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.

Iguaçu Falls (Part three) – An exercise in fiction

On September 29, General (4 stars) Oscar Rossi, couldn't shake off a bad headache.  The evening before, he and two dozens general officers had attended the retirement party for General Adriano Galvaõ dos Santos, the Army Chief.  The affair had lasted until the wee hours of the morning, wine and cachaça had flowed with abandon.  By the time Rossi’s plane landed in Porto Alegre, the rain had stopped and it was daylight.

The political and security climate only made his headache worse.  The economy was in recession, wracked by sky high interest rates, an imploding currency, a confidence crisis, general strikes, and a government in total disarray.  Crime and politically inspired violence had multiplied as police forces, which had been widely criticized for excessive violence, were basically holding back.

Sensing its vulnerability, the Rousseff government had clumsily issued a decree to transfer some of the general officers’ powers to the Minister of Defense.  This didn't go down well, and an unease had developed where it had not existed.

With its economy in free fall, the majority coalition in disarray, the opposition not ready for prime time and the public clamoring for order and better wages, the army was the one force not tainted by corruption or incompetence.

General Rossi was the Head of the Southern Military Command (CMS) which covered the states of Parana, Santa Catarina and Rio Grande do Sul.  Before the oil boom, this region had been at the heart of an industrial Brazil.  It also abutted with Argentina, the perennial regional challenger and occasional historical foe.  Heading the CMS was indeed quite a career achievement for an ambitious 47 year old soldier.

The dinner had not been without controversy and had bared some tension.  Oscar Dürenberger, the brash leader of the 12th Infantry Airborne Brigade, having raised his glass to toast Galvaõ, looked at him straight in the eyes, smiled thinly and asked:” Well General, how long before we have to clean up this mess?”

Silence had fallen over the assembly.  Galvaõ had not risen to the top Army job by baiting his minister or displaying excessive ambition.  He also remembered history.  He held Dürenberger’s stare, lowered his glass, crossed his hands on the dining table, and slowly answered his junior commander:
-“Oscar, there is an elected government in place, it is up to them to figure out what to do and take responsibility.  We are neither cowboys nor crazed revolutionaries!...Besides, if you read your recent Latin American history, you will see that the armed forces rarely grabbed power; more often than not they took over when a substantial proportion of the population pushed them to….and I don't see this happening here.”

When General Almeida from the Northeastern Military Command proposed another toast, to a man, everybody stood up and the discussion veered into another direction.  Yet Rossi was still analyzing Galvaõ’s words in his head, and a brief look across the table convinced him that he was not alone in doing so.

Rossi looked at his watch.  It was a quarter past ten in the morning.  He was still worried, and the fact that he want alone feeling depressed was small consolation.  What would this new day bring?  A lot of change as it turned out.

2,000 miles to the North East, over the draught stricken sertaõ, a large cb cloud system had been gathering foe s verbal hours.  At 10.43 am, a huge thunderbolt hit the 500 kv transmission line and the substation at Sobradinho.  The latter burst into flame and a chain reaction ensued, with circuits tripping one after the other.  For whatever reason, the energy management software at Cia de Eletricidade do Estado da Bahia (Coelba) failed to activate.

Brazil depends on hydroelectricity to the tune of 64%.   But persistent draughts, high transmission losses and erratic government energy policies which discouraged new investments had left the system both unbalanced and inefficient.  Over the course of the previous four weeks, the Ministry of a Energy had discussed the possibility of putting some of its thermal power plants back on line.  Unfortunately, no decision had been made.

The national grid was now tremendous stress; mismatches between loads and generation caused the system to break down into uncontrolled islands, collapsing frequency or voltage.  By 10.55 am the Imperatriz node was taken out of service, and with it the critical North-South electric transmission axis.  The 8,400 MW Tucurui hydroelectric plant was now a useless monument of concrete lost in the Amazon.

Resplendent and majestic in the morning sun, the Itaipu dam was still one of the world greatest engineering and construction marvels. Its massive turbines had a combined 14,000 MW electric generation capacity and their energy was transmitted over a triple set of 750 kv power lines.

At 11.20 am, the northern half of Brazil, down to Brasilia, was in the dark.  The states of Acre and Roraima, already self sufficient and not integrated to the national grid, were spared.

The cascading blackouts kept moving south.  By 11.30 am, with the big economies of São Paulo, Rio de Janeiro, Minas Gerais at full demand for electric energy, the southern grid system went out not massive overload.  Not even the mighty Itaipu could make up for the loss of the Northern power system.  Following protocols, the Itaipu system tripped; 98% of the Brazilian population and 90% of the territory were now without power.

Outside, somewhere behind the officers mess, the Cummins standby generators kicked in.  Shortly thereafter, Rossi's phone rang.

Iguacu Falls, (Part Two) - an exercise in fiction

In Salvador, an early morning thunderstorm washed away torn paper posters, empty soda bottles, as well as an odd assortment of abandoned sneakers, broken wood sticks and debris of the violent confrontations from the previous day. Now and then, an armored police van could be seen speeding silently down empty avenues, lights flashing.

This scene was repeated, with minor variations, in many large cities.  But in the heart of Brazil’s manufacturing, the so called ABC Region outside the city of São Paulo, TV crews were beaming back scenes reminiscent of Apocalypse Now: an acrid haze from still burning tires floated in the streets; blackened wrecks of police cars and buses haphazardly dotted the urban landscape; rows of shops with broken windows and gaping doors added to the vision of destruction and irreality.

TV viewers were served non-stop images of violence from the day before, of interviews with victims and of seemingly deserted cities.  Shocked by the extent of the destruction, many businesses had not opened and, by and large, people had decided to stay home.

Despite the endless televised group discussions and opinionated pundits, viewers were still struggling to make sense of what they had seen: massive crowds surging between concrete city blocks like the sea at high tide, companies of red shirted militias, some on foot others riding motorcycles, giving chase to straggling demonstrators.  But two videos held viewers in their seats: one of a policeman, his clothes set on fire, slowly crumbling to the ground in a silent scream, the other of a police squad, beating two men senseless with their clubs, long after these had stopped moving.  Had the police put their lives on the line in defending the safety of the citizenry or had they behaved like thugs?

The government seemed just as shocked and dumbfounded as the public.  The presidential office had released no communique so far, while the Interior Ministry had condemned the violence and declared a state of emergency.

The main opposition party had been divided as to how to react.  But on September 23rd, the leaders of the PSDB came out with a unified message that President Dilma  Rousseff should resign or be impeached, recalling the words of former PMDB icon, Ulysses Guimaraes, back in 1992 when then President Collor was himself under threat of impeachment for corruption:” He thinks he still he is president, but he no longer is”.

Attuned as ever to where power was shifting, and conscious of its own weakened position as a result of the indictment of several of its most prominent members, the PMDB issued a communique calling for “ the voice of the people to be heard, and for politicians to respect it”.

Fearing an imminent vote of impeachment, the PT and its allies called for “an immediate popular show of support in favor of democracy and against the rabid forces of oppression”.

Soon, thousands of armed milicias petistas and sympathizers took to the streets in Brasilia, encircling the seat of government, the Planalto , as well as the Brazilian Nacional Congress, ostensibly to protect both.  When Vagner Freitas and a handful of CUT followers stormed the news set of TV Brasilia to denounce a presumed coup, the temperature rose by several degrees.

In Goianias, São Paulo, Rio, Salvador, and elsewhere, supporters of the government in place occupied or blocked access to strategic centers of power or industry.  Having been widely criticized for the use of excessive force, federal and local police forces stood by.

The 23rd came and went.  On the 24th, public employees unions called for a general strike.  They were soon followed by those of Petrobras, Banco do Brazil, as well as those of the likes of CSN, Usiminas, GM, Ford and Fiat.

On the 25th, air traffic controllers joined the movement.  The country had ground to a halt.  The PT had effectively broken into several factions, the more extreme being the more vocal, the PMDB was not sure whether to make effective its dominance of the governing coalition, and the opposition was, as usual, divided and not ready to govern.

Brazil slowly drifted into chaos, as basic services were no longer provided, private industry was on strike, the supply chains of commerce were no longer functioning, and the streets were no longer safe.  Change needed to come, and it did on the 26th.