La Der des Ders

Some ninety years ago, World War I ended after causing extraordinary suffering to winners and losers alike.  Survivors swore to do everything in their power to ensure that such a war would be the last of its kind, la der des ders.  This impetus gave us the League of Nations, the Reparations of the Treaty of Versailles and the Maginot Line.  The rest, as they say, is history.

As we are emerging from the worst banking and financial crisis in memory, governments are determined that such a crisis will never happen again.  Parallels between wars and financial crashes can be carried out only so far, but both are rooted in human nature.  The lessons we can draw from the aftermath of WWI are that: as much as it is emotionally satisfying, rushing into action is usually counterproductive; there will be more crises in the future, so that the cost of absolute protection is likely absolute instability or economic stagnation; there are always unintended consequences to seemingly effective new policies; the next crisis will not be a repeat of the previous ones.

We already got a taste of over-reaching with Sarbanes-Oxley, as major foreign multinationals chose to delist their shares from US exchanges and many international companies chose to list in London or Hong Kong rather than in New York.

Today, the legislative ire is turned on the big banks.  In truth, these banks made some horrendous mistakes, such as taking extraordinary risks in order to keep up with the Jones, and some of their high executives showed little sensitivity when the country was reeling.  So the remedy and the punishment are to saddle them with so many regulations and to impose such high capital requirements that they won’t possibly risk to go under again; and they will be made to pay for a long list of safeguards and other measures for the common good.

The truth is that the US economy will not grow without access to credit, and with the demise of securitization, bank credit “is it”.  The other unpleasant truth is that, in a free economy, banks are not obliged to make loans at a loss; in other words, they will pass on their extra costs to their clients.  More pernicious is the apparent belief that erecting a battery of new rules will protect the system, just like the Maginot Line was supposed to protect France from a German invasion.  The real protection will come from vigilant regulators and from enforcing rules that are clear to all and that deal with the fundamentals of banking, such as capital, reserves, proper independence of risk control functions and appropriate incentives.

One of the toxic byproducts of the Great Recession has been the concept of “too big to fail”.  We now have 19 US banks which were designated as too big to fail.  We also have ongoing discussions as to whether they should be downsized enough so as to no longer warrant such classification.  In truth, nobody quite knows what to do about these 19 banks; do they derive an unfair advantage from their new status?  Does this classification strengthen or weaken the US banking system?  Is the state setting itself for a stiffer bill when the next financial crisis erupts?

Historically, it is not the biggest banks that caused financial crashes.  The Knickerbocker Trust which triggered the 1907 crisis was not one of them, but markets worried about it and its affiliates.  Nor was the Herstatt Bank, the bankruptcy of which roiled markets in 1974.  In 2008, Bear Stearns was not one of the largest banks either.  

What these troubled banks had in common were two things: they were big enough and they failed when markets were vulnerable.  A bank doesn’t need to be the biggest to cause concern, but it needs to be big enough for its failure to be noticed and widely reported.  Perhaps more importantly, it very much matters when it fails.  Had Bear Stearns failed in 2006, markets would have shuddered but not gone into a tail spin.  However, if markets are on the edge of panic and a sizeable bank fails, it is only natural for creditors and investors alike to extrapolate and believe that, far from being an isolated accident, this failure is emblematic of the system as a whole.  “If Bank So-and-So had such bad assets, why wouldn’t the others be in the same boat?”

When markets are driven by panic and participants are suddenly unwilling to take on any risk, all bets are off.  Indeed, under such circumstances, whether the US government has the authority to unwind a big investment bank or not, I believe that panic-stricken markets would question which bank was next and if there were sufficient public funds to save the system. 

The 1907 crisis was compounded by the fact that the Federal Reserve Board didn’t exist then, nor did deposit insurance.  The result of the panic was a run on the banks by their depositors.  It is worth noting that the banks that threatened the system in 2008, Bear Stearns and Lehman Brothers, were not deposit takers, as commercial banks are.  Not only did they rely on wholesale borrowings for funding, these borrowings were largely entered on a very short term basis, such as overnight.

Which brings us back to Dodd-Frank and “too big to fail”.  While Citi, Bank of America and others had made shaky loans and poor investments, in 2008 they were not in danger of failing overnight as investment banks were.  They also had intrinsic value, such vast networks of branches and stable deposits; unlike them, investment banks’ most valued assets were staff who could bolt out the door at any time.  Accordingly, it probably makes sense to limit the absolute size of investment banks, and I think that their business models will likely evolve further.

I don’t know how Dodd-Frank will be implemented eventually.  What I do believe is that the biggest universal US banks have gone through massive recapitalization exercises that have endowed them with good quality capital; that they have set up sufficient reserves against bad loans.  They also have gone back to basics, funding loans with deposits unlike some of their bigger international peers that sport ratios of loans/deposits north of 120%. 

Banking crises have always existed, and always will.  They have occurred even in times when debt leverage was much lower than today.  Insufficient capitalization and/or liquidity has often been the cause of bank crises.  But banking is a special activity: what it produces is intangible, invisible; it also deals with money, and not just that of its shareholders, but mostly with that of its depositors and creditors.  For both of these reasons, and unlike any other industry, it relies on trust, or to put it differently, on human emotions. 

For all of the above, a framework based on principles and a reasonable number of clear rules, enforced by willing regulators will achieve better results than one based mostly on thousands of pages of rules.  And rather than avoiding a future big crisis, we should try to set in place a system that will minimize its most adverse consequences.

In the end, those banks that have a strong and positive culture of capital preservation, risk control, client service and where the staff has pride in their institution will not only survive but prosper.  This is difficult to achieve when top performers tend to rotate from bank to bank in search of larger compensation.  Yet as an investor, this is the kind of bank I want to invest in, and there are such banks in the US, Europe and elsewhere.

Preliminary thoughts on the Fukushima accidents

It is too soon to draw definitive conclusions on the exact causes of the Fukushima disaster, but assuming that preliminary findings do not change materially, governments and the energy sectors are in for difficult decisions and fossil fuels have won a reprieve, if they ever needed one.

The primary culprit was a force 9.0 earthquake, the fourth strongest in a century, which in turn caused a huge tsunami which flooded and destroyed crucial portions of the nuclear plants' backup power systems.  Having built these reactors close to the sea looks like a bad mistake, but what should countries like Japan that lack large rivers or lakes do?

The second line of inquiry centers on the age of the plants.  Their “boiling water” design is believed to have contributed to the problem.  Old plants are expensive to maintain, and no matter how much tinkering is done, they won’t be as good as new ones.  This could make it difficult and very expensive for utilities to win life extension permits from their regulators.  Furthermore, the longer a plant is in use, the more spent fuel it generates, and this fuel has to be stored (or reprocessed) somewhere.   

Third, operational practices will come under intense scrutiny.  How many and where spent fuel rods were stored seems to have been a major cause of the explosive chain reactions.  Maintenance procedures, storing of spent fuel rods will be reviewed as will safety systems and their redundancy.

In the immediate future, there is no way to effectively substitute nuclear generation with any other.  In 2009, it accounted for 19% of electricity generation in the US, 29% in Japan, 78% in France and 35% in South Korea.  It is unthinkable to just shut down all nuclear reactors.  Japan alone is likely to need to import an extra 10 billion cubic meters a year of LNG until 2015 just to make up for the damaged Fukushima reactors[1].  That is 4% of global LNG shipments in 2009, a significant number.

Longer term, the picture should be broadly the same.  We expect that there will be the usual calls for green energy, for alternative fuels, but for the next two decades at least, this is unlikely to be of much practical help. 

In 2009, US solar and photovoltaic installed capacity was 640MW.  These 640MW generated 891,000 MWH; this means that capacity utilization was 16%, compared to 90%+ for nuclear plants.  Then there is cost.  As a result of the French government effort to encourage solar power, EDF is on the hook to pay €560 million p.a. for the next 20 years in subsidies to support 973 MW of new solar power.  Even assuming a capacity utilization of 25%, this works out to €266/MWH p.a.!  Direct Energie, a French energy player, is offering to buy electricity wholesale from EDF at €42/MWH… 

The investment cost per MW of installed wind capacity is comparable to that of a nuclear plant, while its capacity utilization is anywhere between 10% and 30%.  To that should be added the cost of backup generation facilities and NIMBY opposition.  So little relief should come from that corner either.

Even under an optimistic scenario, new nuclear plant construction is likely to be delayed, reduced and made more expensive. Which leaves natural gas.  There is lots of it in the US and in Russia.  Combined cycle gas turbines are fast and cheap to build, and not overly polluting. Gas-fired plants are the only large scale and economic alternative to nuclear generation for decades to come.  The recent disaster in Sendai is likely to accelerate the demand for gas, which, combined with the tailwind from recovering and growing global economies will likely cause prices to grow higher and sooner than originally expected. 

Japan is about to compete for new Eastern Siberian and Australian gas with China and South Korea. The traditional and abundant Russian gas deposits are too far to be economically sold in Asia, so that, despite greater capacity in Qatar, LNG prices should rise with demand.  If Germany decides not to extend the life of its existing nuclear plants and not to build new ones, it will have little option but to increase its gas purchases from Western Russia.  Should the UK reduce its nuclear building program, further pressure on gas prices should follow.  As for France, it relies so much on nuclear energy that it will probably maintain an active nuclear program.

Outside Russia and Australia, the largest new gas supplies will come from areas which are prone to unrest and political risk (Middle East, North Africa and Central Asia).  In a sense, and despite current misgivings, this strengthens the case for maintaining diversity of energy sources and keeping a viable nuclear option.

We don’t know what the long term impact of the current nuclear crisis in Japan will be.  For illustration purposes, let us consider two scenarios: (A) nuclear power output remains flat globally over the next 20 years instead of growing at an annual rate of 2.3% as generally predicted.  If this shortfall in energy output is to be made up by greater natural gas production, then the world would need to produce the equivalent of an extra 7.5 million barrels of oil equivalent per day by 2030;  (B), nuclear power output drops by 2% p.a., raising the 2030 call on natural gas to 11.7 mboepd.

To put these numbers in further perspective, under scenario A, the 2030 nuclear energy shortfall would represent 8.4% of global gas production and 43% of the North American gas output.  Under scenario B, it would represent 12.5% of global gas output and 67% of North American output.  Or, natural gas production would need to grow 20% faster through 2030 under scenario A, and 33% faster under scenario B.

Scenario A looks demanding but possible, although a combination of higher gas prices and greater energy efficiencies (in other words lower consumption) would have greater chances of success.  The fact that scenario A could happen does not mean that it will.  In fact, I doubt that it will because the one country most likely to curtail its use of nuclear power is Japan, and its energy consumption growth is expected to be modest over the next 20 years.  Scenario B is not feasible as it would require a 73% increase in natural gas output by 2030.  It would also require a costly buildup in gas infrastructure ( trunk pipelines, LNG carriers, LNG plants, ports, etc.). 

This leads us to conclude that nuclear power might be allowed to drop in relative but not in absolute terms.  Nuclear power producers will likely incur greater costs than today.  How much of these will they be able to pass to consumers is open to question as it will be a regulatory, political and social process.

Under most scenarios, natural gas is likely to see its importance grow as a primary energy source.  It is abundant, present in most continents and relatively clean.  Shale deposits will only boost its desirability.  Unlike wind and solar, it can generate electricity around the clock.  It is safe.  It is the fuel of the 21st century.

Disclosure: We are long US and Russian oil and gas producers and US gas-fired electricity generators.

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[1]  According to Gaz de France.

The Middle East and North African crises

IT’S THE ECONOMY STUPID?

Bill Clinton focused on the economy and defeated G. H. W. Bush in the presidential elections of 1992.  In the process, he made the above slogan famous.  That same slogan was the rallying cry of the winning ticket in 2008.  Will it be again in 2012, or will the recent upheavals in the Middle East and North Africa bring foreign affairs back to the forefront?  It may be too soon to say, but I suspect that the presidential candidates will be less inward-looking than in the past.  Investors will should do likewise and sooner.

It all started in the Ivory Coast last November, where the presidential incumbent refused to cede power to the winner of the election and went on to say that African countries would not go to war to oust him.  His defiance was widely condemned by the UN, European and African countries.  This emboldened many Ivoirians to demonstrate in the streets, but no foreign armed intervention materialized and the standoff continues.

Tunisia was next.  At first, the police and security forces reacted brutally, enflaming the population, but the armed forces soon dissociated themselves from the repression and were instrumental in forcing President Ben Ali to flee.  A similar scenario enfolded in Egypt.  There, the US used its influence to repeatedly call for the ouster of President Mubarak.  As in Tunisia, the Egyptian army refused to use violence to repress demonstrators and facilitated the change in government.  In Libya, Muammar Gaddafi led a violent repression on civilians.  The US called for him to leave as did other governments, but momentum may have swung back in his favor and the country seems on the verge of splitting along historical and tribal lines.  Bahrain, Yemen, Oman are experiencing disruptions to various degrees.  So, it seems, is Saudi Arabia.  Iran is reported to have detained opposition leaders, to prevent large scale demonstrations.

The short and medium-term doesn’t look too bright:

-          Long repressed aspirations and frustrations were suddenly released, and due to the lack of institutional infrastructures, were left to develop according to their own momentum where the end result is unknowable at this time;

-          The demonstrating populations were more united by their rejection of the regimes in power than by what they wanted to achieve afterwards;

-          The successful transition from autocratic regimes to democracy takes (a lot of) time, yet the world establishment pressed for immediate change, raising expectations to unrealistic levels and planting the seeds for disillusionment and instability;

-          Most of the regimes that fell were secular but some of the better organized and more active opposition groups have religious leanings.  A look around the world shows that religion and politics don’t mix very well;

-          As in Yugoslavia, some of the felled authoritarian regimes held together countries with competing ethnic, religious or tribal groups.  While freedom must be welcome, it remains to be seen whether these groups will feel common national identities, and if not, whether the result will be the formation of failed or non-viable states;

-          With the collapse of repressive regimes, police and securities forces have disintegrated.  The armed forces have been reluctant to step in.  Sooner or later, order will have to be reestablished to prevent economic collapses and civil unrest.  The longer this takes, the more difficult it will be;

-          Finally, and for the time being, it is those regimes that have been the most brutal and repressive that have survived, while those that hesitated to shed blood were swept away.  Not a very encouraging lesson.

Without prejudging the final outcomes, it seems that several years may have to pass before new and stable regimes take hold in much of the Middle East and North Africa.  

Given the immediate needs of these countries, their geographic proximity to Europe and their vast energy resources, it is inevitable that Europe and the US will try to help in the transition and rebuilding process.  There are talks of a new Marshall Plan for the region.  France, the UK and the US are pondering how to deal with the shifting political map.  Much has been learned from experiences in Haiti, Afghanistan and Iraq.  One lesson is that rebuilding is arduous and costly.  Another is that foreign sponsors are better off trying to maximize the participation by all segments of the population in the political process rather than trying to steer countries to specific regime structures.

As far as investors are concerned, some lessons can be drawn already.  One is the importance of political risk assessment.  No pundit warned of upheaval coming to the Middle East and North Africa in 2011.  Probably, nobody could.  The point is that, by definition, emerging markets have less stable institutions and less developed financial markets than OECD countries; accordingly, they should carry a substantial risk discount which may, or not, be negated by the premium attached to their higher economic potential.  On a relative basis and over the last twelve months, emerging markets have been overvalued compared to the US.

Second, as the debate about energy independence and clean fuels is revived, the strategic importance of natural gas should become ever clearer.  It is abundant in the US, it is much cleaner than coal (not just regarding CO2 but also mercury and toxic gases), gas-fired power plants are faster and cheaper to build than the alternatives.  Over-production in North America is depressing gas prices, but this may not last too long as new drilling activity slows down and demand rises.  Low cost natural gas producers and power generators are probably worth a look.

The travails of the Middle East may benefit the Russian gas industry.  Already, Gazprom is shipping more gas to Italy to make up for lower Libyan exports.  It will also ship more LNG to Japan to compensate for the shutdown of several nuclear reactors there.  American oil and gas companies have had difficulties in Algeria with state company Sonatrach.  This is not conducive to new investments. 

The recent nuclear accident in Japan may revive European (mostly German, Italian, to a lesser extent British) misgivings about nuclear energy.  Enthusiasm for solar and wind power is confronting the reality of high costs, high subsidies and poor scalability.  Europe and Russia remain far apart about the structure of the gas industry, but they will likely find it to their mutual benefit to try and bridge their differences.

The above observations do not pretend to be definitive; even if they prove generally correct, geographic realities will not change and energy industry trends take years to take full effect.  Pricing, however, takes place at the margin.