Austin Roberts'  Instablog

Much like the common – though oft misguided – reputation of insurance protection, investments in insurance companies have looked like a rip-off during the past few years.  But a thorough look at industry and company-specific fundamentals suggest that improvements may be on the horizon.

Insurance companies make money two ways: underwriting profits and investment profits.  Underwriting profits are generated determining what premiums should be charged in order for the insurance carrier to be compensated for the risk they’re assuming, plus an allowance for profits.  Depending on the type of insurance, there might not be any significant losses on the policies until a few years have gone by.  In the meantime, they are allowed to take the premiums they receive and invest them to generate a return that on capital. 

In insurance lingo, a “hard market” is a market in which capacity has been taken out by heavy losses and insurance prices are rising.  As prices rise, it eventually induces new capital to the industry, thus increasing capacity.  This increased competition will ultimately drive prices back down until they no longer compensate insurance carriers for taking the risks.  This is known as a “soft market.”  A few years later, the losses begin rolling in and the cycle starts anew.

The insurance industry has gone through some seismic shifts in the past year.  Due to huge investment losses and no help from underwriting profits, capacity has shrunk and could shrink further.  Many of the top players in the industry are in a questionable financial condition.  This, coupled with the fact that underwriting quality has gradually eroded since the last hard market ended in 2003, may lead to increasing insurance prices as the companies attempt to restore their balance sheets to competitive levels.

Three Criteria to Consider

There are three ways an insurance company can earn above-average returns on capital: (1) being a low-cost operator, (2) having the strength to say “no” and let premiums dwindle when the competition drives prices to insufficient levels, and (3) earning high rates of return on their investment portfolio.

The most difficult time to analyze an insurer is when the market is soft and the competition writing increasingly stupid business.  The best time to analyze an insurer is immediately after the “stupid” period, when insurance companies are reeling from losses – either from underwriting of investment operations.  At such times, it is relatively easy to identify the companies who have the three competitive advantages discussed above. An advantage in cost is always easy to identify regardless of market conditions.  If they have an advantage in underwriting, their premium growth will have been flat or declining for a few years, when their competitor’s have grown.  Underwriting integrity is probably the most important criteria to have a high-conviction assessment of, because it increases the likelihood that loss reserves are adequate and that they will be able to take advantage of profitable growth opportunities when insurance prices eventually rise again after industry capacity has shrunk.  Earning good returns on float is, like cost advantages, usually easy to identify by looking at historical performance.

 Word of Caution on Management

A rising tide lifts all yachts.  Indeed, if market conditions do improve for insurance companies, we will likely see increasing stock prices across the sector.  However, the insurance industry is fairly unique from an investment standpoint.  Banking is perhaps the only other industry in which the quality of management is of such supreme importance.  It is the number one factor with which investors must be comfortable. 

Insurance companies have significant leeway to fiddle with the financial statements.  They can be creative about finding ways to bury costs, and it is all too common for them have to restate inadequate loss reserves.  Reserving practices have a huge impact on the financial health and value of a company, and there is no way for outside investors to verify the adequacy of a company’s loss reserves.  Even rating agencies and auditors cannot mandate changes in a company’s reserving practices so long as the company is following accounting and regulatory rules.  Thus, management’s interests should be nearly perfectly aligned with those of shareholders.  You will HAVE to trust their estimates on loss reserves.

With the financial turmoil of the past couple of years, I believe there is a greatly increased risk that reserve practices have been compromised in order to maintain the appearance of financial health.  So if you invest in the insurance sector, tread with caution and scrutinize management’s reputation, track record, and incentives.

An Insurer Worth Investigating – Fairfax Financial Holdings (FFH)

Fairfax Financial Holdings (FFH), through its various subsidiaries, writes property and casualty insurance and reinsurance and manage investments.  Their operations are diverse and global, they have a strong financial position, and their management team has an impressive track record, large personal investments in the company, and communicate candidly with shareholders.   How do they stack up against the three investment criteria that should be considered?

FFH does not appear to have a meaningful cost advantage.  As with most other industries, cost advantages are rare in insurance.  The primary source of cost advantages in the insurance industry lie in the distribution channel.  For example, Geico, an auto insurance subsidiary of Berkshire Hathaway (BRK.A), has a cost advantage because they market directly to customers and don’t have the large costs associated with employing insurance agents throughout their markets.

Underwriting results at FFH are a mixed bag.  Their modus operandi has been to acquire underperforming insurance companies and turn them around.  For the most part they have been successful, but there have been a couple of notable exceptions that have dragged down their historical underwriting performance to pretty mediocre levels.  However, the management team at Fairfax truly “get it” in terms of disciplined underwriting. Since they’ve recently alleviated some major headaches from poor acquisitions made in the past, and because they have an enviable balance sheet, they are very well positioned for highly profitable growth if insurance prices harden over the next few years.

Investment results at Fairfax have been nothing short of fantastic.  Prem Watsa, the CEO, and his management team are very savvy investors, and their returns have slaughtered the stock and bond market averages since the company’s inception 24 years ago.  Most recently, they had some grand slam investments by profiting off of the housing market collapse and stock market declines.  These investments have provided them with loads of cash in an environment where many of their competitors have to scramble to get government bailout funds.

Given this information, Fairfax might be worth some research.  In addition to Securities & Exchange Commission filings, the company keeps an archive of every annual report since current management took over operations in 1985.  I recommend reading every Letter to Shareholders in those reports, as it will provide you with a good feeling for how management has performed given the hand they’ve been dealt.

*This is not a recommendation to buy or sell any security.  Do your own thorough research before making any investment.

I’m growing weary of all the natural gas bears that have come out of the woodwork in the past few months as prices have tanked.  I hear an ever-boisterous chorus singing tunes of doom and gloom for natural gas producers, predicting that we are in a supply glut that will only continue to grow with the huge domestic natural gas reserves that have been discovered, the significant new liquified natural gas (LNG) imports that are coming online in the near future, and simply as a result of boom-time overproduction in the past few years.  As much as I find comfort in numbers, I have not been compelled to jump on this bandwagon.

Natural gas currently supplies about 22% of the United States energy needs.  The U.S. has more than 1,744 trillion cubic feet (tcf) of technically recoverable natural gas, of which 211 tcf is proved reserves.  Around 60% of the U.S. onshore recoverable natural gas is unconventional gas, which consists of shale, coal bed, and tight sands.  The remaining 40% are old and quickly depleting conventional gas fields.  Just a few short years ago the vast majority of recoverable resource estimates came from conventional gas, so the 60% of recoverable gas figure is important since it indicates that future supply and demand needs must be viewed in light of unconventional gas production characteristics. These are in sharp contrast to conventional gas production characteristics.  Over the past decade, production from unconventional sources has increased almost 65%, and now unconventional production accounts for about 46% of U.S. production.  Since the economics and production decline rates of each are very different, it creates vastly different implications for the future.  Unconventional gas is anticipated to become an ever-increasing portion of U.S. proved reserves and production while conventional reserves and production continue to shrink.

Marginal cost of production for natural gas ranges anywhere from $4 to $8 per mmBtu, depending on who you talk to.  Keep in mind that sometimes the figures on the low end of the spectrum omit things such as land costs, so it is not always an apples-to-apples comparison.  There are also big disparities amongst the various gas plays.  As a rule of thumb, $6 per mmBtu is probably a fairly accurate overall marginal cost of production.  As unconventional gas plays have become more and more prevalent, production costs have nearly doubled since year 2000 according to Baker Hughes.  This is primarily due to the rise of unconventional gas production.

 Using 2007 production rates of 19.3 tcf, the current recoverable reserve estimates indicate that the U.S. has enough gas to supply the next 90 years assuming that consumption is held constant.  Technology has improved the viability of unconventional gas reserves over the course of the past decade.  But another factor is far more important to the viability of unconventional gas: natural gas prices.  As prices have steadily gone up over the past few years, we’ve seen an explosion of investment in unconventional wells, bringing huge flows of new production online.  Despite a giant resource endowment, the opposite phenomenon will be observed when gas prices fall below the marginal cost of production.  Why?  The rig count has already dropped over 50% since September of last year, half of current U.S. production comes from wells drilled in the past 3.5 years, and first year decline rates of 75% are not uncommon for unconventional gas wells.  Those are stunning figures.  After the initial decline is over and “base production” has been established, it is usually only a fraction of the initial flow rates.  In fact, some of the shale gas wells have been known to whittle down to near zero production after a few short years.  Clearly, a sudden drop in drilling will equate to a dramatic drop in production too.  Newer unconventional gas plays require that the “drilling treadmill” stay powered on in order maintain production levels.  As wells begin their steep declines, more wells must be drilled to fill the void.  The more wells that are drilled, the more wells must be drilled in the future to maintain that level of production.  It will be very interesting to see what happens to production rates, decline rates, and gas prices during the next 6 to 24 months.

 As prices fall below the marginal cost of production, rigs get stacked, drilling slows, and production drops won’t be far behind.  This phenomenon will be much more apparent with unconventional gas plays due to their high decline rates and higher cost of production.  On the other hand, we must expect the natural gas industry to live up to its reputation of wildly over-hyping new gas discoveries despite -- or perhaps precisely because of -- the potential for technology and time to boost reserve figures.  Reserve estimates are little more than educated guesses -- volumetric estimates that tell us absolutely nothing about the workforce, services, or equipment that will be required to turn it into actual usable energy flow.  As they say, a bird in the hand is worth two in the bush.  This basic principle seems to be overlooked by most of those who are bearish on the long-term future of the natural gas industry.

 Michelle Foss at the Center for Energy Economics in Houston, TX has been cited as saying that the gap between U.S. consumption and production will grow to nearly 9 tcf by 2025.  Right now 84% of the natural gas consumed in the U.S is produced in the U.S, and only 3% of the gas used in the U.S. is produced outside of North America.  That will change in order to fill the gap between supply and demand, as more LNG shipments come to U.S. ports.  Natural gas consumption rates will be steadily increasing for a long time in the U.S. and globally, suggesting that the market for natural gas imports will grow increasingly competitive.  The EIA anticipates that LNG imports will grow from 1% of U.S. natural gas supply to about 15% by 2025.  Natural gas sells at a premium in many other parts of the world, including the fast growing Asian markets.  Thus, natural gas prices in the U.S. will have to be sufficiently high to induce LNG shipments. 

 Arguments abound that profess that growing LNG imports will dramatically reduce both the price and volatility of natural gas prices because LNG can be imported to mitigate sudden domestic supply shortages.  What is not being acknowledged, however, is that the unconventional gas that now dominates the U.S. production profile has sharply different marginal costs of production and decline rates, and that those two factors will have huge impacts on natural gas prices.  If producers continue to lay down rigs when gas prices fall below the marginal cost of production, then sharp drops in production rates will quickly follow due to the high initial decline rates of these types of wells.  That will obviously lead to a shortage and a big spike in prices.  Therefore, in order to reduce the volatility of natural gas prices, producers need to be incentivized to maintain production rates even when prices fall below the cost of production. I’ll just go ahead and tell you.....that ain’t gonna happen.  Expect price volatility to continue unabated, despite growth in LNG imports.

 According to the U.S. Department of Energy, renewables only account for about 7% of our current energy supply and by 2030 they will only be able to provide about 8.5% of our energy supply.  In fact, the EIA estimates that oil, gas and coal will still supply 82.1% of our energy needs in 2030.  And unless there are monumental improvements to our transmission grids, supplemental “backstop” energy will have to be available when weather conditions and electrical storage capacity create any void from solar or wind power that must be quickly filled. If you believe there is a reasonable chance that oil production may see meaningful declines in the coming decades, then we will have to get creative to replace oil with natural gas in various parts of our economy -- probably starting with transportation.  The age of the world’s supergiant oil fields, production decline curves, and lack of many new discoveries over the past 30 to 40 years are alarming.  It may be wise to expect oil production to slow over time, but even if we hold it constant it becomes clear that natural gas will be a key to U.S. energy security going forward.  In other words, there is upside potential for consumption rates.

 One way to illustrate what an “appropriate” price for natural gas might be is to compare it, per million Btu, to crude oil.  Although the two commodities are not perfect substitutes, nor do they share identical supply and demand forces, the comparison does have some merit since it highlights which is cheaper in terms of generating energy.  Because a barrel of WTI crude oil contains almost 6 million Btu, the rule of thumb is that WTI oil should trade at about a 600% premium to natural gas.  Using this rule of thumb, $50 per barrel oil prices suggest natural gas prices should be over $8 per mmBtu.

 One last thing worth mentioning is the steep contango in the natural gas futures markets.  Contango simply means that the futures curve is upward-sloping, or that investors think prices will be higher in the future than they are today – usually because there is currently a surplus of natural gas relative to demand.  For the traders selling these futures contracts, the contango creates an incentive to buy cheap natural gas, put it in storage, and deliver it at higher prices in the future.  This also inflates natural gas inventory numbers and can create, to some extent, an illusion of a gas glut.  Since stockpiling isn’t consumption, these inventories may act to suppress natural gas prices later this year and possibly even next year as delivery is made and the market is flooded.  However, this, if it happens, will be an artificial damper on prices and would postpone renewed drilling that much longer.

Recap:

• Large reserves do not equate to cheap recovery of natural gas; there are substantial costs to get the gas out of the ground and to market, and producers will not drill unless they can cover their costs and earn a reasonable return. Natural gas is being consumed by the U.S. economy at a rate that exceeds domestic production.  And the gap is growing wider.  Production is supply, reserves are not.  Watch that rig count!
• Marginal cost of production has risen dramatically in the past several years, and it will stay at current or higher levels due to the large and growing proportion of unconventional gas production; gas prices are currently below the marginal cost of production, and they will not stay there forever.  The longer prices stay low, the bigger the supply/demand problem will ultimately be, and the higher natural gas prices will eventually shoot.
• Natural gas fields tend to peak fast and decline rates are brutal.  These characteristics are even more pronounced with unconventional gas fields.  Again, a big drop in drilling will inevitably lead to a big drop in production, although there will be lag time.
• The longer prices stay below the marginal cost of production, the more out of whack supply and demand will ultimately be.  This will lead to high and volatile gas prices somewhere down the line.