Long-Overdue Portfolio Adjustments

I've been remiss in keeping my portfolio up to date here, having spent much more time hacking away at email teasers on my Stock Gumshoe site that many of you have also been kind enough to subscribe to and read.

But still, I always have intended to keep my portfolio holdings and changes an open book -- so I'm sorry that I'm so late in making these changes here for you to see (and hey, many of them have been short term mistakes so far, so it's not like you're missing anything).

So ... without further ado, here's what I've done over the past month or so.

I sold Naspers (NPSNY), and bought Tencent (TCEHF). With Naspers ADRs going to the pink sheets some of the argument for keeping these shares for Tencent exposure has gone -- volume is much thinner now, and information will be a little harder to find. The other argument for keeping Naspers, that they offer a more diversified exposure to international media and technology properties, is still there, and it still may be the correct one ... but personally, what always attracted me most to Naspers was their major holding in Tencent. There is a significant argument against what I've done if you think Naspers will rebound in its other businesses, because by historical measures the share of Tencent that you get in Naspers is now trading at a discount.

But anyway, Tencent entered my portfolio more than a month ago, before I sold Naspers, and then I added more to my holdings when I sold Naspers a week or so ago. I got a little lucky with the timing, since Naspers has been a little bit depressed due to fear of local market competition and a declining South African currency compared to the dollar, and Tencent has had a nice boom of late.

I've written quite a bit about why I like Tencent, and all of that remains true -- but two things stand out for me: First, that their advertising revenue is growing pretty quickly and they're not showing any signs of losing much IM market share even though their competitors are trying hard; and second, that as a Chinese blue chip trading only in Hong Kong they're going to benefit significantly when more Chinese retail investors are able to invest in Hong Kong.

I think that's likely a significant part of the boost in Tencent shares over the past week or so, the gradual loosening of restrictions on international investing for mainland Chinese -- but I think we're just at the beginning of that trend, and while it's likely to be good news for many Hong Kong-traded Chinese companies (the Hang Seng is at or near highs right now), I think it will be especially good for popular Chinese consumer brands that are only traded in Hong Kong.

And of course, that fits Tencent to a T. I liken this a little bit to the earlier stages of the internet craze here in the US, to some extent -- what were the popular companies for individual investors? The ones they used ... they bought Dell computers, they used Yahoo email or they surfed on AOL, so those were among the more consistently popular investments. Obviously, the exuberance for these investments got out of hand, but I still think that investor psychology to some extent is universal and that the mainland Chinese are going to want to buy shares of companies that they use every day, but which have been until now forbidden investments.

So in for Tencent, out for Naspers. I won't tell you the prices, since these are old trades and you wouldn't believe me -- it would be too easy for me to say I bought Tencent for $3 and sold Naspers for $27, both of which would be significant exaggerations.

What else has changed for One Guy's Portfolio?

Well, I told you about Ambrian, and that has become a significant holding for me as I've added to it through the Summer at what seem to me to be depressed prices. They release earnings this month that I'm very curious to see, but no real news otherwise. Still a very low PE, and still a nice boost from the strength of the Pound for this commodity-focused investment bank.

And I also bought a few shares in one of Ambrian's major holdings and clients, Centamin Egypt (CELTF.PK). This is a gold exploration firm that is trying to revive the Egyptian gold mining industry -- they have an extremely promising mine site near the Red Sea, and they've got a processing plant that's being disassembled in South America and shipped to their mine so that they can begin processing ore next year. The shares are down from where I purchased them, I bought (again on the pink sheets) for 1.05, but what impresses me are the continual upward revisions in their reserve estimates -- every time they drill a a new test hole, it seems, they upgrade the potential gold content of the mine. This, obviously, is a play on the long term price of gold, and some folks might argue that it's a little pricey for a miner that hasn't yet produced (over a half billion dollars already in market cap). Some significant uncertainty remains, particular on timing as they await equipment and plan their mine, but I'm convinced that the risk/reward ratio is quite promising given the richness of the gold field they're aiming to work.

And aside from these pink sheets foreign holdings -- which I also might add more to in the near future, as I would like to own more Swire Pacific and SeaDrill -- I also bought some "regular" companies during the beating the market took a couple weeks back.

I sold my Chipotle LEAP options and used the profits to pick up some Chipotle shares, because I'm not entirely certain that this company will continue to ramp up rapidly but I am sure that the long term prospects are so excellent that I really want some shares in my portfolio. I expect that Chipotle will be to fast food what Starbucks is to coffee and Whole Foods is to groceries, the socially conscious and better tasting alternative (though their food isn't as premium-priced as those two).

I bought Class B shares, at a hair under $90, because I can't come up with any rational reason why the regular shares will trade at a premium forever (CMG is about $10 more expensive than CMG-B). Right now, they're at a premium because some traders don't know about them, the volume is much lower, and McDonald's has many of the class B shares still locked up ... and the difference is possible because B is no longer redeemable for A There was a nice SeekingAlpha summary of the arbitrage opportunity available for Chipotle shares back in June, and while I wouldn't really arbitrage them (short the Class A and go long the Class B) I can't imagine why a long term investor would buy the Class A. Logic will enter the equation eventually.

I also bought some China Fire and Security (CFSG), because it seems to me to be an appealing small cap that plays off of what I can only assume will be significantly increased needs for security and fire equipment as China continues to upgrade their building standards and, more generally, continues to build whole cities from nothing in the blink of an eye. This is a small position that I'm still researching, but the potential looks really good to me.

In other news, I've sold my holdings in two biotechs and used profits to buy LEAP options in those same companies -- Vertex (VRTX) and PDL Biopharma (PDLI). It has worked out well for Vertex, since the stock profits were considerable when I sold and the options have performed very nicely of late as emotion about their HCV drug Telaprevir has again run hot (it runs cold from time to time, too). It hasn't worked out so well for PDLI, though, I did protect more principal from the train wreck that these shares have been of late, but of course the options fell precipitously and may become worthless if PDL is really re-launching itself on a long road toward building as a research company instead of a producing drug company.

To be fair, if your lead drugs continue to disappoint, as PDL's have, it does look appealing to return to the strategy that built the company -- providing basic antibodies for other drugs and letting others take the risks -- I just don't know how long it's going to take them to "right-size" for that plan and redirect their research efforts.

Also in healthcare, I've upped the stability of my portfolio a bit by adding a big pharma name -- Novartis (NVS), which I picked up shares of at $52.99, right around where it's trading now. I like the big generics and over the counter business, their potential pipeline, and the fairly far-off dates for patent expiration for their biggest drugs. This one has been a favorite of analyts all year and has yet to really perform, in part due to some missteps with approvals that seem to me (a non-expert, believe me) to be fairly minor in the grand scheme of things. I thought about buying Pfizer for this part of my portfolio, I was incredibly tempted by their ridiculously high current dividend, but I opted not to make that contrarian play and bet against the problems they're likely to have with Lipitor patent expiration in the near future (still, they do have an awesome cash hoard ... and I might change my mind).

Finally, I just recently picked up a small entry position in HDFC Bank, one of the two Indian banking firms that you can get as an ADR. I bought shares at $83 a week or two ago and am considering adding more if they dip again. I continue to fear that the shares are a little bit expensive, but I also like the growing consumer banking need in India, and banks can often be good proxies for a growing capitalist society. I also do continue to hold the India iPath Exchange Traded Note, too, which is essentially an index fund for the Sensex.

Enough, huh? Other than that, I just have added a tiny position in a company that I probably shouldn't have touched -- mostly because it's an interesting story that isn't making any money, in Raptor Networks, and I continue to dicker around with some small options trading positions that for the last year or so have more or less broken even -- but they keep me busy, and keep me researching new companies (and provide the occasional 1,000% return that really keeps your investing adrenaline levels up).

Overall, there has been more of a trend to foreign investing in my individual stock holdings -- non-US-based companies now make up just under 50% of my portfolio.

I think that's all of the portfolio adjusting I've done that hasn't yet been reflected on the site here -- I'll try to do a better job of keeping up with my writing in the future. I've also got to take a much closer look at some of the real losers in my portfolio of late and try to figure out what to do with them -- that includes Chico's and MMC Energy, both stocks that several of you have emailed me about in recent months, and Akamai, which is still up 100%+ for me but is down close to 50% on the year. Then again, writing about those guys sounds too much like taking my medicine ...

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SeaDrill Moving On? (SDRL)

It looks like the consolidation that many of us foresaw for the deepwater drilling business might not come to fruition after all -- or at least, not to the degree expected. Many of these companies, from Global SantaFe to Noble to Pride International, have been rumored takeover or merger candidates as the day rates for deepwater drilling ships and rigs have skyrocketed.

One of the possible acquirers of many of these companies, however, sounds like they just took themselves out of the game -- and gained a nice share boost in return for that comment. SeaDrill, my largest individual stock holding, was a rumored suitor for Pride International last year, and for Noble and GSF earlier this year, among others (and they have done their share of acquiring, with the biggest one being their takeover of Smedvig ... a company they bought by outbidding and outmaneuvering Noble, by the way).

But now, in an announcement that they were ordering yet another deep water rig, SeaDrill management noted that they "believe that this newbuilding opportunity at the Jurong Shipyard is superior to US Corporate acquisitions from a financial as well as fleet quality point of view.''

So instead of pouring cash into a US acquisition, which had been a top priority for the company, they'll be pouring some of it into a mighty expensive rig that will be delivered in about three years (and even that's pretty early -- the slots at the best yards are pretty full even through 2010 according to some other interested folks).

It's hard to argue with them, considering the relatively high prices of the US drilling rig owners relative to their fleet value -- but I still wouldn't be surprised to see John Fredriksen do more acquiring. It looks like they're going to finally finalize the takeover of the rest of Eastern Drilling that they don't own (though that's really just one rig -- one fantastic rig, but still one rig).

I still really like this investment, though -- not only are the yards quite overtaxed as they build these rigs in a frenzy of demand (including the yards owned by Keppel Fels, which is another of my portfolio companies), but the rig customers are also having to wait in line. It seems that the oil exploration companies, at least, still believe there is a significant amount of oil to be found in the deep waters of the world, and that it will be worth finding and extracting ... after all, though these rigs can cost $500 million, the latest letter of intent SeaDrill has signed with a customer is for $531,000 a day to lease a similar rig. At that rate, the lease payments pay off the cost of the rig in just about three years (without taking into account other costs), which is just about the ratio SeaDrill is still looking for. (The total value of that five-year letter of intent is $970 million, which is close to 2X what they're now paying for a newbuild rig ... not bad)

As long as the rigs are in demand and users are willing to sign five year contracts that don't even start for several years, it's certainly worth it to buy one for over $500 million, even if you won't see it hit the water until mid-2010. Phew. Crazy business, but one with massive cash flows, and if SeaDrill continues along this track without major acquisitions I'd expect them to begin a significant dividend of those cash flows to shareholders within the next couple years, as Fredriksen did with his Frontline tanker business (perhaps in part by selling the rigs off to Ship Finance, which is also riding high, and getting relatively generous lease-back deals). Should be a very interesting company and space to watch over at least the coming three years.

Oh, and it doesn't hurt that the Department of the Interior is proposing opening up the outer shelf to drilling on the West and East coasts ... not just on the (poorer) Gulf coast ... with the leases to begin at a time when there are very few advanced drill rigs available for rent. I don't know if that will go through, it's certainly politically volatile, but if it does the impact on drill rig owners and service companies with US exposure could be significant in the short term.

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Rig Rates Remain High Despite Oil's Fall (SDRL.OL)

Oil prices are continuing to show significant weakness, with today's price so far maintaining the sub-$59 level ... but that doesn't seem to have softened demand for deepwater offshore drilling rigs.

Whether you believe that oil is being manipulated down by the great Bush/Saudi conspiracy and will quickly bounce back after the election (which seems a bit far-fetched), or just that prices even at these levels are still quite high and profitable for the oil companies, I think in the long term the trend for energy costs will be generally higher thanks to increased worldwide demand and slow-to-develop alternatives ... and the oil companies are going to continue spending heavily to increase their reserves. Shell, for one, has already stated that they can make their current exploration projects profitable at $20-40 oil, and prior comments I've heard from some drilling companies say they don't expect a significant reduction in demand for rigs unless oil dips well below $50 and stays there.

So although it is certainly tempting to jump on the cheap oil bandwagon and say that all the producers will cut and run from their E&P projects now, the way they did when oil ranged from $10 to $20 through the 1990s, I don't think that's terribly likely as long as prices stay at the historically high levels of $40 and up (that's just a guess number). I will get nervous, however, if they dip below $50.

Right now, though, I think the oil services pendulum in general has swung too far in the direction of pessimism -- demand for oil is certainly still strong, even if not as overwhelming as we thought it was a year ago, and there is very little true excess capacity in the world even if OPEC shuts off a small amount of their production. The easy oil has been found and burned, with the possible exception of the Saudi reservoirs, and with demand generally continuing to grow as the world motorizes and develops, the expensive oil will have to be produced, too.

And the oil majors clearly realize this -- with their reserves at pretty low levels and a large portion of the world's easily accessible oil politically embroiled, they're still signing deals for difficult fields and spending the money to develop those fields.

The latest I've seen on this is a new deal for a SeaDrill drillship, scheduled to come out of the yard in mid-2008. They just announced a letter of agreement for three years with a "major oil company" at $570 million, which translates to a day rate of roughly $520,000.

I don't know if that's a record for a deepwater drillship, but it's a record for a SeaDrill contract. Current drillships with this general capacity (water depth of more than 4,000 feet is the broad category, though this ship can handle depths of 10,000 feet) are currently going for a bit over $200,000 a day according to RigZone data, and SeaDrill has signed contracts for comparable semisubmersibles (not drillships, but with the same depth capacities) of between 400-480 thousand a day going out to 2012. Their most recent deal was for a semisubmersible with roughly the same capabilities and start date at $473,000 a day in the Gulf of Mexico. For the most part, SeaDrill is succeeding in its goal of getting contract rates for new rigs that allow them to pay for themselves over the first 3-5 years of their working life ... and they're still investing where they can to get the best equipment, including taking over Eastern Drilling and their two under-construction best-of-breed deepwater rigs.

There may well be a glut in the smaller, cheaper jack-up rigs that's driving prices a little lower -- but for the rigs that can drill in extremely deep water or in difficult conditions it's still a seller's market where many rigs coming out of the yards in the next two years are already booked through 2012. SeaDrill has a large portion of it's fleet positioned well to sign contracts at these high rates, but I think all the drillers who focus on deep water should do well despite the pessimism over oil prices.

I could certainly be wrong on this -- Phil Davis does a good job of arguing against energy investments in the current climate, and I'd agree that it doesn't make sense to buy bug integrated oils or oil royalty trusts right now ... and certainly the fact that oil prices have fallen 25% is going to have some significant impact on the sector, even though prices remain well above where they were pre-Katrina. But it seems unlikely to me that we'll see energy prices fall enough that it ceases to be important to find and drill new wells, and I think that's good news for the companies that own the most advanced drilling equipment.

Full disclosure: SeaDrill is my largest individual stock holding.

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Gulf of Mexico Drilling (SDRLF, SDRL.OL)

The news earlier this week that a big oil discovery had been made in the Gulf of Mexico was great for the owners of that property -- Chevron, Statoil (which I used to own, dangit), and Devon Energy -- but it was also good for the owners of deepwater drilling rigs.

And the more that E&P companies focus on deep water projects, the more SeaDrill and the other owners of these rigs benefit -- but SeaDrill is in a unique position.

There are many types of ocean drilling rigs -- but the main ones of significance are jackups and floaters. Jackups sit on pillars resting on the ocean floor and are generally used for depths of up to a few hundred feet, and there are hundreds of these rigs around the world. Semisubmersibles and drillships are floating rigs that can handle the deep water requirements of drilling in water depths of 3,000 meters or so, and there are only a few dozen of these specialized rigs in existence -- even fewer if you're looking for floaters that can handle harsh environments like the North Sea.

As high energy prices (and even if they dip to $50, they'll still be high enough to spur exploration) force the oil companies to look for new reserves aggressively, and most of the easy and friendly reserves are already found, the search is moving to the difficult areas of the world. Sakhalin Island off Siberia is the site of one of the most difficult drilling operations in the world right now and it's giving Shell fits ... but they're still pouring $20 billion dollars in because the world needs that oil, and Shell needs to build up reserves.

I've written plenty about SeaDrill before, and it's my largest individual stock holding -- see here, here and here for a sampling of my fuller writeups about the company, their financial engineering, and their focus on returning value to shareholders as they build a world-leading fleet of ocean rigs.

But some news came out today that made me take a closer look at SeaDrill's fleet and their availability for new deepwater work a la this new Gulf of Mexico field.

Today, SeaDrill announced their first deepwater rig agreement for the Gulf, a prelminary letter of intent (not yet contracted) to put one of their semisubmersible rigs to work for an unnamed company (could even be for this new discovery, they're not saying) beginning as soon as this newbuild rig hits the water in the second quarter of 2008. The deal will bring in $690 million over four years (with two option years), which equates to a day rate of about $473,000 -- not bad, and a serious indication that demand for these high-capability rigs is going to continue to be very strong for at least several years.

When I saw that, I re-checked SeaDrill's fleet status (current one for September is available here as a pdf). Of the estimated 20 or so new deepwater rigs that will be coming online in the next two or three years worldwide, SeaDrill controls 8, 7 of which are still available for contract at these stupendous dayrates ... many more than any other drilling company.

And it's important to remember that SeaDrill and its acquired companies ordered these rigs over the last few years at prices far below what newbuilding orders are getting now from yards like Keppel Fels (KPELY -- which I also own). If SeaDrill can work similar magic with these extraordinarily expensive and desirable rigs as they did with the SeaDrill 3 sale/leaseback (selling the rig to a finance company for twice what it cost them, then leasing it back at sweetheart long term rates), the amount of cash that could flow from this company from 2008 forward is truly staggering. They're also talking about possibly spinning off their more predictable cash-flow-generating tender rigs (shallower water, longer contracts) into a MLP or similar entity to free up additional cash to return to shareholders, and they continue to pursue new acquisitions, with a particular focus on getting more involved in the Western Hemisphere market.

SeaDrill has focused on the deepwater market with most of their newbuilding investment and corporate acquisitions, with the intent of building a market leader in that segment. I think they're already close to that status, and I'm looking forward to reaping the rewards of a company that is in the sweet spot of a bull market in their business, and that focuses on rewarding shareholders through careful financial management of their assets.

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SeaDrill Optimism (SDRLF.PK, SDRL.OL)

I've picked up my shares of Norwegian rig owner SeaDrill (FARO) in a few purchases over the last six months or so -- with an average price of $14.93, well above $12.55 (where the US pink sheet shares last traded).

And yet I remain optimistic. The shares have fluctuated mightily with the price of oil, but are down more than 30% from their highs of last winter, when enthusiasm for this John Fredriksen project was just hitting its peak as SeaDrill dramatically increased its size by winning a takeover battle for Smedvig. Oil and rig rates have not gone any lower since then, at least in broad terms, but the market optimism has certainly declined -- especially in Oslo, where SeaDrill trades.

The case for SeaDrill continues to be made by investment banks -- I wrote a while back about UBS and their upgrade of SeaDrill, an upgrade partly focused on the point that SeaDrill may be able to return up to 8.5 billion to shareholders over the next six years.

And a few days ago another bank, Merrill Lynch, reiterated their upgrade for these shares. The analyst's argument focuses on what makes SeaDrill unique: That they will have a huge portion of their high-quality rig fleet available to sign contracts during what is expected to be a long period of climbing rig rates over the next three years -- fully half of SeaDrill's fleet is not yet contracted for 2008, and I expect we'll see lucrative deals for those units in fairly short order.

Merrill puts the compound annual growth rate for earnings at 127% from 2006 to 2009 based on these assumptions, and estimates that the shares are trading at a 2009 PE ratio of 3.9 -- I know it's pretty ridiculous to go out that far on earnings estimates, but the trend in rig rates is fairly clear and the shipyards are pretty much all booked through 2009, so any new rigs that will hit the water between now and then are accounted for.

That pretty closely mirrors the argument I've made in favor of SeaDrill shares over the past six months -- though unlike UBS, Merrill didn't make a point of emphasizing the tendency of Fredriksen-owned companies to return cash to shareholders (himself included) with generous dividends. I continue to think that there is great potential in SeaDrill's ability to sell their rigs on long term lease-back deals, as they did in what seemed to be an exploratory move with Ship Finance Limited (another Fredriksen company) just last month.

The general strategy for Frontline has been to take high-cost assets and sell them off to investors (Ship Finance Ltd), with very long term leases back to the operating company (Frontline) that provide very low lease rates relative to current market rates and a profit-sharing kicker for the investors. That enables Frontline to turn a profit as long as tanker rates remain above a certain level, without having all their cash tied up in owning these extraordinarily expensive ships. The investment company gets a steady return on their investment, the potential for profit sharing, and the ability to depreciate these expensive assets.

That strategy has every chance of working with SeaDrill, I continue to think -- it's a similar business, with very expensive long-lived assets that are in high demand currently but have volatile rates of return.

And if Fredriksen and Tor Olav Troim can apply the financial engineering to the rig industry with SeaDrill that worked so well in the tanker business with Frontline, I expect to enjoy a nice ride on their newest wealth-creation vehicle.

This is my largest single individual stock holding, and it's also the one I might need to be most patient with, as I wait for their newbuildings to hit the water between now and 2009 and start earning the extraordinary day rates that I expect them to continue to command. Until then, the PE ratio is not going to be any great shakes -- but the prognosis for patient investors looks very good to me.

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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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Counting on Cash Flow -- more SeaDrill (SDRLF.PK)

I don't have anything new to say about SeaDrill after my posting of a few days ago on news that they have opened a financing agreement with Ship Finance, but I did end up buying some shares after thinking about this one over the holiday. I hope that this SFL agreement will build and allow SeaDrill to return a lot of the cash that it has tied up in rigs to shareholders while still building profitability and enlarging the enterprise.

And I'm confident enough in John Fredriksen and his management team, and in their track record at Frontline, that I'm putting a little more money to work here.

So this is just the official notification that I added on to my SeaDrill position this morning with another pink sheet share purchase (SDRLF.PK) at $13.80 (that's between a 1 and 2% premium to the Oslo close, depending on how the next few minutes of Oslo trading go, which is pretty typical for pricing on this issue).

This is now among my largest holdings, and my average cost per share is standing at $14.93.

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SeaDrill Financing Comes Through (SDRLF.PK, SDRL.OL, SFL)

I've written several times about my investment in Norwegian driller SeaDrill (SDRLF) over the past few months, but this is the first big of big news in quite a while.

SeaDrill has been plugging along, re-upping their contracts around the world to keep the rigs busy at higher and higher rates, which is great ... but today they secured the first part of what I hope will be a deep financing agreement with the closely related company Ship Finance Limited (SFL).

Back when I first purchased SeaDrill shares I wrote that I thought John Fredriksen and Tor Olav Troim would bring the same financing strategies into play in the rig business as they had done so successfully with Frontline in the tanker business. I speculated that they might involve the ship financing company that they created, Ship Finance Limited, in providing the liquidity that would allow them to continue growing quickly and build huge free cash flow capacity.

Well, it has begun to happen -- much earlier than I would have guessed. Here's an article that explains the financing deal that was struck, and here's the press release of the official announcement, but basically SeaDrill has sold the SeaDrill 3 to Ship Finance Limited and signed a fifteen year agreement to lease it back at steadily declining annual rates.

The SeaDrill 3 is a brand new Jack-up rig that will earn $166,000 a day starting this month in its initial contract in Nigeria (for about two years, with a market rate option following that). That means for at least the next two years, this rig will earn about $60 million a year and they'll be paying about $40 million a year for financing to SFL (the day rate SDRL pays to SFL will be about $112,000). That's $20 million in free cash flow ($44,000 ish a day), on top of the $210 million upfront that SFL paid for the rig. Not bad, considering that the purchase price of the rig itself, which was just delivered about two months ago, was estimated at only $114 million.

That's exactly the kind of leverage John Fredriksen likes to use for his companies, and it's a sign of the massive amounts of cash SeaDrill has the potential to spin off in the long run. I wrote when I mentioned UBS's upgrade of SeaDrill that UBS estimated they might be able to return up to $4 billion to shareholders over the next three years because of the potential for deals just like this -- that's more than half of SDRL's current market cap, which seems crazy but is modest compared to the cash that flowed to Frontline shareholders during the last few years.

So while I continue to expect SeaDrill to try to build their rig empire to compete with the TransOceans and Global Santa Fes of the world, and to use financing from SFL to pay for that expansion, I wouldn't be surprised to see them start issuing dividends within the next year as well.

There is, of course, a potential for downside here -- as with any leveraged situation. If day rates fall significantly below current rates when leased rigs are up for renewal (for example, if the SeaDrill 3 was up for renewal in 2008 and day rates were below the $112,ooo payments due to SFL), SeaDrill would have negative cash flow on those rigs. But if rates remain at least as strong as they are today for the next three years, or drop less than 20%, SeaDrill will be making lots of money. If rates climb dramatically, SeaDrill has the option to buy back the rig at an agreed upon price or, after three years, to just enjoy the much lower lease payments while they roll in the money.

And that's certainly the way the trend is moving -- SeaDrill also just announced that they've signed a contract extension for the SeaDrill 5, which is a 20+ year old jackup that's not as capable as the SeaDrill 3 (in terms of water or drilling depth), for a day rate of about $195,000 starting next year. It's a much shorter contract of just over four months, but still that shows the kinds of rates these rigs are getting -- this is twice the rate of the current contract for SeaDrill 5.

As a former Frontline shareholder who really enjoyed receiving 30% annual dividends for a little while as the SFL-enabled cash flow went through the roof, I'm hoping this is just the first building block in a long and successful relationship with Ship Finance Limited.

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Gas Investing Dilemma (CKHpd, CHK-D, PDE)

Investors in natural gas are on the horns of a dilemma -- will global demand really continue apace, with LNG investment around the world bearing fruit while prices remain at historic highs (above $6), or is the huge inventory glut we're now seeing just the beginning of a return to the historically low (sub-$4) NG prices that led to its popularity in the US?

There are good arguments on both sides -- the Washington Post had a good article this morning on the glut, implying that investors right now are really assuming a hot summer, cold winter, and active hurricane season. It looks to me like that's the investors in futures they're talking about, since Chesapeake
(CHK) and most of the other energy producers I'm familiar with have hedged a lot of their NG production at prices significantly higher than today's spot rate. The most important part of this article for those who invest in NG companies, in my opinion, is the reminder that the expiration of contracts is one of the most critical moments -- if hedges or contracts are due for renewal when prices are high, no harm done ... but if prices have bottomed thanks to this current supply glut, companies may be forced to sign supply contracts at much lower rates.

But in the longer term, as Bernanke said the other day in what seemed to be his thousandth speech of the year, it seems foolish to assume that energy demand will dry up or that supply will materially increase. With energy companies routinely being too conservative -- as we saw in 2004 when Exxon and all the big oils were priced as if oil would return to $20 a barrel -- I'm inclined to believe Bernanke's assessment that use of fossil fuels will continue to climb as the world industrializes, with at least several years before improving efficiencies can overcome increased overall demand to reduce the usage rate.

The safe bet, in my opinion, is to stay out of any short term (less than a year) gambles on the price of natural gas -- that's just a bet on weather -- and take advantage of any weakness in the natural gas spot rate to pick up shares in profitable energy companies with good long term potential, and plan to hold them for at least a couple years. For me, that's drillers SeaDrill and possibly Pride International, and natural gas developer Chesapeake through their preferred stock.

This worked well for me in the oil runup of 2004 and 2005 with low-priced oil companies like Petrobras, Statoil and PetroChina as company and analyst expectations continued to underplay the increase in demand while oil climbed from $30 to $70, and while I don't expect that kind of dramatic change in natural gas I do think we're underestimating demand and letting solid, profitable companies like Chesapeake trade too low. Your mileage may vary.

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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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