Open Choke

Thoughts on Resource Plays...

Our world changed with "resource plays". For mineral owners, the change was an unmitigated success. The froth created by folks trying to tie up chunks, at any price, before the deliverability of the play was known, created many, many multimillionaire mineral owners before a drop of oil or a whiff of gas was produced.  Areas that were $5.00 per acre were now $1,000 per acre or more... up to $29,000 an acre in some parts of the Barnett and Haynesville before dropping now that Chesapeake is a net seller than buyer.

We will look at these last 3 years as a huge transfer of wealth from the oil industry to the mineral owner.  Small percentages of these areas will be economic.  Unfortunately, it will take years before mineral owners calm down.  Once the expectation of $1000 an acre sets in, it doesn't go away easily.  

THE BARNETT-  This is a real play, and at $7 and MCFG, only a small percentage of it is really economic.  The good part of it is that it can be infill drilled a long way down, which should support good residual prices and the "EXL Model" flip.... drill, prove up undrilled locations, infill just enough to demonstrate viability, and sell.  This allows those high acreage prices to be allocated to 40 or 80 acre locations.  Much easier economics at $10,000 an acre to shove $400k in acreage costs into a $2 MM drill and complete than $6.4 MM into a $2 MM drill and complete with 640 natural spacings.

THE BAKKEN- This is a real play too.  Like the Barnett, cost control will become king.  This play also lends itself to much smaller natural spacings than the legal ones today.  A real plus to the Bakken is that you drill through some of the richest conventional reservoir section in the US to get to it.  Once they downspace to 160 acres, expect to see an explosion of conventional 5 million barrel fields found.

THE MARCELLUS-  I have looked at a few unpuplished production records here, and it concerns me.  This play looks more like the Austin Chalk, with natural fractures playing a big role in producibility.  Although this produces some great up front production rates, draining two miles of fractures doesn't support acreage prices at Barnett plus levels.  The capability of draining this on 40s or 80s or 160s is a long way from being proved, and with natural fractures a real component, a long shot.  This is a real play, but not a good bet at acreage prices over $1000 per acre.

THE HAYNESVILLE- LSD Man.  We can all fly.  And be one with the universe.  All I know is that Aubry McLendon called it the best reservoir he has ever seen a week before he raised a billion in equity, and then he flipped a huge chunk to PetroHawk.  Would you flip Guwar?  I think this play could be big, and again, it is not a one-trick pony with regards to acreage.  This play can be gummed up by operators playing tricks on unit designations in Louisiana, but I hope it is great.  Can't tell you right now.  Wish I was a Caddo Parish mineral owner.

THE WOLFBERRY- Basically, a conventional reservoir, or rather a whole bunch of conventional reservoirs with log normal distribution being accessed by fracs.  AN incredible play in the right areas, and a huge money loser in the wrong.  The Eastern Shelf component looks like it fails as a stand alone, but works as a secondary pay, which means it fails as a driver for huge acrege prices, because they go crazy when the average well is better than payout.  The portion just east of the Central Basin Platform is like a narrow band of pearls.  Lots of string areas, and some great sweetspots.  Rationally, acreage is more valuable than what it costs in the sweetspots and a lot less valuable than what it costs between the pearls.

Of course, this it the opinion of one guy.  Take it for what its worth.  If I were smart, I'd be a lot richer... rich enough, at least, to think it patriotic to pay more taxes. 

Big Enviro

There are over 2,500 "non-profit" organizations focused on environmentalism in the US with over $1.4 billion in assets and $1.o billion in annual income.  Most of this goes towards "education", in other words propoganda. http://www.taxexemptworld.com/search.asp?type=adv&orgadv=enviro

The scale of this is astounding.  In fact, Big (Tax Exempt ) Corporate America is comprised of 1,650,000+ entities with $4 trillion+ dollar in assets, $3.5 trillion+ in annual income industry.  Given that our GDP is $13 trillion, this makes charity in general between 1/3 and 1/4th of our economy.  Rather than feed people or provide access to education, huge chunks are devoted to advocacy and tearing down a capitalist society. http://en.wikipedia.org/wiki/Economy_of_the_United_States

The US consumes around $770 billion per year in oil at $100 per barrel, for a simple scale comparison between "Big Oil" and  Advocacy.  Worldwide, oil production is around $3 trillion dollars, of which less than 10% goes to "Big US Oil".

Interesting, huh?

"Non-Traditional Lending Criteria"

http://www.openmarket.org/2008/09/24/bailout-bills-illegal-aliens-and-weird-lending-practices/

Carlos Royal's SANE Economic Solution...

Real Estate expert Carlos Royal has proposed a solution to the sub-prime meltdown that is about 80% cheaper than buying our banking system...  Take a look at it, and if you agree, forward it to your Congressional Delagation.

A Modest Proposal by Carlos Royal

We have been told that the financial crisis has been caused by homeowners defaulting on their mortgage payments and on falling home prices.  If that is the case, to fix the problem all we have to do is stop the defaults by helping folks make their mortgage payments. 

 

Here is how we do it:  The government goes to each homeowner that is in default and agrees to help them make their payments until they can get back on their feet. This helps the families that are losing their homes directly.  In return for helping folks out, the government would get an equity stake in the home to provide money back to the government when the home is sold. 

 

By making all the mortgages good we make the entire pool of mortgage backed securities good. Wall Street, mortgage lenders and bankers no longer have a problem.  The mortgage backed securities go back to full value.  Plus the $550+ billion written off previously by big financial institutions now becomes profit.   

 

Since defaulting homeowners are now making their payments, foreclosures will stop going back to the banks. The existing inventory of homes and foreclosures will decline and home prices will rebound as banks get out of the home selling business. Currently, for instance, 49% of the homes on the resale market in California are bank foreclosures at discount prices.

 

The cost of this program would decline each year as families got back on their feet and began to make more of their monthly mortgage payments. The money goes to those that need help directly and passes up to Wall Street, the bankers and the mortgage lenders. If the money goes to Wall Street first, it has no way of passing down to Main Street but the reverse is not true. The conduit already exists through mortgage payments to pass benefits up through the system. 

 

The program could be paid for with profits when a home is sold and by income taxes received as financial institutions rebook their mortgage backed assets to full value. 

By starting at the bottom we are working with the smallest number, the number of defaulted homeowners, and only their mortgage payments. Actually, it is not even their mortgage payments but only the amount of help they need to make their monthly payment. We solve the problem at the source.

 

How much could all this cost?  We currently have $10.5 trillion in home mortgages outstanding of which 6.6% are 30 days or more behind on payments.  That works out to $693 billion in mortgages that may need assistance right now.  Say the average interest rate on those mortgages is 7%.  The total interest payment works out to $48.5 billion per year.  Now assume that the government would need to pay 50% of the interest on those mortgages for the next 5 years; the total cost would be only $121 billion.  What if we are wrong and it costs twice that amount?  That is only $242 billion. 

 

It is simple, it is easy and it won’t cost $700 billion dollars more than we have already given to Wall Street.  

Wondering Who To Vote For?

This is a great site...

http://www.votehelp.org/

Last Comment on the Economy...

Good one by Kudlow.  He disagrees with my previous post about the inflationary pressure, though.  I don't think we can avoid that, unless we jigger the CPI to only include poorly made used automobiles and exclude everything else, like we did with housing and food.

http://www.rasmussenreports.com/public_content/political_commentary/commentary_by_lawrence_kudlow/never_sell_america_short

and this one...

http://www.openmarket.org/2008/09/20/700-billion-for-disastrous-financial-system-bailout/

How Did Maybe 157 Billion In Bad Loans Turn Into A Trillion?

If you look at the number of bad home loans that are likely to default, the MAXIMUM number is 157 billion if you do the math...  So, then, the question remains HOW has that translated into over a trillion dollar meltdown of banks and insurers?  A friend, a sophisticated successful commercial real estate investors on an individual basis, passed this article on to me written by his mentor in real estate investment.  It succinctly states the problem, and proposes a solution and removes all partisan hyperbole from the equation.

Mortgage Meltdown

by Carlos Royal

It all started with a noble cause… Increase home ownership in America.

The easiest way to increase home ownership is to make buying a home easier. FHA and VA had been doing this for some time with great results. In fact, the VA program is an excellent example of the concept that it is not how much you put down, but your ability to pay that counts.

Mortgage companies joined in this noble cause making loans easier and easier to get. Real estate home values climbed in value. Why? Because more people could buy. This increase in demand started at the bottom and pushed upward. Existing homeowners found themselves with large equities so they moved up to the next level too. Those that didn’t move up refinanced and spent their equity. This was great for the economy, but maybe not have been the smartest thing to do. 

Investors, seeing an opportunity, jumped into the housing market increasing demand even more. Home prices were going up so much that not only was the down payment removed from the equation to get a loan but also the ability to repay was removed. (This was not smart). Who cares if the buyer can pay, the property will be worth more when the note adjusts or comes due. This attitude by lenders increased the number of marginal buyers and it also increased the number of speculators. Home prices soared even more as demand increased.

The stock brokers/bankers not wanting to be left out jumped in with both feet. Up to this point the real estate was leveraged but mortgages generally were not; that was about to change. A PhD in math and statistical analysis determined that a mortgage could be valued at something other than its face value. It could be valued at its cash flow value capitalized at an interest rate different from the mortgage. The process is simple; you securitize the cash flow and forget the principle balance of the mortgage. In other words, you leverage the mortgage.

Basically here is how that works.

A.   $100,000 mortgage at 8% creates $8,805.12 in cash flow per year for 30 years.

B.    The $100,000 mortgage is funded using 3% government money leaving a 5% spread.

C.   The spread is securitized into $58,149.67 mortgage backed security paying 5%. Who wants to wait 30 years to get their profit?

D.    In effect, the $100,000 mortgage has been sold for $158,149.67 or a profit of $58,149.67. 

If the mortgage runs to maturity everything works out, but if the note pays off early or the mortgage defaults there is a potential short fall of up to $58,149.67. More if the value of the real estate has fallen. You might ask, where did the $58,149.67 go? It was booked as profit, so where do you think it went? The CEO of Fannie collected $90 million, I am told. 

If the problem ended there it wouldn’t be too bad. At least we would know the potential lose of $58,149.67, but it doesn’t end there.

The next part is borrowing of money back and forth on the mortgage or the secuitization to build up book value, fees and insurance costs.

Basically here is how that works:

A.   One brokerage firm says I have a $100,000 mortgage backed security. Will you loan me 90%? In some cases 100%. It is as good as gold.

B.    Brokerage firm B loans the money to Brokerage firm A. Now, brokerage firm B has a $90,000 mortgage backed security.

C.   Brokerage firm B now calls brokerage firm A or another brokerage firm and says I have a $90,000 mortgage backed security. Will you loan me $80,000? It is as good as gold.

D.   This back and forth continues 30 times creating about $950,000 worth of securities using only a $100,000 asset.

E.    If the fees and insurance are 6% each time, basically all the profit has disappeared in fees. 

F.    How big are the write offs? $950,000 in paper goes bad each time a $100,000 mortgage loan defaults if 90% leverage is used.

G.   If however 100% leverage is used then $3,000,000 or 30 time the amount goes bad with each default.

Now you know why and how a few defaults can cause a trillion dollars in bad paper. There is a little secret here that no one is talking about. Did you know that if you could unwind all these transactions the maximum lose is $159,149.67 if the value of the real estate goes to zero? But wait a minute; remember, I said part of the fees included insurance. Each time the ball was bounced back and forth the transaction was insured. Another big, Ooops. The insurance company is on the hook for $950,000 up to $3,000,000 every time one $100,000 mortgage defaults. By the way, in many cases the same guys that insured the loans also made the loans. 

Remember, real estate was going up and so any defaults were being covered by replacement mortgages at larger values. A bubble was building, profits were huge. The Feds decided to act. Alan Greenspan, the Chairman of the Feds said, “We plan to take the froth off the housing market.” This scared the investors and speculators right out of the real estate housing market. This created less demand and real estate prices dropped. Just as the Feds wanted but what the Feds missed was the unintended consequence. The unraveling of the mortgage backed securities that had been passed back and forth so many times that no one seems to know who has the mortgage. See link below.

http://www.globalresearch.ca/index.php?context=va&aid=7413

Lenders fearing the worst began to tighten qualifications to get loans therefore driving more buyers out of the housing market, mostly on the lower end homes. Home prices plunged even more. Between marginal buyers and investors, about half of the demand for housing had left the housing market. Down it went even more.

Defaults started to occur because existing mortgages were more than the value of the homes. Sellers could not sell because they owed too much or there were just no buyers. Owners could not refinance because they now didn’t qualify or their home didn’t qualify. A new attitude developed, “Why make the payments when you owe more than it is worth?” From a financial standpoint that makes a lot of sense even though bankers hate it.

When asked who is responsible, the correct answer is “Not me.“  The finger pointing started, but finger pointing does not fix the problem.  If the source of the issue is real estate home values as most are saying, then there are some simple solutions. Bring demand back into the housing market.

1.      Bring investors back into the real estate market to clean out the foreclosures. Greenspan scared them out of the market with "We plan to take the froth off the housing market." "Oooops, I didn't mean to kill the world financial markets, too." I know this stance would not be popular with politicians; they always like to blame the investors and speculators.

2.     Make it easier to buy homes, not harder.  Just make sure the buyer can make the payments. (forget down payment, that is not the issue and I can prove it.) Just look at VA loans. They require no down payment and almost all buyers pay their mortgages.

3.     A simple solution to helping existing homeowners in default is to write down the mortgage to market. That is what will happen anyway if the property is foreclosed on. In effect, you give the existing owner first right to buy the house at the lower price. The owner has to qualify to make the payments. No down payment is required because he already owns the house.

4.     If the owner cannot make or qualify to make the new payments he has to move. This will not go over well with politicians.

The government is doing the only thing it can do, monitize the debt and burn the worthless securities once they get them. The final effect will be an increase in inflation of 8% to 12% but we will still have banks, a stock market, jobs and an economy. I am glad I don’t have to envision what would have happened with no action.

P.S.  Rents will increase if they tighten the rules to buy houses. And if they make it a requirement, as some are suggesting, that all buyers must have a 20% or more down payment. Then look for house prices to drop even further. This will be another one of those unintended consequences.

Is The Economy Better Under Democrats or Republicans?

I have heard both sides argue this point ad nauseaum.  The Democrats usually cite the fact that under Democratic Presidents, the economy actually has performed better than under Republican Presidents.  Republicans respond that under Republican Congresses, that the economy responds better.  I decided to look at the data myself and found that the statistical analysis of all this hooha is meaningless... when you hear it, you are being lied to by statistics.  I can make the case for either party using rational assumptions, like lag time for effect.  I also looked at it by party controlling congress and party in the white house and all combinations thereof.

Here are some interesting illustrations of presidential and congressional effects that MIGHT be meaningful.  WARNING- Partisans aren't going to like this...

I used End of Year (EOY) Dow Jones average, and US annual GDP, and three components of the GDP- personal consumption, personal investment and government spending (sorry, I just cannot say "investment" here).  I SHOULD have used per capita GDP normalized for inflation.  I will maybe do that in a later post, although the systemics of the problem will mush these numbers like they have these.

 

In this snapshot, I overlay the log normal Dow Jones Industrial Average with Congressional Control on the top color band, and White House Control on the lower color band.  It shows a clear breakdown in performance beginning in 1965, and extending through the Nixon, Ford, and Carter eras, all of which were dominated by a Democratic Congress and initiated, perhaps coincidentally, with the Great Society spending program.  The DJIA grew through the Reagan, Bush I, and Clinton years culminating in a big increase and subsequent collapse due to high tech in the late 1990s.  It has grown within the strong growth band in the Bush II era, despite looking weak next to Tulip Mania of the late 1990s.  Perhaps the Keynesian fiscal policies of the mid 1960's through 1980 should be avoided?   

 

If you click on the image above, I think you can see it more clearly.  I plotted the percentage increase or decrease of the DJIA EOY number from the preceding year.  I then fitted growth acceleration/decleration trend lines per administration.  Only Carter, Reagan and Bush show an acceleration of growth during their admins, although Carter's were from negatives to low level growth.  Clinton's growth trend would have been positive except for the collapse of the high tech bubble beginning at the end of his administration.

 

I then just reversed this, plotting the Congresses and overlaying presidential administrations.  This is really interesting, in that it shows a steady slow down in the percentage growth beginning from the peaks in the early 1950s, and bottoming out early in the Nixon administration.  Late Nixon and Ford reversed it at least to positive numbers and Carter, although not blessed with big growth, ended up with 3-5% growth, although inflation was raging during that time.  Since the DJIA is NOT adjusted for inflation, I should do that to look at real growth.  Next post, then.  The split Congress of the Reagan years show large DJIA growth acceleration, and a slow down to that acceleration with the Democratic congress that followed.  The following Republican Congress preided over the Tech Boom, and ended on a whimper.  The Bush II Repubclican Congress has been a non-event, and the economy has taken a sharp turn southward under our current  Democratic Congress, although Speaker Pelosi insists that the Democratic Congress has no complicity in the current turmoils.

 

This last graph shows various aspects of GDP growth by White House and Congressional Control.  Interestingly, it shows the Great Society Spending in the mid to late 1960's, that slow down and gradual subsequent buildup through the Nixon, Ford, and Carter administrations.  Personal consumption and investment were strong through this period, outstripping Government spending growth.  The Reagan yeas saw a buildup of government spending in lock step with personal consumption GDP growth, and a real drop-off in personal investment.  The Clinton years look very strong with very controlled government spending and solid personal consumption AND investment growth.  The Bush years have really not exhibited as much Government spending growth rate as I would expect, and small but steady personal consumption growth and personal investment growth until this last year, when that dropped to negatives.

All in all, with Congress setting a budget, and Presidents having veto power, responsibility goes both ways.  I think it is WAY too simplistic to argue whether a republican or democrat President is better for the economy.  From this, clearly Johnson was a bad for the economy from a DJIA perspective but equivalent to Reagan and Truman from a GDP and government spending rates basis.  Reagan was great from a DJIA basis, but bad from a GDP and government spending basis. Nixon was good on a GDP and government spending basis but bad from a DJIA basis, as was Ford and Carter.  Clinton was a rock star on all bases.  Bush has been non-descrip to date.

So, I am walking down the 16th Street Mall...

in Denver today, and there is a young woman playing the guitar badly and with fingerpainted abstract mush "for sale".  I asked how it was going and she took the opportunity to lambast "philistines with no appreciation for art", including, to her outrage, "the supposed art-loving democrats in town a couple of weeks ago".  Apparently, they weren't as art-loving as this young woman would have liked. 

Not being a musician, but having plenty of good ones as friends and acquaintences, I know how hard it is to make a living, even with a lot of talent and skill.  I can't imagine the difficulty of making a living doing it when you have little skill, you're doing it on  the street in Denver, and winter is coming on.  Ditto that for artists.

Even though we push hard to dequantify skill and talent in the arts, it does come down to "will someone buy it"?  It is, at its core, a commercial question, and thus marketing skills must be developed as well.  Most people are NOT attuned to skill-less demonstrations of musical or artistic output, thus, the marketing skills needed to survive need to be that much higher.  Sadly, this young woman possessed none.  She was, indeed, absolutely sure of her skill, outraged that the meandering public did not share that outlook, and will soon be singing bitter songs, I am afraid.

Football might have been a better choice for her.  Not because of any particular skill, but because the lack of ability and skill would have been made obvious to her far more quickly and objectively.

If you lack the skills, but have the passion, pursue it by all means.  Just don't expect to make a living out of it or to have others share your enthusiasm.  In a lot of ways, prospects remind me of art.  We fall in love with our own, we think it is obvious, and most people wouldn't appreciate Guwar in prospect form if you showed it to them.  Philistines.

Chesapeake... A Buy?

Every oilman I know has lost money shorting Chesapeake stock.  Too much debt, quickly declining reserves, leasing acreage that they can't possibly get around to drilling for astronomical prices.

Chesapeake has trailing twelve month revenues of 5.7 billion dollars, and 13.7 billion dollars in debt (albeit most of that long term... an important lesson here).  Every oilman walked around smirking that "God Damned Chesapeake" would get theirs soon.  Chesapeake has changed the game for all of us.  Those that quickly figured out the new game have prospered.  Many have decided to "wait it out".  I have been sitting on the fence.

However, Chesapeake has raised close to $8 billion dollars in the last few months.  This takes their debt to revenues to 1:1 and debt to equity from 1.335 to .6 or so (some of this is drilling commitments, so it won't show up on the debt redux, but it serves the same purpose).  This is damned important.  Aubrey Mclendon has shown in the last few months that he can sell his equity at high prices, can package his expensive leasehold and monetize it for significant profit to major companies, and, most importantly, dry off his powder in an environment that will probably prove not to be debt friendly or gas price friendly.

I am thinking of buying some Chesapeake stock.  Call me a traitor if you will.