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Mark Anthony, is an IT professional and who had a scientific research background before joining the information revolution. Visit his blog: Stockology (
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  • Paper Vs. Physical Assets In Futures, Options, And ETFs 2 comments
    Apr 25, 2012 12:14 PM | about stocks: Q, PCXCQ, ACIZQ, BTUUQ, WLT, CLD, ARLP, UNG, USO, TBT, TLT, ZSL, GLD, SLV, CHK

    A few years ago First Solar (FSLR) was Wall Street darling selling for as high as $320 a share, I predicted that FSLR is limited by supply of tellurium, a metal 15 times rarer than gold but once sold for only $7 a kilogram, and called form FSLR to drop to $20 within three years. It did fall to within 2 pennies of $20 and within my three year time frame, but due to different reason: the glut in silicon solar panels. Should I take credit for the $20 call? If a doctor says a patient will die from cancer in three years, but the patient was hit by a truck 2.5 years later, did the doctor diagnosed the cancer patient wrong? You be the judge.

    I mention this story because it reminds me some very popular but very wrong attitudes on how to invest. 99% of investors held such popular positions but they are wrong. I will explain.

    If you don't hold it, you don't have it

    One of my most popular SA articles, The Problem With Almost Every ETF Investment and the more popular Grave Warnings to Precious Metal Investors helped many investors escape huge loss in United Stated Natural Gas (UNG), United States Oil (USO), Direxion Russell 1000 Financials Bearish 3X ETF (FAZ), Direxion Russell 1000 Financials Bullish 3X ETF (FAS), ProShares Ultra S&P500 (SSO), ProShares UltraShort S&P500 (SDS), ProShares Ultra Silver (AGQ), ProShares UltraShort Silver (ZSL), ProShares UltraShort 20+ Year Treasury (TBT), ProShares Ultra 20+ Year Treasury (UBT), and possibly helped some investors to avoid future catastrophes in SPDR Gold Shares (GLD) and iShares Silver Trust (SLV).

    Have you ever wondered why ETFs are suddenly sprouting like bamboo shots? Do Santa Clauses exist to help you profit? Or are they trying to fleece you of your money?

    I am expanding those two pieces and hope this article helps more investors to understand the difference between paper and physical assets. In the gold investment community they say: If you don't hold it, you don't have it. I learned that long ago.

    When I first discussed FSLR and tellurium, a well-respected analyst called me on the phone and when I told him I bought a few buckets of physical tellurium he laughed for a minute. A pundit, who went against my advice and bought TBT at $57, posted a funny video on YouTube. Other analysts called me and asked me where to buy tellurium future contracts. They walked away disappointed that there was no futures contracts in tellurium, and did not want to hear I told them that Asarco has physical tellurium for sale.

    When it comes to investment, people love playing options rather than buying the actual stocks, when it comes to commodity they love flipping future contracts rather than hoarding rice, corn and tellurium at home. When it comes to gold and silver they will rather let the foxes watch the hens, than holding the heavy and cold metals in their palms.

    That's a huge problem. That mentality is what causes catastrophe, both to individual investors, and to the general market, and to the state of the global economy as well.

    Let me say it again: If you don't hold it you don't have it. Let me explain it very clearly what it means. This is an investment 101 lesson that benefits your investment for your lifetime.

    What are physical assets and what are paper assets

    But what are the things you hold and what are the things you don't? Things you actually own with recognized ownership are the physical assets, like stocks, precious metals held at home, and deed of a real estate property. You might have only a piece of paper, like a stock certificate or a paper document called grant of deed, or it might only be just a computer registry, but these are not paper. You legally own a slice of the company, the physical precious metal, and the property. So let me clarify this point: stocks and equities are not paper assets.

    Paper assets are the things you do not hold, but held by some one else and you merely have a claim to a promise some one else made. Debt coupons are paper: You don't own the money; some one took the money and made the promise to pay you back. The commodity future contracts are not physical assets but merely paper: some one took your money and promised to deliver certain goods to you in future. Stock options are paper: some one took your money and promised that you can buy such and such stock at fixed price in the future. A receipt of a precious metal pool account is a paper asset: you were promised that you could get the metal in your hand if you want to, in the future. Any time you think you hold something, but it counts on some one else doing something as promised, then you are holding a paper asset.

    What is wrong with holding future contract based ETFs, stock options and commodity future contracts? They are all just paper assets! Paper assets are wrong because physical assets are limited and provide real investment return, but papers count on promises. Promises have no limits and can be made at any time and can be broken easily. The legal system may make sure promises are honored, but it does not trump over the reality of the physical world, which has limits.

    Most ETFs are Paper Assets That Do Not Work

    After I discovered why an ETF like UNG can not work, dumped it and wrote The Problem With Almost Every ETF Investment on Sep. 15, 2010, UNG dropped from $54 to $14.40, losing 73.3%, USO did not do much better. In an oil bull market USO went from $33.00 to $39.39, a mere 19.36% gain. That seems to be typical of commodity ETFs: On the up side their gains are diminished, on the down side the losses are accelerated. In the long term the values keep decaying towards zero.

    The reason such ETFs have decaying values is because they hold future contracts written by counter-parties. Thus they are just papers and they are zero sum gambles. It is not just because of contango as people talked about. Please refer to my old article for the explanation. The chart below shows some of the examples:

    click to enlarge)

    ETFs that do not hold paper, but claimed to hold non-paper assets, like GLD and SLV, are in a different category. Asset valuation is not the issue for these ETFs. But how do you know these ETFs actually hold what they claim they hold? Would you let a fox watch your hen house? Would you let your friend watch your gold for you? I do not know the folks who manages SLV fund. Therefore I do not have confidence letting them watch my gold, silver and palladium.

    If you don't hold it, you don't have it.

    What is Investment and what is Gamble?

    A SA reader who agreed with my bullish stand on US coal proposed such: Sell some ACI shares at $9.40 and purchase some Jan., 2014 calls of $10 which now costs $5.00. The problem with this trade is this is precisely what his enemy, the shorts, will be doing: short sell shares and then buy calls for protection. The only difference is he starts with some shares and the shorts start with no share. Why would you do precisely what your enemy does, but some how you expect you to win but your enemy to lose?

    Options are zero sum gambles with one side winning and another side losing. A bullish sector does not necessarily mean the call side wins and the put side loses, vise versa.

    Investment is buying at current price and expecting to sell at a higher future price to reap profits. When you buy call options you are paying a future price with a down payment today. How can you expect to make money? In the above example, the investor is willing to buy ACI at $15 per share and he made a $5 down payment, and pay the remainder of $10 in January 2014 to get the shares. But he is selling what he already holds at hand today for only $9.40. I find that logic mind-boggling.

    If you believe a coal stock is bullish, do NOT sell it to buy options. Instead sell some call option to raise money and use the money to buy more shares today. Whoever sold you the shares cheap today happily agreed to pay a much higher price buying back those shares, exercising the calls you wrote. He probably thought he made a great deal selling low and buying high.

    When people learn that I buy stocks, their immediate response is: Oh you are gambling in the stock market. There is a big difference between investment and gamble. The difference is TIME.

    When you gamble, you put your money in, but not your time: you will instantly know if you lose or win. But when you invest, you have to put your TIME in. It's not just time spent in doing due diligence study, although that is important. More importantly you have to sit patiently and let your investment grow its fruit over time. This is the part that most investors tend to forget. This is the important part that separates a gambler from a real investor.

    If you are thinking about clever option strategies that look like can lock you instant profit, you should be alerted immediately. You are not patient enough to allow time to work for you. You want to get rich quick. When you fall into that mentality you turn yourself into a gambler, not an investor. You might win a lottery, but probably no.

    The Problem with Derivatives and Paper Assets

    Likewise, commodity future contracts are also zero sum gambles. Not only it destroys personal wealth, it destroys the global economy as well. Let me give one example in corn in the following fictitious conversation between a US farmer and a Hedge Fund Manager:

    • Banker: Hey Joe, you know you should plant some corn this year. They are selling at $600 per bushel now. But due to China demand they may go up to $1200 by the fall. You can make tons of money planting corn this year.
    • Farmer: Oh yeah. Maybe. But all my neighbors are planting corns, how do I know I will make a profit by the fall? What if corn price falls? I have a family to feed.
    • Banker: Listen Joe. There is this wonderful financial invention called hedging. You can write a future contract to me, promise to sell me some corn in the fall for $1200. I pay the money up front now. You just go ahead plant the corn with no risk.
    • Farmer: (Took the $1200 per bushel money. Went home, check the price of fertilizer etc and decided NOT to plant the corn. Instead he simply purchased the corn from spot market for $600 per bushel)
    • Banker: Hey Joe, my bet on corn has been great. The corn is now $700. It will go up a lot more. How is your corn growing?
    • Farmer: I have not planted any corn at all. Why should I?
    • Banker: Then how will you be able to make good delivery?
    • Farmer: I bought corn and can make the delivery. How are you going to take the delivery then?
    • Banker: I don't take delivery. I have no place to store the corn. I will just sell the future contracts before expiration.
    • Farmer: Then who will buy your expiring contract then?
    • Banker: I don't know, all of my fellow bankers bought future contracts and all need to sell. They cannot take delivery. I wonder who will buy the useless paper if every one sells.
    • Farmer: Whoever needs corn will buy the contracts and ask for delivery of corn. Why is that a problem?
    • Banker: But all your neighbors planted corn and locked in profit already. There is now an over-supply of corn in the market.
    • Farmer: Sell them back to me, for $300 before you lose it all.

    In this example, the farmer hoards corn and locked in profit. He did not need to labor and plant corn. The banker who plays paper future contracts end up losing money because he was not willing to hoard.

    In a normal market, all market participants: farmers and corn buyers need to take their own risks. This forces them to evaluate their risks and gauge how much corn needs to be planted. If they bet wrong they suffer a loss, the market improves because non-competitive losers are eliminated. Things are thus kept in checks and balances.

    Widespread usage of derivatives and financial hedging instruments does not eliminate risks, but simply shifts them from one party to another, resulting in concentration of risks and what Warren Buffet called Financial Weapon of Mass Destruction.

    In the worst case, such FWMD can destroy a whole industry!

    Paper Games Destroy an Industry

    The sophisticated paper games destroy a whole industry known as the shale gas industry, believed to be America's energy future.

    There was a North American natural gas crisis looming some years ago. But almost over night, things changed due to a rosy picture of the shale gas revolution. A technology that was used since 1947, called hydraulic fracturing, found its new use of cracking rigid rocks deep underground to release the shale gas. Suddenly America has a new abundant and cheap energy source that seems to last us 100 years and bring us energy independence.

    Is it really so? Normally when exploring a new field of technology or mining, people should move with caution before things can be solidly proven. But caution is thrown away by the gas industry as they jump both feet in into the shale gas fiasco, signing complicated hedge contracts with banks and getting big money loaned to them. The industry loves to pitch the rosy shale gas prospective to get the loans they need. Banks love to hear the rosy predictions, as they look good on the loan books. Who cares about risks? Every one is hedged. Everyone makes tons of risk-free money. Some companies acquired so much land lease and flip them for profit that they begin to look more like a real estate development company than a gas and oil exploration and production company.

    But the risks have not gone away. The risks stay in the system. The whole episode is a giant Ponzi scheme. The last bag holders are the victims. The reckless shale gas boom has destroyed the natural gas price, pushing it to a decade low of $2.00 per mmBtu, a deeply non-profitable price for both shale gas and conventional producers.

    The Shale Gas Revolution is a Boom and a Burst

    The risk does not stop at price. If what Dr. Arthur Berman and many shale gas critics say is true, shale gas is non-economical even when natural gas prices recover. Many natural gas producers will go belly up, as they cannot pay back the loans they took in the shale plays.

    Investors are frustrated that so far there is no sign of natural gas production slowing, amid record low prices, although the rig count seems to drop drastically. Do the CEOs of these companies care? Why any one cares if the risks are already "hedged" away and the loss will not be theirs? Maybe they just want to illusion of abundant shale gas last a little bit longer so they can flip things and pass the craps to the last foolish bag holders.

    Is shale gas really abundant? Is it really produced at low cost? The 100 years of natural gas supply is more likely only six years left, according to Chris Nelder. That's the gas reserve that is proven and economically producible. The rest are speculative and hypothetical gas reserves that we don't even know if they exist or not.

    Is shale gas production cost low? The per mmBtu cost shale gas depends on two things:

    1. The cost of exploration, well drilling and maintenance cost once production is ongoing and other cost.
    2. The amount of shale gas that will be produced, called Ultimate Economical Recovery (UER).

    The cost is relatively certain. I would put a total cost of a well some where between $15M to $20M, from start to the end of life cycle.

    The UER is less certain, as there is no well that has gone through a whole life cycle yet. We only have models and the first few years' production data. Shale gas wells have remarkable initial production rate but very step decline rate. Within the first year they can lose 80% or more of daily production rate. The industry insists that decline rate will follow a hyperbolic curve, stabilizing in the next few years and flat out at roughly 6% decline rate. They further assume a well can continue to produce up to 40 years. Thus they predict a well's UER to be 3 BCF to 5 BCF, or even more rosy numbers. One BCF is one billion cubic feet. One thousand feet of gas is roughly one mmBtu. So if a well yields 5 BCF and natural gas is $4 per mmBtu, it can bring in $20M, which is a comfortable profit.

    Using existing production data, Arthur Berman showed that shale gas production decline followed a much step curve than hyperbolic so the UER is more likely less than 1 BCF, and wells can not produce for 40 years. When the daily gas output drops to below the worth of maintenance, then there is no point keep producing from the well. There are 12000 Barnett shale wells and the cumulative production by the end of 2010 was 5.64 TCF, which is 0.47 BCF per well.

    The Shale Gas Hydraulic Fracking Explained

    I don't want to get too technical but I just want to explain hydraulic fracturing using a layman's English, from basic physics an average person can understand. The idea is to inject some high-pressured water mixed with some corrosive chemicals deep underground to create cracks in the hard rocks, allowing trapped gas to escape.

    At first the idea makes sense, but it cannot stand scrutiny. The liquid water does not have a mind like a soldier has. A soldier with a determined mind would find where the enemy strong hold is. Attack the enemy to eliminate the strong hold, and move on to next target. You would wish your liquid soldier to attack where your underground enemy is: the hardest rocks; crack it open to create a pass; and move on to as far as possible to liberate the shale gas.

    But water does not want to attack the strong hold. It just wants to find a spot where it can sit and hide and that is only because you are pushing it. It only attacks the weakest point. The water finds a shallow pocket, gets into the chamber, and stays there, and refuses to move forward as far as you want it to go. You end up with a few huge chambers of underground water that liberates some shale gas, but it does not go very far. More over rocks crack only when pressure is applied unevenly. When rocks are surrounded by seeping water from all directions, they do not crack as the pressure cancels.

    Thus the water injection can only achieve limited effect of cracking some rocks and exposing some shale gas. This is why the initial daily production may be high, but it quickly peters out. Some one in the industry claims you frack it once and the well will keep producing for 40 years! That's a fairy tale! Frack it a second time will not make much difference, because the water will just occupy the old water chamber created by the first fracking, instead of going further out.

    Keep in mind that under the huge crust pressure underground, the shale gas exists as solid matter mixed with rocks and sand, not gas. Only when it is exposed to reduced pressure, will it evaporate into gas and flow out through cracks. This fact also limits the amount of producible shale gas per well.

    The Coal Industry is the Right Play, Not the Gas Industry

    Shale gas was a beautiful dream. Now we are waking up to the cruel reality of the limit of current human technology. There is no doubt that natural gas price will recover soon. But if shale gas does not turn out to be economical, how can many of the shale gas players survive the inevitable burst after the boom, especially those who took heavy loans in the shale plays?

    Therefore I caution people on oil and gas stocks like Chesapeake Energy Corp. (CHK), Constellation Energy (CEP), Cabot Oil & Gas Corp. (COG), ConocoPhillips (COP), Anadarko Petroleum Corp. (APC), EOG Resources Inc (EOG), Devon Energy Corp. (DVN), Baker Hughes Inc. (BHI), Southwestern Energy Co. (SWN), Pioneer Natural Resources (PXD), Magnum Hunter Resources (MHR), Kinder Morgan Energy Partners (KMP), Enerplus Resource Fund (ERF), Carrizo Oil & Gas (CRZO), Callon Petroleum (CPE), Enterprise Products Partners LP (EPD), Goodrich Petroleum (GDP), GMX Resources (GMXR), IDT Corp (IDT), Lucas Energy (LEI), Rex Energy (REXX), Approach Resources (AREX), Natural Gas Services Grp. (NGS), Breitburn Energy Partners (BBEP), National Fuel Gas (NFG), Range Energy Resources (RRC), Petroquest Energy (PQ), Unit Corp. (UNT), Transocean Ltd. (RIG), BP plc. (BP) and Exxon Mobil Corp. (XOM). Did I miss any one? Sorry for the laundry list, it shows how many folks rushed into the unproven shale play and how daunting a future they face now. The grave reality has not been reflected in the share prices yet. Don't buy them!

    The coal mining sector is the right play. I already wrote a few articles on why US coal is super bullish, see here, here, here and here. There is no need to repeat my bullish thesis here. The bullish thesis includes that real EIA data does not support the overly too pessimistic view, that the US coal and natural gas industry has the capability to quickly adjust to market condition, and incredible growth of international demand on coal, among other things.

    Many coal stocks are deeply discounted, selling at a fraction of the price 12 months ago, when coal prices are still at profitable margin for some of the coal mining companies like Peabody Energy Corp. (BTU). Why deep discount? Because people read news headlines for 5 seconds and jump on them without a second thought, and never bother to check the real data and facts. I grew up in the communist China and spend my adult life in capitalist USA. I know how to be skeptical to main stream media propaganda and think critically.

    I hold long positions in coal stocks James River Coal Co. (JRCC), Patriot Coal Corp. (PCX), Arch Coal Inc. (ACI), Alpha Natural Resources Inc. (ANR) and Peabody Energy Corp. (BTU). The main reason I liked JRCC and PCX is that they demonstrated incredible gains in percentage, during the 2007/2008 coal rally. I will not dwell into individual stocks but will recommend the whole US coal sector and refer to these names as well: Alliance Resource Partners LP (ARLP), Cloud Peak Energy Inc. (CLD), Cliffs Natural Resources Inc. (CLF), Consol Energy Corp. (CNX), Natural Resource Partners (NRP), Penn Virginia Resource Partners LP (PVR) and last but not least, Walter Energy Inc. (WLT).

    For more discussions on shale gas or whether natural gas displaces coal demand, read my instablog post where I will keep it updated.

    Disclosure: I am long JRCC, PCX, ACI, ANR, BTU.

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Comments (2)
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  • Chung Yen Wong
    , contributor
    Comments (62) | Send Message
    Thanks for the very informative article mark.
    25 Apr 2012, 07:52 PM Reply Like
  • dieuwer
    , contributor
    Comments (2942) | Send Message
    I would like to add that many coal stocks have extremely depressed P/E ratios at the moment. I have seen ratios as low as 5! That will not last. It's completely irrational to be that bearish considering the good financial health of many coal companies.
    25 Apr 2012, 08:55 PM Reply Like
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