Why We Should Borrow in € and Invest in Natural Gas

As the reality sets in of guiding 26 countries (i.e. the EU less Britain) towards agreement on a common set of revisions to the Treaty, the smug satisfaction of the tabloid press and at least a substantial minority of the British population is almost palpable even here on the U.S. side of the Atlantic. One by one, other member nations are commenting on the challenges of not only finding agreement but then achieving ratification through 26 parliamentary processes. The FT has a good synopsis of the growing acknowledgment of challenges ahead. The UK has to avoid any overtly self-congratulatory behavior, but the truth is that for those afforded the luxury of expressing opinions unburdened by the reins of government, seeing any project related to the French founder is never dull. And there’s many decades of suspicion of German power, even though the competition nowadays is thankfully economic and on the football pitch. I must confess I share many of these sentiments myself.

Michael Cembalest, CIO of JPMorgan’s Private Bank and an eloquent, insightful observer, put it well in a recent newsletter. Likening the ongoing Euro debt crisis to Bergman’s “Scenes from a Marriage”, Cembalest observed that, “Holding assets of countries suffocating themselves is not something that sounds very rewarding, unless prices get extremely cheap.” That’s the point. The prescription of austerity may be the right solution, but the widening differential in Real GDP growth between the U.S. and the Euro zone (2.5-3% in 2012) is scarcely likely to make Euro zone assets attractive. The € is becoming a funding currency - a currency with reliably low interest rates for the creditworthy (or those with good collateral). Borrowing in € and investing in U.S. assets – even risky assets like U.S. equities – has been the right position in recent weeks and events are unfolding in a way that’s likely to continue current trends. It’s hard to see why the € should rally much other than on the back of short-covering – and if it does, equities will surely move up as well.  As a result, we continue to be long U.S. equities. We like Microsoft (MSFT) in our Deep Value Equities Strategy, at 7X earnings after adjusting for cash on balance sheet. You’re unlikely to wake up worrying about their future, although there is always the risk of an over-priced acquisition with all that cash sitting around. And we are still short € through owning EUO.

Several weeks ago we switched our investment in Range Resources (RRC) into Devon Energy (DVN). We had liked RRC for a long time, but it had been looking less like a value stock as its price eventually doubled in a year. Shale drilling for natural gas is an area to which we’ve had some exposure for almost two years. Natural gas is likely to represent an increasing share of the means of power generation in the U.S. It is (1) far cheaper than crude oil on a BTU equivalent basis, (2) cleaner than other fossil fuels, and (3) here in the U.S., as opposed to having to be shipped through the Straits of Hormuz past Iran. RRC represents a concentrated bet on the Marcellus Shale, an enormous area that stretches from New York State to Tennessee. RRC strikes us as a well-run company, and we like the management. However, challenges to the shale gas story seem to be multiplying. In August, the EIA sharply reduced its estimate of the Estimated Ultimately Recoverable (EUR) amounts of shale gas in the Marcellus, causing a huge difference between the aggregate potential reserves from all the companies drilling there and the EIA’s estimate.

Recently the New York Times highlighted growing concern about the legality surrounding the transfer of certain drilling leases in Pennsylvania. Fracking, the technique by which drillers pump fluids (mostly water) into deep rock formations, imposing stress on rock formations that then frees up trapped natural gas, continues to be the target of environmental criticism. It has long been blamed for contaminating local drinking water (a movie “Gasland” was made to focus on this) and there have also been questions about how the fracking fluids (which are almost all water but do contain tiny amounts of very nasty chemicals) are disposed of. Just the other day the EPA blamed fracking fluids as the likely source of water contamination in Wyoming. And there’s even suggestions that fracking and the disposal of fluids deep under ground can cause minor earthquakes. Added together, there’s a growing source of potential problems for shale gas. Tighter environmental regulations around drilling would be fine – natural gas prices are so cheap that increased production costs across the industry would simply reduce some of the price advantage, so there shouldn’t be much problem with that. But the risk remains of some environmental disaster requiring expensive remediation. Not the most likely outcome, but a concern nonetheless.

As a result, in Energy our biggest holding is Devon Energy (DVN), which while focused on natural gas has a significant exposure to liquids and crude oil as well. They are all domestic and trade at around the value of their proved reserves (i.e. unproved and possible are thrown in for nothing). We switched our RRC holding into DVN some 2-3 months ago, and while we could have chosen better timing it’s currently looking like a good move.  We also own Comstock Resources (CRK), whose recent acquisition in West Texas was greeted positively by the market since it’s in an area where the company is already active with continued success. And most speculatively, we own McMoran Exploration (MMR), which has nothing to do with shale gas but which is pursuing shallow water deep drilling for natural gas in the Gulf of Mexico. Results from their Davy Jones flow test will be available soon and the stock will no doubt move sharply in one direction or another. The stock trades with a high beta which is not that meaningful since its ultimate value is a binary outcome based on the abovementioned flow test.