s understanding the signals being sent.
In general, it’s a sharp reminder that credit risk is real, especially unconventional investments in emerging markets. That should give pause to the risk asset rally that has dominated discussion for the majority of 2009, an event that has clouded the perceptions of what safe haven assets are. What bounced on the news? The U.S. dollar (UUP). What “safe haven” sold off? Gold (GLD). I understand the appeal of gold, but am skeptical of its ability to be a true store of value in times of crisis. The “hard sell” many goldbugs, and TV advertisements, give on the usefulness of the metal should be another red flag; good assets are bought and not sold.
The bullet-point story isn’t always accurate – consider liquidity, which is the de facto explanation for the surge in asset prices this year. The last time we heard about an overabundance of liquidity was 2007, when the private equity bubble topped out; one year later we had a liquidity crisis. Liquidity disappears in times of market stress, and the source or cause of stress is not predictable. In other words, liquidity does not create a sustainable rally, it’s a short-term technical factor… and although it might be a significant driver of trading, it is imprudent to rely on liquidity to continue driving prices higher, just as it would be to expect a marginal company to always have access to financing.
The Dubai story, at its heart, is one of uneconomical activity. We are guilty of our fair share of that in America, but Dubai’s existence was predicated on the ability to defy nature through aggressive debt-financed building, and it seems the costs have not been fully considered. I’m not sure what value lies in Dubai, because it has higher structural costs than other locations because of its geography and environment, but combining poor economics with a lack of respect for shareholder rights is a recipe for disaster – understand what you own, and make sure your ownership rights are secure.
Quality Large-Cap Retail is Best Portfolio Stocking Stuffer
Christmas is coming, and that means two sets of flurries are on the horizon – snow and retail news. Now that the aftershocks of the 2008 financial collapse have had time to set in, this year will be a test to see how resilient consumers are in spending for the holidays. Retailers, for their part, have been preparing by slimming down; most are carrying record low levels of inventories to avoid the need for post-rush markdowns. But as the fundamentals are uncertain, retail stocks have been rallying with the rest of the market – the Retail HOLDRs ETF (RTH) is less than 13% off its all-time high in July 2007, led by large allocations to Wal-Mart (WMT), Home Depot (HD), Target (TGT), and Walgreen’s (WAG).
Large-cap, diversified retailers lack the appeal of a growing niche apparel company, for instance, but in many cases they look to be safer bets with decent upside in a market that’s looking increasingly overextended. Wal-Mart and Home Depot attract my attention with relatively stronger moats for the retail industry and a consistent history of posting ROEs in the double-digits, and although they trade at higher earnings multiples than a company like GameStop (GME), I believe the sustainability of earnings favors the stodgier retailers. Earlier this year, investment funds that I co-manage (BCIC) sold GameStop stock on a belief that it is a value trap with illusory single-digit forward earnings multiples, as competition for video game sales increases, and video game makers look to connect directly with consumers and disintermediate brick-and-mortar stores. That stock is down 15% in the last week and is close to its 52-week low, one of the exceptions in a market that is making new 52-week highs.
There will be plenty of news on short-term sales trends involving consumer spending in the month of December, but there might be limited comparability with past years because the paradigm may have shifted in this newly frugal economy. If you’re going to play with retail stocks, then, stay high quality and go with solidly entrenched middlemen. Bed Bath & Beyond (BBBY) is one retailer more off the beaten path that also fits that definition – a differentiated inventory strategy, improved pricing power after the Linens ‘n Things bankruptcy, and a modest valuation – and I’m happy BCIC owns it.
On the apparel front, Goldman Sachs (GS) analysts believe the sweater will be the go-to gift of 2009; while apparel is admittedly not my specialty, BCIC recently established a position in Ralph Lauren (RL).