Warren Buffett, arguably the best investor of all time, has his foibles. One such he admitted recently in Berkshire Hathaway (BRK.A)(BRK.B)’s investor letter – his ill-fated decision to buy $2 billion in several bond issues of Energy Future Holdings, which he called “a mistake – a big mistake.” This mistake is part of his broader history of mixed results with energy investments.
Energy Future Holdings, formerly TXU Energy, is based in Dallas, Texas, and is the largest energy generator in the state. It came into being when Kohlberg Kravis Roberts & Co. (KKR) and Texas Pacific Group (TPG) bought TXU out for $45 billion, the largest leveraged buyout in history, and took it private. Shareholders received $69.25 per share, a 25 percent premium. GS Capital Partners, Lehman Brothers, Citigroup (C), Morgan Stanley were equity investors in the deal. Buffett bought $2 billion worth of bonds.
The investment met many of Buffett’s criteria for stock picking and business buying. At the time, the company served 2.1 million customers, it was simple and understandable, it had been producing the same product since 1882 and it produced a product that people could not live without. It was also profitable, with operating revenues that had increased substantially – from $106 million to $151 million – from 2004 to 2006.
However, TXU did not have a particularly wide competitive advantage in the deregulated Texas energy market. It also produced nuclear, coal and natural gas power, and ultimately, Buffett said, it was the plummeting of volatile natural gas prices that derailed the investment.
TXU explained how energy prices correlate to gas prices in its 2006 10-K: “Gas-fueled generation is the predominant supply resource in the ERCOT [Electric Reliability Council of Texas] region in terms of both the installed capacity and electricity generation, accounting for approximately 75% of the capacity and 50% of the energy produced in the ERCOT region. As a result, natural gas-fueled plant operators are the marginal suppliers in ERCOT, and wholesale electricity prices are highly correlated to natural gas prices.
By mid- 2006, electricity prices had risen more than 35 percent, largely as a result of skyrocketing natural gas prices. But by late 2010, the price of natural gas plunged, making it difficult for Energy Future Holdings to meet its debt payments. Moody’s Investor Service described the company at that time as having a “very weak financial profile, untenable capital structure, questionable long-term business plan and material operating headwinds.”
Buffett’s stepping out of his usual bounds cost him greatly. He wrote down the investment by $1 billion in 2010, and an additional $390 million in 2011. He carries the bonds now at their market value of $878 million, and could lose the entire investment if natural gas prices do not increase.
Buffett made another energy investing mistake with ConocoPhillips (COP), which actually resulted in a greater loss than Energy Future Holdings – an estimated more than $3 billion.
Buffett began buying COP stock in 2005 at near $60. Then, in 2008, he poured an additional $5 billion into the position, when the stock reached its all-time high in the $90s. Shortly after that purchase, the price of oil plunged, cutting the price of COP shares approximately in half.
The 2009 Berkshire investor letter also records Buffett’s admission: “I told you in an earlier part of this report that last year I made a major mistake of commission (and maybe more; this one sticks out). Without urging from Charlie or anyone else, I bought a large amount of ConocoPhillips stock when oil and gas prices were near their peak. I in no way anticipated the dramatic fall in energy prices that occurred in the last half of the year. I still believe the odds are good that oil sells far higher in the future than the current $40-$50 price. But so far I have been dead wrong. Even if prices should rise, moreover, the terrible timing of my purchase has cost Berkshire several billion dollars.”
The price has never again reached the level of his 2008 purchases, but he has been selling as it has recovered. It has reached a 52-week high of $81.80.
His investment in PetroChina (PTR) was more successful than either of his two losses in Energy Future Holdings or ConocoPhillips, though he said he still thought he sold too soon.
Berkshire bought 1.3 percent of PetroChina for $488 million, which valued the company at about $37 billion, when he believed it was worth about $100 billion. In 2002, the stock sold near $20. Two factors, Buffett said in his 2007 investor letter, increased its value, the increased price of oil, and its management’s great job in building oil and gas reserves. Oil prices also played in his favor this time. It had gone up from $30 to $75 per barrel.
He sold the stock from $160 to $200 per share. This gave him a profit of about $3.5 billion on a $500 million investment. But unfortunately, the stock still had farther to go. By 2007 it had rocked to a high near $255.
On his PetroChina investment, Buffett emphasized that price was the primary factor that got him interested. “I sit there in my office and I read an annual report and it described a very good company. It told about the oil reserves, told about the refining, told about the chemicals, told about everything else, and I sat there and thought to myself, ‘this company’s worth about $100 billion.’ Now I didn’t look at the price first, I look at the business first. Because if I look at the price first I get influenced by that, so I look at the company first, I try to value it, and then I look at the price and if the price is way less than what I just valued it at, I’m going to buy it,” he said on a television interview after he sold his stake.
Though there were many different factors involved in these investments, price played an important role in whether they were successful or not, showing how important not overpaying is even for Warren Buffett.