September 7, 2008
This is just simply tough, this business of unwinding the radically leveraged bets of unregulated financial institutions - investments banks and hedge funds - and the unregulated bets of radically leveraged institutions - banks, Freddie, Fanny. Bear may be followed by Lehman. Now hedge funds are liquidating and dropping like pop-ups just past the infield as their investors pass the threshold of acceptable pain and call back what’s left of their funds. In the wake of hedge funds’ liquidating sales the real worth of great companies like Transocean becomes meaningless.
The pressure to date has come from a lethal combo of falling real estate values and leverage, but that could change. Next we’ll see operating losses by normal but highly leveraged businesses on the books of LBO funds. Most LBO investments depend ultimately on consumer spending. Even the capital goods cycle largely relates back to consumer spending which is 60-plus percent of the economy. Prospects for consumer spending are looking none too healthy based on last week’s unemployment report. If LBO deals begin to default on their bank credit agreements might the LBOers’ institutional equity investors pressure these packagers and managers of the highly leveraged bets - the KKRs, Blackstones, and hundreds of other lesser known practitioners of leverage - to come to the aid of their failing companies? There is no lack of shoes that can drop as the real economy weakens. We have a veritable shoe store of possible problems.
On the other hand, there is a lot of spare cash lying around. Will the cavalry come to the rescue? No, not the Federal government with its imaginary virtual wealth in the form of taxing power. As Pete Peterson has been saying in his ads and his movie, the federal government itself is as good as bankrupt given its off-balance-sheet liabilities for entitlement programs combined with the demographic time bomb of an aging baby boomer population. It can never tax enough to get back to fiscal rectitude. Fanny and Freddie may be the last great federal rescue effort.
The only real cavalry out there are the state-sponsored investment funds. That’s where all the world’s spare cash is being husbanded. In Dubai and Beijing and even Moscow. They’ve come to the aid of a number of banks and brokers so far but all they’ve gotten for their trouble has been a severe haircut to the original values of their investments. No wonder they seem to prefer buyouts of healthy companies in the energy and steel businesses, for example, rather than rescuing more banks and brokerage firms. But price will clear this market and over time the market will bring the suppliers and demanders of capital into accord. We just don’t know when.
Are we six months from an upturn, that time when the valley looks the steepest but stocks begin to recover? Who knows? Will oil hold above $100 or go down to test $80? Who knows? To say we are there now and that now is the time to step in and buy would be the classic attempt to catch a falling knife. As I’ve said before, all our problems - credit market and now consumer spending and unemployment - hinge on stabilizing the housing market. When we start to see evidence that housing prices are bottoming and housing supply is being absorbed, people will flood back into the market. So far we don’t see that evidence. Instead, what we are getting is stuff like this:
Barry Ritholtz: “Former Federal Reserve Chairman Paul Volcker said the U.S. financial system, dependent upon securitization rather than traditional bank loans, is broken, and may contribute to the weakest expansion since the 1930s…”
Paul Volker: “Growth in the economy in this decade will be the slowest of any decade since the Great Depression, right in the middle of all this financial innovation. It is the most complicated financial crisis I have ever experienced, and I have experienced a few…”
That strikes me as ominous language, a suggestion that this could be The Big One. Certainly we are overdue for a serious economic correction given recent excesses. The Roman Circus images conjured up by the past decade’s Buy-out Kings and Hedge Fund Mavens feels like one of Gatsby’s parties. As does the yawning chasm of inequality between the economic pain of the average worker compared with the uber-lux of theTop 3-5% - an inequity that is being compounded by the unfair U.S. tax system that advantages capital over labor. As Mr. Buffett has noted, his secretary pays a higher tax rate than he does.
August was a second tough month for the EIS portfolio, even with a substantial cash component. I was clearly early in putting back on some long term oil call options which cost me about half of my 9.6% loss for the month. The continuing oil price retracement also hurt my stocks, particularly oil service/drilling stocks as evidenced by the 4.6% decline in the OIH sector fund. Two positions outside of oil - SQM and the shipping company TBSI - were off substantially despite the fact that the general market was slightly positive and that both companies continue to prosper. TBSI is selling at about 2 X EBITDA.
My investment posture is predicated on oil becoming increasingly scarce during the next five years. But a growing oil abundance is the immediate present condition due to temporary supple and demand conditions. Two new Saudi fields with combined announced capacity of 1.7 mb/d are in development; Angola has ramped up nearly 500kb/d in the past year; Iraq has upped its exports 500 kb/d; several years of high oil prices are bringing on more small oil projects that are adding an unknowable quantity of additional supplies to the market; high oil prices have motivated conservation efforts; and the slowing global economy is also reducing demand. In short, we are seeing why commodity traders say, “The cure for high prices is high prices.”
To be sure, the natural forces working to reduce oil supply have not stopped working - the decline of older fields, the fact that there is little or no new “easy” oil left to find, thus making it increasingly more costly in both dollar and energy terms to develop new oil fields. While the long term oil price chart - up and to the right - is still in place, a major retracement like this one (50% would bring the price a shade under $100) always makes an analyst want to go back and check his assumptions.
Underlying my expectation of long term rising oil prices is the ever-dangerous idea that, “This time it’s different.” The difference, of course, is Peak Oil. Peak oil is different partly because it has never happened before despite having been predicted frequently and because we don’t have “peaks” in other commodities. There is no “Peak Wheat” or “Peak Copper”. So the idea of Peak Oil is hard for many commodity experts to accept.
To challenge my Peak Oil belief I recently took advantage of an excellent update to the Wikipedia Megaprojects that appeared at The Oil Drum. Using that information along with some useful posts filed in the megaprojects link on this site, I massaged the basic data to evaluate what it says about oil supply adequacy each year through 2015. I recently posted that analysis along with the data, the adjustments to it, and the conclusions. Bottom line: indeed, as a number of oil analysts who are better known than I have said previously, oil should become increasingly scarce after 2008, Peak in 2010, and become very scarce starting around 2013. If you have not read this analysis, I invite you to consider its arguments and to comment on any way you think they could be improved.
In any event, I am encouraged by what I found in the sense that I feel more strongly that over the medium term oil investments are likely to do well. The trick is, of course, to what extent should one own them in the short term.
Which Way Oil? Ask Russia.
Regardless of what may be the case in 2013 the price of oil can do anything in the short term. I’ve said that repeatedly over the past year. I said it when oil was $135 after I had predicted a 2008 range of $80 - $120. Now as oil has broken below the $111 “resistance” level and most likely will test the $100 psychological barrier let’s repeat together: the price of oil can do anything in the short term.
It can go to $80. To those who think OPEC will do something to support oil above $100 I suggest you consider the likelihood that the Saudis - the most powerful OPEC member - will be happy to drive oil down before the U.S. election if they think that will elect another Republican administration. They also would not be unhappy for a low oil price to put pressure on their Shiite neighbor, Iran.
What is far more likely to support oil above $100 in my opinion - if anything does - is a potential Russian action, perhaps against the NATO naval presence in the Black Sea, which they resent strongly. Russia - despite delivering a couple of warning shots over the bow of a few countries that have “misbehaved” - has been a remarkably dependable oil and gas supplier for Europe and the world. Consider that Russia would benefit financially from the higher oil prices that would result from their withdrawing some oil from the market. Despite their own self interest, they are not overtly withholding any oil from the market, it appears. They may be subtly keeping new Russian oil fields from being developed but their existing production in excess of domestic demand seems like it is being sold on the market.
But the Russians’ patience is being tested by the benighted military affront ordered by the puppet government of Georgia whose President apparently thinks his own Georgia is as close to Washington’s heart as the American Georgia. So Russia gave the world a dose of military reality in Georgia and since then has “promised” a “response” to the NATO naval invasion of the Black Sea. They also recently offered a dose of economic reality, reminding Europe that Russia is about to complete an oil pipeline to the East - to China.
If Russian actions end up supporting the price of oil, they may be motivated by the Bush team. The Russians have (not unreasonably) suggested that the entire Georgian adventure was engineered by Bush/Cheney as an election year promotion of Senator McCain’s campaign, since as a “war hero” (he had no strategic or operational leadership role in Vietnam but he was brave in captivity), McCain would seem to be a stronger candidate if the voters’ focus is on war/peace and not the economy. Clearly Bush has good motivation for helping McCain: the Bush administration has been accused - with some reason - of a number of illegalities that have not been fully investigated - from the Valerie Plame outing to the buildup to Iraq to the use of private contractors to torture to domestic spying. There is no question but that George Bush and Dick Cheney will breath a lot easier if the Justice Department continues to be run by Republicans in the years after they leave office.
Incidentally, as the Georgia event was unfolding there was a report that Israeli military and intelligence operatives were in Georgia prior to the invasion. That makes more sense now in view of this report saying that Israel had a deal with Georgia to trade military hardware and training to Georgia for Israel’s right to use Georgia as a staging base for an Israeli air attack on Iran’s nuclear installations. Apparently by flying from Georgia the distance is far less than from Israel and it would not require American permission to cross Iraqi air space. Add one more reason for Russia deciding that enough was enough in terms of the West meddling in Georgia. I can’t say we wouldn’t have the same attitude if Russia began doing such things in Cuba. In fact, we saw that movie.
Be all of that as it may, the price of oil may stay above $100 or not. My guess is not for two reasons: first, as discussed above there are strong near term supply and demand fundamentals favoring a lower price. Second, markets tend to overshoot. I think supply starts to be impacted under $90, so I would expect the market to overshoot that amount, although I wouldn’t wait for an oil price starting with an “8″ before buying more oil again. Of course, a lot of above ground events will bear on the ultimate reality and those things are unpredictable.
Despite my guess that oil will drop below $100, perhaps below $90, and despite my guess that the U.S. economy may decline a lot further given that weaker consumers spending numbers have only just started to appear, I still own a lot of stocks. It seems counter intuitive, if not just plain dumb. The reason is that the companies I own are well positioned to prosper regardless of the economy and are selling at very cheap prices I believe. Plus, you never know when that cavalry might show up.
The Alternative Future
A few basic truths are becoming clear to the market:
1. The enormous transfer of wealth from OECD to oil producing countries is unsustainable and the political will to turn that situation around by transitioning away from oil in transportation is being developed,
2. A major part of the long term solution is going to be the electric or plug in hybrid electric vehicle, and
3. Batteries of one sort or another will be a key enabling technology. They’ll be NiMH and lithium-ion batteries to start and will eventually evolve into ultracapacitors or other solutions using new technologies that are yet to be known.
Therefore, as I began to discuss in last month’s letter, I have begun to implement an investment focus on batteries in several ways. One is buying small positions in many companies that make and develop batteries. I intend to watch their stock and operating performance closely. A list of such companies - among other interesting information - can be found at EnergyTeckStocks. My sense is that the stocks will tell us which companies are developing the winning technologies long before we see public announcements.
Another is to maintain a strong position in SQM, which is the largest lithium supplier in the world. I may take smaller positions in more speculative lithium operations. Clearly, we are a few years away from major changes in lithium usage based on vehicle batteries but SQM has come well off its highs, it’s other businesses are very strong with good growth prospects unrelated to the global economy, and I think the stock will be a leader when the market turns around.
Another strategy is to own non-Chinese rare earth element mining companies. One of the rare earth elements, lanthanum, is essential for NiMH batteries. China has been the nearly exclusive provider of lanthanum and is now starting to cut back on its export. New suppliers are coming to market over the next two years including two that are public. My sense is that these companies may be very successful. I do not have large positions but I am prepared to add to them if and when the market shows interest. I’ve written about this in several posts that can be located by clicking on the “batteries” link in the left hand column of the home page.
Finally, I have begun to nibble at electric utilities. Some analysts have said that the current underutilized (off peak) capacity of the existing electric grid could power 80% of the cars in America with no additional need for more electricity generating or distribution capacity. I have no idea if the real number is 80% or 40% - but it is probably very significant. The idea is that people will charge their cars at night when a lot of electric capacity is idle. It will be some time before there are enough plug in hybrids or EV’s on the road to make a difference to electric utilities but eventually it seems that the electric utilities could become significant beneficiaries of a transition to electric transportation. Meanwhile, in this god-awful market the utilities may not be a bad alternative to cash.
So that’s it. Hang on for a big opening tomorrow on the back of the new Fanny and Freddie “certainty.” Will it staunch the hedge fund liquidation selling and mark the start of the recovery or be a temporary relief rally? Keep your eye on housing prices.