Warm up with Southwestern Energy (to get long energy)

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Feb 23, 2015
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Southwestern Energy (SWN, Financial), now known for its recent $5 billion purchase / rescue of CHK’s natural gas assets in the Marcellus, is an independent engaged in domestic exploration and production for natural gas and oil. The company has some mid stream operations (natural gas gathering and marketing in Arkansas, Texas and Pennsylvania) which are important, but SWN is going to trade as an E&P company.

Energy has become something of a religion, you either believe or you don’t. Doug Kass, who’s commentary I routinely follow and is often contrarian, equated religion from an investor’s perspective to the precious metal, gold (GLD)… Investors either believe or don’t. In these terms, those who are agnostic can watch from the sidelines but that’s simply not the case for energy.

Today’s economy is propelled by all things energy so there’s no room for atheists. Indeed, all energy isn’t created equal and all sources are enormously different. Considerations of the type (Oil, Nat Gas, Coal) almost pale in comparison to political winds and, most importantly (to me), is the ‘take away’ capacity, extraction costs, and transportation costs. Choosing the right company —Â management, balance sheet, hedging, performance, all complicate the investment decision process further. Compiling all of these only get you started in the investment criteria.

Regardless, neither investors nor consumers can escape fossil fuels. As I’ve written before, native to TESLA’s gigafactory in Nevada, who may be the frontrunner for all things alternative energy, neither TSLA nor the environmentalists will move the needle. I’m not referring to missed sales numbers, earnings, or making judgment about the efficacy of alternatives, rather I merely observe fossil fuels are here and will be with us into the foreseeable future. Specifically, the U.S. Energy Information Administration (EIA) estimates that only about 11% of world energy consumption is from renewables (biofuels, biomass, geothermal, hydropower, solar, and wind). Importantly, in spite of growth and incentives for alternatives, world consumption of energy grows, and EIA’s projection only reaches 15% by 2040. Read for yourself here: http://www.eia.gov/tools/faqs/faq.cfm?id=527&t=1.

When 85% and more of consumption comes from carbon, it’s a small stretch to allocate a percentage of any portfolio to the commodity. Should consumer prices rise, at minimum your portfolio should balance the additional costs at home or at the pump.

This isn’t a call for unrestrained investing in anything energy. Doing so has taken its beating. Investors and energy companies are equally guilty of too much too soon, or too early… either way those of us who were early and long are sorely licking wounds. The pummeling has been a perfect set up for capitulation too given prognostications of double dips back into the low $40’s (WTI). But do so to your peril. Perfect bottom picking are for liars and fools. Careful selection (albeit slightly contrarian) investing will reap rewards.

Returning to SWN where there’s lots of news (criticism) on just about everything energy so SWN is no different. Of late, SWN may have poorly timed its $5 billion purchase of CHK’s Nat Gas assets (CEO Muller says not), but also the issuance of additional equity at $23, a multi year low, no one other than new buyers appreciated much. History may one day weigh-in on the dilution, but that came with acquisition of the lowest cost Nat Gas production out of the Marcellus. CEO Muller plans to invest $ 1 billion more to develop the acreage and specifically its midstream make sure… http://www.swn.com/operations/pages/marcellusshale.aspx.

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A quick glance reveals SWN trading sub $30, temporarily over the last five years, once in 2012 and again now. 2012 historical earnings visited $1.50. But then and now are different, the now is clouded by optimists and Armageddonists; 2015 ranges from highs $2.44 to a low of $0.27, per Yahoo! Finance.

The Trade and How to Express your Opinion:

An investor could buy SWN outright. Without a dividend, this is a capital appreciation and energy play only. Allocating out of something that pays a yield into something that doesn’t is often a hard choice, so unless there’s excess liquidity sitting in your brokerage accounts or you’ve watched from the sidelines without energy in your portfolio, this may or may not serve your alternatives well. Regardless, an entry mid $20’s should reward you, currently offered at $27.24.

Alternative Investment:

Or use options, considering implied volatility remains higher than historical, given the outlook, make SWN an ideal case for Put writing. The following is a 6 months chart courtesy LiveVol. You’ll see 360 day options implied volatility remains higher than historical volatility. Importantly, given the ‘recovery and bounce’ in energy, shorter term options are priced the opposite (implied lower than historical). Translation: Long dated option sales are more advantageous than similar option purchases. I would AVOID option purchases (short term) because there’s little visibility when energy prices may recover, and losing your entire investment is probable.

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Importantly, I look to write the longer term January 2016 Put at a strike that balances my personal risk tolerance with my thesis to profit. Still, many will argue a shorter term contract yields faster ‘theta’ (time decay), but as described above, closer analysis reveals Implied Volatilities LOWER than Historical. That means BUYING short term options would be more advantageous than selling. But I very rarely {emphasis added} ever buy short term options, especially OTM. Again, these are fools errands to lose money, and not to digress, I’ll happily reply to questions.

Additionally, shorter term option sales leave us exposed to an ‘If Put’ cost basis that is higher than I prefer. I want a cost basis that is as low as possible… sub $24, the absolute low if possible. Clipping short term premium does NOT take advantage of the current value pricing. If / when the underlying equity rises, as I anticipate otherwise we’d dismiss the trade, the larger premiums at the current lower strikes will no longer be available. If you write shorter term, you’ll have collected pennies while dollars were today available.

With writing Leaps (long term), we can engineer significant yield to compensate for a lack of dividend and lower our cost basis. Specifically, the Jan ’16 $28 Put offers us $4.05 premium (see the trade bar courtesy ThinkorSwim, and use limit orders), and delivers a cost basis at $23.95 (strike less premium received). This is comfortably below the stronger technical support at ($30) and has a margin of safety that is 14% below the current bid $27.24 (divide the If Put cost basis by the current bid).

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If you are not comfortable owning SWN, or uncertain with the fundamental (slightly contrarian) thesis, watch from the sidelines. Note, however, the sideline is an investment, a bad one where cash (excess liquidity) comes with a negative real yield (interest below inflation).

Disclosure:

Short SWN options. The foregoing is not intended to be specific investment advice, but concepts to consider when investing. Consult your Investment Adviser.