The Guessing Game

One method to deal with uncertainty

Published on:
September 14, 2019
Last Update:

Written by

Noam Ganel is the voice behind Pen & Paper, a value-oriented stock research publication. He  serves as  Vice President in Capital Markets at Silvergate Bank and holds the Chartered Analyst Credential (CFA).

Mathematicians give names to numbers that cannot be expressed as common fractions. Consider the constant Pi [1] or the square root of two as examples. In this week's essay, I make the case that stock investors should copy how mathematicians dealt with uncertainty [2].

A sense of unease

A few weeks ago I bought shares in Gulfport Energy. At about $4 a share, GPOR traded at  four times the trailing 10-year average earnings per share of $1.84 and at less than a third of its reported tangible book value.

Peer companies traded at much higher valuation. Southwestern Energy (SWN on Nyse) traded at four times the 2018 earnings per share but the 10-year average earnings per share we negative[3]. Southwestern traded at roughly the reported tangible book value.

Another peer company, SM Energy (SM on Nyse), with reported book value per share of $2 and 10-year average earnings per share of $0.26, was trading at 60 times the earnings per share and at about two-thirds of book value.

Yet I felt discomfort after buying Gulfport. I attribute the unease to my inability to understand where Gulfport operations will be in five years. There are three factors that drive Gulfport's business. And all three factors are practically impossible to predict over a five-year time frame.


Three factors that affect natural gas price

First are the macroeconomic issues. These macro factors are heterogeneous and myriad in scope: from consumer spending and confidence levels to employment statistics such as Mass Layoff Statistics (MLS). From prices, productivity and wages variables as indicated by the Consumer Price Index (CPI) to international economic indications such as the German Industrial Production.

Macro factors also include supply and demand variables. For U.S- based natural gas investors, that means a visit to the U.S. Energy Information Administration website, and a review of the domestic production [4].

Then gas investors are expected to determine the trends in each of the demand drivers - those being industrial use, electric power, consumption and exports - a Sisyphean  task. Read Forbes' article about Oklahoma gas and oil industry as example.

The second factor relates to natural gas reserves. The natural gas company will determine how long the company's revenue can continue without incurring additional debt or equity issuance. Uri Geller, a psychic known for his trademark television performances of spoon bending, was once employed to predict how much natural gas reserves could be found. This antidote serves as example that it is, at the end of it all, somewhat of a guessing game.

In a May 2019 presentation to investors, Gulfport Energy's management reported on 92,000 in net reservoir acres in SCOOP (read about SCOOP on Enversus blog) and 210,000 net acres in Utica Shale. Management also reported that as of fiscal year end 2018, it had reserves of 1.3 net Tcfe in SCOOP and 3.4 net Tcfe in Utica Shale. But who can tell how much is still buried in the ground?  

Uri Geller was once employed to predict how much natural gas reserves can be found; estimating future gas reserves is, indeed, a guessing game.

The third issue is the regulatory and political environment which greatly affects the price of natural gas. A recent example from the state of Israel demonstrates how. The exploration for the Tamar gas field began in 1999, then a decade after, in January 2009, "Tamar was the largest find of gas or oil in the Levan bain of the Eastern Mediterranean Sea and the largest discovery," reported the Jerusalem Post. Noble Energy joined the drilling activity in 2006 and was the primary benefactor of the discovery.

Nobel's energy investors were thrilled but the Israelis threw a fit. The Israelis blamed their government of dire misuse of natural resources, which belonged to citizens and not in the hands of foreign, private interest groups, and that forfeiting such a national treasure was, in effect, a security threat. This political debacle began five years ago and continues to this day. In short, political and regulatory concerns are real.

GPOR's margin of safety

Merriam-Webster dictionary explains gambling as "to bet on an uncertain outcome." And if we were to use their narrow definition of the word then indeed buying Gulfport was a gamble. But I will propose a wider definition. Let us expand on Webster's definition with "without any margin of safety."

Buying Gulfport Energy was speculative; but at least there is somewhat of a margin of safety.

The wide margin of safety was the result of the low price to earnings ratio and low price to book value ratio. It was the result of today's investors receiving $24 billion of proved developed and undeveloped per share, while five years ago investors received $8.7 billion, and ten years ago they received $740 million. The margin of safety also results from management's buy back strategy and reduced planned capital expenditures for 2019.

***

"You've got to have models in your head," said the famed value investor, Charlie Munger. "And you've got to array your experience - both vicarious and direct - onto this latticework of mental models." My main point in this essay was to advocate that investors should observe how mathematicians had dealt with irrational numbers: they defined the phenomena and moved on with the analysis.    

While researching Gulfport, I understood how uncertain the future price of natural gas would be. So I looked for a wide margin of safety. I then moved on to read about the company.

FOOTNOTES 
[1] Pi is also known as Archimedes' constant.
[2] By giving uncertainty a name and then moving on.
[3] Southwestern Energy reported a 10-year average loss of $1 per share.
[4]  the domestic production is 80 billion cubic feet per day while comparing to the demand is about 90 billion cubic feet per day.