Wednesday, August 22, 2012

Peyto Exploration & Development

Well I guess it's time to reveal the company I said I was about to purchase back in April (Click here for that post).

We'll that company was Peyto Exploration and Development (PEY). I really thought that natural gas (NG) prices were going to stay low for the summer, perhaps even lower than where they are today.  I was surprise to see the run up in the share price since my purchase, up just shy of 45% excluding dividend.  I was hoping to make more purchases during the summer at even lower prices but that did not materialize. 

I did put over 5% of my portfolio in PEY, and wanted to take it to 10%, but I don't think that will be happening now.  (I also purchased for a family member's account)

For those who know me, you already know that I have had a significant amount of my portfolio in Peyto for just about ten years.  Needless to say its been a very successful investment (see chart below).  I started selling over the past couple years, after natural gas prices started falling.  Now that gas prices are at the bottom I feel it is a good time to start accumulating again.  I also happen to hit the bottom of the falling share price this year, within a day, but that was 100% pure luck. 




I wrote a fairly extensive writeup of PEY a few years back on seeking alpha.  You can read it here:  http://seekingalpha.com/article/235455-peyto-energy-has-competitive-advantage.

Peyto is a unique company in the energy space and their track record clearly backs it up. 

When I look to invest in any commodity company I am only interested in one thing.  Who is the lowest cost operator?  Everything else really isn't not all that important.  All the competitors sell the same product at nearly the same price and you have absolutely no differentiation between businesses.  So when you find the lowest cost operator you need look no further because they will make the highest profit margins within the category.  It's really that simply. 

I really don't spend a lot of time looking at other names in the space because being the lowest cost operator is THE ONLY competitive advantage you can have.  You will earn the highest profit margins when commodity prices are high and you be the only company to earn a profit when prices are low. 

Beyond buying the lowest cost company you must also ask yourself what is the price of the underlying commodity going to do?  Since Peyto produces NG, you must be sure that NG prices are going to rise.  You can own the most fantastic business in the world but if their prices are falling your investment is likely to fall also.  Since Peyto is the lowest cost operator, by a large margin, this means they will be the last company to earn a profit as NG prices fall.  We have seen this through this cycle as nearly every NG company is losing money while Peyto is still profitable, even at these current low gas prices. 

Because companies cannot control the price of the commodity I tend to stay away from the sector because the risks are too great.  It's really speculation on the underlying commodity.  All the company can control is production.  Peyto and their operations are with my circle of competence, while commodity prices are not.  Let me explain.

Circle of Competence

I define your circle of competence a little differently than others.  I consider it to be the separation between what you know and what you don't know.  The difference between your facts and your assumptions. 

I have told my son the difference between smart people and dumb people is that smart people understand what they don't know.  Or at minimum they try to determine where that line is.  I have heard this referred to as second level thinking, or critical thinking.  The ironic part is many people have no idea where that line is and more importantly when they cross that line.

So, what about yourself?  Let's take a little test to see if you know where that line is. 

Q1.  Driving due south from Detroit, what is the first country you will come to when you leave the U.S.?

a) Cuba
b) Canada
c) Mexico
d) Guatemala

Are you 100% sure? 95%? 90%? Or less?

Q2.  Which country derives more than 75% of its energy from nuclear power?

a) United States
b) France
c) Japan
d) none of the above

Are you 100% sure? 95%? 90%? Or less?

Q3.  Approximately how many microbes live in the typical person's gastrointestinal tract?

a) 100 trillion
b) 100 billion
c) 100 million
d) 100,000

Are you 100% sure? 95%? 90%? Or less?

(Answers below)

I am likewise just as capable of crossing that line (and don't even realize it when I do).  I am just aware and try to minimize crossing that line but I'm not foolish enough to think that I never cross it.  The more consciously I live, the more likely I will stay in and around my circle of competence. 

So this is what Warren Buffett means when he talks about your circle of competence.  It's separating your facts from assumptions.  The more you can rely on facts and not assumptions the more successful your investment results will be.  Assumptions require judgement, and often a range of possibilities.  Minimizing these assumptions will maximize returns. 

In value investing, the more you can define what you know versus what you don't know the more successful you'll be.

This is how Warren Buffett operates.  He invests in consistent companies that have a strong competitive advantage and pricing power selling at a cheap price.  If a company has very consistent operating history and has a slight hiccup, the market can be unforgiving.  If you know the hiccup is non life threatening and non reoccurring it likely is a good opportunity.  This is what Buffett refers to jumping over a 1 ft bar rather than trying to clear a 8 ft bar. 

Similarly Buffett doesn't need to make assumptions regarding bubble gum, ice cream, carpet or Coke.  Every one of these products will have growing demand in the future. 

How about commodity prices?  How many investors know where prices will end up next year?  If you find someone who knows the answer, I'll introduce you to a liar. 

So when you invest in commodity companies you start with a huge assumption and that assumption plays a huge part of success of the investment.  That is why I typically stay away from commodity companies.

When are Commodity Companies a Good Investment? 

The only good time to buy a commodity is when its price is low.  That usually happens when the prices are lower than the marginal cost of production.  In the NG sector we are experiencing record low gas prices and many producers are losing money.  To me, that represents a great time to invest. 

Coming out of last winter's heating season it was clear we were headed for a NG supply glut and that is exactly what happened.  NG prices have been falling for a few years now and around late 2011 they really started to tank.  They seem to formed a bottom this summer. 

Much of the low NG prices can also be attributed to drilling bonanza in the US shale gas plays.  That will continue while capital continues to flow into the sector while the land grab is on but won't last forever. 

Perhaps low gas prices are the new normal?  If that's the case, many companies might be left holding a lot of worthless assets.  Buyer beware. 

Why Peyto? 

For those familiar with Peyto you will know that they are operationally on a roll.  Production per share has risen dramatically over the past few years.  Last year was an excellent year for drilling results that was masked by low gas prices.

Peyto is currently selling for around 40 times Q2 earnings (annualized) and three times book value.  Goes to show you those metrics don't really matter in some investments.  It's much more about valuing the assets and buying with a margin of safety.  Peyto has the assets and if NG prices rise over the next couple years, Peyto is going much higher. 

Looking back Peyto may be a screaming buy at current prices, but again that hinges on your outlook for NG prices. 

An important consideration for me was the fact that this spring Peyto was selling as cheap as it was during the darkest days of the credit crunch in 2009 (adjust for the increase in production and decline in NG prices).  Technical analysis wouldn't have caught this information.  I watched the stock fall and then it started to sell off really hard for a few days, just before I purchased...  I couldn't resist anymore.  I didn't think twice about buying while the share price was plunging.  Anyway, Peyto was selling as cheap as it was during the recession.  It was also yielding over 4.8% at the time of my purchases.

More recently, Peyto just announced they closed their Open Range (ONR) acquisition.  It was the first acquisition for Peyto since inception.  This was really a great opportunity for Peyto to add to their land base and give them more production capacity in the greater Sundance area.  Open Range brought around 5500 boe/d of production to the marriage and Peyto brought 42,000 boe/d.  The resultant company will be 3.75% owned by Open Range shareholders and 96.25% owned by Peyto shareholders.  Considering ONR is contributing 11.5% on a production basis, I like the deal.  While this is a very simplistic way of looking at the deal, the real value is in what Peyto will be able to do with the ONR lands & facilities. 

For those unfamiliar with Peyto I would strongly suggest checking out their website, where you will find one of the more shareholder friendly companies in the oil patch.  I also think I caught a juicy piece of information in the Q2 conference call.  For that information though, you'll have to listen for yourself.  Enjoy!


Regards,
Kevin

Disclosure:  Long PEY. 

Answers: b, b, a.  You likely guessed Mexico (100% sure), none of the above (70% sure), and 100 million (50% sure).  Don't worry those are typical answers.  (Questions were taken from Jason Zweig's book, Your Money and Your Brain)

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