Sunday, July 09, 2006
(4:15 PM) | Aryeh Rafah:
A Fall Hurricane StrategyEarly in June, several media outlets carried a story about Warren Buffett's decision not to flee from the Gulf Coast. After Katrina and Rita, many companies providing insurance in the region were forced out of business by the volume and severity of claims, and many of the surviving insurers no longer provide flood and storm coverage.
Ever the contrarian, Buffett's General Re (a Berkshire subsidiary) actually increased its exposure to the region. Their premiums are up by a factor of 20, which will bring plenty of early float but won't cover all likely claims in the event of another bad season. So it's a bit of a gamble.
I think this is a gamble worth following, but with a hedge. Three key elements to consider: 1) Much, if not most, of the risk of another awful hurricane season has already been priced into earnings estimates (and hence the stock prices) of exposed insurers, and they've decreased their exposure by charging higher premiums. With the bad news already figured in, a calmer season could produce enormous gains. 2) Recent stormy seasons have deviated widely from the statistical average, so there's no reason to expect Katrinas every year. 3) Natural gas prices are hitting major lows but can be expected to skyrocket in the event of another bad season, so a natural gas play makes for an obvious hedge.
- General Re is privately held and Berkshire Hathaway costs $90,200.00 per share, so those aren't viable candidates. Allstate (ALL) lost 62% of its expected earnings last year due to storms, but analysts expect solid earnings this year even with hurricanes priced in. Montpelier Re (MRH) and Renaissance Re (RNR) are a tad riskier, but are more leveraged and so should generate more exciting returns if the skies stay calm.
- Hedge against the possibility of a really awful fall with natural gas. The two obvious choices are ConocoPhillips (COP), which recently made a big bet on natural gas through an acquisition, and Chesapeake Energy (CHK), the largest independent natural gas company in the US. If big storms hit and knock oil refineries offline again, people will be forced to use natural gas to make up the difference, just like last year.
Bonus: The neat thing about this hedge is that it doesn't correlate inversely: a calm hurricane season doesn't necessarily mean COP or CHK will lose money. Natural gas has fallen from last year's $15 to just $6 due to oversupply, but as the fundamentals kick back in the price should rise naturally to fall back in line with oil prices.
- Options are advisable in order to reduce the risk a bit more. I'd buy deep in-the-money covered puts on the insurers, and naked calls on natural gas since the latter sector is likely to rise no matter what.
- Before your Thanksgiving break, take any profits and send them to
the Red Cross,Oxfam, or some other sufficiently vetted charity.