Fertilizer Bulls Ignoring Planting Cycles

Over the last several weeks, I have read countless analyst reports, news articles and blog entries that have all tried to make the case that the earnings of the fertilizer companies are all set to soar.  The investment thesis proposed by these authors revolves around surging world demand and the recent flooding in the Midwest.  While the flooding has been tragic, fertilizer bulls have argued that the flooding will act as a catalyst for companies such as Monsanto (MON) and Potash Corp. (POT). 

These traders are speculating that farmers will choose to replant their crops in an effort to cash in on surging commodity prices and that to achieve these results they will be forced to relay on tremendous amounts of fertilizer to ensure adequate crop yields.  Given the current supply and demand imbalance in the food markets I have no doubt that the long term thesis for fertilizer stocks is correct; however, in the short term I believe that the fertilizer bulls are mistaken as they are ignoring the basic planting cycles for corn and soybeans.  It is my opinion that it is simply to late for farmers to replant in an economic manner.         

According to the Iowa State extension office the optimum time to plant corn is between April 20^th and May 10^th.  The longer that one delays planting, or takes to replant, the dramatically lower the crop yield will be.  While Fertilizers may help support late plantings, there comes a point where the cost-benefit equation is decidedly against farmers.  I believe we are very close to that point.  After all, we must remember that farmers are some of the most subsidized Americans and the most recent farm bill is but another example of the strong support that farmers have on Capital Hill.  Even if they do not replant they are guaranteed a significant amount of replacement income, that is for some tied to the prices of the crops they would have produced.  Since this is the case, I see no reason for farmers to spend additional money on fertilizer products when they can simply collect from the government at the end of the year.  Below is an interesting chart on corn yields matched up against the planting date.  When looking at the chart it is important to remember that it is nearly July and the ground is still wet.  

Those who farm soybeans are in a similar predicament.  According to the Iowa State extension office the optimum time to plant soybeans is between April 25^th and May 5^th.  Much like corn yields, the yield for soybeans declines dramatically the further into the summer you get.  Soybean crops will be at a great disadvantage then corn crops this summer because they are more finicky and tend to perform poorly in saturated soils and when this occurs disease in the seedlings can run rampant.  Below you will notice that the soybeans chart is quite similar to that of corn.    

Even with high crop prices, I do not believe that the market incentives for growing corn and soybeans are enough to outweigh the risks of replanting this late in the season.  There is simply not enough time left, especially when you can avoid the cost of fertilizer and other inputs and the inherent risks of planting by accepting government subsidy payments.

For Further Review:

Iowa State Extension Office

Disclosure: None

Insider's Showing Faith in Resource America

In my previous article, which can be found here, I detailed why I believe that Resource America (REXI) is extremely undervalued.  Since that article, there have been two developments that have reinforced my belief that Resource America represents the chance to own a company that will without a doubt outperform the broader market in the years to come. 

First, on 6/18 both Resource America’s chairman and Resource America’s CEO each bought $1.5 million shares of Resource America in the open market.  This brings the total value of shares purchased by insiders to over $3.75 million since March of 2008.  Resource America’s chairman and Resource America’s CEO now own close to 15% of the entire company.  This kind of insider activity would be significant under any circumstances.  However, it is even more significant in Resource America’s case because it is happening during the midst of a severe contraction in the credit market.

When Edward Cohen became Resource America’s CEO in 1988, Resource America was a tiny company with only $18 million in assets.   Edward Cohen built both Resource America and Atlas America (ATLS), which I talked about here, from the ground up and created unbelievable returns for Resource America’s shareholders.  Edward’s son Jonathan, who is now Resource America’s CEO, has also been involved with Resource America for years.  You can bet that Edward and Jonathan Cohen know Resource America like the back of their own hands.  If they are willing to put even more of their own money into Resource America at $9 then so am I.

The second recent development was the liquidation of the rest of Spencer Capital’s position in Resource America on 6/18.  Resource America traded almost 2 million shares that day well above its typical volume of 100 thousand shares.  As I talked about in my last article, Spencer Capital has been slowly liquidating its large position in Resource America for months as Spencer Capital’s fund has been shrinking.  Spencer Capital’s liquidation has likely been a significant reason for the drop in Resource America’s share price over the last several months.  The recent liquidation removes the fear of the Spencer liquidation causing further price drops.  Interestingly, Spencer Capital liquidated over 1.7 million shares on the same day that Resource America’s two most involved insiders stepped up to the plate with their own large share purchases.  It looks like Ed and Jonathan were in communication with Spencer Capital and helped arrange transactions where Spencer Capital could liquidate its entire position on one day without a substantial drop in Resource America’s share price.  Spencer Capital sold over 1.7 million shares on 6/18 whereas Ed and Jonathan only bought about 330 thousand shares.  It looks like Ed and Jonathan worked with Spencer Capital to find buyers for Spencer Capital’s entire position.   So, who else could have bought the rest of Spencer Capital’s position?  One possibility is Resource America, as the company approved a $50 million share repurchase plan a few quarters ago that has so far gone unused.  It would not surprise me at all to see in the next quarterly report that Resource America repurchased the remaining Spencer Capital position representing about 7.5% of its total shares outstanding on 6/18.

Management is clearly aware of the profound value in the company’s shares.  The recent closure of an additional $280 million for the company’s LEAF Financial division only highlights management’s ability to succeed in difficult times.  The upcoming IPO of RAI Acquisition, a blank check company sponsored by Resource America, should provide a catalyst for the stock during the second half of the year as the company will have the financial ability to make incredibly profitable deals in the currently distressed market.  

Disclosure: Long REXI 

China Cuts Subsidies, is a Pullback in Oil Next?

I have talked a little bit over the last several weeks about my thoughts on speculation in the oil market and the very real supply & demand imbalance that exists.  While it is clear that oil consumption in the U.S. is beginning to slow the main driver in the increase in the price of oil and other commodities over the last several years has been the ever-increasing level of consumption in the developing world.  China’s consumption of oil alone is probably one of the most important factors in the oil market right now.  That is my I was fascinated by Thursday’s announcement that the Chinese government was going to increase gasoline prices by 17%, diesel prices by 18% and jet fuel prices by 25%.  Other types of fixed energy prices will also be increasing as the Chinese government attempts to fight runaway consumption and an overheating economy.  

Such an action could cause a short-term reversal in the energy markets that could potentially be exasperated by all the fast money that is currently awash in oil contracts.  In the long run, Chinese growth will likely overcome any decreases in consumption that is tied to any further increases in the price of gasoline.  As a result, I would be a buyer of oil and gas related sectors on any significant pullback.     

The Chinese government’s announcement is tied to the fact that it subsidizes the country’s energy expenses.  Many countries worldwide subsidize their gasoline prices and as a result, consumers in these countries do not have the same incentive to conserve that consumers in the U.S. and Europe have.  When consumers do not have to pay higher prices, due to artificial price controls, consumers will not conserve and as a result we are all worse off.   That is why the move by the Chinese government should be applauded as it is forcing the Chinese consumers to begin to start to pay for the replacement cost for the products that they use.  Below is a little chart I stumbled across on the various degrees of gasolines subsidies across the world.  It is rather interesting and shows how many other countries will need to either end or reduce subsidies before any global slow down in oil consumption can even be considered.       

Looking at Oil's Supply and Demand

In recent weeks, there has been widespread speculation on the reason for the most recent incredible rise in the price of oil.  Speculation by hedge funds is one reason given while buying by index funds is another possible reason.  Finally, some people believe that there are fundamental supply and demand factors driving the rise in the oil price.  While I do believe that the energy markets have been pushed around to a degree by their participants, as I discussed here, I wanted to make it clear that I believe that there is currently a significant demand/supply imbalance. 

To begin, I will say that speculation likely does have an impact on prices in the short term but over a long period of time speculators will make or lose money depending on how fundamental supply and demand factors play out.  Speculators may frequently overestimate or underestimate where prices should be causing increased volatility but in the long term the impact on prices caused by speculators should be negligible.  

While we all want to pay less at the pump, higher prices in the short run are beneficial to long term supplies as they help to close the gap between supply and demand that exists at lower prices.  Higher prices cause people to reduce their consumption of oil which saves more oil for the future when supplies are expected to be insufficient.  Higher prices also entice producers to make the investments needed to expand production.  If prices are too low for too long a shortage will undoubtedly develop throwing a terrible wrench into the world's economy. 

The reason that the price of oil is rising and will continue to rise in the long term is simple.  The market expects that there will not be enough oil available in the future if prices are anywhere significantly below current levels.  The price level that is needed to bring supply and demand into balance will continue to change and could drop if enough supply comes online in the future.  Of course, the world will eventually run out of oil since oil is not a renewable resource.  However, for right now it appears that only the most low cost oil reserves have been exploited and that most of these low cost reserves are as a result beginning to decline.  There are many areas worldwide that can still be drilled or mined to produce more oil.  

Most of these areas are however in hostile environments or require expensive recovery techniques that make the processes unviable at lower prices.  Given some time and consistently higher prices, we can expect more high cost oil production to come online.  However, it will take years before a large amount of high cost reserves can provide significant production to help relieve the current supply demand imbalance in world oil markets.  Worldwide oil production has barely risen since the middle of 2004.  Meanwhile oil demand seems to be rising at an increasing rate as developing countries such as China and India rapidly increase their consumption.  If the slow down in the U.S. economy does not affect China and India significantly there is really no way for oil to move significantly down over the longer term.  

The first part of the puzzle is that worldwide oil production has barely risen since the middle of 2004.  This is because the number of low cost oil deposits that are found that can be profitably developed at low oil prices is decreasing dramatically with each passing year.  There is a limited amount of oil in the world and there are geological limitations to our ability to produce oil.  Even when oil is found that can be produced economically it can take years to build the necessary infrastructure to get that oil to market.  It will likely take years before the majority of the new high cost oil will enter the production phase of its life cycle.  The current high level of oil industry profits is without a doubt needed to finance the development of new oil reserves so that more oil can be brought to market in the future.

Meanwhile global oil demand is rising at an increasing rate as developing countries such as China and India require increasingly large amounts of oil to continue their industrialization.  While the drop in oil consumption in the US last quarter is important, the fact that the oil markets did not react to the news suggests that U.S. consumption habits are no longer driving the market.  The main driving factor of the rising price of oil is clearly the ever increasing demand in the developing world, with the situation being exasperated by the lack of increased production.   For years the worldwide demand for oil has been in excess of the supply of new oil.  As worldwide oil inventories have slowly declined the price of oil has climbed.

The imbalance looks small while the rise in the price of oil has been huge.  But it is important to remember two things.  First, oil demand is very inelastic in the short term.  Longer term oil demand is more elastic as people may choose to buy more fuel efficient vehicles or to conserve in other ways.  

Second, looking at past oil supply and demand figures is missing the biggest reason for the oil price climb.  As the primary reason for the surge in oil prices has been the rapidly increasing demand from China and India which is not reflected in past data.                                                     

Currently, Chinese oil consumption is around 7 mb/d but by 2030 Chinese oil demand is expected to exceed the current level of US oil demand.  Similarly huge increases in consumption are expected in other developing countries.  The reason oil prices are skyrocketing is not because there isn’t enough oil to satisfy demand right now but because the market expects that significantly more supply is going to be needed in the future to make up for new demand coming online from the developing world.  These new oil supplies cannot be economically produced without significantly higher oil prices to make production economical and higher oil prices are also needed for consumers to cut back on their own consumption of oil.

Another important factor is that the production in many oil-exporting nations has been in decline due to under investment in new drilling and infrastructure by state run oil companies.  Venezuela and Iran are two countries that fit into this category.  Production in Venezuela and Iran is declining due to years of under investment as oil profits have been funneled into social programs designed to keep each country’s ruling party in power.  Recent political instability in the Middle East has also contributed to the oil price rise.  When the chances of significant supply disruption increase the market responds by raising the oil price.  While these geopolitical issues have also driven  up the price of oil the falling dollar has exacerbated the situation.  The price of oil is dollar denominated so as the dollar drops the price of oil climbs even if oil stays constant in terms of other currencies.  But, of course, the price of oil has been climbing in terms of all currencies.

Markets never work perfectly and in rare circumstances can work quite poorly. However, markets almost always work very well over the long term.  Blaming the most recent rise on purely speculation is missing the big picture as one would then be failing to give the required credence to the macro story. 

I think the best piece of evidence to support my fundamental supply and demand theory is that the price of oil is not the only commodity price skyrocketing.  Food prices, metal prices and all energy prices in general are skyrocketing because the developing world is rapidly increasing its consumption of all commodities.  High oil prices are here to stay and the entire economy needs to adapt to a higher price level.  Oil will remain expensive and to avoid long-term shortages the global economy needs higher prices to force people to make more efficient use of energy and to help finance the development of new oil reserves.  Eventually, geological limitations will limit the ability of the world to increase oil production beyond some point, regardless of price.  I do not think the world has yet reached this point but it will eventually.  I think the price of oil will never again drop to the levels we have become accustomed to in the last several decades and while it may decline in the short term the price of oil will clearly rise over the longer term.   

Priming for Accelerated Growth at Atlas Pipeline Holdings

Atlas Pipeline Holdings (AHD) is an unusual company.  The company does not directly own any hard assets or have any operations of any significance.  Instead, the company holds ownership interests in Atlas Pipeline Partners (APL).  Atlas Pipeline Partners is one of the largest natural gas transporters and processors in the United States.  Atlas Pipeline Holdings owns 100% of the general partner of Atlas Pipeline Partners and 5.4 million limited partner units of Atlas Pipeline Partners.  The company’s ownership of Atlas Pipeline Partner’s general partner entitles Atlas Pipeline Holdings to incentive distributions, via its ownership of incentive distribution rights (IDRs), which allow Atlas Pipeline Holdings to collect a flexible percent of distributions from Atlas Pipeline Partners depending on the rate that Atlas Pipeline Partner’s increases its distribution to unit holders.  Atlas Pipeline Holdings currently is entitled to 50% of all total distributions above $0.60 per quarter per Atlas Pipeline Partners unit.  If Atlas Pipeline Partners wants to pay out an additional $10 million to the company's unit holders, it would also have to pay $10 million to Atlas Pipeline Holdings.  What this means is that Atlas Pipeline Holding’s distribution increases are levered to distribution increases at Atlas Pipeline Partners, with the leverage being substantial over the long haul.

Because of Atlas Pipeline Holding’s ownership of Atlas Pipeline Partner’s incentive distribution rights along with its holdings of 5.4 million Atlas Pipeline Partners units a $0.10 per unit increase in Atlas Pipeline Partner’s distribution would provide enough additional cash flow to Atlas Pipeline Holdings for Atlas Pipeline Holdings to increase its distribution per unit by $0.16.  This occurs as a result of Atlas Pipeline Holding’s lower unit count compared to Atlas Pipeline Partners and Atlas Pipeline Holding’s ownership of Atlas Pipeline Partners units.  Since Atlas Pipeline Partner’s current distribution is so much higher than Atlas Pipeline Holding’s this provides Atlas Pipeline Holdings with a growth rate substantially higher than that of Atlas Pipeline Partners.

Several days ago, Atlas Pipeline Partners announced a significant increase in its distribution guidance due to a restructuring of Atlas Pipeline Partner’s hedge book.  Atlas Pipeline Partners had previously suggested that it would distribute $1.95 during the second half of 2008 with a coverage ratio of 1.2.  Now Atlas Pipeline Partners is guiding for $2.10 for the second half of 2008, allowing the coverage ratio to increase to 1.3.

The following table shows where Atlas Pipeline Partners and Atlas Pipeline Holdings’s distributions should be for the second half of 2008:

	Current Distribution	Annual Rate Based on Second Half Guidance	Growth Over Current Distribution
Atlas Pipeline Partners	3.76	4.20	11.7%
Atlas Pipeline Holdings	1.72	2.42	40.7%

The previous table does not take into account the growth in Atlas Pipeline Partner’s coverage ratio.  Atlas Pipeline Partners cannot increase its distribution without paying equal amounts of cash to Atlas Pipeline Holdings.  Any excess distributable cash flow at Atlas Pipeline Partners that is not being distributed should be considered to really be half owned by Atlas Pipeline Holdings.  If Atlas Pipeline Partners ran with a 1.0 coverage ratio Atlas Pipeline Partners and Atlas Pipeline Holdings would have the distributions shown in the following table.  The following numbers are per unit.

	Based on Current DCF	Based on Annual DCF Based on Second Half 2008 Guidance
Atlas Pipeline Partners	4.14	4.83
Atlas Pipeline Holdings	2.32	3.43

Today’s news that Atlas Pipeline Partners is issuing 5 million additional units to finance the hedge book restructuring should be viewed as a great thing for Atlas Pipeline Holdings.  These additional units will increase the cash flow to Atlas Pipeline Holdings via their incentive distribution rights and they will further increase Atlas Pipeline Holding’s leverage to Atlas Pipeline Partners going forward.  These 5 million additional units should increase Atlas Pipeline Holding’s cash flow and distribution by a further 10% once the issuance is completed.

As if this was not exciting enough, Atlas Pipeline Partners is the pipeline operator with the largest exposure to the Marcellus shale, something I am very bullish on.  Atlas Pipeline Partners can probably sustain at least a 5% annual growth rate for years with substantial upside possible depending on how fast the Marcellus is developed.  I expect to see Atlas Pipeline Partners sustain a growth rate of at least 7% for several years, which is still well below Atlas Pipeline Partner’s past growth rate.

Additional upside at Atlas Pipeline Partners and Atlas Pipeline Holdings may be seen in the future through further commodity price appreciation and/or additional acquisitions at Atlas Pipeline Partners.  Because of the recent commodity price appreciation and modification to Atlas Pipeline Partner’s hedge book Atlas Pipeline Holding’s DCF has likely increased by nearly 50%.  As growth at Atlas Pipeline Partners continues I expect growth in Atlas Pipeline Holding’s DCF to continue to be close to 20% annually without any additional benefit from commodity prices or acquisitions at Atlas Pipeline Partners.

The bottom line is that Atlas Pipeline Partners most recent announcement should be viewed in extremely positive light.  Atlas Pipeline Holdings and its parent company Atlas America (ATLS), which I have talked about here, should both benefit immensely.  The Atlas companies are without a doubt some of the best-run companies in their industry and I believe that this week’s news only reaffirms my bullishness for each of them.    

For Further Review

Atlas Pipeline Partner's Press Release

Disclosure: Long ATLS 

Quest Resources: Expanding in the Marcellus Shale Play

In my previous article on Quest Resources (QRCP), which can be found here, I talked about the significant growth that is possible from the acquisition of developed properties by Quest Energy Partners (QELP), a subsidiary of Quest Resources.  This week Quest Resources and Quest Energy Partners jointly announced a sizable acquisition that will both increases the size of Quest Energy Partners and increases the amount of Marcellus acreage held by Quest Resources.  This represents exactly the type of value creating acquisition that Quest Resource’s unique MLP (Master Limited Partnership) structure provides.  The acquisition is fairly large, with the Quest companies paying $140 million dollars for 78,000 acres of land with 67,000 of those acres lying in the Marcellus Shale.   

Today’s acquisition appears to significantly increase the value of Quest Resources, as it manages to grow Quest Energy Partners while at the same time provide Quest Resources with additional Marcellus acreage, which according to Wachovia can easily be worth as much as $6,000 an acre.   It is difficult to speculate on exactly the amount of value created today until Quest can provide numbers on how much Quest Energy Partners will be paying for the developed properties and how Quest Resources will finance the remaining acreage.  The deal does however appear to clearly be accretive to the value of Quest Resources.  Previously I had surmised that management’s near blunder with the proposed Pinnacle Gas Resources (PINN) acquisition justified a discount to fair value at Quest Resources from $21 down to the high teens.  Following this announcement, it appears that management is on the right track and fully aware of the value that can be created with the company’s MLP structure.  Even before accounting for the additional value created today, I think that Quest Resources no longer needs to have its value discounted due to its management.  The most important thing that gives me confidence in management is that this entire transaction is being made by Quest Resources with Quest Resources then selling the developed properties to Quest Energy Partners.  By having Quest Resources first purchase the developed properties before selling them to Quest Energy Partners it provides the additional benefit of increasing Quest Resource’s cost basis in its Quest Energy Partners stake.  Quest Resource’s cost basis in Quest Energy Partners is important because it provides tax savings as it is depreciated every quarter when Quest Energy Partners distributes cash to Quest Resources and the company’s other shareholders.

This type of transaction should be regularly repeatable potentially creating incredible value for Quest Resource’s general partnership interest in Quest Energy Partners. Furthermore, as more accretive acquisitions are made at Quest Energy Partners it not only increases Quest Resource’s incentive cash flow via Quest Energy Partner’s general partner but it also increases Quest Energy Partner’s distribution per unit providing Quest Resources with rapidly increasing amounts of cash flow to fund high return drilling projects in the Marcellus Shale play.  Quest Resources can then sell the developed Marcellus properties to Quest Energy Partners for cash to fund new projects while at the same time increasing Quest Resource’s cash flow from Quest Energy Partners by increasing the company’s distribution per unit and the general partnerships take from its incentive distribution rights.

Quest Resource’s small size makes the impact of even a small property acquisition significant (and the most recent one was quite large).  With only 2% of the United States oil and gas reserves in MLPs the company should in theory only be limited by the time it takes to integrate an acquisition.  As long as Quest Energy Partner’s is able to grow its distribution rate, Quest Resources should have no problem using Quest Energy Partner’s stock as cheap currency for future growth.  Especially, because the more acquisitions that Quest Energy Partners makes the faster its distribution rate rises and the more attractive of an investment Quest Energy Partners becomes.

Essentially, Quest Resources is like a legal pyramid scheme whereby Quest Energy Partners can create incredible amounts of value for Quest Resources by making a long string of accretive acquisitions.  Quest Resources benefits because of the incentive distribution rights (IDRs) that it holds that generates cash flows from Quest Energy Partner’s expansion.  This creates a form of free leverage for Quest Resources that will allow for incredible value creation.  Quest Resources and Quest Energy Partners are still in the early stages of an incredible growth process that will likely last for many years to come.   

For Further Review: 

Quest Resource's Press Release

Disclosure: Long 

GFI Group: Not Your Typical Brokerage

I have followed GFI Group (GFIG) for sometime.  The stock is currently well off its highs but at its current levels still represents a rare opportunity for investors to profit from one of the world most rapidly growing and changing components of the financial market.  The trading of derivatives has been at the heart of the current credit crunch; this is primarily because the market for individual securities can become illiquid incredibly fast.  Credit derivatives currently account for a little of 30% of GFI Groups revenue.  This slight reliance on derivative trading, which has been disrupted by the credit crisis, has contributed to the decline in price of the company’s stock.  Even with a slow down in the derivative business, the company has still managed to grow its top and bottom lines at a healthy clip.  I strongly believe that significant upside remains for the company and if you are interested, my detailed analysis of GFI Group it can be found here.  

The primary fear with GFI Group’s credit derivative business is that it will dry up because of the prolonged impasse in the credit market.  GFI Groups derivatives business was built on the idea that the firm could profit from placing trades for clients who were seeking to trade less commoditized derivative products.  Generally speaking, the markets for these products tended to be less liquid.  As a result, with the onset of the credit crunch the division growth slowed considerably.    

Even with the current issues in the credit markets, it is clear that derivatives are here to stay.  The brokerage firms that are best positioned to deal with the market will deliver outstanding returns to their shareholders in the future.  It has always been my opinion that all the industry needed was some type of exchange where derivative products could be traded.  Such an exchange would improve liquidity and allow for more oversight of one of finances least regulated markets.  Should such an exchange ever develop, GFI Group, as a market leader is uniquely position.  While per trade revenues would likely decline, the proliferation of trading in derivatives caused by a massive increase in liquidity would dramatically increase GFI Groups total revenue as volume would more then make up for any price declines. 

It would appear that the foundation for some type of derivative exchange is currently being built.  A New York Times article earlier this week outlined a meeting of Wall Street executives that took place on Monday at the behest of the Federal Reserve.  The meeting focused on the need to develop a derivative exchange that would allow for a more transparent and liquid marketplace.  The executives have agreed to move in this direction with the creation of a clearinghouse of sorts for derivatives where investment banks will go to register trades.

If such an exchange were to be developed, I am positive that GFI Group would be the brokerage at the forefront and that it would be best positioned to profit from one of finance’s largest markets.  This new development in the derivatives market when combined with an already extraordinary low earnings multiple, large cash position and a substantial growth rate make GFI Group a long term buy.         

For Further Review:

NY Times Article on Derivatives 

Disclosure: Long 

The Failure of the Energy Markets

Fridays surge in oil prices was extraordinary to watch, but at the same time, I could not help but be a bit suspicious of the commodity’s price movement.  On the day, the price of a barrel of oil jumped over $10 dollars, closing at around $138 dollars a barrel.  This steep increase coupled with Friday’s dreadful employment data helped to give the market one of its worst days of the year.  Generally, signs of a weakening economy (as exemplified in the employment data) would cause commodities such as oil to retreat. 

This was not the case and will likely not be the case in future for a variety of reasons.   For the most part the Federal Reserve lacks the ability to support the dollar through higher interest rates as it is forced to attempt to ease the pain caused by the housing bubble and the seize up in the credit market.  The quagmire that the Federal Reserve has found itself in will likely result in an increase in inflation during the coming year, further weakening the dollar (my take on inflation can be found here).  In an attempt to profit and hedge portfolios from inflation and a declining dollar individuals have begun to speculate in mass in the futures of oil and other commodities, along with the stocks of any company related to the resources.  The resulting increase in the price of oil has only exasperated the job of the Federal Reserve, as the increase in the price of oil is putting massive inflationary pressures on the price of food and all other products that require a large amount of energy.  Dow Chemicals 20% across the board increase in prices is but one example of many more such increases to come if oil remains at its current levels. 

While I am sure that the Federal Reserve and the federal government are aware of the danger that such a surge in the price of oil poses to the economy, I have so far been disappointed in their responses.  Oil expenditures now make up a larger share of the U.S. economy then any period in the last 30 years and serious financial hardship will be brought upon U.S. consumers and manufactures by any further rise in the price of oil.  While I fully recognize the importance of speculators in well functioning commodity markets, I cannot help but wonder after Friday’s surge whether the energy markets in their current state can be considered well functioning.  In a world gripped by fears of “peak oil” and struggling to deal with the near collapse of the credit markets such erratic price movements in such a vital commodity can have profound effects.

Increased demand in the developing world has clearly been one driver in the increase in the price of oil but as we have seen in the past, the future of the U.S. economy often dictates the future state of the world economy.  This makes the current state of the price of oil even more surprising.  The fact that U.S. consumption of oil is actually down from the year ago period is even more interesting as it shows the world’s largest consumer making dramatic changes to slow its consumption.  The volatility in the commodities markets and the rise and speed at which the price of oil has advanced would, I believe, lead any normal person to wonder about the degree to which our commodity markets can be deemed to be considered well functioning. 

While I hate to admit it, I believe that increased supervision and regulation of the commodities market may be in order to ensure that they function properly.  If nothing else, it would allow a suspicious public to sleep easier at night knowing that their suffering is not resulting in exorbitant amounts of money being made by people on Wall Street.  What it comes down to I believe is making the market more transparent and eliminating many of the speculative aspects of the market. 

While speculators are clearly not to be entirely blamed for the dramatic rise in the price of oil they are certainly exasperating the situation.  One of the most potent weapons at the disposal of the regulatory bodies of the commodities markets would be to limit those involved in the ownership of futures contracts to those involved in the production, refining, transportation and usage of oil.  Since this would prove difficult to achieve the government could easily strengthen the Commodities Futures Trading Commission (CFTC) by giving it more investigative authority and the ability to inspect firms trading books.  The increase of margin requirements would also be effective.  Currently, margin levels are between 5-7% for hedge funds operating in the commodities markets, well below the requirement for individual stocks.  This would likely bring down speculation, as it would reduce the leveraged returns available for speculators, compelling them to reposition their capital in other areas in search for market beating returns.

One of the only non-governmental actions I see that would be capable of reducing the volatility and the affect of speculation in the oil market would be for the NYMEX to be merged with oil futures markets in London and the Middle East.  The increased liquidity and size of the market would hopefully quell the volatility and allow for more steady increases and declines in the price of oil.  Such a commodity exchange would also be much easier to supervise, limiting the opportunity for manipulation to occur.                  

While it is clear that the dollar must be supported in an effort to limit the surge in oil, other actions must be taken as the future of the U.S. economy depends on it.  As strange as it may sound, increased regulation and supervision of the commodities market is needed to ensure that the volatility and rapid rise in price that has occurred over the last year is not allowed to wreak havoc on the U.S. economy.  I am not against a rise in the prices of commodities such as oil, all I ask is that it occurs in a manner that prevents people from becoming suspicious of our country’s institutions.   

Defining the California Ratio

Valuing regional banks is a difficult task during even the best of times.  During times such as these it becomes a crapshoot.  This is especially true in areas like California where banks find themselves straddled with homes they don’t want and loans that have become under collateralized do to the fall in housing prices.  In addition to experiencing these issues, banks are also facing the typical run of the mill issues related to a weakening economy.  In areas like California, this has created a perfect storm for state’s community and regional banks. 

The survivors of this storm will be able to dominate a market that in good times, with relatively light competition, could potentially produce phenomenal returns.  As a result, it is important to pick the winners as the losers will surly be absorbed by the strongest banks, taken over by the Federal Reserve or be forced to sit out of the next upswing in the market as a result of a weak balance sheet that has been damaged by the current crisis in the housing and credit markets.   Hedge funds and other smart investors have already begun to look at many of the California banks.  The news last week that Jana Partners has taken a 9.9% stake in FirstFed Financial (FED) is but one example of many more deals to come.  Not all of these investments will be prosperous as these banks still have substantial issues.  To begin investing in these banks it will be important to be able to assign adequate value to the companies you are examining.  One way to do this is to use financial ratios that show the banks remaining available equity after accounting for troubled loans.

I talked about one such ratio last week in my article on the Texas Ratio, which can be found here.  The bank that I used to exemplify the ratio was surprisingly enough FirstFed Financial.  The Texas Ratio, as I discussed in the article linked to above, was developed by Gerard Cassidy of RBC Capital Markets in the 1980s.  Cassidy defines the calculation of the Texas Ratio as the following:

“The ratio is calculated by dividing a bank's non-performing loans, including those 90 days delinquent, by the company's tangible equity capital plus money set aside for future loan losses.”

In the case of FirstFed Financial, the bank had a Texas Ratio of 48% at the end of the most recent quarter, leaving 52% of equity unimpaired in anyway.  In my opinion this is just enough of a cushion to get yourself in trouble as it is too early in the cycle for a bank to be in such a poor position.  The Texas Ratio while being a great early warning system for banks that are in trouble can be refined in my opinion to account for the current situation in California.  These refinements will in my opinion make it a better, more fool proof, tool for measuring the health of banks in California and those in other areas where banks may find themselves swamped by rapidly declining housing prices. 

In looking at many Californian banks, it is clear that they all face many of the same problems.  The vast majority of the banks in question have seen their real estate owned portfolios surge as a result of increased foreclosures.  The real estate is carried on the balance sheet of the banks as an asset, the value of these properties though is questionable and most likely far less then what was originally assigned to them by the bank.  The other asset on the bank’s balance sheet that has ballooned is the number of impaired loans.  The number of these loans has soared as banks reassess the value of the collateral behind their loans.

In creating a new California Ratio to supplement the Texas Ratio, these two issues must be addressed.  Discounting the value of the banks real estate owned portfolio and that of its impaired loans will allow for a much more accurate ratio capable of signaling out troubled banks faster then the Texas Ratio.  The use of this ratio should allow you to sort through the Californian banks faster, in search of one that will make it into the next cycle.  In my opinion, you can define the calculation for the California Ratio as the following:

Calculate the California Ratio by dividing the bank’s non-performing loans (including those less than 90 days delinquent) by the company’s tangible equity capital and the money set aside for future loan losses.  The tangible equity capital should be marked down to account for a reduction in value for the bank’s real estate owned portfolio and its impaired loans.  The bank’s real estate owned portfolio should be marked down to 50% of its stated value while the bank’s impaired loans should be carried at 80% of their stated value.

The California Ratio should allow investors to more properly value the banks that they are examining.  In carrying the real estate owned portfolio at half its stated value you are accounting for the costs of foreclosure and housing price declines since the loans were issued.  The reduction of the value assigned to the bank’s impaired loans will allow you to build into your estimates the damage that will come about to the banks capital base as it should allow you to see future loan losses and foreclosures before they are officially booked on the banks balance sheet. 

For Further Review:

Statement of Ownership in FirstFed Financial by Jana Partners 

Disclosure: None

UPDATE: This article was updated in August of 2008 to reflect FirstFed Financial's correct Texas Ratio at the time this article was originally written.   I incorrectly calculated the firm's Texas Ratio in an earlier article, which can be found here.  I continue to stand by my thesis on FirstFed Financial and my idea of a California Ratio.      

Lehman Brothers: Doing What Bear Could Not.

This week’s news that Lehman Brothers (LEH) maybe forced to undertake a substantial capital raise has caused significant distress in the company’s stock and the financial markets in general.  Lehman Brothers, like other investment banks, is at its core built on two things: liquidity and trust.  Unfortunately, when either of these is lost investment banks tend to cease to function as independent companies.  Bear Stearns (BSC) is only the most recent example of this occurring.

Lehman Brothers efforts to raise fresh capital have caused the market and the company’s trading partners to fear that the company is running short of liquidity and free capital.  When these trading partners, such as hedge funds, asset management companies and other institutional investors, become afraid that Lehman Brothers will be unable to keep up its side of the trades that it undertakes, due to a lack of capital on the investment bank’s part, it is only natural for these firms to lose trust in the company.  If Lehman Brothers trading counterparties pull their business from Lehman Brothers due to a lack of trust, they will impact the firm’s liquidity position, leading to a vicious cycle.  If handled poorly such a scenario could very easily bring down the company.  This same vicious cycle managed to force the sale of Bear Stearns to J.P. Morgan Chase & Company (JPM) in March. 

In order to restore confidence in the company the executives of Lehman Brothers must reaffirm to the market that the firm is in strong shape.  The best way to do this is for the firm to undertake a massive capital raise as it shows that outside sophisticated investors, along with management, believe that the company can survive the current storm in the credit markets.  According to the Wall Street Journal, Lehman Brothers is attempting to raise $3-4 billion dollars before its quarterly report in mid June to help the company offset the losses it has experience in the credit market during the current quarter. 

This is on top of the $4 billion dollars that the company raised earlier in the year.  Such capital is vitally important for the company, as it will allow the firm to survive what have been at times ineffective hedges and any future write-downs in its mortgage portfolio.  The market has viewed this new capital raise as a sign of weakness; I however, view it as a sign of strength.  If the company were really in as bad a shape as shorts such as David Einhorn have stated then why would other sophisticated investors throw more money at the company?  Lehman Brothers balance sheet, to state it simply, is huge, this has been one of Einhorn’s most useful weapons as it has allowed him to continually point to deeper problems in the company.  Any large investor being solicited by the company for capital would likely be allowed to go through the balance sheet in detail before making an investment.  If they were to invest after going through the balance sheet, I would feel confident that the worst would be behind the company. 

The very fact that Lehman Brothers has already pulled down $4 billion this year and is actively seeking more stands in stark contrast to Bear Stearns, which received a paltry $1 billion from Citic Securities (most of which was earmarked for investing in Citic Securities at a future date).  According to the most recent series on Bear Stearns in the Wall Street Journal, the management team of the company led by Alan Schwartz had six opportunities during the firm's final months to take in further capital, all of which fell through.  While Schwartz was quoted in the Journal as saying that, “I just simply have not been able to come up with anything, even with the benefit of hindsight, that would have made a difference” it should be clear that the firm’s inability or for that matter its unwillingness to raise capital was what allowed the firm to fail.  Bear Stearns simply failed to protect the trust that it had built up between itself and its clients. 

In raising further capital Lehman Brothers is not marching down the path of Bear Stearns as some market pundits would suggest.  The situation the company currently finds itself in is very much the antithesis of what Bear Stearns found itself in and for that we should all be thankful.  Lehman Brothers management clearly realizes that they have a responsibility to their bondholders, shareholders and the financial community at large to remain a functioning player in the financial market.  Raising further capital is in my opinion a net positive for the firm and allows them to fulfill their responsibilities.  While dilution will likely occur, it should be considered a necessary evil, as ensuring the firm's survival is paramount.   

If the current capital raise is completed as expected the firm will likely restore the markets trust in the firm as well as pad its liquidity position, doing so will ensure a bright future for Lehman Brothers.   

For Further Review:

Forbes Article on Lehman Brothers Capital Raise 

Wall Street Journal Series on the Collapse of Bear Stearns

Disclosure: None 

Bill Gross: Prepare for Inflation

Bill Gross, the Chief Investment Officer over at PIMCO, was on CNBC late last week talking about inflation.  I did not get a chance to listen to the segment until today but I am glad I did, as it was quite insightful.  It should be clear from watching the video and from the constant chatter in the media that inflation will likely remain a significant overhang for the U.S. Economy in the coming year or so.

One of Gross’s primary arguments is that the housing bubble and the resulting efforts by the Federal Reserve to prevent asset depreciation in the housing sector has essentially tied the hands of the Federal Reserve when it comes to dealing with inflation.  As a result, the Federal Reserve has essentially given up on fighting inflation in an effort to ease the pain of the masses as they try to deal with falling housing values.  This standpoint will result, according to Gross, in “inflation [that is] here to stay for the next year or two.”  Inflation will as a result be allowed to run rampant during that time period as the Federal Reserve, “can’t raise interest rates by 100s of basis points.”

In stating that Federal Reserve “can’t raise interest rates by 100s of basis points,” I believe that Gross is offering us a window into his own personal mindset on inflation.  It is fairly clear that Gross believes that at some point in the future the Federal Reserve will have to raise interest rates dramatically.  If this occurs, our only hope is that enough time is given for the housing sector and credit markets to recover or else a deep recession is likely, in my opinion. 

Gross briefly touches on suitable investments in a rising rate environment, suggesting that individuals reduce their exposure to bonds and position their portfolios in securities that are tied to real assets that appreciate with inflation.  Gross’s recommendation can mean many things, although my favorites include TIPS, REITs, Mutual Funds dedicated to rising rate environments (as I discussed here), “pick and shovel plays” that support commodities and select gold plays.  I am leery of outright commodity plays in most circumstances as I believe that commodity prices will come under pressure should the U.S. enter a deep recession or the Federal Reserve becomes inadvertently successful in strengthening the dollar through higher interest rates being used to quell inflation.  If you have time watch the video, as it is a good one.                   

Video Link

For Further Review:

CNBC Video