On the head of a pin

The Republican primaries are effectively over.  Donald Trump has won.  The Democratic ones continue, with Bernie Sanders hammering at the only Establishment figure left, Hillary Clinton.

2008 was the year Americans felt they had come together behind an historic candidate, Barak Obama.  Eight years later, they are angry, frustrated and more divided than ever since the Vietnam War.  So much so that they are betting on two outsiders who promise to bring the “corrupt” system down. 

Now what?  Reality is starting to dawn on Republican Party grandees that Donald Trump is not their candidate, rather that they are his supporting cast.  Who is the boss?  The question is being asked now and will be answered soon.

Republican mediators hope that Donald Trump will change his tone to unite the Party.  This is unlikely for several reasons.  Dumping a winning strategy has risks for Trump.  Besides, one of the most surprising sights of the primaries was to see prominent politicians taking little offense at being called corrupt, liars, weaklings or told to shut up on live tv.   

My view is that Donald Trump calculates that the Republican Party leaders lack courage and vision and that they will ultimately back him up in order to save their sinecures: better being tame courtiers than proud exiles.

A Trump president would likely go over the heads of Congress and the Senate to appeal directly to voters, make extensive use of executive decrees, and go for big targets: big infrastructure programs, NATO shake-up, big budget and spending battles.  He obviously believes that he would win most of these; he would enjoy the negotiating game;  but the US is not the NY real estate market, or even France, Germany or Russia:  Gamesmanship at the US level has far greater potential destabilizing effects.  Unpredictability may be a good negotiating tactic but it is not a strategy for the world leader[1].  Likewise, loading the US with debt – because if the economy rebounds it is easy to pay it off, and if it fails you just restructure – can’t be the best way to sell  hundreds of billions of US treasuries every year.

The Trump candidacy will have had some positive effects, such as exposing the dysfunctionality of the Republican Party, imbalances within NATO contributions and the not so hard nose negotiating abilities of the Obama administration.  But the negatives of a Trump presidency are difficult to fathom and potentially huge.

What about the Democrats?

Hillary Clinton is unloved and polarizing, but is the safe pair of hands among the last three remaining candidates.  Yet she has been pulled further to the left by Bernie Sanders than she wanted or expected (and her miseries are not over yet).  That Senator Elizabeth Warren is talked as a possible running mate makes that very clear.

She also has hanging over her head, as the Sword of Damocles, the inquiry into her use of a private server and the sharing of “classified” emails.  It is possible but unlikely that the Department of Justice pursue a criminal indictment against her; but if this decision were a close call, some disgruntled FBI or DOJ staff could leak embarrassing related documents; then, we would have a new ball game.

To succeed in the general elections, she would need to retain the support of Sanders’ voters while attracting independents and non-Trump Republicans: no small task.   

If she succeeds, and unlike the other two candidates, she is more likely to seek consensus because she won’t have a solid base of believers.  She would need a good communicator to help get her message through that, as Talleyrand once said, governing is the art of the possible. Would this be her Vice President, her Secretary of the Treasury or her Secretary of Labor?  I don’t know.  Would she succeed?  Way too soon to tell.  Besides, if she didn’t heed Sanders’ entreaties, over time his supporters could set up the Democratic equivalent of the Tea Party.

In summary, and as of today, this presidential election looks like the most frustrating in years.  The two most likely candidates are viewed more negatively than positively.  The two with the greatest fan bases are party outsiders who promise the moon and howl that the political parties whose banner their carry are rigging the primaries against them and their voters.  The cooler headed one enjoys stronger support from party officials than from party members.

Fasten your seat belt but don’t get off the plane!  

Because if you think this political season can't hold any more surprises, THINK AGAIN.

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[1]   But it has been for North Korea.

A flash in the sky

65 million years ago, the dinosaurs ruled the earth. No other specie could compete in diversity, dominance nor offer surer prospects for more of the same for eons to come. And then, suddenly, they were gone. A catastrophic event, perhaps a large asteroid crashing into the sea off the coast of Yucatan. The world would never be the same after that.

For decades, macroeconomic management in western economies was carried out through the competing and complementary efforts of business practitioners (mostly ex-bankers) and economists. The final arbitrages were made by elected politicians.

This balance of influences served us well. “New” ideas were thoroughly debated between theoreticians and practitioners, with the most toxic ones being filtered out. This didn’t prevent preeminent economists like Paul Volcker or bankers like Robert Rubin from making key positive contributions to the economy.

But then came the financial crisis of 2008 and the ensuing Great Recession, and the banker specie became extinct, figuratively speaking.  (Investment) bankers[1] had been playing with fire, resorting to dizzying debt leverage, funding huge quantities of dodgy mortgage loans with overnight funding, betting on derivatives without properly hedging themselves, and the list goes on.

In truth, bankers were not the only ones responsible for the crisis, but they were the richest, they were politically tone deaf and they were the ones standing among the ruins. Politicians were equally despised, but since they couldn't be fired, knew how to quickly blame somebody else, and fake compassion by writing new regulations and imposing huge fines on bank shareholders to atone for the sins of bank executives, they survived.

The economists were neither rich nor elected, and they had two hands (“on the one hand…on the other hand..”). And so the new era of the homo economicus began.

Unchecked, unchallenged, economists rose to the status of doers, saviors, and seers. They were empowered to carry out real life experiments on a massive scale and test their theories in the real world.

The last act of the banker/economist tandem (Paulson/Bernanke) of opening the liquidity spigot and forcing a massive recapitalization of the banking sector was appropriate at the time.

But subsequent and continuing experiments in printing huge amounts of money, forcing interest rates down to zero and even below, and in having central banks buy hundreds of billions of shaky sovereign and corporate bonds have hardly been conducive to inspiring confidence.

Under such altered financial states, home owners may see their equity go up (because of rock bottom capitalization rates), but they also see their investment income collapse to a trickle.  Not likely to encourage splurging.

Working people, if they pay attention, worry that their pension plans are way behind in building up the kind of retirement assets they will need later in life.  In all, some five trillion dollars in public and private US pension plans are affected.  It is even worse in Europe.

While governments have taken tens of trillions in new debt, they expect their national currencies to weaken just enough to facilitate exports but not enough to trigger capital flight.  Good luck with that.  And whose currency is appreciating to soak all these exports?

The current economists’ bold plans remind me of the Collor Plan in Brazil, back in the early 1990s.  One of its key measures to crush inflation was to drastically reduce demand by freezing financial assets.  All of a sudden, households couldn’t touch their investment accounts, could only withdraw US$600 from their savings accounts and up to 20% of their interest-bearing checking accounts!  That monetary freeze was to last six months!  And ultimately the frozen money would only have limited use.

Debasing the currency, targeting private savings, encouraging excessive risk taking may help balancing some equations on paper, but they destroy confidence, and without confidence there is no economic growth.

In fairness to economists, bickering politicians had left monetary policy as the avenue of last resort. But the adepts of the Dismal Science didn’t need much encouragement.

And now these sorcerer’s apprentices must undo their clever constructs, like Disney eponymous character.  I may be wrong, but the reign of the economists is unlikely to challenge that of the dinosaurs.

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[1]  By and large, the most egregious excesses were committed b investment bankers, but some commercial bankers joined the fray.

Sister Souljah moments

It seems that all major political campaigns have their Sister Souljah moment, when the candidate(s) face a high risk question or situation which opens or closes their path to success.

The original one of course was when candidate Bill Clinton, speaking to Jesse Jackson’s Rainbow Coalition, chose to publicly rebuke a well known black activist’s justification of black on white violence.  Clinton did endure harsh criticism from some quarters, but he gained the broader support of moderate Democrats who had had their doubts about him.

In 2012, Mitt Romney and the rest of the Republican presidential candidates had their own Sister Souljah moment, and they blew it.  When a debate moderator asked them if they would accept a hypothetical deal to increase taxes by $1 for every $9 in spending cuts offered by the Democrats, they hesitated, looked at each other, and demured.  How could getting 90% of what you want be unacceptable to those “conservatives” when their idol, Ronald Reagan, famously said he would settle for 80% and fight for the rest another day?  They were so afraid of losing fringe support that they ended losing the support of the majority.

This year, we have seen Republican presidential candidates being called liars and other names in front of millions of TV viewers and hundreds of spectators by Donald Trump, and not responding.  Is their sense of value so distorted that they didn’t think such attack on their honor deserved the most vigorous response?  Or were they afraid of Donald Trump?  Either way, they let their Sister Souljah moment pass and will live to regret it.  So will we.

Yet another such moment came in yesterday's debate: after arguing, sometimes literally, that Donald Trump was unfit to be president, his three opponents pledged to support him if he was nominated.  I am glad they do not work as check captains at my favorite airline.

Oil economics: a peak under the hood

In our previous post, we looked at the current imbalance between supply and demand.  We concluded that this imbalance was clearly due to an excess supply.  We concluded that, barring (likely) geopolitical turmoil, it would take two to three years for crude oil markets to stabilize.

But how will this take place? Which oil sources will be affected the most and see their production curtailed first?  How will producers decide to cut or not to cut output?  Many of the answers can be found in basic oil economics, accounting and finance; in particular, in the difference between profits and cash flows.

Shale oil is the sector which has grown the most, and the one which has been the first to retreat.  There are three reasons for that:

1.     Its upfront (capex[1]) costs are relatively low; as a result the lead time to production is short which represents low entry barriers for small, entrepreneurial and innovative companies.  The result has been a boom in production; it has also made it easier for producers to step back;

2.     Second, as shale well production typically falls 50% to 70% within the first  12 months, shale producers must continually invest in new drilling to at least maintain  production levels, the result being chronic free cash flow deficit;

3.     Thanks to rock bottom interest rates and the popularity of shale, producers had no problem avoiding equity dilution by financing these deficits with ever mounting debt.

But when credit markets tighten and oil prices plunge, shale producers face both deeper cash flow deficits and scarce credit.  They have no choice but to pare down capex and current operations. This retrenchment, combined with the naturally steeply falling production curves, explains why shale oil has been the sector most affected.

At the other extreme, Canadian oil sands producers have very different economics:  their business calls for very high upfront investments and very long lead times to production.  Afterwards, their operating costs are average but they do not need to invest much besides maintenance.  In the current environment, their cash operating costs are close to breakeven while the depreciation of their investments will push them into accounting losses.  Oil sands operators are like copper miners: once they have completed at least 70% of the investment for a new project, and unless long term oil/metal prices are expected to stay very low, they are committed to completing the project, and taking their losses for a while.  Of all the oil producers, they have the least flexibility to cut back on current production.

All other oil sectors fall somewhere between these two extremes.  Most of the non-OPEC and non-shale new production has come from sources which call for high levels of upfront investment.  As producers in these areas are strapped for cash and pull back on new investments, future production will suffer as there will be no quick fix for expensive, long lead time projects.

Accounting will also impact future production in another way.  Most oil producers must adjust the value of their oil reserves to the economic reality.  Typically, they are obliged to verify that the book value of their proven reserves doesn’t exceed the present value of their future cash flows[2].  This test is carried out quarterly, based on the monthly average market oil prices for the previous 12 months[3].  The steep drop in prices since last summer - and the likelihood that they will continue for at least two years - will force massive asset and equity write-downs and inhibit producers from raising additional capital financing.

Finally it is often forgotten that industry costs are just as dynamic as their prices, making it difficult to rebalance supply and demand.

When a cycle of rising oil prices gets under way, it attracts more money to the industry and encourages companies to boost their production.  This reverberates through the supply chain of goods and services: demand for new crews, drilling services and equipment boosts their costs and raises the producers’ breakeven points. 

Conversely, when oil prices fall, the relationship works in reverse: headcounts are reduced, third party contracts are renegotiated and weaker demand for inputs lowers their costs; the breakeven of oil producers goes down and production cuts are delayed as cash margins remain in positive territory.

Again, in a such a scenario producers may show accounting losses, but if they lower their costs to a level that lets them eke out positive cash flows, they will maintain their output as the cash is needed to service debt and stay above water.

This phenomenon was clearly illustrated by the ability of shale producers to defy predictions and survive oil prices well below what was thought to be their breakeven points. 

The result is that the adjustment to falling oil prices is not linear but more akin to a series of waterfalls, where not much happens until a sudden drop follows a shallow decline, followed by another gentle decline and another sharp fall.

When this dynamic plays through the whole industry, and when geopolitical risks are layered on top, one better understands why oil is such a volatile commodity.

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[1]  Capital expenditures.

[2]  Usually, net future cash flows are discounted back to the present at a rate of 10%.

[3]   Should the oil be committed to be sold under multi year contracts, the price imbedded in these contracts would be used.

Crude oil blues

While hard commodities are going through very tough times, crude oil has grabbed most of the headlines, and no wonder: its derivative, gasoline, is an essential product that billions of human beings consume every day.  Oil is also associated with the most volatile areas of the world which are making the headlines of newspapers and TV evening news.

Crude prices have fallen from over $100 per barrel in the summer of 2014 to under $30 today.  Some experts foresee $20 and even $10 before any rebound takes place.  Are they right?  A better question is whether such collapse is cyclical or secular.  Crude oil is a global commodity, largely driven by supply and demand.

Two charts are most instructive in this regard.  The first one shows the quarterly global demand for oil from 1Q 1996 to 3Q 2015:

Source: Bloomberg.

What is striking is how linear and steady the rise in global demand has been over the last 20 years.  Yes, the Great Recession of 2008-2009 cut demand by some 3 million bpd, but that drop was erased in less than 2 years.

Despite a short but a massive global recession, global demand for oil has grown fairly consistently at a rate of 1.5% p.a.  The supposed crumbling of the Chinese economy is not apparent over the 2010-2015 period; indeed, Chinese demand for gasoline grew by 12% in 2015 over 2014[1].  It is also interesting to note that the demand for oil kept rising steadily from 2002 to 2007 and from 2009 to 3Q 2014 despite prices soaring from $19 to $91 and from $36 to $94 respectively.

Put it another way, global demand for oil is fairly price inelastic over the medium and long-term; despite claims that fossil fuels are on their way out, there is little evidence that demand is falling, and I doubt that this will happen for the next few decades.

The second chart shows US oil production over the 1983-2015 period.  It does much to explain why prices have suddenly dropped.   Or why OPEC, and Saudi Arabia in particular, have decided to no longer play the role of market moderator. 

Source: Bloomberg.

After peaking at 9 million bpd in 1986, US production steadily decreased to 5 million bpd in 2008.  However, thanks to the development of shale extraction, it skyrocketed to 9.6 mm bpd in June 2015 before falling to 9.2 mm bpd by year end.  From the end of 2011 to the middle of 2015, shale oil production grew at an astounding annual rate of about 1 million bpd!

With oil at $100 shale was a terrific business.  At $40, it is a losing proposition for most.  Already, US shale production has dropped by 400,000 bpd since June of 2015.  Estimates of another 600,000 bpd cut this year are reasonable, for a cumulative 1 million bpd.

When might global oil markets get back into balance and prices rise to a range of $50-$70 which would permit the commercial exploitation of most sources of crude except for the more expensive shale and oil sands?

If we assume that the sudden oversupply of shale oil caused the current imbalance, then the secular annual increase in global demand of 1.5% (or about 1.4 mm bpd today) should take 3 years to close the gap, everything else being equal[2].  This would get us to the end of 2018.

But it is unreasonable to assume no extraneous factors, especially in today’s world.

First, as we indicated earlier, US shale production is likely to fall further, probably by another 600,000 bpd this year.  This decrease will probably be compensated in large part by increased Iranian exports of 300,000 to 500,000 bpd.

Towards the end of projection period, drastic cuts of close to 40% in investments made so far by the oil industry are bound to result in flat, not rising, production.  Among the world leaders, Petrobras for one has already massively scaled back its growth and may be forced to do more.

Geopolitical factors may cause more significant swings in global supply: Venezuela is teetering on the edge of economic chaos; Libya is in even worse shape. The second largest OPEC producer with 4.4 mm bpd, Iraq is in a state of war with IS.  And then there is the rising tension between Iran and Saudi Arabia where the principal actors don’t want a war but do want to test each other.  Russia is strapped financially and barred from access to the best of western petroleum technology.

Between cuts in US shale, increases in Iranian exports and difficulties faced by OPEC and non-OPEC producers, it is not unreasonable to envisage a net reduction in global supply of 800,000 bpd to 1 mm bpd over the next three years.

Finally, there is the reality that at least 5 mm bpd of new production must be ramped up every year to make up for natural field depletion.  That costs money.  A lot of money.

I don’t know what the oil prices will be this year or the next.  However, I think that, barring major geopolitical accidents or a recession,  the global oil market should get back close to equilibrium by early 2018 through a combination of lower production and higher demand.  Financial markets should anticipate that by six months or so.

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[1]  RBC Capital Markets.

[2]  At present, the US shale production is about 4.2 million bpd.  4.2/1.4=3 years. 

Southern Winds

Finance Minister Levy is leaving his post by year end.  If so, he will have lasted just one year.

Almost a year ago, soon after his nomination, I wrote[1] that while he was highly qualified for the job and would “find some initial freedom of action… [which] could last a couple of years..,[his] remedies and policies.. are the exact opposite of what the PT wants and what President Rousseff has supported in the past. I also wrote that Brazil needed to make profound reforms which “are political in nature and go far beyond the competency of the Minister of Finance”.
 

My misgivings were proven valid even sooner than I expected.  Minister Levy didn’t receive the political backing from his president nor from the PT in congress.  As a result, he could only raise some taxes but couldn’t significantly cut public spending.  The last straw was the government refusal to hold the line at 0.7% for the 2016 primary budget surplus.

 

Nelson Barbosa, currently Planning Minister and a traditional proponent of active government intervention in the economy, will replace him.  He will get along better with President Rousseff but I don’t think that it will mean better decision-making.

Ravaged by corruption scandals, economic recession and depressed commodity prices, the future looks bleak for Brazil.  The political opposition is by and large clean (perhaps because it didn’t have access to the levers of power) but weak and lacking grassroots organization.

Further south, the winds are beginning to blow in another direction.  Mauricio Macri was elected president of Argentina and wasted no time in liberalizing the foreign exchange regime via a dirty float system.  He also cut taxes on the main grain exports which got him the exporters’ agreement to bring back, daily, some $400 million of grain export proceeds.  Finally, Finance Ministry’s and the Central Bank’s teams look very good.

I have no doubt that the Argentine recovery will be rocky at times: undoing several years of ill-advised policies takes time and is politically difficult; the opposition is well organized and deeply resentful of its loss; finally, the world economies are still weak.

But Macri has a number of factors in his favor, besides having adopted good policies and chosen good people:  Argentina is smaller than Brazil, with a population of 44 million vs. 206 million; its population is better educated and economically less unequal; last but not least, he was clear in his campaign as to what his policies would be and voters, in their majority, backed him.

In Venezuela, the heirs to Hugo Chavez have suffered a heavy defeat in the latest congressional elections.  Clearly, the population is unhappy with the abysmal performance of the economy.  External pressure is also mounting for the regime to respect human rights.  More than anywhere else in the region, low commodity prices are shaking political and economic foundations.

Elsewhere in South America, commodity prices are forcing government to revise their policies, although with distinct flavors.

 

The education, social and political reforms which the Bachelet government wanted to carry out have faced fiscal realities: the money is not there; the haste with which they were introduced met a pushback from both moderate politicians and a population facing other priorities.

In Colombia, where oil accounts for half of exports, the government is scrambling to raise tax revenues, ease oil and gas permitting, hold inflation in check with a more aggressive monetary policy and, at last, intervention in the foreign exchange market.  The wild card is the peace process with the FARC: the rebels are increasingly isolated as their foreign backers are short of funds (Venezuela) or considering a change in strategy (Cuba).

In conclusion, the implosion of the hard commodity markets has wrecked havoc in South America.  Populist policies have run out of money and change is forced upon these countries.  The choice is between liberalization, repression and chaos.

Argentina has chosen liberalization, Venezuela has chosen repression, Brazil is heading towards chaos.  Chile and Colombia are so far sticking to a middle of the road regime of open economies and politics.  If the prices for oil, copper and iron ore weaken further in 2016, the pressure will rise further on governments to “do something”.  The more unpopular they are, the harder it will be for them to heed to moderation and rationality.

Optimists will say that a cycle of populism in ending in South America, and that the example of Argentina will favorably influence its large neighbor to the north, Brazil; that Chileans and Colombians are unlikely to turn their backs on two decades of social and economic progress; that Chavismo has lost the legitimacy, credibility and financial means to rule as it wishes.

Pessimists will argue that economic and political liberalism is a foreign concept in South America and that voters not so much want that as an interventionist government largely financed by buoyant commodity prices.

Let me be a guarded optimist.  I do believe that most people aspire to a better life for their families and themselves, greater freedom and pride in their country.  In Latin America, they will also have realized that much of the government bonanza of past years was due to external factors (China’s appetite), not bureaucratic excellence; they have also seen the true cost of government largesse.  For all the above, I think that a new cycle is starting, first in Argentina. 

2016 promises to be interesting.

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[1]  12/7/14 Brazil’s uncertain future post.

Igauçu Falls (Epilogue)

Last week, General Antonio Hamilton Martins Mouraõ, the real head of the Southern Military Command (CMS), was relieved of his charge and assigned to an administrative position in Brasilia.

This was in response and punishment for the general having publicly been critical of the President Rousseff; according to people who attended a conference held last September, the general would have said that, should the President leave office, it would not be a destabilizing event but would mean that “incompetence had been cast aside.”

The general got in even deeper trouble in October when he encouraged members of his Command to attend a ceremony to commemorate Colonel Carlos Alberto Brilhante Ustra who had just died.  The colonel had led the DOI-CODI, a controversial Army unit responsible for “internal security” during the military junta days.

There is no question that the general was out of turn and got what he deserved.  It is however noteworthy that he was so upfront in voicing his opinions.  Perhaps he felt that he was saying out loud what many of his peers were thinking.

At this point, I do not expect Brazil to become so dysfunctional that its armed forces would feel compelled to intervene.  Nevertheless, there are only two large and well organized social forces in Brazil: the Partido dos Trabalhadores (PT) and the Armed Forces.  The former is the ruling political party, it is in trouble and it knows that it is not the only alternative to chaos.