The way to profit from oil right now is from the companies bringing newfound shale supplies to market, not from the commodity’s price.
Those were my words to you less than two weeks ago.
The same holds true for natural gas.
Consider what we learned from Mr. Buffett this week…
In early 2007, Warren bet $2 billion on the bonds of Energy Future Holdings Corp.
He’s about to lose it all.
You’ve probably never heard of the company in its current form. And that’s because it was called Texas Utilities from 1945 until 1984 while it was the publicly-owned holding company for Dallas Power & Light, Texas Electric Service Company, and Texas Power & Light.
The three companies operated separately until 1984, when they merged to become TU Electric…
After buying two international utilities in 1998, it became TXU.
Starting to ring a bell yet?
Ahhhh, 2007
Do you remember it?
The DOW was plowing higher, running from below 11,000 to over 14,000 by October. Oil was screaming toward $100 and beyond. And no one knew what laid just a few months ahead…
It was during this boom time that TXU was acquired for $45 billion by Kohlberg Kravis Roberts, Texas Pacific Group, and Goldman Sachs Capital Partners in the largest leveraged buyout in history.
The deal seemed like a sure winner in the face of a booming stock and energy market — so good, in fact, that Buffett bought $2 billion worth of bonds in the newly-named Energy Future Holdings Corp.
That was exactly five years ago.
We’ve had a Great Recession and a shale boom since. Those two factors have combined to make this deal a flop on a scale not seen since Time Warner/AOL.
Wiped Out
Last week, in his annual letter to shareholders of Berkshire, Buffett warned the $2 billion investment was on the verge of being “wiped out.”
You see, the entire deal was based on the then-high price of $13 per million BTUs of natural gas, which sets the marginal price of electricity in Texas’ deregulated market.
The company could generate cheap electricity with coal and sell it for higher prices based on the the price of natural gas.
But after a shale gas boom, natural gas prices today are more like $2.50 per million BTUs — an 81% drop since the time the deal was struck.
Energy Future’s profits deteriorated along with the price of natural gas. It needs the commodity to be selling for at least $6.15 per million BTU to generate profit margins wide enough to cover interest and operating expenses…
With prices so low, the company lost $1.9 billion in 2011, taking the value of Buffett’s bonds along with it and leading to this mea culpa in his recent shareholder letter:
We wrote down our investment by $1 billion in 2010 and by an additional $390 million last year. If gas prices remain at present levels, we will likely face a further loss, perhaps in an amount that will virtually wipe out our current carrying value… However things turn out, I totally miscalculated the gain/loss probabilities when I purchased the bonds. In tennis parlance, this was a major unforced error by your chairman.
Buffett’s unforced error was that he bet on price and not product.
Those who did the opposite have made a killing as production has boomed and prices have bottomed…
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Shale Gas Billionaires Club
Terrence Pegula was born into a coal-mining family in Carbondale, Pennsylvania.
Some years ago, he borrowed $7,500 from family and friends and started buying up cheap land in what is now known as the Marcellus Shale.
In June 2009, he sold a one-third stake of the land-holding company he created for $350 million in cash to Kohlberg Kravis Roberts (the same KKR that bought Energy Future Holdings above)…
And 11 months after, Pegula and KKR sold the company to a little firm called Royal Dutch Shell for $4.7 billion.
Terrence Pegula just bought the Buffalo Sabres for $200 million.
Or take Jeffrey Hildebrand, who formed Houston-based Hilcorp Energy in 1989 and started buying land in the Eagle Ford Shale.
In 2010, Hildebrand sold a 40% stake in his company to KKR for $400 million. Last June, Hildebrand and KKR sold their 100,000 acres to Marathon Oil for $3.5 billion.
What did these men and KKR do different in these deals than was done in the Energy Future deal?
They bet on product, not price.
It might be too late to buy land and cash out like that in the Marcellus or Eagle Ford… but a natural gas boom in Canada is just getting started, specifically in British Columbia.
Unlike Buffett and Energy Future Holdings, which bet on price and lost it all, this story has an interesting twist.
The gas generated in British Columbia will be exported to Asia via a new pipeline and export facilities in Canada. Because of political ineptitude, we don’t have that luxury in the U.S.
You see, natural gas in Asia is selling for up to $15 per million BTU — 6x higher than it fetches in North America.
You should be able to see what that means…
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Call it like you see it,
Nick Hodge
@nickchodge on TwitterNick is the founder and president of the Outsider Club, and the investment director of the thousands-strong stock advisories, Early Advantage and Wall Street’s Underground Profits. He also heads Nick’s Notebook, a private placement and alert service that has raised tens of millions of dollars of investment capital for resource, energy, cannabis, and medical technology companies. Co-author of two best-selling investment books, including Energy Investing for Dummies, his insights have been shared on news programs and in magazines and newspapers around the world. For more on Nick, take a look at his editor’s page.
