Making Money from a Cleaner California?

Probably everyone saw or heard the news about California passing new emissions rules a week ago -- there was an interesting editorial on it in the Salt Lake Tribune recently, and the Washington Post ran a more detailed article when the bill passed. The Financial Times ran a story on the political debate, and the possible business impact on our most populous state.

So what does this mean for investors? Is there money to be made on the tails of this initiative to clean up California's air over the next 20 years and push toward reaching the standards of the Kyoto Protocol?

California already gets most of its energy from relatively clean sources (if you ignore transportation), compared to many states. You can see from this CA Energy Dept. summary how the citizens of the left coast get their energy -- coal is pretty low, renewable sources fairly high.

But they're committing to reducing emissions over the next 20 years even as their population may be expected to grow significantly ... so what companies might benefit from that?

I think there are a few categories that might be worth looking at:

1. Natural Gas. The biggest impact on the electricity market in California is that the state will essentially no longer accept power from the current coal-generated plants. This accounts for about 20% of in-state generation and an unspecificied but probably significant part of their imported electricity (as the Utah story referenced above would indicate, the plants that rely on cheap Rocky Mountain coal and sell electricity interstate will be cut out of the CA market).

To me, that means natural gas will be in higher demand in California because it is the only efficient, relatively clean power source that's likely to be able to take up much of the slack as coal plants go offline. Who benefits? You've got the big natural gas producers like Chesapeake (CHK) or XTO (XTO), the drillers like Nabors (NBR), which has some gas exposure, or Grey Wolf (GW), which is focused entirely on gas.

You might also look to the pipeline companies, since most of California's natural gas is going to have to come in via pipeline from the key producing areas in the Southwest and the Gulf. Here's a map of the pipelines that currently serve the state, you can see that they've got excellent distribution from the big basins already ... but volume should grow, which is how pipelines make money. I'd guess El Paso's (EP) western pipelines are probably among the biggest beneficiaries, but I haven't looked at it in detail.

2. Coal Scrubbers. Alternatively, instead of boosting natural gas usage for electricity generation, you might see an aggressive push for cleaning up coal plants. That says to me that the engineering and construction companies that build and retrofit power plants, and the manufacturers of emissions scrubbers for coal plants, might get some additional business. That could be a lot of folks, but URS (URS) is probably more focused on coal scrubbers than the other big E&C guys, though most of the coal scrubbing I've heard of is focused on removing sulfur dioxide, not carbon dioxide which is the bigger issue here.

It might even be possible to see some of the coal technology companies climb, too, if coal gasification or newer clean coal technologies might get a boost from this renewed focus on emissions -- that could perhaps be folks like Sasol (SSL) with their coal liquefication system, or Headwaters (HW) with their various coal technologies, for example, though I can't claim to know much about that business.

3. Power plants that already run on natural gas. This could conceivably allow for some significant rate hikes in California, if the demand for energy continues to grow but the suppliers shrink. That tells me that the folks who are already online with environmentally friendly or natural gas-powered power sources will have a competitive advantage (as much as the market remains competitive, at least).

PG&E is the big provider here, but I'm not so interested in getting involved with a huge company like that with a checkered history and significant regulatory risk. I've looked a bit lately at a tiny company that might benefit down the road, MMC Energy (MMCN.OB) is a small OTC stock that recently went public (and is moving soon to the ASE to attract more institutional buyers). MMCN is building a holding company for the small power plants that have been divested by larger (and sometimes bankrupt) utilities in high-growth areas ... and they're planning to refurbish and expand those plants with new natural gas turbines to serve peak overload periods at peak rates.

They came to my attention because they recently bought two natural gas power plants in San Diego (Chula Vista and Escondido) that were offline (they're also buying a decommissioned plant in Bakersfield, and have a letter of intent to buy a Utah plant that's under construction) [September 13 update: MMC Energy yesterday terminated their letter of intent to buy the Utah plant], and got them online for summer peak season, with plans to expand at least one of them. This is certainly a risky company, and it's largely unknown so far (though it has been touted heavily by Energy and Capital, a service I know nothing about ... which makes me nervous). I've read the company's filings (if you're interested, please read at least the 10-QSB) and didn't see any red flags, but it's going to continue raising lots more money to buy and upgrade or restore plants so I'd say there's a good chance of significant dilution in the near term.

4. Renewable Energy Companies. This is the sector that immediately comes to mind for most folks when we talk about reducing emissions, though CA will be hard pressed to replace their coal-fired electricity with solar or wind power within the next 20 years. They are, however, trying very hard to subsidize the growth of renewable energy ... as are other states to lesser degrees, and as are several other countries (notably China and Germany).

This is good news for lots of companies, but there aren't many profitable, reasonably priced renewable energy companies ... even though prices are much more reasonable now than they were last winter in the peak of our oil and natural gas panic.

The wind energy bets are few and far between -- you could throw your money at GE, which makes most of the turbines, but wind energy isn't going to move their needle. Or you could look to the composite-materials companies like Hexcel (HXL) or Zoltek (ZOLT) that make or engineer the materials required for efficient windmills.

Solar energy is a much more wide-open business, and with state and local governments also pushing for more rooftop solar cells in new housing production and subsidizing solar implementation elsewhere, demand for photovoltaics should continue apace, with or without California's new emissions rules. You can look at MEMC Electronic Materials (WFR), which I own, as the supplier of the silicon wafers that go into solar panels, or you can look at the manufacturers like Suntech Power (STP -- my favorite among these with their Chinese connection), Evergreen Solar (ESLR) or SunPower (SPWR -- or look at CY to possibly buy control of SPWR on the cheap).

Will California's plan really fly, or will this plan move to other states? It's way too soon to tell, but the California auto emissions rules certainly had a massive impact on the rest of the country and on auto manufactureres worldwide, and as one of the largest economies in the world you have to accept that state decisions really matter (CA is somewhere between the fifth and 10th largest economy in the world, right up there with Italy and France if treated as an independent nation -- just how big depends on who you ask).

I don't know whether they can pull off an emissions trading scheme with just one state, but it's certainly possible -- and they can definitely cut off all "dirty" power supplies, which will impact the energy business writ large across the Western US in a big way ... whether any of these companies, or others, will actually benefit is certainly an open question, these are just the initial ideas that came to my mind.

In the interest of full disclosure, at the moment I own shares in WFR, preferred (series D) shares in CHK, and call options on CY, and I've been toying with the idea of buying MMCN and may do so soon.

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Best Management?

A reader emailed today to ask what I think about Berkshire Hathaway, and, more generall, which management teams most impress me. I thought I'd answer for everyone in case anyone else is interested.

Berkshire Hathaway is still in my portfolio, and has been for about a year and a half ... but it's at roughly the same price today as it was when I bought it. I have the utmost respect for Warren Buffett, and I'm pleased that they have further clarified the Berkshire succession plan.

I like Berkshire because Buffett has done more with "free money" than anyone else -- his use of the "float" to fund long term investments has clearly been brilliant, as evidenced by his trouncing of the S&P 500 over the last several decades. My position on Berkshire is that I expect it to continue to plod along, acquiring solid companies and using their clout to be the insurer of last resort for many high risk enterprises, at significant profit. But I don't expect any rapid growth -- my fear is that Berkshire will end up so large that it effectively works as an index fund with cheap leverage from the insurance float, and even that is a fine scenario. With new money today, however, I'd be more tempted to put additional funds into Markel, as they have the kind of potential growth ahead of them that Berkshire had 25 years ago, assuming they make the right decisions ... Berkshire just can't grow that fast anymore.

And as for management -- perhaps it would be simplest to just list some of the things I like about some of the managers I trust the most:

In terms of trusting someone to make investment decisions for you, I do think it's hard to go wrong with Warren Buffett -- but if I ever sold my Berkshire shares and wanted a similar value-investing exposure in my portfolio I would have no qualms about giving the money to the investment team at Dodge and Cox Stock, which I already have some retirement money invested in, or with Martin Whitman at Third Avenue Value, who I would consider the single smartest long term stock picker available right now (but he's nearing retirement, too, I expect).

In terms of sharing information fully with investors, and making small investors feel they are on the same page as the management team, I'd trust the Oliveira family, controlling shareholders of Gol Linhas Aereas Inteligentes. Without playing a self-serving game with analysts to lowball and then beat their projections, they manage to clearly open up the books and explain their business, including monthly updates on their business performance -- it's rare for an American company to do that with such enthusiasm, and it's rarer still for what most would consider to be a risky emerging market investment.

Another thing I like to see from management is insider buying -- it always encourages me when executives put their own money, not options, into the company they know best. Of course, they know that, too, so it can be self serving ... but when executives aggressively purchase their own stock I think we'd be wise to follow. On this point, it's worth taking a look at Chesapeake Energy, of which I own preferred shares, and see CEO Aubrey McClendon buying up well over a million shares on the open market in the last couple of months at prices right around where it stands today (mostly higher, in fact). Add to that the fact that he has led the company to make strategic natural gas acquisitions now, when prices are relatively low and pessimism high, and I think you have the makings of a manager who's looking out for the long term interests of shareholders.

There are others who I like as well, for some good reasons. I am a big fan of Selim Bassoul at Middleby, who has shown a real talent for bringing focus and drive to a small company that was too diversified ... and then being aggressive about making acquisitions to shore up their core business in commercial kitchen equipment with Nu-Vu and, perhaps, Enodis if they stay in the bidding for that company.

And if you're looking for a management team that is relentless customer-focused, continuing to bring out product lines that their core consumers will buy and treating those customers like royalty, you need look no further than Chico's -- the shares are taking a beating lately, but I'd trust this management team more than any other in retail to recover from their merchandising hiccup and continue delighting customers. I don't think any other CEO cares as much about the soft side of customer service as Scott Edmonds does at Chico's, and their focus on their "lifetime passport members" and on personally writing to their best customers clearly creates some fiercely loyal consumers. I'm tempted to buy more here, now that it's on clearance.

On a more strictly financial point, I also should mention John Fredriksen, whose right-hand-man Tor Olav Troim heads SeaDrill. Often described as a viking raider, Fredriksen is not someone I'd probably like, and I don't know that he's the person I'd want managing my business if it was something I wanted to hold forever, but as a controlling shareholder he has a track record of being extremely aggressive in unlocking value in high priced assets and returning cash flow directly to shareholders ... including himself, of course. Sometimes his massive dividending out of cash might not be the best long term move for the companies he owns, but it certainly benefits shareholders immensely when he times it right, as he did with Frontline a couple years ago ... and as I hope he'll do with SeaDrill over the next two or three years.

Those are just a few things I like about management -- a focus on investing your money wisely, a propensity for insider buying, eagerness to share information with investor without trying to manipulate them with pointless press releases, a strong focus on their customers and a track record of pleasing them, and a desire to return cash to shareholders. It's not often, if ever, that I find all those things in one company ... but even one of those things, if the story fits well enough, can be enough to get me interested,

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Energy Oooff (SDRL, CHK-D, PDE)

I posted a few days ago that I had bought shares in Chesapeake Preferred (CHK-D, CHKpd) -- those are holding up fine and are, as expected, acting less wildly than the shares of Chesapeake common (CHK). All fine and dandy, and working out like I planned so far.

But the universe of my energy holdings and the energy companies I've considered, which at this point includes only SeaDrill (SDRL.OL) and fellow driller Pride International (PDE), is certainly not looking too healthy. Even if you throw in my solar energy play, which consists of MEMC Electronic Materials (WFR) and some call options on Cypress Semiconductor, the whole shebang is going to heck in a handbasket.

The worst performer, and one of my larger holdings, is SeaDrill. I am keeping a steady hand on this and have averaged down once (way too early, it turns out) ... and if I was willing to overcommit to this volatile company I'd be tempted to buy up more. But the combination of easing oil futures (depending on what day you check), an IEA report on easing oil demand, and the unpleasant Kroner: USD exchange rate has really clobbered the shares, as it has virtually everything on the Oslo Bourse. My holdings are down more than 25%, a state in which they'll find plenty of company in this market but one that I still find unpleasant. I simply must remind myself to focus on the out years -- SDRL is really a 2008-2009 play because of their huge order book of deepwater rigs, and I hope that I'm correct in believing that those who are in at these prices, before earnings pick up, have bought a bargain in the long term.

While SeaDrill is really a long term growth investment, and an investment in the acumen of John Fredriksen, Pride International (which I hold a few short term call options in but nothing else yet) is a possible value play. Pride has long lagged the drilling group in performance, with worse margins and some ineffective management. I theorized that Pride might be a takeover tarket for Fredriksen's SeaDrill a few weeks ago, but even if that's a bit unlikely I am still starting to like the idea of picking up a few Pride shares as a bet on their potential turnaround.

Pride is trading right now at a very, very low forward PE of about 7 -- it's not unusual in that, since all the drillers are trading at low PEs, but they're lower than the others. Since I think this discount is likely to be removed, and the uncertainty about their future business erased as the industry remains flush with business, I like PDE as a turnaround play to pick up its evaluation. The two catalysts seem to be that they are likely to either get a takeover bid or sell off their land-based drilling and services segments, and that I expect the current scandal investigation will eventually dissipate and cease to materially impact the shares. That's just a guess, mind you, but I'm not that worried (financially -- morally I'm not crazy about it) about an oil company bribing foreign officials and don't expect that Pride is any different in this activity than their competitors. I could be wildly wrong, and they could be criminals, which is just one small point of uncertainty that has kept me from buying shares.

The other thing that has kept me from buying shares is the downturn ... I'm hoping that they fall more, and if they do I'll revisit this argument again and perhaps pick some up. Woe is the investor in this market who doesn't have enough cash (me) to pick up shares in all the companies that he thinks are becoming bargains.

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I Prefer Chesapeake (CHK-D)

I just picked up some shares in Chesapeake Energy Preferred (CHK-D, CHKPD, CHK.pd, depending on your ticker service) this morning at $90. Chesapeake, for anyone who doesn't know, is a dominant US natural gas company -- and though the name conjures up skipjacks, crabs and oysters, they actually work primarily in Oklahoma and thereabouts and are based in OK City.

So why buy a natural gas company when the price of gas has dropped like a stone -- from the neighborhood of $15 post-Katrina to about $6 today (I think it blipped just above $6 when inventories were a little lower than expected this morning)?

There are a couple reasons. First is the time of year, for those interested in shorter term trading (or just in finding a nice buy-in point). Summer is a good time to buy natural gas companies because short-term traders bid them up in the fall when winter demand starts to build and inventories fall. And more recently, we've been reminded that late Summer is prime hurricane season and any damage to Gulf of Mexico rigs or pipelines can also drive prices higher.

And second, longer term, is that natural gas remains one of the most important alternative energy plays out there, both for political reasons in reducing dependence on foreign oil and for environmental reasons in reducing power plant and vehicle emissions.

Hydrogen fuel cells would be lovely to have running all of our cars, but you're much more likely to see expansion of natural gas-fueled city buses and personal cars in the near future because the emission benefit is great and the infrastructure is already in place. And even if hydrogen does become a fuel source for transportation, the cheapest and easiest way to get hydrogen is from natural gas or other hydrocarbons. Natural gas also fuels many of the newer power plants, and I expect before too long we'll reach an equilibrium between the lower emissions profile of natural gas and the expense of clean coal technology that makes both of them competitive for electricity generation. I'm no expert on this, but I don't see usage of natural gas declining in the long term.

Add on to that the other important customers for natural gas -- fertilizer manufacturers, chemical and plastics companies, and the growing internationalization of the NG market as LNG becomes a big business in Asia.

So why Chesapeake? The simple reason is that they are the dominant producer of natural gas in the US and are not subject to much disaster risk since their fields are well inland in the plains and Appalachia. They also have hedged their production for most of the year at fairly high prices, about 50% above today's cost, so they stand to certainly make solid profits for the year no matter what.

And they're also aggressive, leveraged, and focused on growing their business -- some small evidence of this is the fact that they're taking advantage of this downturn in NG prices to buy up new fields, with the most recent acquisitions bringing in what they estimate are about 500 new drillsites in Texas. Unlike some of the companies I own, this one is certainly not under-covered -- 20 analysts have 2007 estimates up, and they average about the same as 2006's at near $3.50 a share. I think that's probably a little too conservative, but I certainly think a forward PE of 8 looks reasonable. Some interesting articles posted in the last few months over at Seeking Alpha have also called attention to CHK's value, with Chad Brand in particular putting up a few good notes that are worth a read. And anyone who watches or listens to Jim Cramer will have heard quite a bit about Chesapeake, I'll leave it up to you to decide whether that's positive or negative.

CHK stock has been beaten up pretty significantly, down about 20% from its highs earlier this year. But since I'm looking at this as a very long term investment and would prefer a little less volatility than this Cramer favorite has been demonstrating, and like the idea of a nice yield in this environment that can help support the price, I decided to go with the convertible preferred stock instead.

The prospectus for the preferred stock provides the details, but at today's price of $90 you're getting a 5% yield that cannot be called unless the conversion reaches 130% of fair value after 2010, you're getting preference over common stockholders in any nightmare scenario of bankruptcy, and you get the right to exchange each preferred for roughly 2.26 shares of CHK common.

Right now, the conversion value of these preferred shares is in the mid $60s, and the price would have to hit about $40 to make conversion worthwhile. Eventually, I'm confident we'll reach that price ... and in the meantime, I'm happy not to watch the vicissitudes of the natural gas market and just collect my $4.50 per share each year while I wait for what I expect will be some significant capital gains within a few years. The preferred dividend appears to be eligible for the lower dividend tax rate, too, FYI.

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