Sunday, May 29, 2011

Howard Marks - How Quickly They Forget

In January 2004 I received a letter from Warren Buffett (how’s that for name dropping?) in which he wrote, “I’ve commented about junk bonds that last year’s weeds have become this year’s flowers. I liked them better when they were weeds.”

Warren’s phrasings are always the clearest, catchiest and most on-target, and I thought this Buffettism captured the thought particularly well. Thus for Oaktree’s 2004 investor conference we used the phrase “Yesterday’s Weeds . . . Today’s Flowers” as the title of a slide depicting the snapback of high yield bonds. It showed the 45% average yield at which a sample of ten bonds could have been bought during the Enron-plus-telecom meltdown of 2002 and the 6% average yield at which they could have been sold in 2003; on average, the yields had fallen by 87% in just thirteen months. The idea went full-circle in 2005, when Warren used our slide at the Berkshire Hathaway annual meeting to illustrate how rapidly things can change in the world of investing.

And that’s the point of this memo. Asset prices fluctuate much more than fundamentals. This happens because, rather than applying moderation and balancing greed against fear, euphoria against depression, and risk tolerance against risk aversion, investors tend to oscillate wildly between the extremes. They apply optimism when things are going well in the world (elevating prices beyond reason) and pessimism when things are going poorly (depressing prices unreasonably). Shortness of memory plays a major part in abetting these swings. If investors remembered past bubbles and busts and their causes, and learned from them, the swings would moderate. But, in short, they don’t. And they may be forgetting again.

High yield bonds and many other investment media have once again gone from being weeds to flowers – from pariahs to market darlings – and it happened in a startlingly short period of time. As is so often the case, things that investors wouldn’t touch in the depths of the crisis in late 2008 now strike them as good buys at twice the price. The swing of this pendulum recurs regularly and creates some of the greatest opportunities to lose or gain. Thus we must always be mindful.

The Importance – and Shortcomings – of Investment Memory

A number of my favorite quotations are on the subject of history and memory, and I’ve used them all in past memos. Humorist and author Mark Twain talked about the relevance of the past:

History doesn’t repeat itself, but it does rhyme.

The philosopher Santayana stressed the penalty for failing to attach sufficient importance to history:

Those who cannot remember the past are condemned to repeat it.

And economist John Kenneth Galbraith described the shabby way investors treat history and those who consider it important:

Contributing to . . . euphoria are two further factors little noted in our time or in past times. The first is the extreme brevity of the financial memory. In consequence, financial disaster is quickly forgotten. In further consequence, when the same or closely similar circumstances occur again, sometimes in only a few years, they are hailed by a new, often youthful, and always supremely self-confident generation as a brilliantly innovative discovery in the financial and larger economic world. There can be few fields of human endeavor in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present.

String together these three pearls of wisdom and you get a pretty accurate picture of investment reality. Past patterns tend to recur. If you ignore that fact, you’re likely to fall prey to those patterns rather than benefit from them. But when markets get cooking, the lessons of the past are readily dismissed. These are nothing short of eternal verities, and their collective message is indispensible.

Why Does Investment Memory Fail?

Think back to the emotions you felt so strongly during the recent financial crisis, and the terrifying events that brought them on. You swore at the time that you’d never forget, and yet their memory has receded and nowadays has relatively little influence on your decisions. Why does the collective memory of investment experiences – and especially the unpleasant ones – fade so thoroughly? There are a number of reasons.

First, there’s investor demographics. When the stock market declined for three straight years in 2000-02, for example, it had been almost seventy years since that had last happened in the Great Depression. Clearly, very few investors who were old enough to experience the first such episode were around for the second.

For another example, I believe a prime contributor to the powerful equity bull market of the 1990s and its culmination in the tech bubble of 1999 was the fact that in the quarter century from 1975 through 1999, the S&P 500 saw only three minor annual declines: 6.4% in 1977, 4.2% in 1981, and 2.8% in 1990. In order to have experienced a bear market, an investor had to have been in the industry by 1974, when the index lost 24.3%, but the vast majority of 1999’s investment professionals doubtless had less than the requisite 26 years of experience and thus had never seen stocks suffer a decline of real consequence.

Second, the human mind seems to be very good at suppressing unpleasant memories. This is unfortunate, because unpleasant experiences are the source of the most important lessons. When I was in army basic training, I was sure the memories would remain vivid and provide material for a great book. Two months later they had disappeared. After the fact, we may remember intellectually but not emotionally: that is, the facts but not their impact.

Finally, the important lessons of the past have to fight an uphill battle against human nature, and especially greed. Memories of crises tell us to apply prudence, patience, moderation and conservatism. But these things seem decidedly outdated when the market’s in a bull phase and risk bearing is paying off, and if practiced they appear to yield nothing but opportunity costs.

Charlie Munger contributed a great quote to my recent book, from Demosthenes: “Nothing is easier than self-deceit. For what each man wishes, that he also believes to be true.” In other words, there’s a powerful tendency to believe that which could make one rich if it were true.

I’ve tried to spend the last 42 years with my eyes open and my memory engaged. As a result, a lot of what I write is based on recognition of past patterns. It’s time to put my recollections to work, because I’m definitely seeing a trend in the direction of Galbraith’s “same or closely similar circumstances.”

The Not-So-Distant Past

It seems it was impossible – unless you were John Paulson – to escape entirely unscathed from the financial crisis of 2007-08. Most investors could only hope to have turned cautious in the run-up to the crisis, sold assets, increased the defensiveness of their remaining holdings, reduced or eschewed leverage, and secured capital with which to buy at the bottom in order to benefit from the subsequent recovery.

What might have prompted investors to do these things in advance of the mid-2007 onset of the crisis? Almost no one fully foresaw the impending subprime meltdown, and few macro-forecasts and market analyses were sufficiently pessimistic. Rather, I think investors would have been most likely to take the appropriate actions if they were aware of the pro-risk behavior taking place around them.

One of the most important things we can do is take note of other investors’ attitudes and behavior regarding risk. Fear, worry, skepticism and risk aversion are the things that keep the market at equilibrium and prospective returns fair. When investors fear loss appropriately, too-risky deals can’t get done, and risky investments are required to offer high prospective returns and generous risk premiums. (And when fear reaches extreme levels during crises, the capital markets turn too stingy, asset prices sink too low, and potential returns become excessive.)

But when investors don’t fear sufficiently – when they’re risk tolerant rather than risk averse – they let down their guard, surrender their discipline, accept rosy projections, enter into unwise deals, and settle for too little in the way of prospective returns and risk premiums.

The years immediately preceding the onset of the crisis in mid-2007 constituted nothing short of a “silly season.” It seemed the financial world had gone crazy, with deals getting done that were beyond reason. Investors acted as if risk had been banished. They believed that the markets had been rendered safe by the combination of (a) an omniscient, omnipotent Fed providing a “Greenspan put,” (b) the wonders of securitization, tranching and selling onward and (c) the “wall of liquidity” coming toward our markets, composed of excess reserves being recycled by China and the oil-producing nations. They accepted the alchemy under which financial engineering could turn sub-prime mortgages into triple-A debt. And they viewed leverage as sure to have a salutary effect on returns.

There’s nothing more risky than a widespread belief that there’s no risk . . . but that’s what characterized the investment world. It was possible to conclude in 2005-07 that investors were applying insufficient risk aversion and thus engaging in risky behavior, elevating asset prices, reducing prospective returns, and raising risk levels. What were the signs?

The issuance of non-investment grade debt was at record levels.

An unusually high percentage of the issuance was rated triple-C, something that’s not possible when attitudes toward risk are sober.

“Dividend recaps” went unquestioned, with buyout companies borrowing money with which to pay dividends, vastly increasing their leverage and reducing their ability to get through tough times.

Credit instruments were increasingly marked by few or no covenants to protect lenders from managements’ machinations, and by interest payments that could be made with debt rather than cash at the companies’ discretion.

Collateralized loan and debt obligations were accepted as being respectable instruments – with the risk made to vanish – despite the questionable underlying assets.

Buyouts of larger and larger companies were done at increasing valuation multiples, with rising debt ratios and shrinking equity contributions, and despite the fact that the target companies were increasingly cyclical.

Despite all of these indications of falling credit standards and rising riskiness, the yield spread between high yield bonds and Treasury notes shrank to record lows.

The generous capital market conditions and low cost of capital for borrowers caused buyout fund managers to describe the period as “the golden age of private equity.” Conversely, then, for lenders it was the pits.

In 2005-07, investors suspended skepticism and disbelief, ignored the risk of loss, and obsessed instead about avoiding the risk of missing opportunities. This caused them to buy securities at low implied returns; employ vast amounts of low-cost debt to lever up those returns; loosen the terms on debt they would provide; and participate in black-box vehicles on the basis of investment banks’ recommendations, the nontransparent machinations of financial engineers, and the imprimatur of far-from-perfect rating agencies.

In short, investors were oblivious to risk and thus failed to demand adequate risk premiums. The environment could only be described as euphoric. Here’s how I put it in “It Is What It Is” (March 2006):

The skinniness of today’s risk premiums can be observed most clearly in the high yield bond market, where prospective returns can be calculated with precision and yield spreads are in the vicinity of historic lows, and in certain real estate markets, where actual cash returns are similarly low. But the difficulty of quantifying prospective returns in public and private equity doesn’t mean the offerings there are any less paltry. And, as Alan Greenspan said, “. . . history has not dealt kindly with the aftermath of protracted periods of low risk premiums.”

Market Conditions Today

In May 2005, I wrote a memo entitled “There They Go Again,” complaining that investors were taking excessive comfort from mindless platitude of the type that accompany and abet the creation of every bubble. These are accepted as a substitute for putting rational intrinsic valuations on the assets that are the subject of the bubble, and despite repeated evidence that trees can’t grow to the sky. I touched on the mania for real estate, as well as the growing popularity of hedge funds and private equity. I went on to assert that this behavior – and the supportive underlying capital market trends – had turned the markets into a “low-return world.”

I recite all of this because I have no doubt that investors are making substantial movement back in the same direction. To illustrate, here’s an account of capital market conditions in 2011 (Bridgewater Daily Observations, February 15):

Consistent with the pickup in credit creation that we have seen elsewhere, LBO activity and the credit pipes that are supporting it have recently improved. Since the first quarter of 2010 we have seen a steady rise in LBO activity, starting from a very low base. The rate of activity is now roughly similar to the average level of activity since 1985, excluding the boom and bust period of 2006 to 2009. . . . today’s deals are similar in size but the number of deals has risen by more than the dollar value of deals. We also see that the leverage in the deals is increasing. For example, so far this year the average deal was financed with 30% equity, down from last year’s 38%, though still up from the most leveraged period of 2005 to 2009 when deals were financed with an average of 25% equity. The leveraged loan market has also picked up and an increasing percentage of leveraged loans are going toward LBOs. A few new CLOs and mutual funds have been created that are concentrated on the leveraged loan market, indicative of renewed demand. Investor demand has pushed prices back up to par and allowed a decline in the average credit quality of the loans, with increasing indications of “covenant light” loans getting done.

In other words, in most regards the capital markets – and investors’ tolerance of risk – are retracing their steps back in the direction of the bubble-ish pre-crisis years. Low yields, declining yield spreads, rising leverage ratios, payment-in-kind bonds, covenant-lite debt, increasing levels of LBO activity and the beginnings of the return of levered, structured vehicles . . . all of these are available for the eye to see.

For a case in point, let me recap a note I received from one of our veteran high yield bond analysts regarding a deal that recently had come to market:

PIK/toggle bonds: the company can elect to pay interest in debt rather than cash

Holdco obligation: debt of a holding company, removed from the moneymaking assets

Use of proceeds: to pay a dividend to the equity sponsor, returning half of the equity it put into the company just a few months earlier

The sponsor’s purchase price for the company in 2010 was 1.45 times what the seller had bought it for in 2008

The company operates in a commodity industry where annual sales are shrinking and costs are variable and unpredictable

Negative earnings comparisons are expected, since the environment makes it hard to pass on rising raw material costs

EBITDA coverage of interest expense plus capital expenditures is modestly above 1x

The company is incorporated in Luxembourg, an uncertain bankruptcy environment

The assessment of Oaktree’s Sheldon Stone: “I know they don’t ring a bell at the top, but they should on this deal!”

It’s easy to gauge bond investors’ attitudes. Here are the yield to maturity and yield spread versus Treasurys on the average high yield bond at a few points in the recent past and today:

Yield to Spread vs.Maturity Treasurys

“Normal” – December 31, 2003 8.2% 443 b.p.

Bubble peak – June 30, 2007 7.6 242

Panic trough – December 31, 2008 19.6 1,773

Recovered – March 31, 2010 9.0 666

Shrinking again – April 30, 2011 7.5 492

The yield spread on the average high yield bond is still on the generous side relative to the 30-year norm of 350-550 basis points, a range of spreads that has given rise to excellent relative returns over that period. On the other hand, (a) spreads have fallen back to the normal range from the crisis-induced stratosphere and (b) the lowness of today’s interest rates means that reasonable spreads translate into promised returns that are low in the absolute. The story’s the same for many asset classes.

I don’t mean to pick on high yield bonds. I use them here as my prime example only because of my familiarity with them and because their fixed-income status facilitates quantification of attitudes toward risk. In fact, high yield bonds still deliver above average risk compensation, and they remain the highest returning contractual instruments and excellent diversifiers versus high grade bonds.

If you refer back to a memo called “Risk and Return Today” (November 2004), you’ll see that today’s expected returns and risk premiums – especially on the left-hand side of the risk/return spectrum – are eerily similar to those prevailing in late 2004: money market at 1%; 5-year Treasurys at 3%; high grade bonds at 5%; high yield bonds at 7%; stocks expected to return 6-7%. I said at the time that low base interest rates and moderate demanded risk premiums had combined to render the risk/return curve “low and flat.” In other words, absolute prospective returns were at modest levels, as were the return increments that could be expected for taking on incremental risk. I described that environment as “a low-return world.” I think we’re largely back there.

(Please note that late 2004 was nowhere near the cyclical peak. Security prices continued to rise and prospective returns to fall for two and a half years thereafter. In particular, in the 30 months following the publication of that memo, high yield bonds went on to return a total of 19.7%. So similarities to 2004 don’t constitute a sign of impending doom, but perhaps a foreshadowing of a potential move into bubble territory.)

I want to state very clearly that I do not believe security prices have returned to the 2006-07 peaks. It doesn’t feel like the silly season is back in full. Investors aren’t euphoric. Rather they seem like what my late father-in-law used to call “handcuff volunteers” – people who do things because they have no choice. They’re also not oblivious to the risks that exist. I imagine the typical investor as saying, “I’m not happy, but I have to buy it.” Finally, the leverage used at the peak of risk-prone pursuit of return in 2005-07 isn’t nearly as prevalent today, perhaps because investors are chastened, but more likely because it’s not available in the same amounts.

There may be corners of the market where elevated popularity and enthusiastic buying have caused prices to move beyond reason: high-tech stocks, social networks, emerging markets from time to time, perhaps gold and other commodities (what’s the reasonable price for a non-cash-flow-producing asset?) But for the most part, I think investors are taking the least risk they can while assembling portfolios that they think can achieve their needed returns or actuarial assumptions.

In general, I would describe most security prices as falling somewhere between fair and full. Not necessarily bubbly, but also not cheap.

Especially since the publication of my book, people have been asking me for the secret to risk control. “Okay, I’ll read the 180 pages. But what’s really the most important thing?” If I had to identify a single key to consistently successful investing, I’d say it’s “cheapness.” Buying at low prices relative to intrinsic value (rigorously and conservatively derived) holds the key to earning dependably high returns, limiting risk and minimizing losses. It’s not the only thing that matters – obviously – but it’s something for which there is no substitute. Without doing the above, “investing” moves closer to “speculating,” a much less dependable activity. When investors are serene or even euphoric, rather than discomforted, prices rise and we become less likely to find the bargains we want.

So if you could ask just one question regarding an individual security, asset class or market, it should be “is it cheap?” Oaktree’s investment professionals try to ask it, in different ways, every day.

And what makes for cheapness? In sum, the attitudes and behavior of others.

I try to get away from it, but I can’t. The quote I return to most often in these memos, even 17 years after the first time, is another from Warren Buffett: “The less prudence with which others conduct their affairs, the greater prudence with which we should conduct our own affairs.” When others are paralyzed by fear, we can be aggressive. But when others are unafraid, we should tread with the utmost caution. Other people’s fearlessness invariably translates into inflated prices, depressed potential returns and elevated risk.

Today, pension funds and endowments simply can’t achieve their goal of nominal returns in the vicinity of eight percent if they keep much money in Treasurys or high grade bonds, and they may not even expect public equities to be much help. They’ve moved into high yield bonds, private equity and hedge funds . . . not because they want to, but because they feel they have to. They just can’t settle for the returns available on more traditional investments. Thus their risk taking is in large part involuntary and perhaps unenthusiastic.

So where do we stand today?

General interest rates are some of the lowest in history.

Yield spreads are about normal.

Returns on low-risk assets are reasonable in relative terms but skimpy in the absolute.

Investors are forced toward pro-risk behavior because of the lowness of returns in the safer, low-risk portion of the risk/return curve.

Thus investors are jettisoning the conservatism they adopted at the depths of the financial crisis, in many cases not out of choice.

Investors are once again engaging in risky behavior, albeit not at peak levels of riskiness.

Those of us who calibrate our behavior based on what others are doing should increase watchfulness and, as Buffett suggests, apply rising amounts of prudence.

How Did Things Get This Way?

Just two and a half years ago, in the depths of the financial crisis, I was convinced that pro-risk psychology had undergone lasting damage. With investment banks, rating agencies and financial engineers defrocked, no-lose investments collapsing, account balances decimated and investors disillusioned, it seemed it might be years before market psychology recovered. And yet markets began a dramatic recovery in early 2009, investors have returned to bearing risk, and many indices are back in the vicinity of their pre-crisis peaks. What’s behind this turn of events?

In 2007 and 2008, governments around the world rushed to support financial institutions and stimulate economies. They did this by making liquidity readily available and cutting interest rates to near zero.

Everyone knew the rate cuts would stimulate the economy by encouraging borrowing and reducing the cost of doing business, and that they would increase the profit margin in lending, buttressing financial institutions. But I don’t think anyone fully appreciated the impact they would have on reviving pro-risk behavior.

In short, the rate cuts made it unrewarding to hold cash, T-bills and high grade bonds. Investors looking for returns in line with their needs – or income on which to live – were literally forced to move into riskier asset classes in pursuit of returns in excess of a few percent.

Much of the money that normally would be invested in the giant Treasury market simply couldn’t stay there because the yields were so low. Thus large amounts flowed toward smaller markets where they were quite capable of lifting prices. Nothing can reduce returns, worsen terms or raise risk faster than “too much money chasing too few deals.” It’s disproportionate flows of capital into a market that give rise to the disastrous race to the bottom such as we saw in 2005-07. Greater sums are provided to weaker borrowers at lower interest rates and with looser terms. Higher prices are paid for assets: first less of a discount from intrinsic value, then the full intrinsic value, and eventually premiums above intrinsic value. These processes account for many of the trends decried here.

In addition, I would point out that the pain of the crisis was surprisingly short-lived. The real panic began on September 15, 2008, the day Lehman Brothers filed for bankruptcy. Until then, the world seemed to be coping and investors retained their equanimity. But Lehman, Fannie Mae, Freddie Mac, Merrill Lynch, Washington Mutual and AIG fell like dominoes in short order, and in the last fifteen weeks of 2008 people were paralyzed by fear of a global financial meltdown.

And then things turned in the first quarter of 2009, primarily, I think, because people were coerced to move further out on the risk curve as described above. Since then the markets have risen dramatically from their lows.

In distressed debt, for example, the post-Lehman days and weeks were characterized by terror, uncertainty, forced selling, illiquidity and huge mark-to-market losses. But if you look back, you see that the panic and pain – and thus the greatest buying opportunity – really lasted only fifteen weeks, through the end of 2008. Prices continued downward in the first quarter of 2009, but without the deluge of supply brought on by the previous quarter’s forced selling. By April prices were headed up. So the lesson was painful but short-lived and, apparently, easily forgotten.

As usual, the cyclical upswing is circular and self-reinforcing. It takes on the appearance of a virtuous cycle that will proceed non-stop, and it does so . . . until it fails. Here’s an example of the process at work:

The pursuit of return caused people to move from Treasurys to high yield bonds.

The revival of demand enabled companies to raise money.

The reopening of the capital markets made it possible for companies to do bond exchanges and refinancings: extending maturities, extinguishing covenants and capturing bond discounts, converting them into reduced amounts of debt outstanding. In some cases equity could be issued to delever balance sheets.

These remedial actions improved companies’ creditworthiness and brought down the default rate on high yield bonds from 10.8% in 2009 to a startling 1.1% in 2010, the greatest one-year decline in history.

The resulting price appreciation produced profits for those who’d bought, turning investor psychology more rosy and producing envy – and thus a rush to join in – among those who had been slow to invest.

And the combination of these things convinced people that conditions had improved, making them still more willing to take on increased risk.

I thought the lessons of 2007-08 had been etched into people’s psyches, and that the return to pro-risk behavior would therefore be slow. But clearly that hasn’t been the case.

Prudent Behavior in a Low-Return World

The 2005 memo I mentioned earlier, “There They Go Again,” proceeded from the discussion of the low and flat risk/return curve contained in “Risk and Return Today” to ponder what investors might do in times of low prospective returns and risk premiums. The possibilities fell into just a few categories:

Go to cash – not a real alternative for most investors.

Ignore the lowness of absolute returns and pursue the best relative returns.

Forget that elevated prices might imply a correction, and buy for the long run.

Reach for return, going out further on the risk curve in pursuit of returns that used to be available with greater safety.

Concentrate investments in “special niches and special people”; by this I meant emphasizing strategies offering exceptional bargains and managers with enough skill to wring value-added returns from assets of moderate riskiness.

Of all of these, I consider reaching for return to be the most flawed, especially if it’s done without being fully conscious (which is often the case when return becomes hard to come by). I’ve described this approach as “insisting on achieving high returns in a low-return world” and reminded people of Peter Bernstein’s admonition: “The market’s not a very accommodating machine; it won’t provide high returns just because you need them.”

Here’s what I wrote in May 2005:

Given today’s paucity of prospective return at the low-risk end of the spectrum and the solutions being ballyhooed at the high-risk end, many investors are moving capital to riskier (or at least less traditional) investments. But (a) they’re making those riskier investments just when the prospective returns on those investments are the lowest they’ve ever been; (b) they’re accepting return increments for stepping up in risk that are as slim as they’ve ever been; and (c) they’re signing up today for things they turned down (or did less of) in the past, when the prospective returns were much higher. This may be exactly the wrong time to add to risk in pursuit of more return. You want to take risk when others are fleeing from it, not when they’re competing with you to do so.

Even six years later, I can’t think of any responses to a low-return world beyond those enumerated above. Limit risk, sacrificing return. Accept risk in pursuit of return, and pray the consequences will be tolerable. Or strive to find ways to augment returns through means other than risk bearing.

None of these possible solutions is perfect and without pitfalls. In fact, each brings its own form of risk. Staying safe entails the risk of inadequate return. Reaching for return increases the risk of financial loss. And the search for “alpha” managers introduces the risk of choosing the wrong ones. But, as they say, “it is what it is.” When it’s a low-return world, there are no easy solutions devoid of downside.

The Right Approach for Today

One of the things that makes investing interesting is the ever-changing nature of the route to profit, the pitfalls that are present, and the tools and approaches that should be employed. Conscious decisions regarding these things should underlie all efforts to manage capital, and they must be revisited constantly as circumstances and asset prices change. What’s right today?

First, should you prepare for prosperity or not? By prosperity I mean a return to the happy days of the 1980s and ’90s, when reported economic growth was strong and consumers were eager to spend. My answer is that we’re not likely to see anything like that, in large part because in those decades the gap between stagnant incomes and vigorous consumption growth was bridged through buying on credit. Instead, in the years ahead I think (a) growth in employment and incomes will be sluggish, (b) consumers should be restrained in their borrowing as a result of having experienced the crisis, (c) consumer credit shouldn’t be available as readily, and (d) borrowing against home equity will be much less of a factor, especially because home equity is so scarce.

Second, should you worry more about losing money or about missing opportunities? This one’s easy for me. First, the macro uncertainties tell me we won’t be seeing a highly effervescent economy or market environment. Second, other people’s increasingly aggressive behavior tells me to seek cover. And third, since I don’t see many compellingly cheap assets, I doubt there will be gains big enough to make us kick ourselves for having invested too cautiously.

And that brings me to my third question: what tools should you employ? In late 2008 and early 2009, you needed just two things to achieve big profits: money to commit and the nerve to commit it. If you had caution, conservatism, risk control, discipline and selectivity, you probably achieved lower returns than otherwise (although having factored those things into your analysis might have given you the confidence needed to implement favorable conclusions in that terrible environment). The short answer was simple: money and nerve.

But what if you had money and nerve in 2006 or early 2007? The results would have been disastrous. In those times you needed caution, conservatism, risk control, discipline and selectivity to stay out of trouble. In short, when the market is defaulting on its job of being a disciplinarian, discernment becomes our individual responsibility.

So then, which is the right set of equipment for today? I think we’re back to needing the cautious attributes, not the aggressive. An unusually large number of thorny macro issues are outstanding, including:

the so-so U.S. recovery;

the U.S.’s deficit, debt ceiling impasse and dysfunctional political process;

the economic impact of deleveraging and austerity;

the over-indebtedness of peripheral eurozone countries;

the possibility of rekindled inflation and rising interest rates;

the uncertain outlook for the dollar, euro and sterling; and

the instability in the Middle East and resulting uncertainty over the price of oil.

With all of these, plus prices that are fair to full and investor behavior that has increased in aggressiveness, I would rather gird for the things that can go wrong than ensure maximum participation if things go right. (Of course that’s not an unfamiliar refrain from me.)

The other day, the investment committee of a non-profit on which I sit decided to take the first steps toward marshaling resources and managers so as to be ready to buy into beaten-down assets after the next round of bubble and bust. And it wasn’t even my idea!

We can never be sure what will happen – and certainly not when – but it’s important to be prepared for what’s likely to lie ahead. And understanding the inevitable pendulum swing in the way investments are viewed – from weeds to flowers and back – is an essential ingredient in being able to do so.

May 25, 2011

P.s.: I hope you’ll consider rereading “Risk and Return Today” (November 2004) and “There They Go Again” (May 2005) (see Hopefully they’ll strengthen the case for reflecting on past patterns and help you think through the current conditions. You might also take a look at “The Cat, the Tree, the Carrot and the Stick” in “What’s Going On” (May 2003) for a metaphorical look at the process of risk acceptance. Today’s echoes of those past times are worth noting.

Friday, May 27, 2011

Updated SkyWest Energy Presentation

Nice little pop today, not sure if this had anything to do with it.  Bought a pretty good slug between $.55 and $.47.

Maybe should have bought some more.  Will likely get another chance at a better price...always do.

Saturday, May 21, 2011

Petrobank History

With the upcoming AGM I thought I'd read through the annual reports from the date of John Wright and team taking over and make some notes.   Simply cutting and pasting what I find interesting:

Letter from former Petrobank Chairman in the first Wright era annual report:

"The Western Canadian Basin has become, over the past fifty years of intensive exploration and development, a difficult place in which to find and develop economic reserves of oil and natural gas. As our reserve base grows it becomes increasingly challenging each year to gain ground, despite Petrobank’s past record of achievement.

Capital markets have also indicated that Canadian oil and natural gas producers must change their traditional
value creation models in order to compete for investment capital.

Entering 2000, your Board was faced with these realities which indicated a change of direction for Petrobank
was necessary. Most of the former directors of Petrobank, including myself, have long experience in oil and
gas exploration and development, both in Canada and internationally. This background influenced the Board’s decision in March to commit to an arrangement to change the corporate direction of Petrobank under a new and strong management team. Earlier this year, Petrobank’s Board had four options presented to it:

1. Outright sale of the company.
2. Merge with another junior public oil and gas company.
3. Hire a new CEO to direct a strategic merger and acquisition program.
4. The Caribou Capital proposal to provide new strategy, new management, and new capital.

After two days of meetings, the Board chose and approved the Caribou Capital proposal over the other three alternatives for the following reasons;

First, the new management team has demonstrated an outstanding record of achievement in developing a global company and creating significant shareholder value. Over a three-year period ending in 1999, they
built Pacalta Resources Ltd. from a small Alberta junior oil and gas company into a company with an
enterprise value of over one billion dollars. In the process, the management team set an example of how
to conduct successful international operations.

Second, the new management’s plan is, in our view, a credible strategy for building Petrobank into a global
player while achieving maximum value for the shareholders. The strategy involves the development of Petrobank both in Canada and internationally and is more fully explained in the President’s Letter to the

Finally, the strong shareholder support we received to proceed with the Caribou Capital proposal confirmed
our conviction that this was the best course for the Company to take. The Board believed that Petrobank shareholders would benefit much more from the proposal for new management with a new international strategy than if we elected to pursue any of the other three available options.

Personally, and on behalf of present and former members of the Board of Directors, I want to thank all of the
management and employees who have worked so hard over the past six years to bring Petrobank to the point where it can be transformed into a significant global player. To those who have stayed through the transition, and to the people who have joined Petrobank as part of the new and expanded team, I would like to say welcome, and good hunting!"

Hathor Exploration

Let's make some notes from what I can find round the internet.


It was a couple of weeks ago that technical analyst Bill

Carrigan...a guy whose work we really admire, suggested

the uranium sector was starting to bottom and would be

his favorite sector in the resource sector. He suggested at

the same time that it would take a couple of more weeks of

bottoming for the other sectors in the resource area and

boy, has he been right about that! Remember his call of

selling the resource sector back in early March? Bang-on


His idea on uranium and his pick was Uranium Participation

(U) and it has definitely had a bottoming process,

although it has not started to go up yet. On the other hand,

there is Hathor Exploration that in the last couple of days

has started flying.

President Mike Gunning has been doing presentations

around Bay Street and he was featured on BNN (once

again, you absolutely must-see this presentation: Click


and it looks like there is going to be some further analyst

coverage. The surprising news on the resource number

was the size. When you are getting up to 58 or 60 million

pounds, that is significant and add in the Far East and you

are flirting with 70 million pounds. This is some of the

higher grade uranium on the planet in the perfect jurisdiction

(Saskatchewan) close by potential buyers such as

AREVA, Cameco (and hopefully not Denison) and Hathor is

now finally leading the uranium sector.

If you want to do some dreaming, consider this: Uranium

One (UUU) at the end of March closed their purchase

of Mantra, the Australian firm in a billion dollar plus deal

for their assets in the middle of a national park in Tanzania,

Africa and had a very, very low grade. It was sold at the

equivalent of $10.00 a pound. Now work out what Hathor

might be worth ..

Hathor Exploration* (HAT : TSX : $2.46), Net Change: 0.16, % Change: 6.96%, Volume: 1,754,073

On a weight-gain program. Hathor Exploration announced an initial resource statement for the East Zone, effectively doubling the amount of the contained U3O8 lbs at its 100%-owned Roughrider uranium project. The East Zone is estimated to contain 118,000 Inferred tonnes at 11.59% U3O8 for 30.13 million lbs of uranium contained. In total, Roughrider now contains Indicated + Inferred resources of 555,800 tonnes at 4.7% U3O8 for a significant 57.9 million lbs of uranium contained. Unlike the West Zone, the East Zone resource is not uniformly mantled by a rim of low grade mineralization; however, there is abundant low grade mineralization surrounding the deposit that is not included in the current resource model, and represents additional resource potential. A Bay Street analyst commented that he now expects Hathor to focus on the recently discovered Far East Zone, which could also considerably increase the Roughrider resource. A uranium deposit of this size could also encourage potential suitors to start looking at Hathor. Generally, an Athabasca uranium deposit past the 50 million lbs is considered a threshold to become attractive for development and a potential acquisition target from a senior developer. Later in the day on Tuesday, after one analyst highlighted that Hathor's "huge Roughrider deposit makes it a tempting takeover target", Hathor's CEO Mike Gunning told BNN the company would be open to a takeover from any uranium miner. “If you were a uranium miner for the next 30 years, you want to be in the Athabasca basin,” Gunning said. Adding that, “For the first time, Roughrider is presenting a potential entry point for any of these companies.”

Conclusion: We continue to recommend Hathor at BUY and increase our 12-month share target price to C$5.60. We believe Hathor is fast becoming a take-over target. Its 100% owned Midwest Northeast project should be attractive to just about anyone - whether they already have projects in the Athabasca Basin such as Cameco (CCO-T: C$25.92, Not Rated), AREVA, Denison (DML-T: C$1.95, Not Rated), or those that might be interested in getting into the Basin.

With the addition of another 30 MM lbs grading 11.58% U3O8 to Hathor's existing 27.8 MM lbs, the now 58 MM lb U3O8 Roughrider deposit located in the Athabasca Basin has become one of the world great uranium deposits (Figures 1 & 2). Excluding the low grade, its average ranks it fourth in the world after McArthur River, Cigar Lake and Phoenix. Roughrider also overtakes Phoenix in size. We expect further growth - the initial Roughrider Far East resource is expected in the fall.

Hathor's Roughrider deposits are now worth US$3.3 billion in situ using today's rebounding US$57.75/lb uranium spot price. The market cap of the company is only C$250 million….we believe that this is well undervalued and something has to give. We have increased our Roughrider assumption to 69.5 MM lbs from 53.2 MM lbs and value these pounds at US$7/lb U3O8…a 36% discount to Cameco's EV/lb and a 30% premium to the producer group average. We believe this premium is warranted due to the deposits high grade nature, favourable jurisdiction, proximity to infrastructure (road, power line, airport) and the world's only high grade uranium mill at McLean Lake just 17km to the east.

Roughrider now totals 58 MM lbs U3O8 - most of it high grade

· 118,000t grading 11.58% for 30.13 MM lbs U3O8. This new East resource is all high grade and very insensitive to cut-off grades. SRK Consulting used a 0.4% U3O8 cut-off as a base case. The resource remains unchanged at 30 MM lbs is one were to use a 1% U3O8 cut-off. Using a 3% cut-off the deposit still totals 29.2 MM lbs of U3O8.

· Consistent lower zone makes the difference. The lower basal zone at Roughrider East is more consistent than first anticipated and has held up well from hole to hole. This zone was added to the two known upper zones to make up the core of Roughrider East. The East Zone also grades in line with the high grade core of the West Zone.

· Hathor over-delivered. The East resource is better then we had expected. We were looking for 22-24 MM lbs U3O8 at ~6.75% U3O8 based on our back of the envelope mineral inventory for just a 40m x 40m x 40m core of high grade situated around Line 20 W. This deposit is 100m west of the Roughrider west resource and immediately east of Roughrider Far East. It measures 120m along strike, 40-50m wide on average, 80-100m thick, and is located at 250m depth or about 30-50m below the unconformity. We re-iterate that this deposit lies within basement rocks which are much preferred for rock quality and ground stability when dealing with unconformity style uranium deposits.

· Focus on the high grade core. We identify ~54 MM lbs of high grade uranium from the 58 MM lb total resource and believe that this is a better way to look at the economic potential of the deposits. Hathor's breakdown of the Roughrider into inferred and indicated resources suggests only 40.7 MM lbs of high grade mineralization. We believe it is more suitable (although not NI-43-101 compliant) to consider the high grade core of Roughrider West in relation to its lower grade shell, and then to consider Roughrider East (Table 1a and 1b).

Table 1a shows the breakdown of total resources at the Roughrider Uranium deposit using 43-101 compliant categories. This suggests only 40.7 MM lbs of high grade mineralization. Table 1b shows the breakdown of total resources while identifying the high grade core of the West Zone and a total of 54.3 MM lbs of high grade.

Source: Company Reports, Dundee Capital Markets

Strengthening our valuation

· We increase our Roughrider assumption to 69.5 MM lbs U3O8. This is up from 53.2 MM lbs as reality has blown away our previous estimates. We value Roughrider using a pounds-in-the-ground valuation of US$7/lb - until we see some visibility as to timing of production, capital and operating cost assumptions. We had used US$8/lb. HAT is currently trading at an EV per lb of $4.04. This compares to $5.23/lb market value for the producers and C$2.37/lb for the developers. We believe that a take-over value of $7 to $8 per lb seems reasonable.

Friday, May 20, 2011

Sterling Resources

Seems that Breagh might be worth $3 or so on a 2P basis, and that Cladhan quite like also at least that.

$6 vs stock price under $2.

Just starting to look at this, don't know it at all.  Like the idea of a big selloff from people disappointed by exploration failure who were looking for a homerun.    Perspective of value likely gone once a stock has tumbled this far.

Ithaca Energy

3x this year's cash flow.  2x next year.

Ithaca announced a dry hole today on the Jacky field (47.5% interest), a location that was drilled to maximize the recovery of the field. The hole encountered oil, but was too thin to be good producer (water incursion may have occurred early); it may instead be used as a water injector and thus serve the same purpose. Production may be effected downward by a few hundred barrels a day; however, by year-end, production is estimated to double to 10,000 bd, from the Cook and Athena fields (to be followed by Carna, Stella, and Harrier), a doubling from the current estimate of approximately 5,000 bd.

The stock was down over 10% on the news of the Jacky location; a large drop considering Jacky’s 2P reserves of 1.2 million barrels represents 2% of the Company’s 51.8 million barrels (including the Cook acquisition in 2011). We expect to see the stock price advance as we approach the onstream date of Athena later this year. Drilling of the horizontal leg is currently underway at Athena – results of which could possibly be the next news event.

Our Strong Buy recommendation is based on the growth in production and cash flow that is underway. The stock is trading at 3.1 times this year’s cash flow of

.65 and at a 40% discount from asset value. In 2012, cash flow could be close to $1.00. We maintain our target of $4.00

Sterling Resource

A bit of an overreaction ?

Sterling Resources – SLG-TSXV, $1.88

Stock Rating: Strong Buy Target Price $6.00

Sterling’s stock has been more than cut in half from its (very) recent high of $4.94, the result of an unfortunate coincidence of bad news in a bad market. Romanian government intransigence and two dry holes at Cladhan have taken the stock to 80% of our $2.50 proven and probable asset value – largely based on just the Breagh field.

A more appropriate number would include the possible reserves, since the field is still in the development stage, and since the Company’s tax pools will shelter it from years of taxation, the 3P pre-tax calculation shown below is relevant, and conservative considering there are no reserves booked for the Cladhan field, which is an economic discovery and will be onstream in 2014.

Forecast Pricing Before Tax After Tax P.V. 10% mmboe mm /boe Reserves Proved 23.7 $377.7 $15.94 Probable 9.1 $124.9 $13.73 Possible 8.2 $120.9 $14.74 Total 41.0 $623.5 $15.21 Working Capital $138.4 Debt
.0 Net Asset Value $761.9 Shares Outstanding, Basic 152.7 Asset Value per Share, Basic $4.99

Sterling is our top pick for long term investors seeking a diversified exploration and development opportunity. Cladhan, despite some reduction in its ultimate upside, will likely rival Breagh in valuation once reserves are booked. We maintain our Strong Buy and target of $6.00.

Wednesday, May 18, 2011

Another Interview With John Wright

Petrobank is spending $90mil to move forward with THAI this year.  Consider this from the linked article:

"After a custodial stint in Ecuador overseeing the operations for AEC, he came back to Calgary and led a group of investors in a friendly recapitalization of Petrobank, then a junior natural gas company, taking over as CEO in March 2000.

Petrobank's share price has grown from around $1 to almost $40 and the company has evolved into four companies, with a combined market capitalization of more than $14 billion."

That is $40 per PMG spin-off .  Why would someone that successful take this big of a step with THAI if he didn't know it to be ready ? I think the sensible answer is that he wouldn't.

Brief Mention of John Wright Aggressive bid for Ranger

Hadn't come across this before.  Will need to dig more.

Wright Discussing PBG early Bakken days

Early THAI Article

From 2004 before the pilot phase began

Charlie Munger Buying BYD in Q1 for Daily Journal ?

When he only buys something every few years it is hard not to be interested.

First Energy on PMG

Tuesday, May 17, 2011

Zodiac Exploration

I'd written about this one before after some insider buying.  One of a couple of ways to play the Monterey Shale which doesn't seem to get a lot of respect at this point.

First Energy Presentations

A few worth checking out.

Canaccord on Petrobank Quarterly Release

I pretty much agree with all of that.  One thing they don't mention is that more land was acquired in the Kerrobert area, on top of the Plover property they added earlier in the year.

John Wright mentioned in a January conference that there are 50 lookalikes to their Kerrobert property within 50 miles of Kerrobert.  And 20 billion barrels of oil in Saskatchewan of which only 5% has been recovered with conventional methods.

Imagine how much fun Petrobank could have in Saskatchewan alone with THAI if it is ready to roll as they obviously think it is given their move to commercial development.

I think the Kerrobert Q1 production is basically meaningless.  The two existing wells are completely different from the 10 new wells, and were down for construction on the expansion anyway.

They are reaching a big fork in the road.  First quarterly release from them which excited me in a while.  Will try to write more later.  I have to lay a beating on some lads on the golf course today.

Monday, May 16, 2011

Berkowitz and Canadian Natural Resources

How does he go from suggesting Murray Edwards is the next Warren Buffett and having a huge position in CNQ to having no interest whatsoever ?

Thursday, May 12, 2011

Westfire Energy and Orion Merge

Not sure what to think of this.  Was hopeful Westfire would be taken out at a big premium in the next year.

Interesting combo of two I follow (Orion owned by Sprott Resource)

Wednesday, May 11, 2011

Petrobakken Q1 Conference Call Notes

I'm not exactly sure what was so disappointing in the results.  They hit 43k per day in March showing the growth is coming.  The fact that they had to shut in 10% of production in April for weather issues does not impact the fact that production is ramping up.

36 wells that are either simply waiting to be completed or have yet to be fracked (intentionally).  Get those caught up and you can see where the growth can quickly continue to come from.

Don't get me wrong.  Not real happy with PBN, in it for the unappreciated PBG assets.

Tuesday, May 10, 2011

Thursday, May 5, 2011

Buying Westfire Energy (WFE)

Had an order in under $7.85 that I didn't expect to get.  Happily did, reasonable amount.

Will happily buy more if it goes lower.  Added a little bit more Novus Energy.  Little bit of Bankers Petroleum.  And a little bit of Arcan. 

Waiting for Skywest to head a little lower to add some more for it.

Keep selling boys.  I'm mentally prepared and have the cash for a much bigger drop.

Some Notes on CHK Q1 Call

Wednesday, May 4, 2011

List of Energy Recaps including Westfire

Not a bad place to look for smart, proven managers looking to build some value and sell.

Dusting Off the Wallet and Buying Some Stocks !

It has been a while.  Feels good to do some more serious nibbling.  Yesterday and today have been buying the following:

SkyWest $0.50
Novus Energy $1.06
Westfire Energy $8.20
Bankers Petroleum $8.00
Arcan Resources $4.15

Would be buying more Petrobank, but I'm full already.  At $80 oil the above group is priced very attractively.  If we average $100 oil over the next few years these are steals.

Am buying very slowly though.  Would be quite happy to see them all drop another 40% which is not impossible if oil actually had a real sell off.

I think there are notes on the blog on all of these.  Will write more in the coming weeks.

Charlie Munger Interview With Becky Quick

Charlie should take over for Kudlow.

BMO Notes on Arcan Resources

Monday, May 2, 2011

Don't Understand Obama Oil Policy

End tax breaks so we have less cash to develop domestically.  Then call on foreign producers to increase production to ease high oil prices.  Fewer American jobs, more reliance on countries who don't like the States.

Wrote about it here:

Picked up some more SkyWest (SKW) today at $0.49.  Will keep averaging down if it keeps dropping.  Have an article through CGI on it that I will post once they have it on their site.

Sunday, May 1, 2011

Arcan Resources - Scotia Capital

Page 27

Arcan Resources - Likely eventual acquirer

Pengrowth comments on Swan Hills

Arcan Resources


ARN reported 2010 results and year-end reserves.

Reserves Up ~26% per Share

• ARN reported year-end 2P reserves of 21.1 mmboe, a 124% increase (26% per

share) vs. YE2009. Reserves are highly weighted to the Swan Hills Beaverhill

Lake, where the company completed 15 (12.9 net) horizontal wells through


• 2P FD&A costs came in at $25.05/boe (including FDC). This is at the higher

end of the range for companies within its broader peer group but comparable

with other light oil focused producers.

• Q4/10 production averaged 2,800 boe/d, which was slightly above our estimate

of 2,700 boe/d. CFPS for the year came in at $0.32 per share, which was in line

with our estimate and consensus.

More Positive Tests from Ethel

• Arcan tested two more Ethel wells "in the past few weeks", which tested at

600+ boe/d. One of these is likely the 12-11 well (see Exhibit 1), which the

company previously press released in March (see our note here). The additional

Ethel test is positive as it further validates the prospectivity of the Ethel region

(south of the established Deer Mountain Unit).

• Toward the southern end of ARN's Swan Hills land base, the company

completed a multi-stage stimulation on an existing horizontal well, which

tested at 400 bbl/d; ARN is encouraged by the result and may stimulate other

existing horizontals.

• Three of the wells with prior plugging issues have been worked over, with two

being placed back on production at 100 boe/d (up from 40 boe/d).

• ARN announced current production of 3,000 boe/d and expects to average

4,000 boe/d for the year (exit 5,000 boe/d), generally in line with our prior

expectations. ARN expect to drill 20 to 25 BHL horizontals in 2011 with a

capital budget of $135mm.

Maintaining Outperform

• Reserve adds were strong during 2010, reflective of the company's successful

delineation program within the Beaverhill Lake. Based on the updated reserve

figures, we estimate a year-end NAVPS (based on the RBC price deck) of


• We expect the company's next series of well results in the Ethel pool (expected

Q2/11) to be the most significant potential catalysts for the stock. We maintain

our Outperform rating and $5.50 price target.

Arcan Resources

Compiling Notes

 GLJ reserve bookings of 12.5 mmboe imply EURs of 245 mboe per well

Hztl BHL wells in Deer Mtn u#2 (under waterflood) accorded 350 mboe,
while new wells outside unit with similar IP rates assigned just 220 mboe.

 F&D costs imply highly economic development potential
Future development capital of $188mm accorded to BHL adds imply future
F&D costs of ~ $15/boe, yielding a +2x recycle ratio at $90/bbl oil prices.

 GLJ report validates our BHL type-well & project model
We continue to model $6mm well costs (incl. cost of waterflood); drives
type-well EUR of ~335 mboe, a 44% IRR, & NPV10% of $5.1mm/well.

 Project NPV could approach $13/share; Reiterate Strong Buy rating
Our 8-year, 215 well project dvlpm’t model recovering 75 mmboe yields a
project NPV10% of $7.35/sh.; a 400-well 10-year model drives $12.90/sh.

Q4 SkyWest Management Comments

Year in review

2010 was a very successful and exceptional year for us. We began the year with the new management team in June of 2010 with a focused, well-defined strategy to increase our exposure to light oil value and growth opportunities in the Cardium play. Our execution was purposeful and disciplined as we increased our leverage to oil production as well as assembling an inventory of oil opportunities for future growth.

As a result, SkyWest drilled nine out of nine successful Cardium wells (100% success), which had better than expected results, based on our typical type curves and economic forecast. We have had tremendous growth in both production and undeveloped acreage in the past 6 months. SkyWest has strategically focused on the Cardium play and has accumulated three core areas which we feel are some of the best lands geologically. The areas we are focused on are in the Willesden Green, Carrot Creek and Pembina areas located in west central Alberta. The Company has also insured that its product will not be restricted for production based upon the infrastructure we own or control in each area.

SkyWest started as a private company in December 2009 and completed our reverse take-over of EMM Energy Inc. on June 21, 2010. Historical production was approximately 300 boepd with a commodity blend of 75% gas and 25% oil and NGL's. SkyWest became a publically trading entity on June 22, 2010 and commenced its drilling operations in August of 2010. The Company has grown from 69 mboe to 10,963 mboe of reserves. SkyWest currently has 130 net Cardium locations in inventory in our core areas which provided us with a strong foundation from which to grow and our strong internal performance have provided us with a substantial amount of development and exploitation upside in areas that are accessible year round.


SkyWest drilled and completed 3 gross (3 net) Cardium horizontal oil wells in Q1 of 2011 which included 2 earning wells. The 3 wells were all completed with water based nitrogen foam fluid and averaged approximately 500 boepd per well over an initial five to seven day test period. SkyWest's current production is approximately 1,650 boepd (approximately 45% oil and NGLs resulting in 70-75% of the Company's revenues) and there is currently 900 boepd behind pipe awaiting tie-in. We anticipate a portion of the behind pipe volumes to be on production in May and the remainder in July, adding approximately 500 boepd of stabilized production. SkyWest plans to drill the remainder of its 2011 capital budget on 5 to 6 net Cardium horizontal oil wells, the first of which will be spudded immediately after break-up with the related production coming on stream in late Q3 or early Q4 of 2011.


The Annual and General Meeting of our Shareholders will be held at Livingston Place, in the Second Floor Conference Centre, 250 – 2nd Street S.W., Calgary, Alberta on May 26 2011, at 3:00 p.m. (M.S.T.). All shareholders are cordially invited and encouraged to attend.

Q3 Skywest Letter to Shareholders

As an early stage emerging E&P Cardium oil focused company, we have experienced tremendous growth

since becoming publicly traded only five months ago. We have now executed four acquisitions, are closing

in on a $100 million dollar market cap, have amassed 32 quality net sections of Cardium acreage and have

drilled 6 Cardium horizontal wells which have exceeded our expectations.

• Our first well, which was drilled in Pembina south at an I.P. of 530 and has a 60-day average

production rate of approximately 185 boepd. SkyWest currently has a 43.75% working interest in

this well and after closing the proposed private company acquisition we will have a 77.50%

working interest in the well.

• Our second well at Willesden Green (100% working interest) was drilled in late August of 2010

and results were better than expected. The well had an I.P. of 948 boepd and it is anticipated to be

on stream December 1, 2010. SkyWest expects this well to produce at approximately 400 to 700

boepd for a 30-day average.

• Our third well at Willesden Green also commenced drilling in September of 2010 (100% working

interest). The well was successfully stimulated and had an I.P. of 985 boepd. This well is expected

to be on production in December 2010.

• Our fourth well (25% working interest), was drilled in October in Pembina south, was also

recently successfully stimulated and had an I.P. of 570 boepd. After closing the proposed private

company acquisition we will have a 70% working interest in this well.

• SkyWest has completed drilling operations on 2 additional Cardium horizontal wells, one in the

Carrot Creek area and the other in the Pembina south property, these wells will be completed in

the next few weeks. Wells seven and eight will also be underway shortly.

SkyWest has just recently announced two new acquisitions, which we are very excited about. One was an

asset purchase, which closed on November 19, 2010, whereby SkyWest acquired 6 gross sections (2.175

net) of operated Cardium acreage along with a 30 Mmcf/day operated gas facility in the Willesden Green

area. Willesden Green is a very active area and this fits right into SkyWest’s core area and strategic plan.

The second acquisition was a private oil & gas company. The proposed private company acquisition

consists of 400 boepd of production (50% oil and NGLs). On a combined basis, the acquisitions will add

another 7.2 net sections and 28 net locations of Cardium focused acreage in our core areas.

As a result of the successful horizontal drilling program and the two acquisitions, we have revised our

guidance to exit 2010 with approximately 1400 to 1600 boepd. SkyWest plans to continue our aggressive

drilling program into 2011 .

SkyWest is very pleased with our better than expected results and we look forward to continued success

throughout 2010 and into 2011. SkyWest’s focus on the Cardium will create value and growth through

organic drilling and strategic acquisitions. I would like to thank all of our shareholders for their

tremendous support and would also like to thank our Board of Directors for their invaluable wisdom and


On behalf of the Board of Directors

Q2 2010 SkyWest Letter to Shareholders

Message to Shareholders

Well it’s been quite a journey these past 8 months. Since incorporation of SkyWest as a private Company
with a market cap of $1.5 million dollars, we have seen SkyWest expand and grow into a $50 million dollar
market cap Company today, which to us is very exciting.

SkyWest is a pure Cardium Player and is focused on drilling and development of oil production in the Cardium zone. In the past 3 months, SkyWest completed its reverse take-over of EMM Energy Inc. (‘EMM”) and Stratosphere Energy Corp.

(“Stratosphere”), closed its initial finance of just over $22 million dollars and is in the final process of
closing an additional $10 million dollar flow-through financing. In total SkyWest has raised over $32
million dollars in the first eight months of 2010. Note that the first six months of results for 2010 only
represent a prorated 8 days of financial and operating results of EMM and a prorated 13 days of results of

SkyWest has now kicked off its 2010 Drilling Program with the first well in the south Pembina field. The
well has been drilled and we expect to complete the well within the next couple of weeks. SkyWest has
also commenced drilling operations on its 2nd location in the Willesden Green area, which should be drilled
by the end of August. With all the new technologies in completions that are evolving, we continually
monitor and assess results of completions in the Cardium formations in the W5 area of Alberta to determine
if new technologies will enhance production rates and lower the capital costs of completion. For now, we
are going to utilize an oil frac system which we feel is currently the best completion fluid available.

Since our closing of the EMM deal, SkyWest has been aggressive in expanding its Cardium position by
way of farm-in and land acquisitions. We have entered into a 6 ¾ section farm-in in the south Pembina area
for the Cardium, a farm-in with a private Company in a 1.25 section Cardium play , and have acquired an
additional 2.8 sections of Cardium acreage in the latest crown land sale. This to date, gives SkyWest 35
sections of Cardium acreage ( 24 net sections – 15,360 net acres) .

SkyWest’s current production is in the range of 350 to 385 boe/pd. We are very excited moving forward
with our drilling program for the year, as we have scheduled the drilling of a total of 10 gross (7 net)
Cardium horizontal wells. Our exit production rate is expected to be approximately 900 – 1100 boe/day
being weighted towards oil and NGLs

We hope that you are as pleased as we at SkyWest are in the growth and evolution of the Company over the past 8 months. We look forward to delivering additional value to our shareholders into the future and
would like to thank our shareholders for their support. I would also like to take this opportunity to thank
our Board of Directors for their tremendous support, wisdom and the valuable knowledge they bring to

Skywest April Presentation