Costs Spiral for LNG Projects - Dan Amoss

by Dan Amoss

Russia, Iran, and Qatar control the largest natural gas resources in the world — enough to dominate the future business of shipping liquefied natural gas (LNG) to consumers around the world. But of the three, Russia and Iran don't even show up as LNG exporters in the trade statistics. According to the latest BP Statistical Review, the three biggest exporters of LNG are Qatar, Indonesia, and Malaysia.

Russia and Iran have legacies of Marxist policies and generally have trouble getting along with their neighbors, so they haven't exactly been fostering the type of environments that attract international investment. And investment is what they both desperately need.

Iran is a basket case, and as long as the clinically insane are running the show, the country is unlikely to attract the investments in technology and capital assets it needs to transform its natural gas reserves into a tradable commodity. But Russia is apparently open to foreign investment, as long as that foreign ownership is limited to small, non-controlling stakes.

Despite all the headlines of Russia confiscating big projects started by international oil companies, the country doesn't want them out entirely. On July 9, BBC News reported that state-controlled gas giant Gazprom, after discovering how difficult and costly it would be, is sheepishly reapproaching the companies it had kicked out of the Shtokman gas project:

"Russian gas monopoly Gazprom has said it is close to pairing with foreign firms to start developing the world's largest offshore gas field.

"The comments made by one of the firm's top executives, Alexander Medvedev, mark a dramatic U-turn from its tough stance last year.

"Last October, Gazprom said it alone would exploit the untapped Shtokman gas reserves in the Barents Sea.

"Signing a deal would be a major boost for any of the overseas firms involved.

"Norway's Statoil and Hydro, ConocoPhillips and Chevron in the U.S., and France's Total had all been shortlisted as potential members of a consortium to start pumping gas from the strategically crucial Shtokman field on the ice-free Kola Peninsula.

"But Gazprom dealt them all a huge blow last October when its chief executive Alexey Miller said Gazprom would take control of 100% of the resources.

"The 1,400-square-kilometer field has the potential to become the world's largest offshore gas field with 3.2 trillion cubic meters of gas contained in reservoirs 2 kilometers below the seabed -- itself at a depth of 350 meters.

"The cost of the operation has been estimated at between $20-30 billion, which Gazprom would have to foot if it decided to go it alone.

"Mr. Medvedev [said] Gazprom was in talks with foreign companies to allow them to 'share in the economic benefits of the project, share the management, and take on a share of the industrial, commercial, and financial risks.'

"This would be through overseas companies taking a stake in the company created to operate Shtokman, while Gazprom will retain control of the license to the field."

To place it into context, Shtokman's estimated reserves of 3.2 trillion cubic meters translate to about 113 trillion cubic feet, or the amount of gas the entire U.S. economy consumed over the past five years.

This is a smart move on Gazprom's part because the estimated development cost of $20-30 billion is probably a fraction of what it will ultimately turn out to be. Many projects that resemble Shtokman in scope and complexity are struggling with major cost overruns.

This plays right into the hands of companies like Chicago Bridge & Iron, Foster Wheeler, and the infamous Iraq contractor Kellogg Brown and Root (KBR — recently spun out of Halliburton). The stocks of these companies are expensive for good reason: They're all big players in the engineering and construction of LNG liquefaction terminals, so their businesses will benefit as this market grows and continues to experience cost inflation.

Despite the fact that it's proceeding at a slow and expensive pace, the continued growth in liquefaction capacity raises the possibility of the LNG market eventually looking like the oil market does today — with a few players dictating the terms under which they'll export gas. Rumors of a planned OPEC-like natural gas cartel have even popped up in recent months.

But they are way ahead of their time.

In order for a gas cartel to develop, its members must control huge shares of low-cost global gas production and cooperate to suppress supply. Not to mention the fact that the majority of gas consumption would have to be shipped via LNG — rather than pipeline — so it can be sold to the highest bidder (like the oil industry). The LNG market may not develop to this degree for another 20 years, if ever.

Petroleum Review Sees Cost Pressure in LNG "Megaprojects"

Chris Skrebowski, editor of Petroleum Review, follows the progress of major LNG projects as closely as he follows major oil projects. Drawing from his observations of the Energy Institute's IP Week conference, Skrebowski explains that the marginal cost of LNG is increasing rapidly:

"Considerable uncertainty remains for projects due to startup in 2010 and later. In the course of a presentation during IP Week, Andy Flower, an LNG consultant, produced a listing of projects that had been expected to get final investment decisions (FIDs) in 2006. This is because no FIDS have been signed off in the last 18 months."

Apparently, a lot of engineering and design work is under way, but companies remain hesitant to fully commit capital to liquefaction projects. Rapid increases in Greenfield construction costs have "reversed all unit costs reductions in the last 20 years. This means new liquefaction trains will have markedly higher unit costs than recently built ones."

Since Asian and European markets will experience growing demand for reliable supplies of seaborne LNG, the regasification terminals slated for construction on the Gulf Coast (primarily by publicly traded Cheniere Energy) may face the prospect of having to pay unprofitably high prices to import LNG to the U.S. "The problem is that the lack of new [liquefaction] projects is now certain to produce a supply shortfall around 2012 [emphasis added]. The time from [final investment decision] to first gas is normally around four years," writes Skrebowski.

U.S. Gas Supply Will Rely More Upon LNG and Drilling Activity

What does a potential shortage of LNG by 2012 mean for U.S. gas consumers? First and foremost, it means that the U.S. must keep drilling intensely on its own land to maintain the domestic gas production its home heating, electricity, and petrochemical industries rely heavily upon.

The big white space in this chart is the portion of U.S. gas demand that's fulfilled by homegrown drilling. About 80% of gas demand is produced locally, while 17-20% is piped in from Canada (shown in blue) and 3-5% is imported as LNG (shown in red) — mostly from Trinidad and Tobago:

Zooming in to a smaller scale shows the trends since January 2001. Pipeline imports from Canada decline each year during the "spring breakup." When the ground thaws each spring in Canada, it becomes too soft to move around heavy drilling equipment, so production and exports to the U.S. temporarily decline:

But beyond the seasonal swings in gas imports from Canada, an important trend is emerging. I make note of it in the chart above. A growing share of Canadian gas production will be consumed by tar sands projects as production is projected to grow by a few million barrels per day over the next decade; this mined substance consumes a great deal of natural gas as it's upgraded into useable fuel.

Furthermore, in its quest to cut down on carbon emissions, the Canadian government is pushing for the replacement of its coal-fired power plants with gas-fired plants. So what remains of Canadian gas resources may eventually be piped to domestic power plants, rather than exported to the U.S.

A final blow to U.S. pipeline imports: Gas supplies will continue to be limited as long as the Canadian rig count remains near the bottom of its five-year range. Last Halloween's decision by the Canadian government to phase out the tax-favored status of energy trusts not only upset scores of income investors; it also dramatically curtailed drilling projects that are vital to sustain oil and gas production — and exports to the U.S.

So despite the fact that LNG imports have grown to satisfy about 3-5% of U.S. demand, this is no reason to expect gas prices to collapse. In fact, this 3-5% figure will have to double and triple in the coming years to compensate for lower Canadian imports.

Lastly, a look at domestic gas production (the maroon section of this chart) shows a flat trend since 2001. This has occurred even as the rig count has soared. So the U.S. will need a healthy, growing domestic drilling rig fleet to avoid shortages in the future:

Rising Drilling Intensity Reveals Need for Rig Fleet Overhaul

As many industry and government sources point out, the U.S. sits on plenty of untapped natural gas resources — especially "unconventional" gas. This is gas that's "nonassociated," meaning it's not a byproduct of oil production, and it requires more significant investment in fracturing and pressure-pumping services to start and maintain production. On the bright side, the best operators in unconventional plays experience drilling success rates north of 95%; so it's more of a manufacturing operation than it is "wildcatting."

But the key aspect to remember about growing unconventional gas drilling activity is that it will require a large rig count and a growing oil field service industry.

In a Feb. 27 Strategic Investment weekly update entitled "Opportunity in Unconventional Natural Gas," I wrote:

"I constructed the following two charts to illustrate this rising trend in drilling intensity. This information is publicly available on the Web sites of the Energy Information Administration (EIA) and oil field equipment and service company Baker Hughes.

"The blue line is the Baker Hughes Natural Gas Rig count in the 'lower 48' United States, including offshore basins. By 'gas' rigs, Baker Hughes refers to rigs drilling for natural gas in U.S. territory. Out of the total U.S. rig count, gas rigs now comprise about 84% of active rigs, with oil rigs comprising the other 16%:

"As you can see, 10 years of monthly data refute the oft-repeated line, 'Newly built drilling rigs coming online will lead to a glut of natural gas and cause prices to crash.' This is cited as a reason why so many drilling and E&P stocks remain cheap.

"The second chart combines the two data sets from the first chart — it's monthly U.S. gas production divided by the monthly rig count. A simple regression line shows a clear trend running from 3 bcf per month per rig 10 years ago to 1 bcf per month per rig in 2006:

"What conclusions can we draw from this chart? Well, it lends heavy support to the view that drilling demand will more than absorb any increase in the rig population. Most E&P companies are earning huge returns on invested capital at current gas prices. So they will bid aggressively to put newly built rigs to work on their drilling projects.

"Another conclusion? Just maintaining current natural gas production will require a steady uptrend in rig activity (the blue line in the first chart). This can be achieved by building more rigs and refurbishing the huge population of rusted-out rigs left over from the early 1980s drilling boom…

"So disregard headlines about the impending wave of new rigs destroying the drillers' profit margins. Many will be put to work on unconventional gas projects where break-even gas prices are in the $2-4 per mcf range. Unconventional gas production is very drilling intensive because operators are seeing 60-70% production decline rates after the first year of production from a new well."

So what investment conclusions can we draw from the trends transforming the natural gas industry?

First, growth in LNG trade is important to satisfy demand. Most of the world's largest gas resources are located far away from major population centers, as you can see by looking at the map of the Shtokman field. There's no shortage of LNG shipping or regasification capacity at the moment, but there's a growing shortage of liquefaction capacity. Once the billions are ultimately spent to build out this capacity, U.S. importers may very well have to outbid Asian and European customers for LNG. This makes U.S. gas drilling activity all the more important.

Second, since the existing land drilling industry was largely constructed during the early 1980s oil boom, most of its equipment is nearing the end of its useful life. Lots of new rigs are being constructed, but they'll be necessary to replace those that are retiring. This trend is long lasting and will favor forward-looking rig operators and equipment companies.

Despite its week-to-week ups and downs, there's a sustainable boom under way in manufacturing, refurbishing, and operating the equipment necessary to meet the demanding drilling environment of the 21st century.

Good investing,
Dan Amoss, CFA

For Whiskey and Gunpowder

Dan Amoss is managing editor of Strategic Investment, the highly respected US newsletter. Previously Dan worked at Investment Counselors of Maryland - investment advisors tor one of America's top small-cap value mutual funds over the past 15 years.

Investing in Iraqi Oil - Dan Amoss

by Dan Amoss

Corruption Smothers Oil Industry in Iraq

Free markets are the lifeblood of a civilized society. But they are fragile. If they are to survive, contracts must be honored and property rights must be protected.

Beyond these basics, free markets work optimally when everyone follows the “Golden Rule” and treats everyone else as they’d like to be treated. Corruption -- including the use of political influence or violence to achieve results -- smothers free markets and the civilized societies they nourish. Once corruption gets out of control, everyone forgets about serving their fellow man and focuses their full attention on how they can game the system.

Sadly, corruption is a serious problem in Iraq -- a problem that started out as a way to “get things done” within the bureaucracy of Saddam Hussein’s gradually decaying dictatorship. Now it threatens the future economy and stability of the entire Middle East.

Pipeline Thefts and Violence Plague Northern Iraq

The giant Kirkuk oil field in the Kurdish region of northern Iraq has been fought over since it began producing oil over 70 years ago. The Baath government realized that control of Kirkuk was necessary to solidify its grip on the Iraqi oil industry, so in 1975, it initiated an “Arabization” program. Over the next few decades, Arabs from southern Iraq were incentivized by the government to displace ethnic Kurds in Kirkuk. Ever since the 2003 ouster of Saddam, the tables have turned, and the Kurds have fought for as much autonomy as they can get.

Yet despite the autonomy they’ve gained, the Kurdish leadership -- even with the help of the Iraqi government and the U.S. Army -- can’t ensure that Kirkuk’s crude oil gets shipped to market into reliable fashion.

The Wall Street Journal recently published a front-page story about uncontrollable pipeline siphoning in Iraq. The pipeline system delivering oil out of the Kirkuk region is too widespread to protect, so it’s an ideal target for a wide range of unsavory characters: “unruly desert tribes, bomb-planting insurgents, corrupt security forces, cross-border smugglers, and operators of small domestic refineries. At those refineries, U.S. officers believe, raw oil is turned into fuel and sold on the black market, where it’s used in vehicles and to power home generators. This loose confederation has all but crippled production in Iraq’s northern oil fields, even as the political future of this ethnically mixed city and its underground riches hangs in the balance.”

In the midst of this free-for-all, how can an Iraqi government that relies heavily on oil export revenues remain financially viable? The WSJ article continues:

“In the second half of [2006], one stretch of pipelines connecting Kirkuk with the Turkish Mediterranean port of Ceyhan -- the main outlet for Iraq’s northern oil exports -- pumped oil for only 43 days. The rest of the time, the pipes sat idle, leaking crude through dozens of holes drilled along their 200-mile run through the Iraqi desert. One pipeline has been broken into 39 times so far this year, according to U.S. military officials.

“The holes help explain why, four years after the U.S. invasion, Iraq hasn’t been able to match its prewar crude production levels of 2.5 million barrels a day. This year, Iraq is averaging 1.9 million barrels, mostly from southern oil fields that haven’t suffered the unrelenting sabotage seen in the north. Kirkuk currently produces 180,000 barrels of oil a day, but under normal conditions, it could produce an additional 400,000 barrels a day.”

Sectarian and tribal loyalties complicate the situation even further:

“The Northern Oil Co. has found itself at the center of the ethnic tensions. Of its 12,000 employees, only a few hundred are Kurds…

“Mr. Abdullah, the Northern Oil director, has been hiring Kurds, though he admits only 500 or so have come to work. Being an oil worker here has become increasingly dangerous. Pipeline repair crews have been hit by roadside bombs and shot at. Sunni insurgents have been dropping leaflets in Kirkuk telling all government employees, including oil company workers, to quit or face a bloodbath.

“Last summer, Adil al-Qazaz, Northern Oil's director-general at the time, went to Baghdad to visit the Oil Ministry. After his meeting, he was snatched by gunmen on the street, never to be seen again…

“Among the Iraqi security forces, the strategic infrastructure battalions have one of the strangest histories. In the aftermath of the U.S. invasion, Northern Oil tapped the Sunni Arab tribes to protect the pipelines running through their turf. Mr. Hussein used a similar system, mixing intimidation and rewards to secure cooperation of the tribal sheiks. After 2003, the oil company started direct payments to the sheiks, who would in turn distribute the money to the tribal guards. Essentially, the tribes were being paid to refrain from attacks on the pipeline.”

Despite the fact that southern Iraq hasn’t suffered the “unrelenting sabotage” occurring in the north, there’s little reason to expect a much better long-term outcome.

Smuggling and Iranian Control Plague Southern Iraq

Ghaith Abdul-Ahad, a journalist with the U.K. newspaper The Guardian, crafts very insightful articles from interviews that are clearly difficult and dangerous to get. In “Oiling the Wheels of War,” he takes us into the underworld of oil smuggling in Iraq:

“On the banks of the Shatt al-Arab in southern Iraq, a family business is thriving. For the Ashur, a small clan of about 50 families, it’s worth several million dollars a week. Costs are steep, especially for security. But profits are tidy and business is booming.

“The Ashur smuggle oil. For years under Saddam Hussein, they worked as mere guards at Abu Flus terminal at the mouth of the Gulf. But as the state collapsed after the U.S. and British invasion in 2003 and economic anarchy set in, they took over the port and became the quasi-official authority there. Never have the family’s fortunes flourished as in the last three years. They built their own underground oil tanks in their farms, where fuel tankers empty their cargoes to be pumped later into small pontoons. A cousin of the family estimates that they make about $5 million (£2.5 million) a week from smuggling oil.

“When another tribe tried to take over the ports, the family hired gunmen from outside Basra to defend its fiefdom. ‘We were paying $250,000 every week for gunmen just to make sure that we keep our terminals and preserve our rights,’ said the cousin, Abu Harith.

“The family operation is a dispiriting example of how large swaths of Iraq’s economy and mineral wealth have vanished into a legal vacuum, where the state is absent, law enforcement is nonexistent, and the spoils are shared by politicians, militias, and smuggler gangs.”

Groups like the Ashur clan seem as powerful as any organized crime ring in history. Militias fight over neighborhoods in oil-rich southern Iraq as fiercely as mafia elements defend their “turf.” Only their effect on society is even worse, because they control politicians and police officials. So the authorities wouldn’t want to do anything about this smuggling problem, even if they could. Abdul-Ahad provides a bit more color on a society that’s corrupt to the core:

“Oil is not the only industry steeped in corruption. Businessmen in Basra say anything connected to the state requires payments to militias and parties. In construction, for example, Abu Harith said: ‘There are two deals with parties and militia; one, they give you the contract for a price, but then you have to provide your own security; the other deal is that for a certain percentage of the contract, they will provide you with gunmen. No other militia will attack you.” In his last four contracts, he has paid $500,000 in bribes.

“But oil is the biggest racket of all in a country with the world’s second largest reserves. Oil worth millions is being smuggled out of southern Iraq every day and sold on the black market. The proceeds fund militias, mobsters, and corrupt politicians with cash that far outstrips the state’s financial resources.

“The smuggling also fuels factional fighting around Basra as each group tries to control its portion of the supply.

“One tanker captain, who is in his second decade of oil smuggling and owns his own ship, told The Guardian how lucrative the trade could be. ‘The big profits are to be made in crude oil,’ he said. ‘You rent an oil tanker, and after your first trip, you can buy the tanker.’

“The infrastructure of smuggling was set up under Saddam in the late 1990s, during the U.N. sanctions, when illegal oil shipments became the main method of getting cash into the country. Smuggling was an officially condoned policy…

“The captain, who specializes in crude smuggling, explained the process: ‘It depends on the officials manning the terminal when your tanker arrives. Usually it’s a committee of three-four; they are all of one [political] party. Your contact with that party arranges everything in advance.’

“Once the tanker is filled, another official usually arrives -- a surveyor hired by the government to inspect the cargo -- who is bribed to pass everything off as legitimate. The route of the tanker then differs, depending on its papers.

“The main risk is being stopped by patrolling U.S. or British vessels. ‘If I have official papers then all is fine, even if I am carrying twice the stated shipment,’ said the captain. ‘When I don’t have papers, we cross into Iranian waters, we carry an Iranian flag and bribe the Iranian coast guard. It’s a great business for them too. If we are arrested by the Iraqi navy, it’s easy. They are involved in the party, after all.’”

So every politician in southern Iraq has his hand in the till. We shouldn’t be surprised that the Iraqi parliament is making little progress in initiatives to secure the country. Most Iraqis are positioning for what they expect will be a violent land grab once the U.S. eventually withdraws its forces.

The violence in Baghdad may be getting all the press, but a far more significant development for global oil markets is Iran’s strengthening influence in Shia-dominated southern Iraq. In “Welcome to Tehran,” Abdul-Ahad’s interviews in Basra paint a picture of a critical port city now controlled by militias -- including several Iranian proxies. According to a senior Iraqi military intelligence official, “In Basra, Iran has more influence than the government in Baghdad…If a war happens, [the Iranians] can take over Basra without even sending their soldiers.”

Union Heritage of Iraq’s Oil Workers

Considering all the turmoil in the most oil-rich area of the world, it’s hard to argue that there shouldn’t be a geopolitical premium in the price of crude oil. The price of oil should embed an “insurance” component that fluctuates with the odds of a major supply disruption. To argue otherwise is to ignore the conditions under which most of the world’s oil is produced.

But the challenges facing future Iraqi oil production don’t end with corruption and sectarian violence. International oil companies with state-of-the-art technology have meager chances of gaining -- and holding -- concessions to produce Iraqi oil. Not only would they have to operate in the midst of warring militias, but they’d also have to go through the 26,000-member Iraqi Federation of Oil Unions.

In "Iraq Oil Union Has Storied Past", Ben Lando from United Press Intl. highlights the strong feelings Iraq’s oil workers have about the oil law under development:

“Hassan Jumaa Awad wants Iraq’s oil to stay under state control, and the unionists, who have long worked the rigs, to be supported in developing the national resource. But this is no request from the president of the Iraqi Federation of Oil Unions.

“It’s a demand.

“‘Since we are working to make progress in production, we need a real participation in all the laws that are related to the oil policy,’ Awad told United Press Intl., speaking on his mobile phone from the southern port city of Basra. ‘We are the sons of this sector and we have the management and technical capability and we have the knowledge on all the oil fields.’

“The IFOU represents more than 26,000 workers organized under various unions in the oil-rich southern and northern areas of Iraq. Shiites, Sunnis, and Kurds, together they’ve operated Iraq’s oil sector before, during, and after Saddam Hussein. Their rights to officially unionize are still denied under a 1978 Saddam law, one of a few of the former president’s laws the U.S. occupation and the Iraqi Parliament upheld…

“Kurdish and central government negotiators reached a deal last month on the framework for a law governing Iraq’s oil. Details on ownership rights and revenue sharing are still far from finalized. The Iraq National Oil Co. would restart, but compete with foreign oil companies, who could win contracts giving them partial ownership of the respective fields.

“INOC ‘should have full privileges,’ Awad said, ‘and we don’t agree on the production partnership.’

“Iraq’s oil has been nationalized for four decades. Iraqis view it with a pride of ownership, something the law would reduce if the contract language allowing for foreign ownership stands.

“‘We think that to reserve sovereignty of Iraq is to be able to control the oil wealth,’ Awad said, and foreign investment should be limited to technical assistance. ‘I wish if the foreign companies were to come into Iraq, that they help us,’ Awad said. ‘Not to suck the blood of the Iraqi people.’

“The unions were kept in the dark, as were most members of Iraq’s parliament, until the draft law was leaked to the media. Even then, it was still out the reach of most of Iraq’s citizens…

“The IFOU could shut down Iraq’s production if the draft hydrocarbons law stands. With oil revenue funding 93% of the federal budget, that’s a large bargaining chip…”

Iraq’s oil industry will probably resemble Saudi Arabia’s in the future, with no foreign ownership of resources in the ground -- not good for those hoping for endless cheap supplies of oil from the Middle East.

And what exactly lies under the ground in Iraq?

Nobody knows for sure. But institutions like the Energy Information Administration and BP act as if they do. They publish OPEC reserve figures as if they were concrete facts.

So I’ll leave you with a set of figures from BP’s recently published Statistical Review of World Energy. I drew BP’s estimates of oil production in Iraq and Iran since 1965 into this chart:

I included dotted lines to draw your attention to the eight years in which the horribly destructive Iran-Iraq war occupied the full attention of the entire fighting-age generation. The war also consumed the economies of both countries. Production dropped dramatically and recovered very slowly.

Yet it’s an amazing coincidence that during this same time period, while fighting a war involving millions of soldiers, both Saddam Hussein and the Iranian mullahs had the resources and ability to conduct what appear to be massive oil exploration programs. At least that’s what you’d think looking at the chart of stated crude oil reserves below:

The real story behind these reserve numbers is that they are simply fudged out of necessity and likely overstate recoverable resources by a significant amount.

Sure, oil field technology developed in the 1980s allowed for the production of oil that would previously have been out of reach. But these reserve increases have more to do with OPEC production quotas than reality. In the 1980s, OPEC decided to tie production quotas to reserves. This created a huge incentive to overinflate reserves, especially for the cash-strapped Iraqis and Iranians desperate for oil revenues to fund their war.

We have every reason to question these figures. And we have every reason to expect that no matter how much oil lies under the ground in Iraq, it will be produced in an erratic, unreliable fashion.

Good investing,
Dan Amoss, CFA

For Whiskey and Gunpowder

Dan Amoss is managing editor of Strategic Investment, the highly respected US newsletter. Previously Dan worked at Investment Counselors of Maryland - investment advisors tor one of America's top small-cap value mutual funds over the past 15 years.

Big Growth Opportunities in Wellhead Equipment - Dan Amoss

by Dan Amoss

Oil and gas resources once thought completely out of reach have now arrived in the fuel tanks and furnaces of consumers around the world.

Opinions differ about the future capabilities of oil field technology. Some argue that technology will allow us to unlock trillions of barrels worth of oil out of unconventional and not-yet-discovered resources. Others argue that every technology in use today was developed 20 or 30 years ago; not only that, but growing service industry bottlenecks could halt several desperately needed development projects in their tracks.

While both sides of this debate have valid points, I think it's important to remain focused on the progress under way at major projects and depletion of large existing fields, and not argue about potential resources 30 years into the future. We want to profit from the decline of Peak Oil and its subsequent political instability now.

Since the advent of the oil business, scientists and engineers have developed a series of very remarkable technologies. Oil field technology tends to compound at a steady rate, extending the boundary of what was long considered the absolute limit of exploration and production.

Resource owners usually want to produce a hydrocarbon reservoir as fast as safety and engineering limits allow, so it makes sense that most oil field technology was developed to accelerate the process. The concept of "time value of money" doesn't end on Wall Street; it extends to the oil patch. Producers are under pressure to satisfy the demands of employees, bankers, tax collectors, and shareholders, so the sooner oil and gas arrive, the better.

This picture of working to beat the clock not only applies for newer discoveries, but it also applies for projects that strive to extend the lives of older fields. Oil field equipment and services have become very expensive and are likely to become even more expensive in the coming years. The free market is the driving force behind oil field technologies.

If there's thought to be a few million more barrels of oil left in an old well, an operator will go ahead with an enhanced oil field recovery project if the return on investment is high enough. But if oil and gas prices fall and service prices remain high over the course of this project, this operator can lose a lot of money. So timing is of the essence.

Oil service stocks that can grow regardless of operator budgets are difficult to find. But I recently discovered one for Strategic Investment readers that’s fairly unique. It’s fairly insulated from the booms and busts of the oil field investment cycle, yet has incredible growth potential. Its technology has proven to be very valuable for operators extending the lives of older wells, but it also plays a key role in unlocking the value of low-quality oil and gas. Its equipment and expertise will remain in very high demand by oil field operators around the globe for years to come.

How Sour Crude Can Lead to Sweet Profits

Low-viscosity, or "sticky," heavy crude and sour crude with high levels of impurities like sulfur require extra steps in both wellhead processing and refining. The initial step in crude oil refining really occurs at the wellhead, the site where it's first pulled from the ground.

The trend toward heavier, sourer crude oil will directly benefit manufacturers of specialized wellhead equipment. These lower grades of crude make up a steadily rising share of global oil production because, just as you'd expect, the sweetest, lowest-hanging fruit in the oil patch tends to be picked and consumed first.

More barrels of crude will require upgrading, particularly the abundant, yet barely accessible heavy crude from sources like the Orinoco Belt in Venezuela. Technology is what the Venezuelans, the Russians and the Saudis need, and they will pay up for it.

Some of the biggest wealth-creating companies of the next generation will be those that can unlock the value of these politically unstable resources - without committing billions in capital to projects that can be seized overnight.

I’ve already told my Strategic Investment readers all about a company that specializes in manufacturing oil and gas production equipment. It sells this equipment into most major oil and gas basins around the world, and it’s a great way to play on the growing natural gas market.

With that said, the odds are the next few years will look like the last few - a period of growing resource nationalization not unlike hoarding. Leaders of countries sitting on vast reserves are taking actions in the best interest of their people (or their personal Swiss bank account) and telling major oil companies to get out.

Vladimir Putin and Hugo Chavez wouldn't have kicked the big oil companies out if they hadn't planned on granting major development projects to big service companies like Schlumberger, Baker Hughes and Halliburton, just because of the fact that most of their countries’ remaining reserves are difficult to produce.

"Megaprojects" Hampered by Bottlenecks

Yet despite having access to the best oil field technology in the world, most big projects still suffer from bottlenecks, delays, and cost overruns. This phenomenon is widespread enough that it supports the core ideas behind the Peak Oil theory - most notably that the "easy oil" has already been consumed.

Chris Skrebowski, editor of Petroleum Review, became a leading Peak Oil theory proponent after initially setting out to prove that it was nothing more than worrywarts seeking to make headlines. With decades of international oil field consulting and research experience, he ran the numbers and concluded that data on both historical production and future projects were not precise enough to assume ample oil supply as far as the eye can see.

So Skrebowski started a "megaprojects" database to track the projects widely expected to satisfy growing demand. He's noticed an undeniable trend of delayed startups and shortages of everything from drilling rigs to qualified personnel. Assuming that the current backlog of projects proceeds without a hitch, he expects that "24.8 [million barrels per day] of new capacity [is] due to come onstream between January 2007 and December 2012."

An extra 24.8 million barrels per day of new capacity may sound like plenty for the world's 2012 production needs. After all, it represents a little over 4% annual growth over the next six years. But this ignores depletion of the existing base, the elephant in the room that most Peak Oil critics either overlook or avoid.

Skrebowski warns that the data behind the existing base, especially from national oil companies like Saudi Aramco, are not transparent enough for us to make happy assumptions about long-term supply. If average global depletion is running a little over 4% per year - a fair estimate - the world is likely to have the same oil production capacity in 2012 as it has today. With relentless demand growth, flattening worldwide production would send oil prices well into the triple digits for good.

Skrebowski draws two conclusions from his latest megaprojects analysis. "First, data on production, project performance, and depletion rates are wholly unsatisfactory, particularly for the OPEC producers. Second, the large volumes of new capacity being added between 2007-2012 may not translate into the sort of increased production flows the world economy needs to underpin economic growth."

Companies that play critical supporting roles in extending oil and gas production will be great investments over this 2007-2012 timeframe.

Good investing,
Dan Amoss, CFA

for Whiskey and Gunpowder

Dan Amoss CFA is managing editor of Strategic Investment, the highly respected US newsletter. Previously Dan worked at Investment Counselors of Maryland - investment advisors tor one of America's top small-cap value mutual funds over the past 15 years.

Beware of Windfall Profits Taxes - Amoss

by Dan Amoss

It's impossible to make the case that there's a perfectly free market in oil or any other globally traded commodity. Production limitations, depletion, military conflicts, nationalization risks, taxes, and environmental regulations -- they all muddy the waters of a market that many would like to be clear and efficient.

The international oil trade does not operate in a vacuum. Despite what energy resources may or may not lie underneath the ground, "aboveground factors" matter very much and tend to matter more as prices rise. Just because we can use computer models to estimate that so many billion barrels of oil are in some reservoir in some remote part of the world doesn't mean that this potential supply will affect prices five or even 10 years from now, if at all.

As my colleague Byron King pointed out in "Bakhtiari's Event of the Century," concerns about oil scarcity are not likely to be taken very seriously until the world faces a crisis -- a crisis that could impose serious change on financial markets. I agree with Byron that the issue of future scarcity will be addressed only "if informed people and the industrial and political policymakers of the world actually take Peak Oil as a serious matter and set policy accordingly."

Unfortunately, right now, long-term perspective hardly exists in industrial and political policies. A pair of economists recently tested the logical assumption that most free market operators extract oil as fast as they can, rather than maximize the productive life of a reservoir. Why? From the perspective of those funding massive projects, a barrel of oil produced this year is far more valuable than a barrel produced 15 years into the future.

Technology Cannot Completely Mitigate Oil Scarcity

The history of large oil projects shows that technology -- while vital to extending the boundaries of exploration -- has rarely been able to reverse a depleting field once it's passed peak production. In a paper entitled "Technology and Petroleum Exhaustion: Evidence From Two Mega-Oilfields," John Gowdy and Roxana Julia, two economists from Rensselaer Polytechnic Institute, tested the assumption that technology can ramp up oil production on demand. Here's the abstract:

"In this paper, we use results from the Hotelling model of nonrenewable resources to examine the mainstream view among economists that improvements in recovery technology can offset declines in petroleum reserves. We present empirical evidence from two well-documented mega oil fields: the Forties in the North Sea and the Yates in West Texas. Patterns of depletion in these two fields suggest that technology temporarily increases the rates of production at the expense of more pronounced rates of depletion in later years -- in line with Hotelling's predictions. Insofar as our results are generalizable, they call into question the view of most economists that technology can mitigate absolute resource scarcity. This raises concerns about the capacity of current mega-fields to meet future oil demand."

The "Hotelling model" refers to a rule outlined by 20th-century economist Harold Hotelling. Hotelling was noted for his work on the economics of nonrenewable natural resources. He argued that prices for scarce natural resources rarely include an accurate premium for scarcity. But as we're seeing, the scarcity premium, or "fear premium," is growing and is likely to increase as more evidence of scarcity arrives.

Generations ago, Hotelling was ahead of his time in arguing for a scarcity premium. It simply can't develop when aboveground supplies are consistently ample. But this has changed over the past few years. Rather than being seen as a mere commodity price, the price of oil should be viewed as a combination of production costs, profit, taxes, and scarcity premium. Economics textbooks tell us that, over the long run, a commodity will sell at its marginal cost of production, but evidence is growing that the different grades of crude oil are making oil less and less of a "commodity" in the economic sense.

Available Oil Becoming Heavier, More Sour

The widely held assumption that technology can immediately address a shortage of crude oil fails to address the quality of the crude we have to work with. World refining capacity is not optimized to deal with the reserves that remain. David Wood & Associates clearly shows in the following diagram that light, sweet crude is growing increasingly scarce. This diagram, published in the April issue of Petroleum Review, is a great snapshot of the oil production that refiners have to work with. The size of each of these bubbles is proportional to 2005 production volumes:

Source: www.dwasolutions.com

Wood concludes from his studies that "The average global crude oil currently produced has an API gravity close to 32 degrees and a sulfur content in excess of 1 weight percent (wt %). Only some 20% of global oil production supply can be classified as light and sweet, with the remaining 80% or so classified as medium/heavy and sour [emphasis added]."

But perhaps more importantly, "Medium-gravity, sour crudes dominate the oil production from the Middle East and Russia, and heavier crudes are dominating remaining oil reserves." This chart, from the July 2006 issue of Strategic Investment, shows that over time, crude has become heavier and more sour. The axes on this chart are the opposite of David Wood's chart, but the red dots show a clear historical trend of declining average crude quality:

This trend is reflected in growing spreads between the prices of West Texas Intermediate blend, which is a type of light, sweet crude, and imported crude oil blends, which tend to be heavier and more sour. If you want to participate in the investment boom, pay close attention to new refinery construction projects and the refiners that are consistently forward-looking.

Economist Ed Yardeni included the following chart in his firm's latest energy publication:

Source: www.yardeni.com

How are foreign producers reacting to the fact that most of their reserves are of lower quality and will be expensive and difficult to produce and refine? They'll take their time to ramp production to meet Western demand -- and charge higher prices. This involves reasserting control over their remaining resources. Yardeni made a great point in a recent morning briefing:

"We still believe that the cheapest oil in the world is in the U.S. stock market. The sector's profit margin was 10.4% during Q4 2006, exceeding the S&P 500's 8.5%. P/Es have been held down by investors' perceptions that oil prices and forward earnings aren't likely to rise much from here. We agree, but they aren't likely to fall much, either, from their lofty heights. So the industry should have lots of cash flow and M&A activity over the next couple of years. The most challenged industry, yet the one most likely to have plenty of cash for acquisitions, may very well be integrated oil and gas, with the sector's biggest market cap share at 63%. National oil companies are increasingly demanding that the international majors basically accept a service fee for managing their production without much, if any, upside [emphasis added]. This might be one reason why analysts' long-term expected earnings growth for the sector has dropped from a record high of 12.3% three months ago to 10.0% in March."

Service fees? This goes a long way in explaining why executives at big oil companies like to keep public attention focused on their mega-projects, rather than talk openly about the chance that leaders of oil-rich, underdeveloped countries may choose to follow the Hugo Chavez/Vladimir Putin playbook.

Geopolitics Remains a Wild Card

ASPO-USA's latest Peak Oil Review describes the situation on the ground in Nigeria in the wake of last weekend's presidential elections. This country must give several big oil executives sleepless nights, considering the billions they've invested in major projects within reach of violent, kidnapping gangs:

"Among the more interesting incidents surrounding the election was a failed attempt to blow up the national election commission's headquarters with a gasoline truck, plus a massive assault by insurgents on the Bayelsa State Government House in the capital Yenagoa. Nine boatloads of insurgents emerged from the creeks, overcame the police and military forces in the town and burned the governor's mansion and a police station. The governor, who is also expected to be declared the new vice president of Nigeria, was forced to flee the city for his life.

"The raid illustrates the growing power of insurgents to strike at will and overcome corrupt and ineffective police and military forces. Some weeks back, the insurgents announced a stand down during the run-up to the election but vowed to be back unless the election led to significant changes -- which it clearly did not.

"Nigerian oil production dropped by another 100,000 b/d during March to 2.15 million b/d. Although the Nigerian government has been saying recently that Shell will soon resume 300,000 b/d of shut-in production [at Forcados], Shell has yet to confirm this claim. Foreign oil workers in Nigeria now are largely confined to fortified compounds and travel to job sites by armored vehicle or helicopter [emphasis added]. A number of companies have pulled out of the country.

"There was nothing in the recent elections to suggest that the situation will improve soon. The insurgents have said they will step up attacks following the election and usually make good on their promises. Prospects for reduced Nigerian oil production seem likely."

This is a situation in which those fighting for a larger share will keep fighting until they get it. Pressure on the Nigerian government to share the oil wealth will keep mounting. Oil companies operating in the region should beware windfall profits taxes, or even forced changes to production-sharing agreements. Algeria recently set a very alluring precedent for those countries looking to balance the interests of both their citizens and the oil companies.

It's Mayday for a Few Big Oil Companies

Last week's Wall Street Journal had a piece describing this trend:

"Even some nations that are new to the oil game are demanding stiff terms. Some of the biggest finds in recent years have been in Angola, which has popularized an oil-production contract built on progressive taxation. As oil prices rise, boosting an oil company's rate of return, Angola's share of the proceeds also goes up."

This "progessive taxation" idea will probably catch on elsewhere -- a good reason for energy investors to own a few oil service stocks. Regardless of how the resource wealth is shared, more oil field exploration and development must be done. It looks like the Venezulan government has decided to move forward with major development projects practically on its own, but it may enlist the services of companies like Schlumberger or Baker Hughes when it runs into trouble down the road.

Next Tuesday, May 1, marks the end of private control of the vast heavy-oil deposits in Venezuela's Orinoco basin. This is obviously negative for long-term oil supply, as Chavez has already demonstrated that PDVSA cannot even maintain its conventional oil production. How anyone can expect much out of the Orinoco Basin -- as long as Chavez is running things -- is beyond logic. The Journal continues:

"To grab more of that profit for itself, the Venezuela government broke existing contracts. Income taxes on heavy-oil projects over the past couple years rose to 50% and royalty rates doubled, to 33%, having previously been raised from the original 1%. The government also legislated that the state oil company, Petroleos de Venezuela SA, be given a 60% stake in existing fields by May -- and thus a majority of future profits."

Fadel Gheit, an energy analyst from Oppenheimer & Co., concludes the article with an image any baseball fan will recognize: "'This is like drafting a kid to the major league and he's making $100,000 a year. All of a sudden, he is hitting 50 home runs. Guess what, he wants to renegotiate his contract, and under the circumstances, one can understand the way Chavez feels.'"

Despite how distasteful it is to view the world from the perspective of a socialist dictator dismantling his country, Gheit makes a good point. It may not be great for oil consumers, or follow the rules of the free market, but a few more emerging oil-producing countries may look to "renegotiate their contracts." What big oil could lose in volume over the coming decade, it must make up in price -- if regulators allow such a thing. So energy investors should hedge positions in big oil stocks with positions in leading oil service stocks.

Good investing,
Dan Amoss, CFA

for Whiskey and Gunpowder

Dan Amoss CFA is managing editor of Strategic Investment, the highly respected US newsletter. Previously Dan worked at Investment Counselors of Maryland - investment advisors tor one of America's top small-cap value mutual funds over the past 15 years.

Levered Technology, Unlevered Drillers - Dan Amoss

by Dan Amoss

My colleague Byron King wrote to you about the allure of private equity in his recent two-part series, "Energy and Private Equity." He describes how quite a few companies are weary of the mounting costs of listing their shares on public exchanges -- Wall Street's short-term focus being among the worst.

As Byron points out, the advantages of "going private" are numerous and growing. I want to expand on Byron's ideas by contrasting the capital structure of two well-known companies -- cell phone maker Motorola and offshore driller GlobalSantaFe -- and why private equity and merger activity is likely to continue bidding up drillers.

Most private equity deals seek to optimize the target company's capital structure, or the appropriate mix of debt and equity claims.

Debt holders have a priority claim on the company's assets, while equity holders have a residual claim. If things go wrong, debt holders are first in line at bankruptcy court, but their exposure to the good times is basically limited to a fixed stream of payments. Equity holders are left with nothing if the company a) goes bankrupt and b) there's nothing left after creditors liquidate what's left of the assets in an attempt to recoup as much of their principal as possible. But equity holders enjoy all the extra cash flow when business is booming.

When used appropriately, debt, or "leverage," can greatly enhance shareholder returns. Private equity, aka "leveraged buyout," funds generally look for businesses with solid competitive positions that consistently generate cash. Private equity deals are heating up into a craze because the supply of cheap credit appears to have no limit (until all of a sudden, everyone discovers that there is, in fact, a limit).

Private equity funds first pool together their capital. Then they leverage their buying power by layering debt on top of their capital. This allows them to buy much larger businesses -- and streams of future cash flow -- than they otherwise could buy outright with their limited funds. Returning to the concept of capital structure, the debt holders get paid a fixed 5-6% per year and the equity holders have a claim on the rest, whether it ends up being a total loss or a stream of cash that's even larger than they anticipated.

Motorola's Levering Shareholders' Exposure to Creative Destruction

Motorola's recent disappointments have been numerous. A glut of cell phones is building in the supply chain and the fallout is not going to be pretty. Wireless carriers are giving them away with minimal contract commitments. The title of this article on Bloomberg yesterday says it all: "Motorola's Zander 'Running Out of Scapegoats' as Profit Fades":

"Earnings and revenue this year will be 'substantially' below its forecasts because of plunging mobile phone prices, Schaumburg, Ill.-based Motorola said yesterday. Zander, who already is cutting 3,500 jobs, said the company will overhaul marketing and product design to make its prices competitive without sacrificing earnings.

"The world's second biggest maker of mobile phones also named a new president and detailed a plan to step up its share buyback program amid a proxy fight with shareholder Carl Icahn.

"Instead of sparking optimism, the news set off criticism of Zander's choice for the promotion and a product plan that investors said didn't show enough concern for bigger rival Nokia Oyj's recent advances in the market."

Bloomberg then describes Motorola's big management shake-up in the wake of this ugly news:

"Motorola's choice for its new president and chief operating officer, Greg Brown, who runs the networks and enterprise unit that sells networking devices to companies and government agencies, also drew fire.

"'There's not a single senior Motorola executive that had more predictions go wrong,' said Albert Lin, an analyst at American Technology Research in San Francisco, of Brown. He rates the shares 'neutral' and said he doesn't own them.

"Motorola also said Chief Financial Officer David Devonshire will retire. Director Thomas Meredith will be acting CFO.

"Motorola expects a loss of 7-9 cents a share, its first loss since 2004, on revenue of $9.2-9.3 billion this quarter. Motorola didn't provide new full-year figures.

"'I never would have thought that they would go into a money-losing situation,' Lin said."

Lin "never would have thought that they would go into a money-losing situation." This statement is puzzling because it's not that hard to imagine a situation where Motorola goes into the red. Short product cycles and high R&D spending requirements can combine to produce red ink very quickly when business sours.

In recent months, Motorola shareholders had gotten excited about the leveraged recapitalization efforts of Carl Icahn. Mr. Icahn has been branded with the title "corporate raider," yet his tactics have a record of creating value for shareholders when management and the board of directors slack off on this responsibility.

The recent cell phone boom left Motorola with plenty of excess cash that Icahn believes it doesn't need. Since Motorola's business doesn't entail managing a multibillion-dollar bond portfolio, Icahn is pressuring the company to disburse all excess cash to shareholders through share buybacks (allowing for enough of a cash cushion to fund operations through the rapidly approaching down cycle).

Here's a suggestion to Mr. Icahn: Why not consider targeting one of the many cheap offshore drillers? Most have already booked up their rigs for a few years under long-term contracts at very attractive dayrates. These contracts provide very visible cash flows, so perhaps a recapitalization is in order?

You have a business for which the underlying assets are increasing in value, not deflating. State-of-the-art drilling equipment has not yet succumbed to the global deflationary pressures we see in businesses like cell phone and chip manufacturing. Cell phone manufacturing capacity is overbuilt yet still receives more and more capital investment worldwide -- good for consumers, bad for producers. But offshore drillers emerged out of a 20-year recession just a few years ago.

Furthermore, while earnings visibility is very low at most technology companies, several offshore drillers know the next few years of earnings with a fair degree of confidence. To top it off, they'll have very valuable rig fleets at the end of the high-visibility period. Who knows what the cell phone industry will look like?

Technology businesses are not considered as "capital intensive" as drillers, but in my view, the ever-present challenge of technology obsolescence more than offsets this. Carl Icahn's efforts may pay off for shareholders in 2007, but they will magnify, or leverage, the shrinking shareholder base (shrinking due to share buybacks) to the downside of technology's creative destruction.

Examining the Effects of GlobalSantaFe's Cash Flow on Its Balance Sheet

When you buy a stock, you are essentially buying a claim on the company's assets and the cash that those assets generate when they are put to productive use. If you look at the assets on a balance sheet from the bottom up, you see that the least liquid assets are toward the bottom and the most liquid assets are closer to the top. Management's top job is to extract as much value out of these assets as possible, gradually converting them to cash over long periods of time:

Using this "back-of-the-envelope" model, I forecast what the trends in GSF's cash flow and balance sheet will look like in the future. These financials are certainly easier to project than Motorola's. This model has the following conservative assumptions: revenues peak in 2008 and slowly decline, net profit margins peak at 35% in 2007 and slowly decline, and annual capital requirements (working capital and capital expenditures) remain in the range of 17-22% of revenue:

The key estimate this model provides, highlighted in yellow, is "free cash flow," which is defined as net cash from operations minus capital expenditures.

A more accurate measure of free cash flow is net cash from operations minus maintenance capital expenditures. Free cash flow is a measure of the cash available to fund dividends, share buybacks, and growth projects after accounting for the spending necessary to maintain the existing business.

My model estimates a free cash flow peak of $1.6 billion in 2008, followed by a slow decline. But I'm confident that free cash flow will be higher than this because the estimate highlighted in yellow includes capital expenditures high enough to fund an expansion of GSF's rig fleet, which will in turn add to GSF's future cash flows. I'm assuming that all excess cash is returned to shareholders via stock buybacks. This produces the compelling returns I outline in the bottom row of the table. These share buybacks can be accelerated if more debt is issued (a "recapitalization").

Here's the key point I want to make about GSF and all the other contract drillers: Free cash flows will be so high that most of them must buy back hefty amounts of stock, raise dividends, or expand their rigs fleet quickly to avoid having too much cash pile up on their balance sheets. This is a nice problem for any company to have, but it puts them right in the cross hairs of private equity funds, aggressive peer acquirers, and activist investors like Carl Icahn.

Spreadsheets Must Pay Attention to the Outside World

Free cash flow models are only as good as the assumptions on which they are based. So investors must remember to test a model's assumptions when they see one. The "micro" analysis of projecting financial statements into the future cannot be separated from the "macro" analysis vital to these projections. The assumptions underlying my GlobalSantaFe model would have to be thrown out the window if, in fact, a huge glut of oil supply were about to come on the market and stay there for a few years.

But my research over the past few months indicates that the odds of this occurring are very low. Peak Oil has already occurred in many areas of the world including the U.S., the British and Norwegian sectors of the North Sea, and now Mexico.

What happens in every country after passing peak production? Demand for drilling skyrockets. The North Sea has been a very active offshore drilling market in recent years, and there's no sign of a slowdown.

GlobalSantaFe maintains an indicator of industry health called the SCORE (Summary of Current Offshore Rig Economics). It compares the profitability of offshore rig dayrates with the profitability of dayrates during the 1981 peak of the offshore drilling cycle. When the SCORE index is at 100, dayrates equal "the sum of daily cash operating costs plus approximately $700 per day per million dollars invested." (Source: GlobalSantaFe):

Approaching this in a simpler way -- the profit generated by a typical offshore rig when the SCORE is 100 means that its owner is recouping his capital outlay in just four years. In the 130s, you can imagine how quickly rig owners like GSF are "monetizing" their rig fleets.

As for oil demand, it's important to remember that higher prices are more likely to slow demand growth, rather than reverse it. Global oil demand hasn't contracted on a year-over-year basis since the early 1980s. John Segner, portfolio manager of the AIM Energy Fund, puts these numbers into context in a recent Barron's interview:

"China is still using only 6.5 million barrels of oil per day. We are using 20 million barrels per day here in the United States. China is 25% of the world population. The Chinese are getting off bicycles. They want air conditioning. They are getting housing. If China slows, it would just be a bump in the road. Oil-demand growth could slow down, but the chance of it going below 86 million barrels [per day], say, next year? I just don't see that happening. And I don't see a lot of capacity growth. Supply-demand is still going to be tight.

"Energy [investments are] going to do very well. The multiples have been contracting for the better part of 12 months. And we are toward the end of that correction more than we are at the beginning of it."

Drilling Rigs Will Inflate Faster Than Houses

Amid the rumors of a $100 billion private equity bid for Home Depot, I find it surprising that there has been little private equity interest in exploration and production (E&P) or oil field service companies.

Perhaps financial engineering could unlock some value for Home Depot shareholders, but there is only so much you can do with a large retailing business model. Plus, the company is still exposed to the housing bubble's hangover. It's impossible to quantify just how much "spec" building and home equity refinancing money found its way into Home Depot cash registers over the past three years.

HD's price-to-earnings ratio when business is firing on all cylinders is a lot lower than when it's not -- especially when you think about the effect of spreading lower sales across a high fixed cost structure (big box stores) and the financial burden of holding slower-turning inventory.

Home Depot may be a good buyout someday, but I think potential buyers can get a better price at some point over the next two years.

Think about the "leveraged" income strategy employed by most landlords. Assume that a landlord purchases an apartment building with a 10% down payment and a 90% mortgage. If rents provide enough income to offset mortgage interest and maintenance, the landlord is left in a position where his equity goes up and down by a factor of 10-to-1 with each fluctuation in the value of the apartment building.

Leveraged exposure to a long-term real estate bull market is how most real estate moguls have made their billions. If an opportunity comes along to borrow money at a low fixed interest rate and buy a cheap asset that is both inflating in value and throwing off income, it's hard to lose.

Why not consider contract drilling businesses?

I'd bet that a fleet of drilling rigs will inflate in value at a faster pace than physical buildings over the next 10 years. I'd also bet that quite a few savvy investors recognize this and we'll see more mergers, acquisitions, and private equity transactions as the energy bull market continues to roll on.

Good investing,
Dan Amoss, CFA

for Whiskey and Gunpowder

Dan Amoss CFA is managing editor of Strategic Investment, the highly respected US newsletter. Previously Dan worked at Investment Counselors of Maryland - investment advisors tor one of America's top small-cap value mutual funds over the past 15 years.

Revisit Fundamentals When the Market Panics

by Dan Amoss

This week, the stock market flashed warnings that investors should fasten their seat belts and revisit fundamentals. The fundamentals underlying the broad market are weakening, so if you are invested in the stock market, you want to be in the right sectors.

As my colleague Chris Mayer wrote in this space on Wednesday, "Diligence and discipline and selectivity are keys. As I've said before, we don't invest in the market. We invest in specific opportunities in the market. Not the produce section, but specific avocados, onions, and melons."

I view my Strategic Investment recommendations in a similar light. While my top-down approach differs a bit from Chris's bottom-up approach, we share the goal of finding winning stocks for our readers. Macroeconomic analysis can increase the odds of finding them. If the produce section is consistently good, we want to look for opportunities there -- and avoid the overripe beef in the meat department.

The Picture of Panic

The CBOE volatility index (VIX) indicates how volatile speculators expect the stock market to be in the future. More specifically, the CBOE defines the VIX as "a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices." When it's low, stock options are cheap, and when it spikes upward, stock options become expensive. During Wednesday's meltdown, the VIX recorded one of the largest percentage spikes in its 14-year history:

To what can we attribute such a move? Who's to blame?

Not very much has changed over the past week. Simply put, risk now matters. The market often chooses to ignore fundamentals until they suddenly matter. After nearly everyone's joined the bullish camp, the slightest defection back toward the bearish camp can produce the type of market action that we saw Wednesday. Markets go into a free fall when buyers sit on their hands, waiting for the plunge to stop.

For too long, the market has been caught up in such pointless distractions as anticipating the Fed's next interest rate move or using the three-week Northeast U.S. weather forecast to trade natural gas futures. While such distractions make nice stories for the financial media, they shouldn't form the foundation of investment decisions.

My advice to Whiskey & Gunpowder readers is to take a good look at the fundamentals supporting the value of every stock you own. Then separate the wheat from the chaff. You want to buy and hold solid companies with favorable macroeconomic winds at their backs. And you want to avoid overpaying for these shares.

What would I define as "overpaying"? Here's where we delve into the art/science of security analysis. A stock may appear cheap if it has just delivered a few years' worth of impressive earnings results. But it may, in fact, be expensive if a one-off economic event like the housing bubble temporarily boosted earnings. If earnings per share decline 50%, a 15 P/E stock immediately becomes a 30 P/E stock. Traders will punish this stock, likely pushing it back down to its typical 15 P/E range -- or below.

S&P 500 Price-to-Peak-Earnings

How can we judge if the market is cheap or expensive when earnings fluctuate so wildly? One of the best ways to do this is to calculate the market's price-to-peak-earnings ratio. The market as a whole is pretty well defined by the S&P 500, an index of the largest 500 stocks on U.S. exchanges (measured by market value). It's now trading at about 18 times peak earnings, so it's quite expensive by historical measures. And peak earnings happen to be the earnings from the last 12 months, when conditions have hardly been better for Corporate America.

Steve Saville, editor of The Speculative Investor, incorporates Austrian Economics-based analysis and advanced charting into his newsletter ideas. He was kind enough to allow me to reproduce the following chart for Whiskey & Gunpowder readers:

Source: www.speculative-investor.com

Steve dissected 80 years of market history into secular (long-term) bull and bear markets. Only instead of using indexes, he defines bull markets as periods of expanding P/E ratios and bear markets as periods of contracting P/E ratios. Market prices and earnings can move up together, down together, or independently of each other. But major peaks and valleys in the price-to-peak-earnings ratio provide reliable signals of change in the market's long-term tide.

The public's fear of consumer-level inflation spiraled out of control in the 1970s. This period was pretty unique in financial market history. It demonstrated that investors are not willing to pay a high multiple of earnings in a high CPI (consumer price index) environment. Look at the 1966-1982 bear market in the chart. While earnings grew rather dramatically over this 16-year period, the S&P went practically nowhere. The price-to-peak-earnings ratio compressed all the way down to about 8 by 1982. Who cares about earnings growth if it just keeps pace with CPI inflation?

I agree with Steve that we are in a secular bear market similar to the 1966-1982 market, where the index went nowhere, but the price-to-peak-earnings ratio contracted to single digits. While history never repeats exactly, it often rhymes.

If I had to go out on a limb and choose the most likely outcome over the next decade, I'd expect the S&P 500 will fluctuate in a trading range between 1,000-1,500, while earnings grow enough to push the price-to-peak-earnings ratio back below 10.

Look also at the 1995-2000 period on the price-to-peak-earnings chart. The initial dividend yield was low starting in 1995, and dividends didn't grow much over the next five years, but returns were huge. Investors were willing to pay double the P/E ratio to get into stocks because they feared missing out on the biggest boom in history. These market returns were driven by speculation, not fundamentals, and the consequences were costly during 2000-2002.

A Closer Look Reveals Strength in Energy Earnings

So which market sectors will remain attractive investments through a period of higher market volatility? You want to own companies that produce what consumers need and can afford without exotic financing arrangements. The energy sector provides a great starting point for your search.

Veteran economist Ed Yardeni produces great chart books. Here is one that provides us with a good perspective on how much energy sector earnings have contributed to overall S&P 500 earnings. Since the 2003 bottom, energy stocks in the S&P 500 have grown from 5% to 10% of the index's market value. But this huge price move was supported by fundamentals. Energy's share of total S&P 500 earnings grew from 6% to 13% over this time frame. This trend has plenty of room to run over the next decade because the bull market in energy stocks has not pushed them to overvalued levels:

Source: www.yardeni.com

Many are worried that the commodity pricing environment cannot possibly get any better. But at 3% of the average family budget, gasoline is not prohibitively expensive. Neither are the other energy commodities. Gasoline prices could climb to 10% of the family budget without significantly altering demand.

If this were to happen, consumers would just cut 7% worth of discretionary or leisure spending to offset this price hike. Given the good probability of this occurring over the next 10 years, you want to own stocks whose earnings benefit from higher energy prices and avoid stocks whose earnings will be undercut by them.

Source: www.yardeni.com

Government Refuses to Let the Free Market Allocate Scarce Resources

Odds are good that the government will eventually throw a wrench into orderly free market gasoline pricing. Many in Congress think that consumers should not have to prepare for a long period of expensive gasoline. The U.S. Congress appears ready to fight on their behalf if this occurs. The Oil & Gas Journal reports:

"U.S. House Rep. Bart Stupak (D-Mich.) introduced legislation aimed at preventing price gouging for gasoline, natural gas, and other forms of energy. The bill, which has 78 cosponsors, would give the Federal Trade Commission explicit authority to investigate and prosecute anyone found artificially inflating energy prices, he said...

"Under the bill, FTC would be empowered to exercise its new authority at each stage of energy production and distribution. It would be allowed to impose fines up to $150 million against corporations and fines up to $2 million and jail sentences up to 10 years for individuals found guilty of price-gouging...

"Stupak said that during the 109th Congress, 123 House members cosponsored a similar bill he wrote, and several more signed a discharge petition to bring it to the floor. 'There was strong support for my bill, but the Republican leadership blocked it from being considered. This Congress, I look forward to working with my colleagues on both sides of the aisle and to help protect the American consumer from energy price gouging,' he said."

This sounds frighteningly similar to Venezuelan dictator Hugo Chavez's actions in Venezuela. He is threatening fines and imprisonment for shopkeepers who hike prices above a government-mandated inflation limit. But these sorts of price controls only prompt suppliers to start smuggling and black market operations. One way or another, the free market will ensure that goods like gasoline supplies will flow to consumers willing to pay the highest prices.

The government tried price controls in the 1970s and only created frustrating gas lines. Thinking that they help the little guy, price controls actually bring about the very shortages that lead to hoarding and inflationary spirals.

But government influence over the economy doesn't stop in Congress. The Federal Reserve is the other half of the dynamic interventionist duo, with plenty of inflationary tools at its disposal.

Liquidity From the Free Market May Dry Up...

"Liquidity" has become the new buzzword explaining why financial markets have remained tranquil and expensive. But the past few days of action in the stock and credit default swap markets hint that this wave of liquidity may be drying up.

A good parallel to the wave of liquidity was the IPO environment for tech stocks in 1999-2000. Companies with little chance of developing profitable business models were easily financed. Investors lined up around the block, desperate to buy ownership stakes.

Near the peak of the Nasdaq, speculative demand for IPOs indicated that we were in a new era of easy financing for IPOs. Liquidity seemed abundant. But within months, it had vanished and every tech IPO over the next few years became difficult to finance. Subprime mortgage lenders are the IPO buyers of the housing bubble, and they have left the market completely or dramatically tightened lending standards.

...But the Fed Will Be the Inflator of Last Resort

Markets can seize up and go into free fall when a flood of free market financing dries up. New Century and NovaStar will certainly not be hungry for subprime paper. They'll be lucky to survive their recent implosions.

So the Federal Reserve will attempt to rise to the rescue. Many believe that it will be powerless against the forces of deflation, but it's not smart to bet against central bankers' ability to destroy the value of paper money. The Fed will act in concert with most central banks around the world to keep the inflation game going.

A large, increasing global debt load creates constant demand for the money and credit necessary to service it, and if the free market refuses to supply the money and credit, central banks will. The free market's supply of credit dried up during the Great Depression and the Fed's inflationary ability was hampered by early 20th-century banking and monetary policy restrictions. It was powerless to stop a cycle of defaults.

The Fed's 21st-century inflationary tool kit is far more potent and flexible. Deflation cannot happen when governments can create infinite quantities of money and credit at zero cost -- and are insensitive about returns on investment, malinvestments, bubbles, and ever-growing trade deficits.

But bailouts do not happen without consequences. The faster central bankers inflate their currencies, the faster gold will return to its place as real money in the eyes of the public. You'll want to have a full allocation of gold-related investments as insurance.

Prepare for the Next Wave of Inflation

So the Fed and the federal government will attempt to magically protect us from both stock market crashes and gasoline shortages. After years of relative tranquility, stock market investors are due for some turbulence. If you are exposed to financial markets, it's not too late to reassess the fundamentals supporting the value of your investments.

In the inflationary environment I expect, you'll want to avoid holding long-term bonds and increase exposure to select precious metals, energy, and "old economy" infrastructure stocks and minimize exposure to consumer discretionary stocks. Companies vital to the production of developed and emerging market economy needs -- energy, food, and water -- will enjoy strengthened competitive positions.

Replacement values of the physical assets on their balance sheets will grow year after year, supporting their stocks' values. An entrepreneur (assuming environmental permitting were even possible) could probably not construct an oil refinery for anything less than twice the cost of buying the portfolio of refineries offered by shares of Valero in the stock market.

Conversely, what sorts of barriers to entry characterize an apparel retailing business? All you need is access to credit, low-cost clothing supplies, and a lease at the local shopping center. Companies that can deliver consistent, sustainable (i.e., not one-off, housing bubble-driven) earnings should assume market leadership positions in the near future.

I plan on profiling such companies for my readers and for attendees of the March 14-17 Investment U conference in Phoenix.

Good investing,
Dan Amoss, CFA

for Whiskey and Gunpowder

Dan Amoss, CFA is managing editor for Strategic Investment and a contributing editor for Whiskey & Gunpowder. Dan joined Agora Financial from Investment Counselors of Maryland, investment advisor for one of the top small-cap value mutual funds over the past 15 years. As a buy-side analyst, Dan refined his value investing approach by meeting with corporate executives, sell-side analysts, and writing proprietary research for the fund’s management team.

Dan brings to Strategic Investment the unique experience of an institutional background and a drive to seek out the most attractive investments within favored "big picture" trends. He develops investment ideas for SI readers with a global network of geopolitical and macroeconomic analysts. Dan holds the Chartered Financial Analyst® designation, a professional designation widely recognized within the investment community.

Accounting Reflects Housing Market Reality

by Dan Amoss

"Subprime" mortgage lending is a disaster unfolding before the eyes of financial market participants. Subprime refers to the practice of providing home mortgages to those with spotty credit histories in return for a few extra basis points of interest.

The Mortgage Lender Implode-O-Meter Web site has gained a wide following as an online obituary for the most aggressive, irresponsible lenders. This site, maintained by concerned citizen Aaron Krowne, has only been up shortly. Yet the site's headline flashes the statement "21 lenders have now gone kaput" since about December 2006. Krowne really cuts to the chase in his description of the unfolding disaster:

"It appears what had to give is now finally giving: the latest subprime loans are going delinquent the quickest, and it seems likely that their prior kin will soon follow (and many of these will likely end up in foreclosure). Further, I expect a large swathe of prime loans to go bad (the prime/subprime distinction is quite fuzzy anyway). Originators cannot handle the buybacks, and so when challenged by them are immediately folding [emphasis added]. The phenomenon is just getting started. What will the banking industry -- often all or part owners in these enterprises -- do? Stay tuned."

Lending in the NEW Century

Most of these companies concentrate on the "origination" side of the lending business, because it's considered the sweet spot. You simply approve your customer's credit application, perhaps buy some sort of "credit enhancement," and sell the mortgage to Wall Street, where it will be bundled together with similar mortgages and sold to some poor sap managing a bond portfolio at an insurance company.

One subprime lender in particular, New Century Financial, has been caught with its pants down and now faces financial restatements, shareholder lawsuits, and an uncertain future.

New Century is a "canary in the coal mine" for the entire mortgage industry. Its recent struggles should not be ignored as company-specific. NEW stock is a good gauge of the credit market's willingness to fund high-risk mortgages:

The availability of subprime credit is drying up as fast as this stock is falling. So what does Implode-O-Meter Web master Aaron Krowne mean when he says, "Originators cannot handle the buybacks?" New Century provides an example. The latest (300-page) 10-K explains:

"We sell whole loans on a nonrecourse basis pursuant to a purchase agreement in which we give customary representations and warranties regarding the loan characteristics and the origination process. We may be required to repurchase or substitute loans in the event of a breach of these representations and warranties. In addition, we generally commit to repurchase or substitute a loan if a payment default occurs within the first month or two following the date the loan is funded, unless we make other arrangements with the purchaser. The majority of our whole loan sales are sold on a servicing-released basis."

Last week, New Century announced that it hasn't been accounting properly for what it calls "early payment defaults." Scores of borrowers are defaulting before the ink on their mortgages even dries. So now New Century is responsible for repurchasing untold numbers of loans backed by homes that are not only illiquid, but probably worth less than the mortgage's face value.

To make matters worse, New Century is facing a liquidity crisis by violating several covenants on its own lines of credit. Creditworthiness is a rather important characteristic for lenders to maintain. The laundry list of Wall Street firms providing these lines probably agrees (we'd hope) and are likely to balk at extending credit at the time New Century needs it the most.

In a final toss of cold water on the widely anticipated housing recovery, New Century management says that these "early payment defaults" had not bottomed, and had in fact reaccelerated in the fourth quarter of 2006.

Many aggressive mortgages are turning sour so fast that, hopefully, regulators and accounting authorities will crack down on the aggressive accounting tactics that have inflated New Century's earnings figures.

Other suspected earnings inflators are Countrywide Financial, Downey Financial, and FirstFed Financial. Negative amortization mortgages have been popular among these institutions' customers because they feature advertisements like "Get a $500,000 mortgage for $250 per month." But the fine print describes how the difference between this payment and a realistic payment is added to principal -- hence "negative" amortization. The principal grows over its life, rather than contracting like a conventional mortgage.

These three players have been booking their customers' payment procrastination as real earnings. Since this behavior is a good indicator of future default, how should such loans be recorded on their balance sheets? They may be "performing" now, but a big chunk of them will stop performing in the near future. The housing market is fresh out of greater fools to bail out overleveraged speculators. At such time, most of the earnings that have been booked from these toxic mortgages will be erased.

Nobody seems to have a clue what the real earnings are in this business, since executives have plenty of leeway to play around with "lost reserves" accounting, making earnings what they want.

HSBC: Oops! Our Accounting Doesn't Reflect Reality

On the same day as New Century's announcement, mortgage giant HSBC Holdings announced a major increase in loan loss reserves, which will directly hit earnings. HSBC's press release explains:

"The impact of slowing house price growth is being reflected in accelerated delinquency trends across the U.S. subprime mortgage market, particularly in the more recent loans, as the absence of equity appreciation is reducing refinancing options. Slower prepayment speeds are also highlighting the likely impact on delinquency of higher contractual payment obligations as adjustable-rate mortgages reset over the next few years from their original lower rates.

"We have reviewed critically the impact of these factors in determining the appropriate level of provisioning at Dec. 31, 2006, against the Mortgage Services loan book. We have taken account of the most recent trends in delinquency and loss severity and projected the probable effects of resetting interest rates on adjustable-rate mortgages, in particular in respect of second-lien mortgages. It is clear that the level of loan impairment provisions to be accounted for as at the end of 2006 in respect of Mortgage Services operations will be higher than is reflected in current market estimates.

"We now expect that the impact of increased provisioning in this area will be the major factor in bringing the aggregate of loan impairment charges and other credit risk provisions to be reflected in the accounts of the Group for the year ended Dec. 31, 2006, above consensus estimates by some 20%." [Emphasis added.]

HSBC and New Century executives are sending very clear messages about future mortgage default risk, so why are two key purchasers of default risk choosing to merge? And why doesn't their accounting reflect worsening real-world conditions?

MGIC and Radian Increasing Exposure to Defaults

On Tuesday of last week, mortgage insurer MGIC Investment Corp. (MTG) announced that it will be merging with rival Radian Group Inc.. Radian shareholders will receive 0.9658 shares of MGIC in the formation of the new "MGIC Radian." MGIC was the subject of my last Whiskey & Gunpowder article, "Holding the Housing Market Bag, Part II." Wall Street seems to love the deal, sending the stock up sharply:

But the market is "missing the forest for the trees" by celebrating the cost savings of this deal. The "forest" is the risk in the existing book of business and the "trees" are the operational cost savings (i.e., redundant worker layoffs).

On the conference call the day of the announcement, both management teams extolled these cost savings and that popular M&A buzzword "synergies." But I expect that they will regret being distracted by a complex integration when they should have battened down the hatches in preparation for this year's mortgage defaults. So I found it interesting that Radian CEO S.A. Ibrahim, who will become MGIC Radian's CEO in a few years, can't wait to lead the charge into even more exotic credit insurance markets:

"We have an opportunity in the traditional MI [mortgage insurance] area, as well as in offering new kinds of credit enhancement solutions, because the market can no longer really be defined as traditional MI alone. Really, the market for credit enhancement should be viewed as much broader than MI. it's somewhere between the traditional MI which is a $600 billion [market] and the $9 trillion in mortgage debt outstanding, and it is going to be defined by the companies that can define that frontier." [Emphasis added.]

Neither management team mentioned risk on the call -- only opportunities. Would the analysts on the call bring it up? A grand total of two questions out of about a dozen focused on reserve accounting and risk in the existing books of MGIC and Radian. The first came from Goldman Sachs analyst Andrew Brill:

Q: "Do both companies use similar claims factors in their reserves? What have you factored in terms of reserve changes that might be needed as the books get combined?"

A: "We have very similar approaches, but we go about it differently. But ultimately, we get to a reserve base based upon experience on the claims side and severity, and as we looked at the actuarial reports that [MGIC] prepared and [Radian] prepared, [we determined that] the range of the reserve, in theory, is very close. We have different approaches for it, but 'net-net,' the average case basis is very similar when you look at the detail [so we do not believe that there will be any reserve adjustments]."

Management basically reiterated their reserve accounting policy of looking through the rearview mirror at the wonderful boom times in the housing market. This is likely to come back and bite them. Another analyst, probably from the buy side, asked the only other difficult question:

Q: "What is the strategic rationale for this merger outside of the cost reductions, considering the likely management distraction at a time of worsening losses?

A: "We have the issue of running the business. Relative to the business itself, I'm encouraged by what's going on in the business with the return of insurance in force growth as persistency increases with higher rates and the increasing penetration of MI... The loss side of the business is there. I think both [MGIC's and Radian's] portfolios are well managed. We both thought, looking at our books, that [paid losses] would be up about 10%. But we think that's well controlled."

By the end of this conference call, you can tell which analysts are helping management sell MGIC stock to the public with softball questions and which analysts are really trying to properly balance risks and opportunities.

In a presentation a week earlier at Citigroup's 2007 Financial Services Conference, MGIC CEO Curt Culver addressed the issue of default risk. He stated confidently that the trend in future defaults will be highly correlated with the job market. He expects MGIC to emerge from the subprime disaster unscathed because the company did not overly expose shareholder capital to the riskiest mortgages.

But this housing cycle went far beyond any past cycle. Near the peak of the housing bubble, a huge proportion of buyers were investors with no intention of ever moving into the homes they were buying. This inflated purchase prices and lowered the margin of safety for buyers actually intending to move in. Clearly, the higher the mortgage payment required to get into a house, the lower the household's ability to consistently make that mortgage payment.

Merger Accounting Muddies the Water

A great example of how merger accounting can misrepresent reality is the experience of Tyco Intl. investors. Wall Street loved former CEO Dennis Kozlowski's voracious appetite for acquisitions, hailing the company as the "next GE."

That is, until early 2002. Then, the seams fell apart as the Enron scandal and a recession combined to shed light on the real value of the hundreds of businesses Kozlowski had rolled up.

This rollup strategy included an accounting tactic called "bootstrapping earnings." Here's how it worked: Tyco used secondary issuances of its high P/E stock to acquire low P/E companies in stodgy, "old economy" industries. After the books closed on these acquisitions, Tyco would automatically show higher earnings per share. Throughout the 1990s, this conglomerate consistently produced investor-pleasing earnings growth:

How was this wave of acquisitions treated on Tyco's balance sheet? Whenever an acquiring company pays a premium above the target company's book value, the difference usually ends up as "goodwill," an intangible asset on the acquirer's balance sheet. Goodwill and other intangibles cannot fund dividends quite as consistently as capital assets, like plants. Tyco's intangible assets swelled from $6.4 billion in 1998 to $35.3 billion in 2001.

This was a big red flag. How could investors possibly asses the intrinsic value of the underlying businesses? Tyco is not a software company, in which nearly all assets are contained in minds of programmers and lines of code. As such, the explosion of intangible assets was not justified.

It turns out that a good chunk of Tyco's performance in the 1990s was function of a virtuous feedback loop: high investor expectations led right back to even higher expectations as follows:

The past few years have been a period of discovery about the real value of Tyco's conglomeration of businesses. As of early 2007, Tyco management is seeking to speed up the process by splitting up into separate operating units. Apparently, the magic of "synergies" no longer applies.

Tyco is an extreme example of the shenanigans that can occur behind the smoke screen of complex acquisition accounting. While Tyco is a portfolio of manufacturing businesses, New Century is a portfolio of subprime mortgages, and the new MGIC Radian will be a portfolio of insurance policies on $290 billion worth of home mortgages, they all share the common trait of being difficult to value. Now, MGIC Radian's merger accounting will make it even more difficult to value.

MGIC and Radian both trade for 9-10 times earnings, so Tyco-style "bootstrapping" will not be a factor. Changes to loss reserves are the factor that really moves the needle on EPS in the mortgage insurance business

I wouldn't be surprised to see MGIC management slip in an impairment charge or increase loss reserves as the MGIC and Radian financial statements join in holy matrimony. Merger accounting would provide a convenient diversion. I'll be watching closely for management to update their accounting to match reality in the housing market.

Good investing,
Dan Amoss, CFA

Dan Amoss, CFA is managing editor for Strategic Investment and a contributing editor for Whiskey & Gunpowder. Dan joined Agora Financial from Investment Counselors of Maryland, investment advisor for one of the top small-cap value mutual funds over the past 15 years. As a buy-side analyst, Dan refined his value investing approach by meeting with corporate executives, sell-side analysts, and writing proprietary research for the fund’s management team.

Dan brings to Strategic Investment the unique experience of an institutional background and a drive to seek out the most attractive investments within favored "big picture" trends. He develops investment ideas for SI readers with a global network of geopolitical and macroeconomic analysts. Dan holds the Chartered Financial Analyst® designation, a professional designation widely recognized within the investment community.