This one is bound to stir up some controversy. I'm sure there will be no shortage of bearish responses, which is what I want. Somebody talk me out of Harvest Natural Resources (HNR). Tell me what I'm not taking into account. I'm currently long with an average price of just over $10. (Yes, Mohnish Pabrai tipped me off to the stock a couple of years ago when he started buying). Here goes:

Would you take a bet with approximately the following odds:

10% chance of a 300% or higher return
70% chance of a 100% to 300% return
15% chance of a 60% loss
5% chance of a 100% loss

Those are the conservative odds that HNR offers investors at today's prices. (Yes, I'm aware that last sentence is going to bring some strong rebuttals).

I don't have the time or desire to completely fill everyone in on the company's background, but I'll try to give you a very quick rundown. HNR is an oil & gas company whose only producing properties are in Venezuela. As you probably know, Hugo Chavez (Venezuela's President) is nationalizing several industries, including oil & gas. They effectively re-wrote their contracts with foreign oil/gas companies, requiring them to take a minority (40%) stake in their projects and requiring them to pay enormous back taxes. The process is pretty far along now, the taxes have been paid, the contracts have been signed, and now they are just waiting for final approval from the Venezuelan government before they can bill PDVSA (the government oil company) for what they are owed. It is just a matter of time. On 4/1/06 Venezuela terminated all operating service agreements, so HNR has no agreement setting out its rights and obligations. Therefore, they cannot report revenues, earnings or oil reserves under GAAP until the mixed company is completed. Later this year they are expected to restate their results retroactively (once they have finalized their contract with Chavez), which should act as a catalyst for the stock price.

Good, shareholder-friendly management team. They have a good track record. Current mgmt took over the reigns in 2000, and thus far have done what they said they would do by successfully performing a turnaround. In 2000 the company had $250M of debt and their operating income couldn't meet the company's interest payment.


Back-of-the-envelope numbers for HNR are as follows:

Current market cap = $362 million or less than $10 per share

Cash = about $4 per share

In the event that the contract with Chavez gets finalized, they expect roughly $225 million from Venezuela for the past 4 quarters. That figure is already post-royalty, but it is still subject to a 50% tax, so it would be about $113 million net to HNR. That's worth $3 per share. Total value – if the contract gets finalized – is now at $7 per share.

A conservative estimate (using a conservative 20% discount rate) of the present value of HNRs reserves is worth about $560 million or $15 per share.

So there is $22 per share right there. Add to that the value of any growth that they are able to realize after the Chavez contract is signed, and this could easily be in the mid-$20's within a year or two. In August 2006 HNR signed a MOU with Venezuela to develop 3 additional oil fields. If I remember correctly, the company has already done 3D seismic reports on the field and they are quite promising. Finally, they also have an offshore China property that is the subject to territorial dispute between China and Vietnam. Vietnam has executed an agreement on the same offshore acreage with another company. The territorial dispute has lasted many years; there's been limited exploration and no development activity. The property is 50 miles southeast of an oil field, adjacent to BP's giant natural gas discovery, and 100 miles north of Exxon's Natuna discovery. The contract area covers several similar structural trends, each with potential for hydrocarbon reserves in possible multiple payzones. This property is a sort of moonshot option for shareholders. It has value, but I have no idea how to put a # on it.

That last thing worth mentioning is that since this whole Venezuelan fiasco started, HNR has had its access to capital markets cutoff. Once the contract gets finalized, they should once again have access to capital markets and be able to grow outside Venezuela. Management has made it clear that they intend to diversify away from Venezuela asap, and they have been exploring possibilities for the past couple of years.

That value is obviously only going to be realized if the contract gets finalized and production gets ramped back up. So, one must ask themselves what the odds are of expropriation or of Chavez not following through with the contract with HNR. But the odds seem to be very low, like under 5%. In the odds that I presented earlier, I was ultra-conservative in that I ascribed a 20% likelihood (15% chance the shareholders get HNR's cash, 5% chance management blows it and shareholders get nothing) that Chavez takes HNR's properties for no compensation. Venezuela needs the technology and expertise of foreign oil companies, and it appears that HNR has historically had a pretty good relationship with the Venezuelan government. Chavez has actually stated that he WANTS foreign investment in Venezuelan oil. Venezuela needs foreign oil companies to invest as much as the foreign oil companies want Venezuela's oil.

The following link contains an insightful interview with Hugo Chavez from last year:

http://www.progressive.org/mag_intv0706

Some highlights:

"Q: Speaking of the free market, you've demanded back taxes from U.S. oil companies. You have eliminated contracts for North American, British, and European oil companies. Are you trying to slice out the British and American oil companies from Venezuela?

Chvez: No, we don't want them to go, and I don't think they want to leave the country, either. We need each other. It's simply that we have recovered our oil sovereignty. They didn't pay taxes. They didn't pay royalties. They didn't give an account of their actions to the government. They had more land than had previously been established in the contracts. They didn't comply with the agreed technology exchange. They polluted the environment and didn't pay anything towards the cleanup. They now have to comply with the law.

Q: You've said that you imagine the price of oil rising to $100 dollars per barrel. Are you going to use your new oil wealth to squeeze the planet?

Chvez: No, no. We have no intention of squeezing anyone. Now, we have been squeezed and very hard. Five hundred years of squeezing us and stifling us, the people of the South. I do believe that demand is increasing and supply is dropping and the large reservoirs are running out. But it's not our fault. In the future, there must be an agreement between the large consumers and the large producers."

Former HNR shareholder. Went in and out 3 times over between 2002 and 2004.

Venezuela needs foreign oil companies to invest as much as the foreign oil companies want Venezuela's oil.

That's what I thought when I made my investment and I'm lucky to have gotten away with so much profit, at least the latter 2 times. The point is, if Chavez reneged on a deal, why would you believe in the sustainability of his new deal. Any stock dependant on someone who steps on the UN podium in front of that marble teal-colored wall and says it smells like sulfur.....eeehhhh.... ya it is controversial. I have not followed the company closely in a while. their very enjoyable CEO retired last year (forgot his name...the british guy).

Anyway, do you have any details about any efforts to develop in Russia or did they pretty much place that on the back burner?

That value is obviously only going to be realized if the contract gets finalized and production gets ramped back up. So, one must ask themselves what the odds are of expropriation or of Chavez not following through with the contract with HNR.

Another thing to consider is the possibility that the oil services industry will be expropriated.

Venezuela's threats to "nationalize" 18 oil rigs currently operated by outside firms sent a shock wave through the local oil services industry at a time these services are in high demand around the globe.

Executives at drilling firms said foreign rig operators could easily try and move equipment to other markets if the business environment worsens, hurting the country's ability to produce oil.

At the same time, Venezuela may be forced to lean on foreign oil service firms to keep the oil flowing until it follows through on plans to begin assembling rigs in country to help spawn a domestic oil services industry.

That means Venezuela may exempt from its nationalization drive some oil service company activities on which the country depends.

http://www.rigzone.com/news/article.asp?a_id=45194

jkm929

The point is, if Chavez reneged on a deal, why would you believe in the sustainability of his new deal.

Need we worry about ten, or even five years out? What is the probability of the bill passing the assembly & Chavez's signature, which could happen in a matter of weeks or a few months?

This would likely help unlock a great majority of the value. Given the political risk, we could be looking at a holding period of only 3 months to 2 years. After that, I don't know if you want to invest with a management team that includes Hugo at the head of the table.

But a high probability double or triple that becomes low uncertainty with the swipe of a pen? I just keep asking myself why Chavez would take HNR this far down the aisle and then dump them at the altar. Yes, he's crazy but he's not insane. Or is it the other way around?

BBQ

I just re-read my post and apparently I was getting a little excited when I posted my proposed odds of the HNR bet. It should have read as follows:

10% chance of a 200% (NOT 300%) or higher return
70% chance of a 100% to 200% (NOT 300%) return
15% chance of a 60% loss
5% chance of a 100% loss


The point is, if Chavez reneged on a deal, why would you believe in the sustainability of his new deal.

I don't have complete faith in Chavez's new deal. But as long as Chavez doesn't reneg for at least a few years, HNR should be a good investment. HNR will have time to diversify their assets, consider a sale of their Venezuelan assets, etc, in the meantime. Also, it is notable that the "old" deal that Chavez reneged on was originally inked by a much more pro-capitalistic government. Chavez didn't draw up the old deals.


Anyway, do you have any details about any efforts to develop in Russia or did they pretty much place that on the back burner?

The Russian properties that they used to own were sold off a few years back. They are still looking at Russia as a potential growth area (meaning they are considering the purchase of Russian properties/projects), but they are also considering many other areas of the world. In other words, it's on the backburner.


Venezuela's threats to "nationalize" 18 oil rigs currently operated by outside firms sent a shock wave through the local oil services industry at a time these services are in high demand around the globe.

Old news. I believe the real story is in the next line:

Executives at drilling firms said foreign rig operators could easily try and move equipment to other markets if the business environment worsens, hurting the country's ability to produce oil.

"...hurting the country's ability to produce oil." Let's back up and take a look at the big picture for a second. PdVSA, the state oil company, supplied Venezuela with $75 billion in revenues in 2006. Oil exports supply Venezuela with 80% of foreign revenues. In Venezuela, the economy is suffering, inflation is high, poverty is commonplace, there is high crime, and so on. PdVSA itself is supposedly having financial issues. PdVSA generally has a lack of skilled workers (the skilled ones have mostly been scared off and replaced with loyal Chavez backers). Furthermore, the foreign oil companies possess advanced technology that PdVSA does not, and the foreigners -- and only the foreigners -- have the ability to get Venezuela's heavy crude out of the ground, processed, and turned into dollars (or Bolivars, as the case may be) at a rate that will allow Venezuela to hit its stated goal of 5.8 million barrels per day by 2012.

The HNR bet is essentially this: Venezuela is going to HAVE to play nice (relatively speaking) for at least the next few years. If they don't, it could throw a MAJOR wrench in Chavez's social funding, domestic popularity, and potential to become a world power. Chavez has every incentive to keep foreign oil companies around -- at least for a few years. When analyzing the political risk here, you have to look beyond the daily headlines and think about incentives. Does Chavez want to cut ties with the USA, Italy, Spain and the rest of the world? Maybe, but can he afford to? NO. If he steals their property, his oil revenues will be cut drastically (close to 1/2). It ain't gonna happen. Furthermore, if he expropriates, there is almost no chance that any foreign companies would consider returning if Venezuela screwed themselves financially and had to drop to their knees begging for foreign investment to return. I think expropriation is just out of the question.

The process for HNRs new contract is in the eleventh hour, and management has made it sound like they believe it will be wrapped up sometime this summer. I think BBQPork summed it up pretty well in his reply.

Interesting company--one question

Briefly looked through the 10K and wonder what the company's rights are as far as the acreage and the mineral rights and if that really matters in an environment dominated by an idealogue like Chavez

Does HNR own the acreage and the mineral rights? And if they do does it really make a difference legally in a country where the definition of legal may change at the whim of the one person that is running everything unilaterally?

As in Rwanda, rights to land and resources are trampled and if legal rights to farmland can be tossed aside, are rights to any other valuable resource safe? Chavez could just as easily confiscate HNR properties and mineral rights and dismiss the contract with no explanation and no legal recourse (I think). But I would definitely like to hear your opinion as HNR is an attractive investment aside from the unfortunate exposure to Chavez


Clash of Hope and Fear as Venezuela Seizes Land B/i>



The squatters arrive before dawn with machetes and rifles, surround the well-ordered rows of sugar cane and threaten to kill anyone who interferes. Then they light a match to the crops and declare the land their own.

For centuries, much of Venezuela's rich farmland has been in the hands of a small elite. After coming to power in 1998, and especially after his re-election in December, President Hugo Chávez vowed to end that inequality, and has been keeping his promise in a process that is both brutal and legal.

Mr. Chávez is carrying out what may become the largest forced land redistribution in Venezuela's history, building utopian farming villages for squatters, lavishing money on new cooperatives and sending army commando units to supervise seized estates in six states.

The violence has gone both ways in the struggle, with more than 160 peasants killed by hired gunmen in Venezuela, including several here in northwestern Yaracuy State, an epicenter of the land reform project, in recent years. Eight landowners have also been killed here.

“The oligarchy is always on the attack and trying to say you are no good,” Mr. Chávez said to squatters in a televised visit here. “They think they're the owners of the world.”

OK. Nice points. But in that case, let's go back and ask: if he needs them so much, why did Chavez start up with them in the first place??

Here's what we know
- So we know that Chavez wants to drill the oil and get the revenues
- Provided that it does get drilled, we know that Chavez wants a lower, not higher, cost of doing that (and this isn't a probem so far because he's been reducing the cost).
- Furthermore, margin expansion might compensate for a little less drilling, although they might have a stated goal of top-line production.

Now, HNR needs Chavez too because of their financial situation. Has Chavez been tougher with companies that need him like HNR?

So far, my impression is that Chavez will compensate HNR roughly to the point where returns exceed the cost of capital somewhat. Another thing i was wondering: do you think Venezuelan gov. officals analyze HNR's finances very thoroughly?

The Fool, "captainccs" lives and works in Venezuela and probably can provide some valuable insight into Chavez etc.....

KitKat,

Does HNR own the acreage and the mineral rights? And if they do does it really make a difference legally in a country where the definition of legal may change at the whim of the one person that is running everything unilaterally?

The government of Venezuela owns all mineral rights. However, this is nothing new. It has been that way for a long time (before Chavez was ever in power, I believe). As respects the "new" contract, there is no difference in mineral rights when compared to the old contract.



Chavez could just as easily confiscate HNR properties and mineral rights and dismiss the contract with no explanation and no legal recourse (I think).

Correct. That is the risk. However, for reasons I explained in my last post, I believe that this is highly unlikely to happen in the next few years. Perhaps ultimately, but not in the next few years.


Valueguy88,

if he needs them so much, why did Chavez start up with them in the first place??

Chavez did NOT start up with them in the first place. Foreign oil companies, including HNR, were in Venezuela for years before Chavez came to power. This is not the first time Venezuela has nationalized their oil industry. It was previously done in the 1970s and then in the early 1990s (I believe I'm correct on the dates) they started allowing foreign investment again to help increase production. Venezuela gave foreign firms very attractive terms and conditions (ultra low royalties and low taxes, and I think they may have been providing some compensation for capex too) to come back. At the time, oil/gas prices were much lower and I don't think oil companies were just real excited about the prospect of returning to Venezuela, hence the attractive terms.

I'm a bit confused by the wording of your question, but hopefully I answered the question you asked.


Now, HNR needs Chavez too because of their financial situation. Has Chavez been tougher with companies that need him like HNR?

Good question. HNR does need Chavez too. But Chavez has not been tougher with companies that need him like HNR. The same rules have applied to all foreign interests, including the majors (Exxon, ConocoPhillips, etc). In fact, I believe that if he was going to get tough with any of the oil companies, HNR would be toward the bottom of the list. HNR is a little player in Venezuela. This is entirely speculation of course, but if Chavez was going to make a big statement by expropriating or unfavorably altering the contract for one of the oil companies, who do you think he would do it to? Harvest Natural Resources, or Exxon? I can think of only one reason Chavez would do such a thing, and that would be to show that he's going to play tough. He would make that kind of a statement with one of the big boys, not with HNR.


So far, my impression is that Chavez will compensate HNR roughly to the point where returns exceed the cost of capital somewhat. Another thing i was wondering: do you think Venezuelan gov. officals analyze HNR's finances very thoroughly?

I think you're mistaken about Chavez compensating just beyond the cost of capital. Under the new terms and conditions, HNR is still making a killing. Re your 2nd question, I doubt that they are analyzing each companies finances. If they are, they haven't let on by drawing up seperate contracts for each company. Make sense?

10% chance of a 300% or higher return
70% chance of a 100% to 300% return
15% chance of a 60% loss
5% chance of a 100% loss


I know you adjusted the 300% to 200%, but

You still have a huge gap in your % return. In my opinion, the gap is the most probable outcome in the short-to-medium term. I am talking about range of
less than 60% loss ----> 100% return

I say 90% chance of missing gap outcome, and adjust your other outcomes by a factor of 10...but that's just me



Hohum

10% chance of a 200% (NOT 300%) or higher return
70% chance of a 100% to 200% (NOT 300%) return
15% chance of a 60% loss
5% chance of a 100% loss

This is precisely the problem that I have with Pabrai's methodology. Computing accurate odds is impossible, given that there are always so many variables that we cannot know about a company, the individuals running it, and the investment environment (regulatory issues, political risk, etc).

Pabrai treats an investment like he is measuring coin flips, or calculating simple odds for Blackjack or Roulette in a casino. But this isn't a heads or tails simulation where we get to create an elaborate experiment. In the case of Harvest Natural Resources, either Chavez will eventually sign off on the bill or he will not.

And what are the odds of Chavez signing? With the very limited knowledge of the situation that I have, I believe it is a high probability, although there is so much that I don't know I couldn't possibly pin a number on it. 50%? 99%? I dunno. I can't predict the behavior of my wife, the person I know best in the world (besides myself), so how can I tell how Senior Poco Loco's neurons are going to fire that day?

I believe that we fall victim to the delusion of overly precise numbers when we make decisions based upon confidence in something in which we cannot have knowledge. For instance, I went thru this exercise when evaluating NETeller for investment last year.

Once the UIGEA legislation was shot down as a standalone bill, I calculated the odds of passage during the remaining days of last year's legislative session as being very, very low. Of course the possibility of the bill being tacked onto a must pass bill (port security) was present, but it was not probable.

So when the bill passed in the closing minutes, dare I say seconds, of the last hour of the last day of the session, I didn't get to flip the coin a second time. All of that Kelley Method crap didn't matter a lick at that point, and I took a nasty loss. And looking back at the situation, I can't say with any confidence that I had miscalculated the odds; I just flat out lost the bet. Sometimes the improbable just happens.

BBQ

Once the UIGEA legislation was shot down as a standalone bill, I calculated the odds of passage during the remaining days of last year's legislative session as being very, very low. Of course the possibility of the bill being tacked onto a must pass bill (port security) was present, but it was not probable.

So when the bill passed in the closing minutes, dare I say seconds, of the last hour of the last day of the session, I didn't get to flip the coin a second time. All of that Kelley Method crap didn't matter a lick at that point, and I took a nasty loss. And looking back at the situation, I can't say with any confidence that I had miscalculated the odds; I just flat out lost the bet. Sometimes the improbable just happens.


In various discussion on various TMF boards I've read similiar thoughts on prediction of odds based on legislation being passed or not. The single, repeatable, story I keep reading is that when investors have been burned is when trying to put odds on legislation in the US or abroad.

BBQ,

Lazy Sunday, hence I'm constantly checking the boards and quick with a response. I promise I won't always dominate the board like this.

Anyway, I think you're right and your wrong.

Computing accurate odds is impossible, given that there are always so many variables that we cannot know about a company, the individuals running it, and the investment environment (regulatory issues, political risk, etc).

You're right, computing accurate odds is impossible. This is where most investors fall victim to false precision. I'll invoke Buffett's famous quote: "I'd rather be approximately right than precisely wrong." It is critical that precision and accuracy not be confused. Many people feel that if they cannot precisely measure things, they shouldn't invest. However, all investments -- especially those surrounded by uncertainty -- have murky outlooks. Nonetheless, if one falls within your circle of competence, it is at least possible to come up with a range of outcomes and ballpark their respective probabilities. In fact, that is absolutely a necessity for me.

If I'm wrong on the probabilities or the outcomes, shame on me. But if an unfavorable outcome occurs, and I've taken that into account even if it's just a low-probability event, I'll be perfectly happy. You have to go into the investment knowing that there will be a poor outcome some percentage of the time. The key is to stay within your circle of competence, think of the range of outcomes, assign conservative probabilities, and buy when the odds are drastically in your favor. HNR may turn out to be a nasty loss for me, but if I had 5 uncorrelated bets with HNRs probabilities and payoffs, I would sleep very well at night even though I know that one of those bets is very likely to be a stinker. The expected value would still be positive.

One problem with this strategy: it is impossible to know, even in hindsight, whether or not I was accurate on the ranges, probabilities, and/or payoffs. Nonetheless, I beleive it is a critical step.

On a related but seperate note, I believe that there is a reason that HNR-type investments do not appeal to the vast majority of investors, even good ones. I just read Mauboussin's More Than You Know book, and he had some good thoughts on this topic. He mentioned how it is a fallacy to think that if you're right at least 51% of the time, you'll come out ahead. He went on to say that it is not the frequency of your correctness that matters, it is the magnitude of your correctness. He had an analogy that if you have a bet that will be a 100% loser 90% of the time, but 10% of the time it will go up 25X, you have a (very) postive expected value assuming you can make 10 such bets. That is an extreme example, but it illustrates the point well. Cited in the book was a study done by Kahneman and Tversky that shows that that a loss has about two and a half times the psychological impact of a gain of the same size. Therefore, people naturally are a lot happier if they are right frequently. But being right frequently is not necessarily consistent with good investment results.

I don't want to dwell on the odds that I ascribed to HNR too much, because no matter how much it is discussed just about everybody will come up with different numbers. The concept, however, is extremely powerful in probabilistic fields such as investing.


All of that Kelley Method crap didn't matter a lick at that point, and I took a nasty loss.

The Kelly Method is only useful in the context of your overall portfolio. Using the Kelly method, you will occassionally take nasty losses. That's the nature of the beast. The Kelly method will (I believe) generate the best returns. That's also the nature of the beast. I'm fine with that.

Something that I believe Pabrai understand very well be failed to discuss enough is that "Heads I Win, Tails I Don't Lose Much" should be viewed in the context of your overall portfolio. That is why some (but not much, if you're good) diversification is necessary. I run a small pool of money (family money at this point), and my results have been and will be quite bumpy. But our expectations are set accordingly. It takes a certain kind of temperament. Investors must be on the same page, and this approach is definitely not for everyone.

In the prior example where you could make 10 bets, each with a 90% chance of total loss and a 10% chance of a 25 X gain, you could very well show a 90% paper loss and still come with the expected positive gain.

You're right, computing accurate odds is impossible. This is where most investors fall victim to false precision. I'll invoke Buffett's famous quote: "I'd rather be approximately right than precisely wrong." It is critical that precision and accuracy not be confused.

John Maynard Keynes said something similar:

"I would rather be vaguely right, than precisely wrong."

jkm929

This is precisely the problem that I have with Pabrai's methodology. Computing accurate odds is impossible, given that there are always so many variables that we cannot know about a company, the individuals running it, and the investment environment (regulatory issues, political risk, etc).

BBQ,

I don't think Pabrai has an explict formula for calculating expected outcomes. He makes you think that he does in his writings, but that is only a way for him to visually demonstrate the concept.

For example, he has mentioned that he doesn't use spreadsheets/Excel to calculate intrinsic value, yet that's exactly what he does in his books when he talks about discounted cash flows. In Mosaic and Dhandho Investor, he explicitly lays out the discounted cash flow formula and goes through examples on how to use a two stage DCF, but in interviews he always says if he finds himself yearning for Excel, he takes a pass.

I believe he has a very implicit formula for estimating probabilities and estimating intrinsic value (much like Buffett and others). His method for doing these things is not as black and white as he makes you think in his books.

John

If there is a considerable margin of safety, the difference in expected outcomes isn't necessarily material if you play with the inputs. A range of outcomes based on variations in the variables is usually effective, and I'm sure that Pabrai does something similar.

I think he is just trying to make a point about the simplicity of his business cases. Take a look at his write up of FFH on VIC,

http://www.valueinvestorsclub.com/value2/guests/view-thread....

obviously he surpasses his standard of only needing a few paragraphs to demonstrate value. It doesn't really matter to me either way; if it takes a single paragraph or five pages of text & multi-stage DCF's, who cares as long as you get an outstanding investment idea in the end.

Cowboy's point about utilizing this method in light of an overall portfolio strategy is important, since if you can win a majority of these types of bets the portfolio will still grow despite occasional losses. Keeping the positions non-correlated is crucial, in case an entire sector snaps (e.g., subprime).

But I do think he uses the "Heads I Win, Tails I Don't Lose Much" language regarding individual positions. In this regard, the probability models are less effective, because a single improbable outcome can result in disproportionate losses. My example with NETeller demonstrates this -- on a single investment basis I took a severe loss, but the damage to my portfolio wasn't tragic.

BBQ

Yes, it does make sense. I suppose if one gets comfortable with the fact that Venezuela will assert its national pride every few years (give or take whatever else from other influencial factors) this is actually looking pretty interesting.

Being undereducated about Chavez and Venezuela, I nevertheless feel that investing money in a company whose fortunes could be dealt a blow at any time at Chavez's whim is a leap of faith and likely to be a big mistake.......Has anyone here followed the travails of Crystallex(KRY)? This mining company has been waiting for several years to get a final permit to operate a gold mine on a large proven reserve. Many jobs would be created, but still no go ahead.

I calculated the odds of passage during the remaining days of last year's legislative session as being very, very low...., but it was not probable.
...I didn't get to flip the coin a second time. All of that Kelley Method crap didn't matter a lick at that point, and I took a nasty loss.

Kelly Criterion, assuming that's what you meant, hinges on being able to calculate your odds/advantage precisely.

As any NFL gambler can tell you, NOT being able to do that simply ensures a slower rate of loss than other methods. I am not sure where coin flips enter the discussion, except deciding who gets to choose kick or receive before the game starts.

Naj

But I do think he uses the "Heads I Win, Tails I Don't Lose Much" language regarding individual positions.

Legg Mason's Bill Miller once said something to the effect of, the most you can lose on a stock is 100% but you can gain an unlimited amount (assuming long positions and no leverage of course). And, realistically, even when you are dead wrong, it's rare to lose 100%. From this perspective, it can make sense to take bets where you can lose big, because you can gain even bigger.

Despite your skepticism of Pabrai's investment thesis with HNR (which I share), I think that the probabilistic / Kelley Betting mindset is exactly the appropriate way to think of a portfolio of investments, just as it is with a sequence of 100 hands of poker or blackjack. If you make 100 bets at 60/40 odds, you'll most likely come out ahead, even if you lose a bunch of them.

Another angle on this is that if you are able to better identify the odds than the market, you can make a bet where the odds are in your favor. For example if the market believes there is an 60% chance of failure and there is really only a 30% chance, then the price will probably be very cheap relative to the probable outcomes. If you make this bet once, you may win or lose, but if you make this bet 100 times, you'll generally come out ahead.

The problem I have with something like HNR is the extreme difficulty -- or perhaps futility -- of assigning even rough odds to the outcome. I think betting on things like legislation and lawsuits is very problematic due to the unique nature of each event and the lack of relevant historical data. It's fine to pull some percentages out of your butt and declare them to be accurate, but if it is a unique one-time event, it is probably impossible to do so with any basis.

On the show Mythbusters, they concoct crazy physics experiments, such as making a cannon using technology available only in 3rd century BC. One of the mad scientists (Adam Savage) has a habit of assigning odds to the outcome of the experiment right before they pull the trigger, i.e. "10% chance nothing happens, 70% the ball leaves the cannon, and 20% chance that it blows up". But this is all in fun of course, he really has no idea, and hasn't done any hard research into it, he's just trying to sound authoritative. It's just a way of quantifying a gut reaction.

Another question is why you would want to bet on something as unpredictable as the passing of legislation or the outcome of a lawsuit. And if you were willing to do so, there are probably unlimited chances to make similar bets. But it seems like there would certainly be better opportunities for investment that don't carry as much uncertainty.

T

From this perspective, it can make sense to take bets where you can lose big, because you can gain even bigger.

On the subject of odds, it has been a while since I've been a parrot:

*slow-growers are low risk, low gain
*stalwarts are low-risk, moderate gain
*asset plays are low risk and high gain if you're sure of the value of the assets
*cyclicals are low risk and high gain or high risk and low gain
*faster growers are high-risk, high gain. The higher the potential upside, the greater the potential downside.

people forget that Lynch said his most important holding ever was Chrysler which many suggested might go bankrupt when PL bot it. In fact, right there in One Up Lynch gives the odds:

*if everything goes right, up 400%
*if everything goes wrong, down 100%

He made 15-fold on it.

And an unrelated comment - this is another example of why PL's record is understated. He made C 5% of his fund, the most allowable. He says in Beating that he would have made it 10 to 20% if he'd been allowed. My understanding is that the corporate money he managed outside of Magellan did far superior, though I don't have the figures to verify that.

And finally - it is ironic how many ideas are recycled and repackaged. They have to be. Otherwise, we'll never learn what others before us already know.

just 2c

faster growers & TURNAROUNDS are high-risk, high gain

(what a typo - it was the turnaround nature of these things that caught my eye in the 1st place)

*slow-growers are low risk, low gain
*stalwarts are low-risk, moderate gain
*asset plays are low risk and high gain if you're sure of the value of the assets
*cyclicals are low risk and high gain or high risk and low gain
*faster growers are high-risk, high gain. The higher the potential upside, the greater the potential downside.

So where does Chrysler fall on this spectrum? It doesn't seem to be any of these, more like a "turnaround" or "temporarily distressed" (or more accurately "distressed, possibly temporary").

Didn't Lynch also say that turnarounds rarely turn?

And an unrelated comment - this is another example of why PL's record is understated. He made C 5% of his fund, the most allowable. He says in Beating that he would have made it 10 to 20% if he'd been allowed.

Not criticizing Lynch at all. But he'd be willing to invest 20% of his money in something that has a chance of going to zero?

T

So where does Chrysler fall on this spectrum?


Sorry again - I typo it out - he said turnarounds were high risk, high return. C was a turnaround.

Didn't Lynch also say that turnarounds rarely turn?

don't know what you mean - He did say that "Never bet on a comeback while they're playing 'Taps'" and also cautioned against buying on bad news just for the sake of buying on bad news (cause bad news has a habit of getting worse) but all these actions were related to following events in the story and recalculating odds as new information revealed itself.

But he'd be willing to invest 20% of his money in something that has a chance of going to zero?

fwiw, it is right there in print, and he spent portions of two different books talking about the stock. Plus, one of his points was your point - you bet with eyes wide open and also that you don't have to loose 100% . The bet can be adjusted as new information and the stock price changes...

Not criticizing Lynch at all. But he'd be willing to invest 20% of his money in something that has a chance of going to zero?

fwiw, one last extrapolation - just theory and musings, but I think Lynch meant that he could loose 100% of his money if something totally unforeseen happened (and he mentions how long the BS gave him to wait) - but his job, esp. in pre-reg FD, was to be in possession of all the facts that were available at the time so he could understand what was 'foreseen' and be completely aware of what might happen AS it happened (and given the extensive array of contacts Lynch often sounds as much like a Fed Chairman as master investor in his search for all things nugget). In the book Lynch talks about touring C and seeing the new models and talking to the CEO.


A last nugget from the Train books:

As far as that goes, you can sometimes make 20-fold, while the most you can lose is 100%. The public doesn't understand that."

Back to work - looking at Petsmart with the 900+ stores and 4-5 years away from 1400 store saturation and wondering what they will do. In Lynch terms, company is a late 2nd stage fast grower (successful concept in the later stage of expansion before hitting the dreaded 3rd stage saturation) which is going to have to transition to something else before too long - hopefully not a slow grower, though the free cash flow makes it an asset play at the right price.

The bet can be adjusted as new information and the stock price changes...


Exactly. I believe Lynch started with a much smaller bet on C but as the story improved he kept buying, a great example of how to average up on a turnaround after an investor really gets in tune with the story. When he was making his largest buys on the company, he wasn't risking a thing.


-Jim

don't know what you mean - He did say that "Never bet on a comeback while they're playing 'Taps'" and also cautioned against buying on bad news just for the sake of buying on bad news (cause bad news has a habit of getting worse) but all these actions were related to following events in the story and recalculating odds as new information revealed itself.

Whoops, I'm mixing up my idols -- the "turnarounds rarely turn" comment is from Buffett, not Lynch.

I spend a lot of time with these "distressed / misunderstood" companies because that is where I think there are a lot of market inefficiencies. That appears to be what Pabrai does as well, since he always seems to buy in after some kind of decline, or in the face of some recognized but difficult-to-quantify risk.

This is also not unlike Buffett's investments in GEICO, American Express, and other distressed companies. Though he appears to have made his investments on the tail end of the scandals or problems, when the price was higher but the risk was much lower.

T

people forget that Lynch said his most important holding ever was Chrysler which many suggested might go bankrupt when PL bot it. In fact, right there in One Up Lynch gives the odds:

*if everything goes right, up 400%
*if everything goes wrong, down 100%

He made 15-fold on it.

I smell ad copy for the Rule Breakers marketing team.

Chrysler is a great example of a company that was widely perceived as risky, but that should not be tossed into the "crapshoot pile." If I remember correctly, Lynch said that he always looked for companies that were widely underestimated.

*if everything goes right, up 400%
*if everything goes wrong, down 100%

If Lynch had 5 uncorrelated bets, each with Chrysler's (perhaps overly-simplistic) odds, that made up 100% of his portfolio, his results would have been gangbusters. He might have had one position that turned to a total loss, but having two positions take a total loss would be extremely unlikely. And with this highly-concentrated portfolio, it seems to me that one probably still should have been more worried about being struck by lightning than having 3 total losses. Even so, with 2 positions that turned a 400% gain, he still would have come out ahead (with a 60% overall total portfolio gain) if the other 3 went belly-up. Again, the magnitude of your correctness matters just as much, if not more than, the frequency.

When investments are looked at in terms of probabilities and payoffs, putting 20% of your money into something that may go to zero is not necessarily suicidal, or even just stupid. If you're likely payoffs are big enough, it is actually a conservative (though very volatility-prone) way to manage money.

At a fairly recent speech at the U of Florida, I heard Buffett say that if he was managing small sums of money today, he wouldn't see the need to diversify beyond 6 investments. Granted, Buffett has a knack for finding investments that have huge upsides and almost no chance of principal loss -- a talent I do not share with him -- but it is still noteworthy. Similarly, Charlie Munger has said on multiple occassions that he doesn't feel any need to diversify beyong 3 or 4 carefully chosen investments/businesses.

I smell ad copy for the Rule Breakers marketing team.

Hey, not just Rule Breakers. You should see the piece of dreck that hit my inbox from MF Stock Advisor today. -- Hurry!!! Send us money today before it's too late and we'll tell you all about "The New American SUPER BRAND." -- Yeesh! My bad for having subscribed back in the day and getting on their spam list.

,<<<<<<<<<<<Similarly, Charlie Munger has said on multiple occassions that he doesn't feel any need to diversify beyong 3 or 4 carefully chosen investments/businesses.>>>>> That's fine for C. Munger, but.......but he's a rich man and probably has savings in 8 or 9 figures in T-bonds and the like

That's fine for C. Munger, but.......but he's a rich man and probably has savings in 8 or 9 figures in T-bonds and the like

Well he wasn't always a billionaire, and he had most of his net worth focused on just a few investments before he was.

It is true though that part of the reason that he seems to have no problem with having his entire net worth in 3 or 4 investments is that if one of them went to zero, he would suffer in terms of performance, but not in lifestyle. And, at some point, lifestyle is more important than performance. That is, what's the difference in lifestyle really between $400M and $300M, assuming that one of your four $100M investments goes to zero?

Statistically, you get a lot more diversification going from, say, your 2nd to your 3rd investment, than you do from, say, going from your 9th to 10th investment (assuming no correlation between investments).

T

That's fine for C. Munger, but.......but he's a rich man and probably has savings in 8 or 9 figures in T-bonds and the like

Concentrated bets have been Mr. Mungers's modus operandi ever since he was young and poor. It makes no difference that he is rich now. BUT, it does explain why he IS rich now.

That's fine for C. Munger, but.......but he's a rich man and probably has savings in 8 or 9 figures in T-bonds and the like

To me, it's all about thinking in terms of percentages (my investments/my net worth). It makes no difference to me if I'm managing $4,000, $40,000, or $4,000,000; I'm still going to keep my portfolio in 3-10 different ideas.

John

On a related but seperate note, I believe that there is a reason that HNR-type investments do not appeal to the vast majority of investors, even good ones. I just read Mauboussin's More Than You Know book, and he had some good thoughts on this topic. He mentioned how it is a fallacy to think that if you're right at least 51% of the time, you'll come out ahead. He went on to say that it is not the frequency of your correctness that matters, it is the magnitude of your correctness. He had an analogy that if you have a bet that will be a 100% loser 90% of the time, but 10% of the time it will go up 25X, you have a (very) postive expected value assuming you can make 10 such bets. That is an extreme example, but it illustrates the point well. Cited in the book was a study done by Kahneman and Tversky that shows that that a loss has about two and a half times the psychological impact of a gain of the same size. Therefore, people naturally are a lot happier if they are right frequently. But being right frequently is not necessarily consistent with good investment results.

I just have one quick thought on this topic of investing with a probabilistic mindset. While I'm sure there's a lot of truth to Mauboussin's point that probabilistic investment opportunities arise because of behavioural factors (e.g. people derive the most satisfaction from a high frequency of being right), understanding the math is unfortunately less than half the problem here. As I think another poster already alluded to, it's in the estimation of probabilities where people most often go wrong.

Now for some gross generalizations.

I think that people usually have a really good grasp of the extreme probabilities. They understand when a particular event has less than a 5% chance of occurring, or more than a 95% chance, for example. If the event is something that they've never seen happen (out of many chances), or they've only seen it happen once before, it's easy to mentally put it in that < 5% bucket. Conversely, if they find it difficult to recollect times when the event didn't occur, they put it in that 95%+ bucket. If the particular event seems particularly unique, most people try to find examples of similar events and run through the same thought process. People generally take this sort of an approach because if you're not basing the probability on some sort of historical data or knowledge or experience, you're just pulling numbers out of the air.

The problem is everything between 5% and 95%.

Unless something is highly unlikely to occur, or highly likely to occur, people usually don't really have any clue what the true probability is. I'm sure they often THINK they do, but the reality is they don't. In some circumstances you might be able to get comfortable that the probability is less than 50%, but even that leaves you with a huge range. The problem is that if you've seen something (or something similar) happen 4 times, or 11 times, how is your brain supposed to map that into a probability? There's no way (in most cases at least) that you're mentally keeping track of the number of times the event was possible -- and if you're hoping to use some sort of historical data or knowledge to form an opinion from, the number of times the event was possible is usually going to be pretty big, otherwise you're dealing with a sample size that is likely too small to draw useful inferences from.

As a result of this, I find that the idea of probabilistic investing is usually useless (despite the mathematics of it making perfect sense). Unless there is a 95%+ chance that a company is trading at a cheap valuation, I can't imagine making an investment. Unless you've got a wealth of data that allows you to make precise estimates, thinking that there is a 70% chance of an enormous return just isn't good enough. For most people that 70% estimate could just as easily be 15%, regardless of how confident they are in their estimates of those probabilities.

I think this sort of theoretical stuff ("just calculate the expected value! Duh!") is greater for writing books and sounding smart, but its unfortunately not very practical for investing.

it's in the estimation of probabilities where people most often go wrong.

I concur with the idea that people often get probability estimates wrong. That is the reason I posted this HNR idea in the first place. I wanted to see if anybody had anything intelligent to say as respects the probabilities (but especially the outcomes) I set forth for this investment. No doubt about it, estimating probabilities is the most challenging part of investing.

I don't think "the estimation of probabilities is where most people go wrong" though. I don't think most investors even think in probabilistic terms.

The problem is everything between 5% and 95%.

Agreed again. The A-bomb scenarios, fraudulent management, etc can usually be whittled down to < 1%. Like you said, the problem is everything between 5% and 95%. That is why the odds have to be drastically in one's favor before placing a big bet. It has to be obvious, given that you have a sufficient set of facts to base a decision on. Naturally, these types of opportunities usually only present themselve under extreme circumstances (HNR, Chrysler, American Express, Geico, Washington Post, etc). They are rare, all the more reason to bet big when you come across them.

As a result of this, I find that the idea of probabilistic investing is usually useless (despite the mathematics of it making perfect sense). Unless there is a 95%+ chance that a company is trading at a cheap valuation, I can't imagine making an investment.

You're right on when you say that estimating probabilities is where most mistakes are likely to occur (for probabilistic investors, anyway). But, in my mind, that's no reason to dismiss it as something that works in theory but not in practice. It does work in practice if done correctly. Speaking of working in theory and not in practice, your post sounds somewhat EMT-ish. Do you think markets are strong-form efficient?

Unless you've got a wealth of data that allows you to make precise estimates, thinking that there is a 70% chance of an enormous return just isn't good enough. For most people that 70% estimate could just as easily be 15%, regardless of how confident they are in their estimates of those probabilities.

I disagree. Do you have a reason that backs up why you think it is improbable that HNR's contract gets approved? If so, I may agree with you and I would love to hear your thoughts. But just saying that that may be the case because people can fool themselves into believing what they want to believe, or believing what their limited memory/experience suggests is correct, isn't a selling point for me. That's just me though.


I look forward to reading your response. Thanks.

I think that people usually have a really good grasp of the extreme probabilities. They understand when a particular event has less than a 5% chance of occurring, or more than a 95% chance, for example.

I'm pretty sure behavioral finance teaches exactly the opposite. The principals of LTCM, N Taleb, black swans, fat tails, and AA losing to 8-3 all teach us that it is human behavior to equate the improbable with the impossible. In fact, it appears that Taleb basically makes his living off investors mistaking the improbable for the impossible

In fact, it appears that Taleb basically makes his living off investors mistaking the improbable for the impossible.

The word is that after years of losses, Taleb quietly wound down his fund sometime last year. His black swan just didn't show up quickly enough for him to make money. Taleb is such a jerk that I actually caught myself, however briefly, smiling at the notion of his failure.

Best,
Redneck

I don't think "the estimation of probabilities is where most people go wrong" though. I don't think most investors even think in probabilistic terms.

Definitely, that's why I joked that this topic tends to be brought up more often in theoretical discussions rather than practical ones. I meant that for anyone attempting to apply a probabilistic approach, the estimation of probabilities is the problem.

Agreed again. The A-bomb scenarios, fraudulent management, etc can usually be whittled down to < 1%. Like you said, the problem is everything between 5% and 95%. That is why the odds have to be drastically in one's favor before placing a big bet. It has to be obvious, given that you have a sufficient set of facts to base a decision on. Naturally, these types of opportunities usually only present themselve under extreme circumstances (HNR, Chrysler, American Express, Geico, Washington Post, etc). They are rare, all the more reason to bet big when you come across them.

Maybe its just a matter of definition then, but to me, for the odds to be drastically in my favor, I have to have come to the conclusion that the horrible outcome is extremely unlikely to occur (i.e. less than 5%). As I said before, that's because it's usually impossible for me to really know whether something is 20% likely vs. 40% vs 60%.

You're right on when you say that estimating probabilities is where most mistakes are likely to occur (for probabilistic investors, anyway). But, in my mind, that's no reason to dismiss it as something that works in theory but not in practice. It does work in practice if done correctly.

While I can't rule out that there are certain individuals that are somehow blessed with a unique ability to assess probabilities with limited amounts of information, my experiences suggest that these individuals are exceedingly rare.

Speaking of working in theory and not in practice, your post sounds somewhat EMT-ish. Do you think markets are strong-form efficient?

Not sure what gave you that idea, but definitely not. Most markets seem to me to be highly inefficient.

I disagree. Do you have a reason that backs up why you think it is improbable that HNR's contract gets approved? If so, I may agree with you and I would love to hear your thoughts. But just saying that that may be the case because people can fool themselves into believing what they want to believe, or believing what their limited memory/experience suggests is correct, isn't a selling point for me. That's just me though.

I have no opinion on the probability of HNR's contract getting approved. I don't think that I'd be able to convince myself that its <5% likely, so for me its not worth thinking about. My post wasn't meant to be specific at all to HNR. I have no opinion on the company whatsoever. Just run through this exercise for yourself (no need to share it with the board): take your probabilities, add/subtract 20-30% to them, and formulate an argument for why the new probability distributions aren't right. Ask yourself honestly how compelling you find those arguments. If it works for you, then that's great! Absent great data or relevant historical knowledge, I just think that's a difficult thing to do.

I think that people usually have a really good grasp of the extreme probabilities. They understand when a particular event has less than a 5% chance of occurring, or more than a 95% chance, for example.

I'm pretty sure behavioral finance teaches exactly the opposite. The principals of LTCM, N Taleb, black swans, fat tails, and AA losing to 8-3 all teach us that it is human behavior to equate the improbable with the impossible. In fact, it appears that Taleb basically makes his living off investors mistaking the improbable for the impossible

That is something entirely different -- that extreme events occur more often than would be predicted by a normal distribution. I agree that that is the case with investment returns, but it has nothing to do with the point that I am making.

EI, I thought your point was...

I think that people usually have a really good grasp of the extreme probabilities... and The problem is everything between 5% and 95%

most folks have a very good idea of how to handle a coin flip or the chance of a second child being born with cystic fibrosis

most folks have alot of difficuty with unlikely events like an out of the money short put or the probability of drug side effects. The understimation of rare events is just more proof that folks have trouble with the rare event...

sorry for the mistunderstanding

I have no opinion on the probability of HNR's contract getting approved.

Neither do I, nor do I think calculating such a probability in this case to be particularly useful, but I would think one could calculate a reasonable probability for HNR's approval by figuring how many foreign (or specifically US) oil companies have been taken this far down the aisle and then dumped at the altar. I don't know what the answer is to this question, but I suspect it may be zero or if not zero a small percentage of the total oil companies "betrothed" to Venezuela.

I have no opinion on the probability of HNR's contract getting approved.

Neither do I, nor do I think calculating such a probability in this case to be particularly useful, but I would think one could calculate a reasonable probability for HNR's approval by figuring how many foreign (or specifically US) oil companies have been taken this far down the aisle and then dumped at the altar. I don't know what the answer is to this question, but I suspect it may be zero or if not zero a small percentage of the total oil companies "betrothed" to Venezuela.

Correct, it is zero. In the last conference call, management said that 3 (or 2 or 4 -- can't remember for sure) companies have already made it all the way through the process, their contracts are executory, and they are in a position to bill PdVSA for what they are owed.

The understimation of rare events is just more proof that folks have trouble with the rare event...

sorry for the mistunderstanding

No problem for the misunderstanding. Let me explain what I mean.

What you are referring to is when people assume statistically improbable events are impossible. For example, investors might assume that the company with a historically clean-cut reputation has 0 chance of embezzling money, but the probability is actually 0.02% and things like deeply out of the money put options need to reflect this.

What I'm referring to is that people can usually tell when something is statistically probable (i.e. greater than 5% chance of occurring) vs. statistically improbable (i.e. less than 5% chance of occurring). I don't believe I've ever read anything in behavioral finance that suggested people have trouble telling whether a particular scenario is statistically probable vs. improbable, but if you've seen any papers that say this, I'd love to see them.

Come on Redneck,

You can't just throw something vague like this out there. Dish it out, man. I'm in the middle of Taleb's book right now, and would be interested in the bonus colour.

BBQ

I think that people usually have a really good grasp of the extreme probabilities. They understand when a particular event has less than a 5% chance of occurring, or more than a 95% chance, for example.

I'm pretty sure behavioral finance teaches exactly the opposite. The principals of LTCM, N Taleb, black swans, fat tails, and AA losing to 8-3 all teach us that it is human behavior to equate the improbable with the impossible

Sports handicapping markets [and horses] tell us the same. Anecdotally, I've collected on
Tyson losing to Douglas at 45-1 or so
Reds Sweep A's at 50-1 in WS
Syracuse wins NC at 28-1, placed week before Tourney,
LSU was 125-1 to win NC last year and MichSt 50-1 the year before in mid-season, both cruised to the final four [where you could easily hedge for massive +EV]

Were all those odds *really* btw 1-4%? Absolutely not. But the vast majority of people can't distinuish btw 2% and 9% odds of winning.

Naj

Hi Cowboy, this has been a good thread, and thanks for the idea. I was wondering if you could delve into the specifics of your best-case scenario. Let's say everything falls into place with the government in the best possible way. What does the company look like?

From what I understand, they would own a 40% interest in the new entity Petrodelta. What would your estimate be for the BOE/day production?

I am also a little confused as to the royalty and tax structure. Let's say that Petrodelta grosses $1,000,000 in revenue. Does HNR get 40% of that ($400,000) and then have to pay a 33% tax on and a 50% royalty on that? So it their take-home then 17% of $400,000? Or are the royalty and taxes taken off the gross proceeds before HNR gets their minority interest? (sorry some of this is probably basic accounting stuff)

The reason I am asking all this is that even in a best-case scenario I am wondering how this is a 2 or 3-bagger. It just seems like their future results will be a lot worse than before. And I imagine their bargaining power going forward won't be very high as a minority interest owner. It's almost like they'll be hoping for whatever scraps Hugo and PDVSA are willing to throw to them.

It kind of seems like one of those where I feel a lot more comfortable taking a bet if I can either lose 100% or get a 5-bagger+ (asbestos stocks for instance) versus losing 100% or getting a 2-bagger.

I was wondering if you could delve into the specifics of your best-case scenario. Let's say everything falls into place with the government in the best possible way. What does the company look like?

Hard to say exactly what it would look like. If EVERYTHING went right, the offshore Asian property dispute would get settled in HNRs favor, they would find huge reserves there, and that would translate into mega-bucks for shareholders. Like I said earlier though, that really is a crapshoot so I've given it a value of zilch for now.

In early 2006 Venezuela suspended all of HNRs drilling ops, so their results/production has taken a major hit. Once the new contract is ok'd, production will get ramped back up, plus last fall they added 3 new fields to their deal with the Venezuelan government. Those new fields look promising based on 3D seismic results, etc. No idea how much that could add to their production though.

As is usual with ideas that are surrounded by uncertainty, the upside is very murky. I think it's safe to say that if everything went perfectly, this could be anywhere from a 3 to 5 bagger. That's the best case scenario I can picture though. Keep in mind that the PV10 of their reserves is around $23 or $24 per share right now (can't remember if that includes the 3 new fields or not -- my notes aren't in front of me). In my first post where I discussed the value of their reserves, I think is said they were worth $15 per share but that's because I used a 20% discount rate to be conservative.

Finally, one would need to add the value of their growth (assuming they diversify outside of Venezuela as well as grow their operations within Venezuela). This is also a tough one to value. I'll have to let you reach your own conclusions. In all likelihood, this will be a 1- or 2-bagger.


From what I understand, they would own a 40% interest in the new entity Petrodelta. What would your estimate be for the BOE/day production?

Again, my notes aren't in front of me. But I'm not sure I've ever tried to pin down the exact BOE/day that I expect. I looked at the figures in their SEC filing last year before drilling was suspended and used those as a "base case". The new fields should significantly add to their production as well.


I am also a little confused as to the royalty and tax structure. Let's say that Petrodelta grosses $1,000,000 in revenue. Does HNR get 40% of that ($400,000) and then have to pay a 33% tax on and a 50% royalty on that? So it their take-home then 17% of $400,000? Or are the royalty and taxes taken off the gross proceeds before HNR gets their minority interest? (sorry some of this is probably basic accounting stuff)

HNR owns 80% of the entity that has a 40% stake in Petrodelta, so HNRs net interest is 32%. You've got the taxes and royalties backwards. The royalty is 1/3, and my understanding is that a 50% tax is applied after the royalty. So in your example they'd get $320K. After a 1/3 royalty, it would be $105,600. After the 50% tax, it would be $52,800. This is one of my first oil/gas investments, so I'm not savvy as to when the royalties are applied. If I had to guess, the royalties are applied before minority interests are accounted for, then each entity has to pay the 50% tax after they get their share. Either way it should have the same result.


The reason I am asking all this is that even in a best-case scenario I am wondering how this is a 2 or 3-bagger. It just seems like their future results will be a lot worse than before. And I imagine their bargaining power going forward won't be very high as a minority interest owner. It's almost like they'll be hoping for whatever scraps Hugo and PDVSA are willing to throw to them.

Their future results should be better than before. They have the same properties they had before, which they should have producing at least at the pre-suspension levels. Then you add in the other growth from the new properties that I already mentioned. Re their bargaining power, they never had much to begin with. I don't see much of a change in terms of bargaining power (other than the risk of expropriation, of course).


It kind of seems like one of those where I feel a lot more comfortable taking a bet if I can either lose 100% or get a 5-bagger+ (asbestos stocks for instance) versus losing 100% or getting a 2-bagger.

Not that this is a big selling point, but in all likely-hood this would still be at least a 4$ stock if Chavez expropriated, resulting in a 60% loss. I don't see a 100% loss as a likely possibility. You'll have to form your own views on the upside/downside on HNR.

KRY, a Canadian gold mining company with a license to mine a large deposit in VZ. has found that waiting for a "final" permit to begin mine construction has been like "Waiting for Godot",,,,I think over 2-3 years and counting. Vz. is a no-no imho

missash, Venezuela is certainly not known for moving hastily through the approval processes. But moving at a snails pace is entirely different than not moving at all (i.e. expropriation). I'm aware of a number of companies that have made it through the approval process, but I'm not aware of any (though there very well could be some that I haven't heard of) that have not made it through.

Regardless of whether I'm right or wrong, it seems to me that I'm posting too much just to make the same point over and over. So unless something brilliant is brought up, this will probably be my last HNR/Venezuela post.

I'm not familiar with KRY or the circumstances specific to them, but your post reminded my of an article I read not long ago:

http://gold.seekingalpha.com/article/30469

Those of you that are following the HNR or Venezuela situation may enjoy reading it, despite it being mostly about the mining industry.

LSU was 125-1 to win NC last year and MichSt 50-1 the year before in mid-season, both cruised to the final four [where you could easily hedge for massive +EV]

Just curious, how would you implement that?

LSU was 125-1 to win NC last year and MichSt 50-1 the year before in mid-season, both cruised to the final four [where you could easily hedge for massive +EV]

Just curious, how would you implement that?

Futures bets off and online, TradeSports/BetFair, etc.

Using numbers, Jan 2006 LSU dropped from 75-1 to 125-1 after a slump. Buy $1000 of LSU futures there to win Natl Title.

LSU recovers, beats Fla in regular season, gets 4 seed, luckily gets a very weak Dook 1-seed, cruises to Final Four.

Now, LSU is 2.7-1 to win title. You could hedge by selling your futures, betting UCLA to win next game, or take UCLA and points [thus winning both sides if LSU wins but does not cover] or a combo of all three.

If you sold some of your futures, you could realize a gain of $25k if LSU won and $37k if they didn't win - and they lost to UCLA last year.

If you never hedge and they don't win it all, you lose the $1k. Simple.

Naj

Cowboy 1981

I broadly agree with your analysis; as such I am long HNR.

I have a quibble with your analysis of the value of the cash to be received by HNR once the agreement becomes effective. In summary, I think the net income to HNR for the 12 months ending March 31, 2007 will be around $29mn, or $0.77 per share. The cash dividend from Petrodelta to HNR will be less, owing to increased expenses and capital commitments. Of course, as time passes, the income and net cash should grow.

I have also analyzed the share price of HNR to its per barrel of oil value, and to the discounted income expected from its reserves. In short, at $10 per share, I think HNR is trading around a 70% discount.

Finally, I can't resist offering one of my favorite quotes from Warren, somewhat on topic:

"I prefer businesses domiciled in the U.S. Susie and I each have one share of a stock I bought in 1955. It looked very safe at the time. It was a marvelous stock. There's just one problem. Its property is located in Havana and Castro seized it. We can't get title to it. It just sits there. We've got huge claims against the government. And it's never going to be worth anything. I keep it around to remind me of what can happen. The rules in other countries can change overnight."

More thoughts here:

http://valuevista.blogspot.com/2007/06/hnr-is-oil-gas-compan...

Doh! When calculating their reimbursement, I was failing to account for their 32% interest. Appreciate you catching that.

I have also analyzed the share price of HNR to its per barrel of oil value, and to the discounted income expected from its reserves. In short, at $10 per share, I think HNR is trading around a 70% discount.

Could you break out how you calculated their PV-10?
What is your determining price? The operational cost per boe? the expected depletion rate of the reserves? (How many years to exhaustion.) I assume that you used P1 only, and not P2 as well (P1 is proved reserves, P2, probable). And, considering the ambiguities, what number did you base for P1?

As it happens, I did briefly discuss PV-10 on another board recently; its importance in valuing an E&P. It is a fairly straightforward bit of quantitative work, with the only tricky number, sometimes, is tweaking out the operational costs over the lifetime of the reserves.

It might be worthwhile for people here to see an actual workout.

(For those who are unfamiliar with PV-10, it stands for Present Value discounted by 10%. The standard method to calculate the current value of proved oil and natural gas reserves.)

Could you break out how you calculated their PV-10?

HamletsMill--

I compared the HNR share price to its PV10 value.

In its proxy dated November 6, 2006, HNR includes an independent report on its reserves prepared by Ryder Scott, as of April 1, 2006. In part, the summary of the report reads:
http://sec.gov/Archives/edgar/data/845289/000095012906009424...
Reserves for the SMU fields were determined using reservoir performance methods. Reserves for the new fields to be added to the Mixed Company were determined primarily based on the volumetric method, except for cases in which there was sufficient historical data to support the performance method. The hydrocarbon price used in the reserve report was the estimated market price as of March 31, 2006. The WTI crude price on that date was $66.25/barrel. Based on historical correlations, the estimated market price for oil at the field is $45.81/barrel. Development and operating costs were based on historical data at SMU provided by Harvest, adjusted for location and quality of crude, and include only directly applicable to the leases or wells. Where applicable, a portion of the general and administrative costs allocated directly to the leases and wells was also included. No deduction was made for indirect costs such as general administration and overhead expenses, loan repayments or interest expenses. Royalty charged by the Venezuelan government of 33.33 percent has been deducted, and therefore, is not included in either the net reserves volumes and revenues.

The key numbers from the report are:

Estimated after-royalty, but before VZ tax, income, discounted at 10%.

Proved $616mn
Probable 317
Possible 792
Total $1,725

Subtracting a VZ tax of 50% would leave discounted net income for reserves of:

Proved $308mn, or $8.20 per share
Probable $159mn, or $4.22 per share
Possible $792mn, or $10.55 per share
For a total of $863mn, or $22.96 per share.

HNR enterprise value is $261mn, or about $7.00 per share. Thus at $7 per share, HNR trades at a 70% discount to total reserves value, and less than the PV10 value for just proved reserves.

This value does not give any credit for the possibility that HNR may improve the reserve position. HNR has had a good record in the Monagas fields. In 1992 when HNR entered Monagas, proved reserves were 18mn barrels and HNR produced 124mn barrels in the following years.

You referenced a prior post of yours: As it happens, I did briefly discuss PV-10 on another board recently; its importance in valuing an E&P. It is a fairly straightforward bit of quantitative work, with the only tricky number, sometimes, is tweaking out the operational costs over the lifetime of the reserves.

I'm not sure I found it, but I did find this:
http://boards.fool.com/Message.asp?mid=24413974
My method comes up with $23.76 net present value for CHK.
That does not include the P2 (probable reserves). A practical rule of thumb is to assume that 50% of P2 will be exploitable. It is customary to give a greater discount to the present value of those; I generally use 12%.
I never use P3 – afraid I am a bit more skeptical of potentials.

Applying your methodology (as I undertand it) for HNR the numbers woould be:

P1 -- $8.20 (calculated at 10% discount)
P2 -- $2.00 (Calculated by assumed PV@12%=300mn, before 50% VZ tax and 50% haircut)

To the $10.20 of value, we would add net cash of $3.00.

What do you think?

Regards.

Just a few comments on PV-10 (and how it applies to HNR)

Proved Reserves: Ryder Scott is well regarded. I believe they are the most widely used consultants for public companies. I would accept their estimates as being robust.
I am sometimes willing to incorporate probable reserves, after I have spent time looking at time and picking the brains of some people, but generally I'm cautious about using them as a basis for expecting above average returns on investment.

Determining price: the SEC rules allow for using a snapshot price, but some, myself included, prefer smoothing out by using past spot prices and future contracts (the WS). In my case I use a rolling 36-month look back and the forward 36-month futures (Both data freely available through the EIA and NYMEX). That gives me currently a determining price, based on WTI, of $63.94.
The advantage of this method is that it can be easily updated and offsets some of the volatility – giving a better long-term view of value.

For global producers, I use another, slightly lower, estimate, now about $60. Part of the difference is due to the nature of West Texas Intermediate, the quality of oil and locations.

Costs: This as I said can be tricky. A glance at HNR's report indicated real present costs of about $8 to $9. Which is a good number - “average” costs run around $11-12, (this includes finding costs, lifting costs and other directly related expenses) and can run much more (think offshore rigs, difficult geology and geography). However, as fields are depleted, this frequently, most often, op costs rise – the need for more wells to keep up production, possible injections, etc. Not to mention finding crews and equipment in an increasingly competitive environment. I typically guesstimate that costs will average 50% higher than current over the lifetime of a field.

All in all, HNR does seem to trading at a substantial discount – the risk premium no doubt. Ah, one last comment, it isn't unusual for E&P companies to trade below PV. There is a lot of understandable conservatism among investors and analysts for what has been traditionally a semi-cyclical sector, and, to be blunt, a whole lot of denial about what is happening to petroleum.
Very few people are looking out and forward to the widespread implications, both good and bad, of the changes in the demand and supply curves…

Well, I hope this discussion hasn't been too boring to all of you that don't follow oil. As for any errors of fact, feel free to jump up. This, as usual for me, was done ex tempore, and is definitely not ex cathedra.

This sounds like a good news to HNR:

Venezuela To Begin Paying Dividends To Oil JVs -PdVSA Executive

http://money.cnn.com/news/newsfeeds/articles/djf500/20070612...

Dhandho, baby!

My #8 position just became my #5 position. Pork ribs for everybody!

http://energy.seekingalpha.com/article/38728

Congrats to those who were long!