The Greatest Transfer of Wealth in History
Iíve made it clear for a year that I believe we have entered what will be the most serious depression in history. It also will involve the greatest transfer of wealth in history.
There are two basic classes of assets. There are paper assets and real assets. An ounce of gold is a real asset. A copper mine is a real asset. A house is a real asset. An oil field is a real asset.
Over the counter derivatives now total over $596 trillion dollars, (click here [pdf]) ten times the size of the world economy. Those are paper assets, their value is derived from some other asset. That derivative size is what is going to destroy the worldís financial system, itís all fraud.
A mortgage is a paper asset. A T-Bill or T-Bond is a paper asset. A $100 bill is a paper asset. Itís pretty easy to see that a $500,000 mortgage on a house now worth $250,000 isnít worth very much. Latest figures show 9.6 million homes in the US have negative equity. How many of those loans are going to be paid back?
According to an ex-Fed Director, both Fannie Mae and Freddie Mac are bankrupt. They were leveraged 65-1. For those comforted by the thought of the FDIC bailing you out should the banking system fail entirely, you need to realize the FDIC is leveraged at 130-1. We are told that the collapse of Washington Mutual alone could bankrupt the FDIC.
In a depression, no real assets appear or disappear. Paper assets, on the other hand, turn to vapor. But the ownership of real assets will change as the real assets move from weak hands into strong hands.
Iím going to show investors a specific investment that normally would be off the radar screen but because of what is going on in the financial system should, perhaps, be considered.
Ivory Energy (IV-V) has been an advertiser for about a year. In July of last year (2007) the company purchased two existing oil fields in western Saskatchewan. They used an interesting debt instrument, Convertible Debenture to pay for the acquisition, (IV-DB).
A convertible debenture is an interesting product because it has elements of two different investment alternatives at the same time. It is both a bond and a warrant. In the case of the IV-DB, the interest rate as a bond is 9.5% and the company will retire it at par (100) in July of 2012 but may start retiring it as early as 2010 at the companyís option.
The debenture is also a warrant to buy Ivory Energy shares at $1 at any time between now and when it is retired. If the price of the stock was $1.50 today and the people holding the debentures exercised them, the company would get the benefit of not having to pay interest on the notes but unlike a warrant, the company wouldnít see any new cash.
One very important aspect of Convertible Debentures that investors need to think about because itís so important today, is that these debentures are usually sold as long-term interest-bearing instruments and are very illiquid. Hedge funds or large investors buy them and hide them under the mattress. In normal times, with an issue of $28.5 million, a few hundred thousand dollarís worth of debentures might trade hands in a year.
Ivory Energy is a heavy oil producer. Their theory a year ago was that they would buy the two oil fields, bring in capital; drill more wells and be producing 3-4 times as much oil today as they were a year ago. But like most companies, their grasp exceeded their reach. Production increased to as much as 850 barrels per day in November and declined to a low of about 500 barrels in April of 2008 before starting higher.
While Iíll fault management for being too optimistic, the original plan called for 1200 barrels a day by February, they did increase reserves and are now increasing production. A May 20th, 2008 press release announced a net present value of $.71 a share based on an independent reserve report at $56 oil. The oil is still in the ground. It really doesnít matter very much if they produce it last month or a year from now. I like the future for energy so Iím perfectly ok with oil in the ground.
Due to totally exterior events, the financial chaos ensuing in the overall financial market was having an effect on both the price of the IV shares and the price of the debentures. Starting in January, a large holder of debentures started dumping them on the market, seemingly at any price.
We are all well aware of companies such as Merrill Lynch and E*TRADE dumping investments at pennies on the dollar. Well, some of those investments they are giving away may be diamonds in the rough if you will look closely.
In the case of the debentures of Ivory, they went from selling at par (100) in November to as low as 55 last week. I was an investor in the private placement of Ivory last year and have invested in the debentures since because they were the least cost way to invest into what I saw as an excellent energy company.
Let me work the math out for readers who have never looked at convertible debentures before. The units were issued in July of 2007 at par, (100) with 200 warrants attached to each $1000 face of debentures. Itís handy to have warrants that are quoted and trading because at any time we can look at the quote and see what the value of the warrants is today.
In any case, originally the DBs were issued in units of $1000 paying 9.5% a year. The company will retire them at par (100) no later than July of 2012. So the DB has three elements of value. It has the warrant feature, it has the current interest rate and it has the yield to maturity.
As of last Friday, the Ivory shares were trading at $.28 giving the company a market value of about $13 million. That seems cheap for a company with a NPV (Net Present Value) of $.71 a share. The IV-DB was quoted at .55 or 55 cents on the dollar.
We know the value of the warrant (IV.WT) that was quoted at $.05 on Friday as a bid. We also can determine the current interest rate with the DBs at 55. Take the yearly payment (Thatís $950 per $10,000 face) and divide it by the current price of the DBs which is 55) giving a current interest rate of 17.27%.
The yield to maturity is the difference between todayís price of 55 and the maturity price of 100 in four years. The difference is 45 points spread over four years or 11.25 points per year. If nothing else happens, the DB should be worth 11.25 points more in August of next year, through maturity. If you take todayís price and factor in an increase of 11.25 points for each year, you will realize you have a yield to maturity of 20.45% per year.
So here are all the numbers for the DB. The DB is quoted at 55 asked on Friday last. It has a value of 5 points for the warrant portion, a yield of 17.27% based on the current yield and an additional 20.45% yield to maturity for a total yield of 37.72%.
Wait just one minute, thatís nuts. Here is an oil producing company with a real asset paying 37.72% and being convertible into shares of the company as well. No, thereís more. On Thursday last they announced completion of a gas well that will be in production later this month at a flow rate of 5.46 million cubic feet per day. Ivory owns 14% of the well. By my figures, after expenses, they should be making about $3000 a day, 365 days a year from this one well and they are drilling another development well next door where they own a 20% interest. I figure that single well is worth $10-$15 million all by itself.
Thatís totally nuts. Here is a company with a market cap of $13 million that owns an oil well worth more than that. Has the world lost its collective mind?
Actually yes, and I first brought it up with management in January and again two months ago. There are 7800 hedge funds out there. Many of them have invested in paper assets that have evaporated. Now they must dump their very real assets to raise money. Remember when I said that DBs are illiquid? Well, one single fund has dumped a bunch of Ivory debentures paying a 37% return onto a very illiquid market.
Itís just my opinion but I believe the guys running companies have a certain obligation to look out for the best interests of their shareholders. I cautioned Ivory management of what was going on many months ago but was pretty much ignored. When they realized someone was dumping onto a very illiquid market, they should have picked up the phone and found an existing investor with strong hands to soak up what seems like a pretty good investment. They didnít and the decline in the debentures rolled over into the shares and every shareholder has gotten creamed. Itís totally irrational but there are going to be a lot of irrational investment decisions made in the days ahead.
Ivory Energy is not about to go belly up. But by allowing the price of the debentures to be cratered by one seller, Ivory have allowed the common shares and debentures to trade at a price that infers an impending collapse of the company. Itís not going to happen. They are producing at a rate of 610 barrels of oil a day and getting $96 a barrel. The latest announced well will add another 100-150 barrels of oil equivalent per day. That is a pretty good deal.
So if any of my readers are interested in a 37% return on a long-term investment with a warrant kicker, itís available and for Canadian investors, can be leveraged. Canadian brokerage firms will loan up to 95% of the current value on Convertible Debentures. I have shown readers just how to determine current yield and yield to maturity, there is no mumbo jumbo to these investments.
I want to caution everyone, these are not Beanie Babies and this isnít eBay. Do not buy these with the intention of trading them. They are selling for pennies on the dollar because someone else was a damned fool and had to dump them. Do not buy unless you are buying them for a long term hold or want to exercise them as warrants if and when Ivory goes above $1.
There are going to be a lot of examples where someone gets forced into liquidating very real assets for pennies on the dollar. At times during the last great depression, the bluest of blue chips were paying 15% dividends. Itís going to happen again. For those who keep some powder dry, assets are going to fall into your laps. Do your own due diligence.
I like Ivory management but they were remiss in not sorting this out months ago. It created a lot of opportunity for investors but should have never taken place in the first place. I also want management to realize itís time to put up or shut up. If they want to keep their well-paid jobs, itís time to match performance to promises.
Ivory Energy is an advertiser. We are investors in the company and in the debentures for the same reasons I have outlined above. I donít expect prices to decline from here. They are absurd today. I also donít expect that situation to last for long. I am biased but the math is straightforward.
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February 20th, 2018
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