Investing

Felix Salmon writing for Reuters talks about a meeting with Mohamed El-Erian of PIMCO fame...

"On the subject of PPIP, though, I did ask El-Erian about how much value there is in clipping tails. If the government promises to absorb all losses beyond the first 15 cents on the dollar, how much does that raise the amount of money you’re willing to pay for any given asset? I was trying, in effect, to come at a value for the FDIC guarantee in the PPIP plan, but I didn’t get very far.

The answer, you see, is basically “it depends”. Every asset has a different probability distribution, and if you think that there’s a good chance the asset is actually worth 90, the tail-clipping at 85 is much more valuable than if you think the asset in reality is more likely to be worth 110. In short, it’s a long and laborious process of looking at every asset individually determining a probability distribution, and doing some math on it. How many good credit analysts are out there and capable of doing that kind of analysis? I think it’s not nearly enough, but El-Erian is a bit more bullish on that front: he thinks that if you create the right incentives, people will start to work this stuff out."

I've reproduced these paragraphs because Felix and El-Arian have taken something quite well known, put options, and made them sound mystical requiring some special kind of analysis. It doesn't! It requires the use of option pricing. The tail-clipping is simply a put sold by the government. That is why it's worth more the closer the intrinsic value is to your purchase price. Your purchase price minus 15% is the put's strike price. A put is obviously worth more the closer it is to being in the money.

The long laborious process of looking at every asset and determining its probability distribution translates to looking up historic volatility as an input to the options pricing model. In the absence of such data you could use a bottom up variance based on similar assets.

So putting this together, how does the government guarantee work. You believe a bond portfolio is worth 50c. You might bid 35c for the portfolio. Now if the government gives you a put 15% below your strike price you'll bid more because that put has value. Say the put is worth 4c. In that case you can bid 37c and you're still ahead by 2c.

The inputs to price the put are the strike price (15% below your purchase price), the current value (your estimate of intrinsic value), the volatility (calculated either bottom up or from trading data) and the time to expiry (however long the government guarantee runs for).

I wrote about Opti in November '08 here. Since then they have made some major changes to their capital structure. They sold 30% of their project equity to Nexen, their partner, for cash. This generated just enough cash to survive. If the whole company was purchased on the same terms, then there would be enough money to redeem the bonds at 80c on the dollar. Equity would be worthless.

The worry now, after the recapitalization, is whether or not they can meet their new covenants. It's relatively easy to analyse OPC's cash flows and it seems quite likely that they will meet the covenant in Q3 09. Failure to meet the covenant is not necessarily a death sentence. They can simply not draw against the revolving loan (in which case the covenants don't matter) or they could negotiate temporary relief. My analysis shows they will have about 100M drawn on the revolver by Q3, though they could manage this to a lower number. The covenant is the ratio of the drawn down revolver amount (first lien debt) to EBITDA with a maximum ratio of 2.5 to 1. The price of oil isn't terribly important due to OPTI's hedges. I have assumed a flat $45 for the year.

On this basis EBITDA will be around $44m annualized which provides a debt ceiling of around $110M. The January '10 quarter looks to be more of a problem. I expect annualized EBITDA of nearly 56M which provides a ceiling of $140m but I expect debt to be drawn down by about 146M. Again they can probably manage away $6m but it's quite tight. From Q2 2010 I expect OPTI to be well within this covenant.

The next interesting problem is their ability to participate in future phases of development. They expect 6 phases, with the current phase being phase 1. I don't expect they will be able to participate in phases 2 or 3 without substantial, additional financing. I have assumed they will not be able to secure such financing.

Assuming:

• No participation in phases 2 or 3
  
• Substantial repayment of debt, starting in 2011
  
• WTI of $60 in 2010 rising to $75 by 2013 and then rising by inflation
  
• A high risk period cost of equity of 22.6%
  
• A low risk period cost of equity of 10%
  
• A 30% discount based on chance of a B3 bond defaulting over the high risk period (if the bond defaults then equity is worthless)

Then OPC is worth about $2.31. It has traded as low as .61c but is currently trading at $1.82. There is probably a small option value in their right to participate in future phases (if oil is trading at $200 then they will be able to secure funding for the earlier phases). This is not reflected in my valuation; $2.31 is a conservative floor.

The fair value estimate is based on considerable risk. As they de-risk their business their value will increase substantially. At a fixed 10% discount rate (all the other assumptions remain constant except the 30% discount) OPC is worth $7.30.

In January I completed discounted cash flow estimates for PAN and MCR. They are both up substantially since then. My fair value estimate for MCR is $2.27 and PAN $2.38.

In comaprison to the blended analyst estimates I have a higher value for Mincor and a lower value for Panoramic.

The model assumes a Nickel price of $7 by 2011 rising by inflation and a constant .65c AUD to USD exchange rate.

From today's price MCR (.96) has 137% upside and PAN (1.58) has 50%.