Monday, January 19, 2015  8:00:03 PM

ECB Suspense

by Jim Brown

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The world markets are waiting for the ECB decision on QE due out on Thursday. With the currency markets in turmoil as a result of the Swiss decision this ECB announcement is going to be critical. Some say the Swiss central bank was acting on inside knowledge of what the ECB is going to announce and their move on the franc was confirmation the ECB would announce QE.

Whatever prompted the Swiss to remove the peg on the franc the move caused havoc around the world. Multiple funds were destroyed. Currency trading firms were put out of business. Losses around the world have amounted to billions of dollars. Extreme volatility has taken over the currency market with everyone guessing what will be next.

The S&P futures were up and down on Monday as the rest of the world was open for trading. As of late Monday night they are down -4 from the Friday close so despite the volatility there has not been much movement from Friday's close.

The earnings cycle has not been positive for stocks with a large number of guidance warnings and earnings misses and we are just getting started. The activity will accelerate this week and the outlook is declining every day. Analysts are now expecting only 2% earnings growth, down from 8.1% expectations a month ago. The energy sector will be the biggest loser followed by banks and international companies hurt by the strong dollar.

Crude oil is still weak with it trading down -1.25 at $47.50 Monday night. Citigroup is projecting $32 as the low for Q1 and that would represent a lot more pain for the sector. Bargain hunters are starting to pick through the carnage in hopes of finding future winners but the energy earnings cycle is not for another 2-3 weeks and some of the reports are going to be ugly.

Goldman Sachs raised their estimate for projects at risk to $2 trillion if prices remain under $50. Very few fields currently being developed or planned to be developed are economical at $50. Companies will cancel those projects or shelve them for the future. This is going to cost hundreds of thousands of jobs and the companies that profit from a surging energy business are going to really suffer. The Dallas Fed said Texas alone will lose more than 140,000 jobs.

When you stop and think about the impact of $2 trillion in spending to the U.S. GDP it becomes very troubling with our total GDP just over $17 trillion today. Obviously not all of that $2 trillion is going to be cancelled and that spending is spread over several years of a projects life but this oil crash will have a lasting impact on our economy.

Once the energy sector begins to report earnings, layoffs and cuts in capex spending the analyst community is going to start slashing earnings estimates for 2015 and 2016. S&P estimates have already been cut from the high estimates of $135-$138 back to $120-$125 and that is a material disruption in expectations. Any further cuts under $120 will have a negative impact on the market.

I am laying this out for everyone because this will become an increasingly heavy weight on the market. We have already suffered from the market declines in December and January but they may not be over. The ECB decision could add to the volatility depending on what the ECB decides.

I am worried we are going to have another market event like we saw in October. At Friday's close the indexes were only down about -2% for the year. In October we saw a -9% decline. We could easily retest the 1,800 level on the S&P. We have only tested the bottom of our current uptrend channel three times in three years. We are due for another cleansing cycle and the oil crash and deflation in Europe could trigger it.

The upside to this scenario is that low gasoline prices will be a long term benefit to the economy. The average driver is going to save $750 a year in gasoline expenses and that money will be put right back into the economy as it is spent on other items. This is a stimulus program the government could never afford to provide.

Once the cleansing cycle is over and crude prices begin to rise again, which they always do, the market will be primed to rally for the rest of the year. The next few weeks could be painful for investors but we should be ever watchful for the buying opportunities that will be available.

I could also be wrong and the market goes straight up next week. If that is the case then our existing plays will benefit. If we decline from here then we can add to the existing portfolio. Personally, I would like to see a continued dip so we can get it behind us.

EXXI - Energy XXI

Energy XXI is the largest producer on the continental shelf in the Gulf of Mexico. They produce more than 60,000 bpd and have proved reserves of 329 million barrels plus hundreds of available drilling locations. The value of their reserves at today's prices is more than $17 billion.

On the surface it sounds like a great little company. In early 2014 they had a market cap of more than $6 billion. They paid $3.5 billion for EPL, another shelf producer and doubled their production. Today they have a market cap of $237 million and that is not a misprint.

The problem with EXXI was their acquisition rate. They acquired leases from Exxon, Apache, EPL and others over the last several years. They went on a spending spree that cost them more than $6 billion. While they were accumulating all these producing properties they struggled to actually produce them. They spent all their money on acquiring and not as much on developing.

They acquired a large number of old leases from Exxon with the intent of reworking the existing wells to generate new production and drilling new wells in those existing fields. They were well on their way and production was surging but the old infrastructure left by Exxon could not support it. There were leaks, pressure problems and pipeline bottlenecks everywhere. They simply could not push the rising production through the old pipelines. They had to back up and completely overhaul all the pipelines, pumps and compressors and that cost them 18 months of development time.

Three years ago they invested millions in a partnership with McMoran Exploration in the ultra deep effort. McMoran blew $1 billion on one well and although they found large quantities of gas they were unable to produce it for technical reasons related to the well. After two years of trying every conceivable fix they gave up. The company was failing and Freeport McMoran rescued it by purchasing the company back in 2013. It was originally spun off from FCX years earlier.

Freeport looked at all the efforts McMoran had started and picked out the ones with the most promise to begin development. After two years those wells are starting to be put online and EXXI will still have a 15-25% interest when they are complete. That failure by McMoran Exploration cost EXXI time and money and investors lost interest. The upside is still there but until Freeport gets all the wells to production status it is just one more line item on EXXI's asset list.

I view EXXI as an acquisition waiting to happen. Freeport McMoran could easily be the acquirer. They are making a big push in the Gulf now that they have all the takeover problems resolved. Since EXXI has a large stake in many of the McMoran wells it would be an easy way for FCX to buy back that stake and acquire another 329 million barrels of easy to drill reserves. Because all the EXXI leases are on the shallow water continental shelf the wells are cheaper and faster to drill. There is existing infrastructure already in place.

EXXI said in a presentation in 2014 that they had over one billion barrels of possible reserves because of all the leases they own in proven fields and blocks adjoining proven fields. They just don't have the cash to develop all the potential opportunities they have.

The oil crash is going to make it even worse for EXXI. The 50% drop in the price of oil is going to reduce their operating cash flow significantly. Since nobody is loaning money to oil companies today they are trapped. They are sitting on a goldmine but they can't afford to drill it.

This makes them acquisition bait for a larger and better capitalized company. At their current proved reserves of 327 million barrels and a market cap of $237 million they are valued at less than $1 per barrel. What company would not want to pick up the potential of a billion barrels of oil for relative pocket change?

The problem is that everyone has their hands full today. Back in June when oil prices were $107 almost every other week somebody was buying deepwater leases in the Gulf and scheduling monster development programs. Now those programs are in trouble. You can't drill $500 million deepwater wells and spend $1 billion on a production platform with oil under $50. Everyone is faced with high dollar development projects and low dollar oil.

The big companies like Exxon, BP or Shell don't want to own thousands of shallow water wells producing 350 bpd each. That is a nuisance for Exxon and that is why they sold their shallow water fields to EXXI three years ago. Exxon wants big projects with the potential for big production.

Fortunately there are a lot of midrange companies that could acquire EXXI and still have money for development. Unfortunately they may not want to act until oil prices firm. With Citigroup predicting $32 oil any acquirer may be expecting to acquire assets even cheaper.

I am a believer in EXXI. I completely understand their problems and their potential. I think their shares are a good investment for the long term. If they are not acquired in the near term the eventual rebound in oil prices will lift all stocks. EXXI shares are so low they don't have much room to fall any lower. Our downside is limited and the upside potential is excellent.

Because we don't know what is going to happen in the energy sector over the next six months I am going to recommend buying protection for our position. If oil does drop into the $30s anything is possible.

I am recommending we buy the EXXI shares, currently $2.53 and the March $3.00 ITM put, currently $1.05. That makes our total cost $3.58 and we are almost 100% protected against any unexpected event for the next two months. That gets us past the Q4 earnings cycle and we will have a lot better idea about the direction of energy by March expiration.

Earnings are February 5th and that is the biggest pothole for EXXI in the near future.

Buy EXXI shares, currently $2.53, no stop.
Buy March $3 put, currently $1.05, no stop.

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