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Introduction

In Mathematics, there is a method when you have to exclude and discard first all the wrong solutions before ending up with the correct solution to a problem. In Investing, the equivalent method is when an investor stays far from specific companies which have increased odds to impact negatively the yield of his portfolio. As a New Year starts, we all place our bets for a high yielding portfolio rejecting the potential laggards and loading the potential winners. After checking my database of 2000 companies, I decided to write an article about the companies that I will not put into my shopping list for 2013 providing also the rationale behind my decision.

The Companies To Avoid

1) Cobalt International Energy (NYSE:CIE): I follow closely about 1000 energy companies that operate worldwide and I analyze them from time to time in my articles. My followers have read about them and they have also benefited much from my picks, starting from the unknown C&C Energia (OTC:CNCEF) of my first article that yielded 60% since the date I recommended it, to the obscure Rock Energy (OTCPK:RENFF) that was suggested just a couple of weeks ago and has yielded 22% thus far.

I also picked 5 undervalued Argentinian energy stocks in late November 2012, which have yielded significant returns so far since the date I recommended them. Apco Oil (NASDAQ:APAGF) has returned 50%, Petrobras Argentina (NYSE:PZE) and Transportadora (NYSE:TGS) have yielded 30%. Even the giant YPF (NYSE:YPF) has yielded 30% thus far. Gran Tierra (NYSEMKT:GTE) is the only company that still hovers at the same levels.

In other words, I am not a risk averse type of investor. However I am a fundamentals-driven investor and I have never been a fervent supporter of the exploration ventures due to their above-average risk. The unexplored land and the unproven oil potential do not excite me at all. When an exploration company does not discover the potentially high impact wells or when the drilling results show no commercially viable hydrocarbons, the disappointment and the steep price corrections are the next episode of the story.

The study case of Niko Resources (OTCPK:NKRSF) and its dry wells in Kurdistan where WesternZagros Resources (OTCPK:WZGRF) also operates, along with the exploration failures in Indonesia make me very hesitant about the exploration ventures.

Houston American Energy (NYSEMKT:HUSA), Porto Energy (OTC:PNRXF), CGX Energy (OTCPK:CGXEF), PetroFrontier Corporation (OTCPK:PFRRF), Horn Petroleum Corporation (OTCPK:HPMCF), Rodinia Oil (OTC:RDOIF) and its world-class onshore assets in Australia's Officer Basin are always there to remind me of this speculation I am talking about.

Cobalt has a 40% WI on Blocks 9, 20 and 21 offshore Angola and 21% WI in Diaba Block offshore Gabon. Diaba Block covers an area of 3,500 square miles. Although I have read a lot about the geology of Brazil and its potential similarities with West Africa's geology, Cobalt's results so far do not prove that the Brazilian success is duplicated at the African coast.

Cobalt is the operator on all three Angolan Blocks (5,600 square miles) and are pre-salt projects. In 2012, it discovered Cameia in Block 21 with a rate of 7,400 boepd. However, regarding the African Blocks, the presentation also notes that there are "no known technical barriers to commercial development."

Cobalt also holds 600K net acres in Gulf Of Mexico. The results from that front are mixed as of today:

a) In April 2012, Cobalt drilled the Heidelberg #1 exploratory well and did not encounter commercial hydrocarbons.

b) In February 2012, Cobalt announced the successful results of its Heidelberg appraisal well, located in Green Canyon block 903 in the Gulf of Mexico. That well encountered approximately 250 net feet of oil pay but Cobalt has only a 9.375% WI in the Green Canyon 903 Heidelberg block.

c) In June 2012, Cobalt announced that its Ligurian #2 exploratory well on Green Canyon Block 814 in the Gulf of Mexico did not encounter commercial hydrocarbons.

d) In Dec 2012, the company announced an oil discovery at its North Platte prospect (60% WI) on Garden Banks Block 959 in the Gulf of Mexico.

However this is not a shallow well but it is a very deep and expensive one. North Platte is located in approximately 4,400 feet of water and was drilled to a total depth of approximately 34,500 feet.

From a fundamental perspective, Cobalt has zero production currently and there is no guarantee that it will find commercially viable oil quantities on its Blocks. Additionally, it has been losing money and it has negative operating cash flows every quarter. This is why it completed a financing in early 2012. I also wrote on Dec 9, that the company would need a second financing as it ran out of cash. The corporate announcement came just two days later to confirm me.

After the second financing which is debt actually, Cobalt also boosted its long term debt at $1,4B and the Enterprise Value at $12B. Despite all this, the company trades well above its book value (PBV=4,5) currently. This premium is huge and is not supported by the fundamentals.

2) Painted Pony Petroleum (OTCPK:PDPYF): I do not see a light at the end of the "natural gas tunnel" in 2013. Gas production in North America is expected to flatten out in 2013 as the momentum from connecting already drilled natural gas wells subsides while lower rig counts kick in. EOG Resources' CEO Mark Papa is pessimistic and he believes that the natural gas prices will not rebound soon, but the depressed natural gas prices will remain for the next three or four years. This is why he is shifting his company away from natural gas and towards oil. It is clear that he does not see any near term strong catalyst that can turn thing around significantly in 2013 impacting to the upside the operating cash flows of the natural gas players.

Painted Pony Petroleum is a heavily natural gas weighted player who produces only 6,300 boepd (77% natural gas). The good thing is that the company is long term debt free but the good things end here.

Painted Pony has an Enterprise Value as high as $740M and estimated Funds from operations at 40$M (annualized). So it trades for $117,000 per flowing barrel and 19x the Funds from operations (annualized). Both ratios are whopping.

Even if we consider a premium based on acquisition criteria, Painted Pony is a very expensive junior producer. Just a couple of recent acquisitions from the natural gas sector prove it clearly. Tourmaline Oil (OTCPK:TRMLF) acquired Huron Energy for $47,000/boepd few months ago. Huron is a producer of 5,500 boepd (95% natual gas) and Tourmaline paid $258M for it.

Moreover, Peyto Exploration (OTCPK:PEYUF) acquired Open Range for $32,000/boepd in July 2012. Open Range produces 5,500 boepd (90% natural gas) and Peyto paid $175M for it.

3) Paramount Resources (OTCPK:PRMRF): This is another heavily natural gas weighted producer of 20,000 boepd (85% natural gas) with an Enterprise Value of $3.5B and estimated Funds from operations at $60M (annualized). So it trades for $175,000/boepd and almost 60x the Funds from operations (annualized). Both ratios are obviously staggering.

Even Halcon Resources (NYSE:HK) which is the most richly priced oil weighted company has lower metrics than Paramount. An investor may assume that Paramount Resources has such sky high metrics because it is debt free. However, he will be grossly disappointed because the company has a whopping D/CF ratio of 10x (annualized).

Both Paramount Resources and Painted Pony Petroleum haven't taken a beating yet but the stocks keep hovering close to the highs of their charts despite both the dismal outlook for natural gas and their sky high valuations.

4) James River Coal (JRCC): The coal industry is undergoing a major transformation and the outlook for coal is not stellar, to say the least. It seems that this is not just a hiccup as the sector has to face several headwinds.

On the one hand, the demand for thermal coal in North America is going to be severely hurt by both tighter environmental regulations and the glut of natural gas which has risen along with the increase in hydraulic fracturing of shale rock. In March 2012, the U.S. Environmental Protection Agency proposed the first limits on greenhouse-gas emissions from power plants, the largest source of carbon dioxide linked to climate change. The rules will permit emissions from new power plants at 1,000 pounds of carbon dioxide per megawatt-hour, about the level for a modern gas plant, the EPA said, effectively precluding construction of new coal-fired plants.

According to the latest news, the things seem to deteriorate for the demand of thermal coal going forward as the Government plans new anti-coal regulations after the Presidential election.

On the other hand, the demand for metallurgical coal in 2013 will also remain steady as China's economic growth has started to stabilize and its annual growth rate in 2013 will not be substantially different from 2012 levels. It is estimated that China's economy grew 7.5% in 2012, down from 9.2% in 2011 and 10.3% in 2010.

The only hope for the met coal going forward comes from India but the Indian economy does not seem enough to save the game.

Two recent events add two more ominous signs for the sector:

a) St. Louis-based Patriot Coal (OTCQB:PCXCQ) filed for bankruptcy protection few months ago.

b) Billionaire Wilbur Ross, who built a company from distressed U.S. coal assets and sold it last year for $3.4 billion, says the industry's current slump differs from earlier setbacks and may last for years because of the shale-gas boom.

James River is primarily a thermal coal producer and the demand for thermal coal is expected to be hit more than coking coal demand in 2013 as mentioned above. The company trades well below its book value currently (PBV=0,4) but I believe this is a value trap as this producer has been losing money for the first three quarters of 2012.

I do not expect the company to turn into profits in Q4 2012 as nothing has changed fundamentally during the last three months and eventually the operating cash flows will remain weak. Furthermore, EBITDA will most likely remain negative as they have been negative for the last 3 consecutive quarters. All these factors make the long term debt repayment difficult to handle.

5) Consol Energy (NYSE:CNX): This is another company from the coal sector whose outlook is quite gloomy as mentioned above. Despite this, Consol Energy keeps trading with a significant premium (PBV=2) like it belongs to a thriving sector with bright prospects of future growth.

Additionally, Consol's debt ratios are high. The D/CF ratio (annualized) is 5 and the D/EBITDA ratio is as high as 6. EBITDA dropped much in Q3 2012 and this is a clear warning for the future.

I believe Consol will cut its meager dividend and it will have to proceed with more asset sales in 2013 to lower its debt and navigate the macro hurdles that are thrown at it in 2013.

What could partly save the coal industry is the completion of the LNG export plants in USA and Canada. Once USA and Canada start exporting their domestically produced natural gas resources effective 2016, the price of natural gas will likely rise and it will not remain at the current levels which are between 1/3 and 1/6th of the world price. Until then, the fundamentally weak or overvalued coal producers will either go broke or correct substantially.

Conclusion

The preservation of the capital is the primary goal for any prudent investor. This is my priority too and this is what I always take into account when I recommend stocks in my articles. Eventually, I am certain that the uncertainty surrounding the aforementioned 5 stocks will keep them out of my shopping cart for 2013.

Source: These 5 Commodity Stocks Could Drop Significantly In 2013