Monday, October 15, 2007

Harvest Natural Resources

Harvest natural Resources is an oil and gas company headquatered in Houston, Texas. It's business activities lies mainly in oil rich Russia and Venezuela. Currently, it's prime asset is the right to drill for oil and gas in the fields of Venezuela and they have been operating under an OSA(operating service agreement) in Venezuela under which it would produce oil and deliver it to PDVSA(Petroleos de Venezuela)

The main risk investing in Harvest Natural Resources is that of a political one. This is due to the company being subjected to continuing expropriation through renegotiated contracts or broken contracts with the Venezuelan Government where the venezuelan Government acts to modify the property rights of the company under its sovereignity. During the last quater of 2004, the Venezuelan government witheld drilling permits and since then production levels were cut with large back taxes charged to these companies operating in Venezuela. Operating Service agreements were deemed illegal by the state government and companies which were operating in Venezuela had to be reorganised as mixed companies with majority stakes being controlled by the state. As an example, the Venezuelan Government recently converted 32 privately run oil field contracts into 21 state dominated joint ventures last year and this is exactly what is taking place in the backyard of Harvest Natural Resources. As i write this HNR is trading at a price of $12.55.

With regards to Harvest Natural Resources, the net effect is that Harvest Natural Resources now owns 40% of Petrodelta and PDVSA owns 60% of Petrodelta. PDVSA also owns 69% of Lagopetrol, Hocol owns 26% of lagopetrol, encopek petroleo owns 3.1% of lagopetrol and Carte De Inversiones Petrobras owns 1.6% of Lagopetrol. In case, you do not understand what i am talking about above, PDVAS(venezuela) now owns 69% of Lagopetrol and also owns 60% of petrodelta. Petrodelta and Lagopetrol which is an approved joint venture can then go on to set up a sales contracts with the PDVSA.(Get the picture?)Essentially, Chavez is doing this to generate addtional revenue for a poverty stricken country. Under the new changes, Harvest natural Resources can also operate in Venezuela till 2026 rather than 2012 under the operating service agreement. HNR has to pay taxes @ 50% and is also subjected to a 33% rolyalty. Subsequestly , HNR operating as Petrodelta will then invoice PDVSA from April 1st 2006 till 30th June 2007 and this will prove to be an estimated 275 million. After forking out its back taxes and operating expenditures and much needed working capital, Petrodelta will be expected to distribute the rest of the funds back to HNR. This has been revealed by Form 8K which was filed on the 18th of September.

Valuation(according to Q2)

Shares outstanding: 37.74 million shares

Market Capitalization: 473.6 million

Net cash(cash less debt): $1.71 per share

Enterprise Value per share : $10.84

Proved Barrels: 45 million

Probable Barrels: 31 million

Possible Barrels: 74 million barrels

Enterprise value per Barrel(proven, possible, possible): $2.72

Enterprise value per proven barrel : $9.09

Enterprise value per proven barrel is $9.09 while large integrated oil and gas companies frequently trade at an enterprise value of $15 - $18 per proven barrel. While using enterprise value may be subjective as there can be many unknown variables and it is too simplistic an approach.

Using Discounted cashflow with the following assumptions as per Ryder Scott Report:

1) 10% discount rate
2) 50% tax rate
3)Value of proven reserves:$616 million before tax rate
4)Value of Probable reserves:$317 million before tax rate
5)Value of possible reserves:$792 million before tax rate

Intrinsic value of reserves after 50% tax = approximately $24
Current price: $12.55
(The Ryder Scott group is actually an independent group of petroleum consultants that specializes in certifying and valuing reserves and they have been in business since 1937.)

In addition to the valuation metrics above, one can also spot a few catalysts:

1)Net of royalty income, Petrodelta will receive $275 million according to management. After costs incurred for the period of approximately 46 million, a 40% interest in petrodelta and 50% tax rate , HNR will obtain 45.8 million which is equal to $1.21 per HNR share. Any dividends distributed to HNR will be a catalyst to stock price moves to the upside.

2) Now that the mixed company has been reorganised, a huge part of the political risk has been removed. HNR can continue to operate in Venezuela. In the 3rd quater of 2006, despite having reported a negative number for earnings(-1.36 yield to date), HNR did in fact earn approximately $0.25 per share in Venezuela although it suspended drilling. Continued drilling in Venezuela would make a positive inpact to its income statement in the future, the extent of which cannot be estimated as yet.

3) 25 June 07 - HNR's board approves a $50 million buyback. This would enrich existing shareholders
Quote" Having achieved Venezuelan National Assembly approval for the formation of Petrodelta, we have eliminated much of the uncertainty that has negatively affected the value of our share price and hindered our plans for further development in Venezuela and elsewhere," Unquote
4)Removal of political uncertainty and future of harvest natural resources

5) Pabrai Investment funds have invested a substantial portion of their net worth into HNR. Activism may take place and we believe that as a substantial shareholder, Pabrai will be able to advise the management on what can be done to increase intrinsic value. This will help to narrow the gap between intrinsic value and current trading price.

Our opinions about the downside:
Now that the mixed company has been reorganised, it removes much of the uncertainty of operating in Venezuela. The downside is the complete seizure of assets by the Chavez Goverment in the future. But will that happen? As it is HNR has been operating in Venezuela for the last 15 years and has had a good track record of 'milking' the oil fields. Instead of doing it themselves, Venezuela which is a country lacking in technology and money would have to make use of HNR to pay for drilling of oil fields which can be rather capital intensive. In other words, i think they would prefer HNR around instead of themselves or some unknown and unproven company to do the oil drilling. This will bring in additional revenue streams for the Venezuela goverment.

What me and manpreet did:

We sold in the money current month put options @ strike 12.5 with the premium of each contract being $0.7. If the trading prices lifts above $12.5, we get to keep the premium. If it does not, our buy in price would have been $12.5-$0.7= $11.8 Buying in at $11.80 ensures that i have an approximate 50% margin of safety.

Friday, October 12, 2007

Moody's and Subprime Crisis

Moody’s main business model

It rates commercial and government entities based on their credit worthiness. It also performs rankings on such entities using a standardized ratings scale. It has a 40% market share worldwide in the ratings business.


During the 2003 to 2006, mortgages based credit securities became an important source for profits. Profits soared as the Moody’s began to rate such securities to feed the growing appetite of investors who sought higher returns.

After the bursting of the Internet bubble in 2000 and the events on September 11, the US economy seemed to be bad shape. The Federal Reserve sought to lower interest rates in order to simulate enterprises and make it easier for people to borrow money to invest in businesses. Hence, during the early 2000s, interests rate fell to about 1% and this soon began to create a massive liquidity bubble

The cheap money was soon used by entities such as hedge funds, banks, insurance companies and mutual funds to buy assets. Similarly, central banks across the world followed suited and soon a massive bubble began to form globally. During this time, the spread between the junk bonds and treasury bonds began to narrow, fuelling a boom in leverage buy outs led by a host of private equity firms.

Mortagages and Securitization

Investment bankers securitized mortgages and loan them as packages to investors. Ratings firms such as Moody’s played a part by rating them using their models to make it easier to sell them.

With the growing appetite of investors (i.e. hedge funds) who were willing to purchase such mortgage backed securities, mortgage lenders soon began chasing customers who had a poor credit histories and more likely to default by offering loans with variable rates. During this period, interest rates were low so customers were able to afford the interest on the loan. Some of the mortgage lenders were even more aggressive and introduced deferred payment schemes which offered low initial monthly payments and pushed interest further away into the future. Such aggressive practices allowed high risk customers who were likely to default to borrow money for acquiring new homes.

Subprime mortgage lenders then packaged such these loans and securitized them to generate revenue. However, one of the problems for Moody was how to rate such mortgage backed securities…

Moody’s devised several complex financial models to help rate such securities. However, this proved to be a Herculean task as many of these financial models use past historical data and assumed historical volatilities would be the same. Moreover, such complex models are difficult to understand and could never be 100% accurate as it’s often difficult to take in all the information especially in a dynamic marketplace. Lastly, financial models fail to take in account that much of the markets movements are driven by psychology (i.e. fear and greed) which can never be truly reflected in financial models. Hence, due to the mispricing of risk in these financial models, many of the mortgage backed securities were awarded dubious ratings.

Hedge funds, hungry for returns especially in the competitive world of money management, had scooped loads of such securities using leverage in order to juice their profits. Many of these funds had relied on ratings firms such as Moody’s to rate such bonds and tended to buy those of higher investment grade (especially in the sub prime market) for safety. Using leverage on such risky investment products only made the situation. Unbeknown to the rating firms, subprime mortgage lenders had adopted aggressive practices to boost securitization revenue.

In my next article, I will touch more on Moody’s and look at its financials.



Monday, October 08, 2007

Leverage is not for the faint hearted

Following the recent gyrations in the financial markets, one does worry about the degree of financial leverage some of these market players take to achieve better returns.One favorite play by such market players is the yen carry trade.What makes the yen carry trade so dangerous? Read on....

Highly leveraged yen carry trade makes the prospect of financial tsunami more real. Due to the thin spread between currencies, traders have to use leverage in order to realize profits to justify the enormous risks in currency trading. For example, a trader borrows 1000 yen from a bank and converts the funds into US dollars and buys a bond with that amount. Assuming that the bond pays 5.0% and the Japanese interest rate is set at 0.25%, the trader makes a profit of 475 bps. However, using leverage can reward the trader very handsomely. If he uses leverage with a factor of 10:1, he can stand make a profit of 47.5% provided if the exchange rate remains stable.

However, if the yen gains strength and gains from120 yen to 110 yen, the trader now makes a loss. His loss is now 8.3% (120-110/120).But in this case, he has used a leverage factor of 10, so his actually loss is 83%.Clearly this strategy is fatalistic if the Japanese Yen gains strength which can be worse if the investor has made investments into dubious financial instruments such as subprime CDOs, CDS.

In the financial markets, it’s often difficult to measure the size of such carry trades as they involve several currencies. Compounding the already bad situation is the use of swaps, derivatives and futures. Given the increasing diversity of the trades, even seasoned market watchers are unable to predict the next sudden unwinding of the yen carry trade.

The BOJ’s policy of keeping interest rates may cause “distortions” in asset allocations and flows of capital globally. Recently, the Bank of Japan decided to raise interest rate by 25 bps to 0.5 %.This created fears among government officials who felt any increase in interest rates may affect Japan’s slowly recovering economy which is estimated to grow at 2% this year. In Japan’s case, a weak economy needs to keep interests low in order to “stimulate enterprise and investment in economic growth”. Thus, any further increases would be "very gradual" according to the Bank of Japan, leading market players to continue borrowing yen to invest in higher yielding assets abroad. This will only further exacerbate the already worsening situation.

A recent study by Barclay capital raised a few eyebrows. In the study, Barclay stated that “"The magnitude of Japan-funded carry is reaching scary levels, in our opinion," and added that "even if the macro environment remains benign for carry trades, we cannot rule out the possibility of a sudden unwinding of positions that simply feeds on itself.". Even a small fluctuation in exchange rates would cause traders to unwind their positions as they would be unable to afford the losses due to the large amount of leverage that they have employed.

Types of investors

Japanese Insurance companies: Insurance companies make profits through 2 ways

1) Underwriting. Using actuarial science to help quantify risks and determine how much to charge for the insurance policy being underwritten.

2) Investing the premiums from the insurance policies. The insurance companies earn
returns by investing the “float” into a portfolio of equities and bonds

Given the zero interests rates environment, insurance companies were forced to invest abroad in higher yielding assets.

Japanese retirees: Due to the ageing population, more and more Japanese are living longer. However, these retirees need increased returns to meet their old age needs. Investing in the Japan would be difficult given the deflationary environment and low interest rates. Hence, these retirees are forced to invest abroad to seek better returns.

Speculators: The speculators borrow large amounts in yen and aim to use leverage to help generate large profits. Their investment horizon is normally short term and are quick to close money losing trades. This can have an adverse effect especially when the yen carry traders are rushing back to convert foreign currencies back to yen. This can cause the yen to gain in strength, causing further losses to traders who are still holding their position. A sudden influx of financial flow back to Japan can destabilize the foreign currencies and lead to sharp drops in the global financial markets as these traders unwind their positions suddenly.

Time to time,such fluctuations in the market will lead to good value investing ideas.Being patience and waiting for those fat pitches is what investing is all about.