Berkshire Hathaway's famous shareholder letter for 2011 was published this weekend. By now, you'll have seen quite a few articles written on it, but none probably focused on something that's rare with Warren Buffett: A large, unprofitable, trade. After all, this is the man who managed to sell credit swaps into the heart of the Great Repression and come out ahead.
So what was this misstep Warren Buffett took? It's right there on page 4:
A few years back, I spent about $2 billion buying several bond issues of Energy Future Holdings, an electric utility operation serving portions of Texas. That was a mistake - a big mistake. In large measure, the company's prospects were tied to the price of natural gas, which tanked shortly after our purchase and remains depressed. Though we have annually received interest payments of about $102 million since our purchase, the company's ability to pay will soon be exhausted unless gas prices rise substantially. We wrote down our investment by $1 billion in 2010 and by an additional $390 million last year.
At yearend, we carried the bonds at their market value of $878 million. If gas prices remain at present levels, we will likely face a further loss, perhaps in an amount that will virtually wipe out our current carrying value. Conversely, a substantial increase in gas prices might allow us to recoup some, or even all, of our write-down. However things turn out, I totally miscalculated the gain/loss probabilities when I purchased the bonds. In tennis parlance, this was a major unforced error by your chairman.
This shows that Warren Buffett is mortal, and can be surprised by events he didn't consider or foresee. So Warren Buffett ended up taking a substantial loss in, of all things, the bonds of an electric utility!
It's sometimes hard to understand what can hit and sour our investment. In this case what happened was that natural gas (NYSEARCA:UNG) plunged (for motives I explained in my article "The Reason Why Natural Gas Is So Cheap") not long after Warren Buffett established his position. It might seem odd why this particular company, generating and distributing electricity, could be impacted by natural gas (NYSEARCA:GAZ) going down. But what happens, is that Energy Future Holdings generates electricity mostly using nuclear power and coal, with 10,300 MW of its 15,400 MW generation assets being fueled by those two fuels. The problem is that natural gas got so cheap it started setting the electricity prices on the margin - making them lower, with this either lowering the rates Energy Future Holdings was getting for its juice, or displacing its (coal-fired) generation altogether. Either way, it had a huge impact on profitability leading to Warren Buffett's losses.
This also shows how reality can take huge turns. Not long ago, it was considered that whoever held coal-fired generation assets had a low cost advantage. Then natural gas plunged. Even though this drop might not be permanent, it might well last years due to the fact that it's based on a technological advance that should provide higher natural gas production for a long while - the fracking of shale. So it might make sense to check each electric utility out there to see who is too exposed to coal generation capacity. For instance, about 32% of GenOn's (NYSE:GEN) generation capacity is coal-fired. NRG Energy (NYSE:NRG) has 28.5% of its generation assets in either coal or nuclear (here I ignored the oil-fired generation as these are probably peakers), so it's no wonder its stock has been pressured as well - even though it's far from being under the trouble Energy Future Holdings got itself into.
There are three conclusions to be drawn here. One is that Warren Buffett is human and makes mistakes.
The other is that the presently low natural gas price can have a substantial impact on the profitability of electric utilities that have a lot of generation assets. Since price for electricity is set on the margin, natural gas can lower prices for every generator, but will punish even more extensively those that have a lot of non-natural gas generation and worse still, a lot of coal-fired generation.
And finally, with electricity prices set on the margin it can happen that natural gas-fired generation plants will displace coal-fired plants, so this implies lower coal consumption. As such and for as long as natural gas prices remain so low, one can expect an impact on coal prices, volumes and producers. It is then perhaps not surprising that coal producers, as represented by the Market Vectors Coal ETF (NYSEARCA:KOL), have been under significant pressure.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.