Tuesday, July 20, 2010

Fred Olsen Energy

The tragic accident in Deepwater Horizon oil drilling rig and the resulting oil spill as well as all previous major oil spills are horrible reminders of just how dangerous oil drilling and transportation are to the environment. In addition, the use of oil in transportation and electric generation is also pollutive and adds ever increasing CO2-level in atmosphere. Therefore, nature would be much better of without us using it.

Deepsea Delta semi-submersible drilling rig in North Sea (source: Wikipedia)

Unfortunately, oil is very much needed by the global economy now and far into the future. Therefore, oil drilling and transportation will have to continue. All the easy oil deposits have been probably already found in the land and under the sea. The demand for deepwater drilling rigs have been growing and the demand for shallow water rigs have been declining or staying flat for years (reference: see page 14).

I have been looking more companies in the oil and gas sector to my portfolio and Fred Olsen Energy (Oslo OSE: FOE) looks attractive. Fred Olsen Energy provides exploration and production services to the offshore oil and gas industry. It has 7 drill rigs, 1 accomodation platform and 1 drill ship which it rents for oil and gas companies. Currently it has no exposure to Gulf of Mexico. Most of the rigs are in the North Sea currently.

Compared to many of its competitors Fred Olsen Energy is small. However, the offshore drilling segment of the company is very profitable. Engineering and fabrication segment is loosing money, but the amounts are not significant compared to the main segment. The balance sheet reveals that the company has quite high debt load. However, it looks to be manageable especially in the current abnormally low interest rate environment.

The first half of 2010 has been weak in terms of revenue, but still the company has respectable cash flow from operations. The contract status of the fleet seems to be also in order. Five out of Nine rigs/ships have contracts in place until 2013-2015. The rest are shorter term. There seems to be a slight oversupply still in the floater market. I am sure that that and the contract status are reflected by the valuation of the company already.

What caught my eye in the first place was the forecast figures I saw in recent Arvopaperi magazine for this company (source: Facset):

P/E 2010: 4,9
yield: 8,19 %

The forecasts are even better for 2011. Looking at the Q2 raport from the company, I am not sure if these are conservative enough given that both revenue and profits are way down from 2009. At any rate, these valuations are so low that I think there is sufficient margin of safety for me. The latest dividend was NOK 10. The shares of the company are trading right now at 178 NOK.

Wednesday, July 14, 2010

Nautilus Minerals

Exploration stage mining companies are sort of lottery tickets. You can loose pretty much all your money in investing in them or then you can make spectacular gains. It all depends on what the company finds and if the mineral deposits are feasible to mine.

Last week, I took a small position in an exploration stage company called "Nautilus Minerals" (TSX/AIM: NUS). I am typically not interested in exploration stage companies, but this particular company does something that at first sounds like sci-fi: Their first mine will be located 1600 meters below the surface of Pacific Ocean near Papua New Guinea. In fact, long ago it was sci-fi. Jules Verne envisioned underwater mine in his book "Twenty Thousand Leagues under the Seas" back in 1870. I haven't read it, but I sure am familiar with Captain Nemo and Nautilus (the submarine) that were introduced by this book. It seems that Nautilus Minerals have taken their name from Nautilus the marine creature (not the sub) based on their logo.

The Nautilus, as pictured in "The Mysterious Island". Source: Wikipedia.

Oil and gas industry went offshore in the 1940s and now it might be the time for mining companies to do the same.  Nautilus Mining will use existing offshore oil technologies to cut ore from the seafloor and pump it to the surface as seawater slurry. Once the ore is dewatered, it will be shipped to shore for processing.

Recently published independent engineering study titled "offshore production system definition and cost study" related to the first ever underwater mine "Solwara 1" reveals some very interesting things. Indicated and inferred resources combined and valued at market prices for metals put the mineral deposit somewhere around 1,6 billion USD (at the time of writing). Most of this is copper (about 1 billion USD) and gold (about half a billion). Extraction requires 383 million USD capital expenses and approximately 150 million operating expenses (estimated based on $70 USD per tonne OPEX). The difference of resource value minus direct CAPEX and OPEX is over 1 billion USD. Naturally not all of this can be clarified as profit as there are other expenses involved in the process (such as smelting and refining).

Nautilus Minerals has about 169 million shares outstanding (diluted) and 196 million USD in cash (additional 40,7 million USD if all options etc. are excercised). The required CAPEX needs to come from somewhere. Either they have to issue more shares or then they need to sell some of the future revenue for cash today. So let's assume they sell more shares. Let's further assume that they can cover this by issuing 131 million shares putting total shares outstanding to 300 million.

Now, to justify the current share price of 2.11 CAD (about 2.05 USD) they would need to be able to make profits in the range of 600 million (net present value of future profits). If successful and completed within the CAPEX and OPEX estimates, the Solwara 1 alone should give this kind of profit with a healthy margin for error.

Yes, there are some very big IFs since this is a pioneering project. There are also big risks that the whole concept of underwater mining comes under attack for environmental or other reasons although the company claims that the environmental and social impacts are smaller than those associated with conventional land based mines. Also, between now and the completion of the mine, the company will have negative cash flow (Q1 2010: -13,3 million USD) due to exploration and other operating costs that are not related to mineral extraction from Solwara 1.

Solwara 1 was granted environmental permit in December 2009 and the company is expecting to have the mining lease in place during 2010. The company has over 450.000 square kilometers of tenements in five jurisdictions. There are many other high grade mineral deposits already found besides the Solwara 1.

Recently the stock has gained a lot and has been trading with wild daily swings up and down.

Wednesday, July 7, 2010

Technical Analysis and Roulette Systems

I'm not a big fan of technical analysis. I simply do not believe that past can be used to predict the future in apparently random system. Speaking of which.. Long ago, I read a book on roulette betting systems. One of the simplest strategies known as "martingale" is based on making only on those bets giving double return (red/black, even/odd etc.). Then you are supposed to double the bet after each loss in order to eventually win the amount that you first bet.

Picture author: Conor Ogle, source: Wikipedia

So, if you start with $10 you will eventually win $10 and get your bets back. The strategy is flawed to begin with, but this one of the reasons casinos use zero and double zero in addition to capping the maximum bet. Given that you would have 50/50 chance and very large amount of money to use for betting, you would beat the casino every time. And that's not OK for casinos.

But let's assume for a while that there would be a casino with roulette which has no zeros and no cap for maximum bet. I.e. betting on black/red would really be a 50/50 chance. This would be then equal to coin tossing (head or tails), which is typically used as an example in many books on probability.

The biggest flaw in the martingale strategy even in case of 50/50 chance winning is that it requires very large amounts of money to get even a small win. Let's assume you want to win $10. The table below gives you the probability (p) of loosing "n" bets in a row. It also shows what bets you need to place using the strategy.

Even though it is very rare (1 in million) to see 20 heads (or 20 black) in a row, it is not impossible. In fact, in the roulette book, the writer said that he had witnessed a streak of over 20 of the same color. Assuming that you would win on the 20th bet, you would still need some 5,2 million dollars to claim your 10 dollar victory.

To make odds better, the writer introduced a "system of five". Meaning that you wait until there has been eg. five times black and then you start applying martingale using red. Unfortunately, this strategy does not increase you chances of winning at all. Even if you would wait until 10, 15 or 20 of the same, you chances would not increase.

You still would have chance of 50% in loosing the next bet and the table above does not change one bit from that point forward. I believe it is a very common error to think if you see someone get 10 times heads in coin tossing, the probabiliy of next heads is low. The probability of seeing 10 heads in the row is 9,77% (i.e. low), but in case that is already in the past then it won't matter. The next toss carries 50%/50% probability for tails/heads in the same way that every single toss does.

Similarly I believe that technical analysis does not give significant advantage, because what has happened in the past won't matter now or in the future. You might get lucky and it works for awhile, but eventually you will loose if that is the only strategy you have. Naturally, technical analysis can be used as a tool among others to determine what is going on in the market. I.e. understanding what has happened until now.

Basically the casinos and the online brokers have the same design. The more you play, the more you will loose to the "bank". Therefore, it is no wonder that many brokers and the like advocate technical analysis. The more trades there are the more money they will make. People implementing true buy and hold strategy are lousy customers for brokers.

Still, if you want to gamble with your money, it is much more wise to gamble in stock markets than to do so in a casino. Because your odds are much much better and you can limit your losses more easily.

Thursday, July 1, 2010

Two new reactors

Finnish Parliament gave today approval for construction of two new commercial nuclear reactors. One new reactor will be built by energy company Teollisuuden Voima (TVO) in Olkiluoto. Fortum owns 26,6% of TVO. Therefore, as long time supporter of nuclear power and shareholder of Fortum, I am naturally happy about the decision.

TVO has two existing reactors in operation, one 1600MW reactor (TVO3) being built and one more in the planning pipeline (TVO4). The fourth reactor is likely also in the range of 1600MW meaning that both new reactors will be each equivalent to 2-3 currently operating reactors. Fortums's share of each new TVO 1600MW plant is roughly 425 MW. In comparison, Fortum's fully owned reactors in Loviisa are producing 488 MW each.

Picture: Picture. Fortum’s Loviisa nuclear power plants from air. Source: Wikipedia.

The other reactor will be built by Fennovoima in either Simo or Pyhäjoki in northern Finland. Behind Fennovoima are various Finnish entities with 66% stake and the world’s largest privately owned energy company E.ON from Germany with 34% stake.

Fortum applied, but did not get preliminary green light for third reactor to Loviisa. It remains to be seen when and if it gets go ahead for that. The Loviisa plants are quite old (built in early 1970s) so eventually they need to be replaced.