I am very skeptical of OPEC’s ability to actually curtail production. OPEC agreed on Wednesday to cut production by 1.2 million barrels per day and bring the ceiling of production to 32.5 million barrels. Oil prices rallied almost 15% on the news, as the market was not prepared for this outcome. Chatter before the meeting had been that cuts were unlikely. I’m doubtful this price move means anything, other than the fact that punters in the crude oil market got caught offside.
First, Indonesia “suspended” their membership in OPEC. Production of crude in Indonesia has been declining for years. They failed to reinvest in their fields and now are a net crude oil importer. They had already suspended their membership once, and according to the EIA, “The government's annual crude oil and lease condensate production target, which has not been reached each year since 2009, is 825,000 b/d for 2015, revised down from an original goal of 900,000 b/d.”
Second, lets parse this statement, “Hence, it is under the principles of good faith that countries participating in today’s meeting agree to commit themselves to the following actions:” So under principles of “good faith” there is going to be an agreement amongst . . . wait for it. . . . Russia, Saudi Arabia, Iran, and Iraq and others to cut their production. Further, the good folks in Algeria, Kuwait, and Venezuela are going to monitor compliance of the agreement. Granted, there are no tools to enforce compliance, but you know, you may not get invited to the next indoor ski event in Dubai if you break the rules.
Meanwhile, many of these countries are running massive budget deficits. Iran and Saudi Arabia are waging a proxy war in Yemen AGAINST each other. Iran in fact got to increase production a little, which comes right out of Saudi Arabia’s 486k barrels a day of production cut. Plus, Russian Oil Minister Alexander Novak say they would cut “gradually”, but they did not say from what level. Venezuela, one of our “reliable” monitors, is on the verge of civil society breakdown. The debt in its state run oil company, PDVSA, trades at 36 cents on the dollar. People are without food and medicine. Yet, don’t worry, they are going to kick in 95k barrels a day in adjustments. That’s a cool $5,000,000 a day in much needed hard currency. That could buy a lot of rice and beans for starving children. But don’t worry, they are in. Saudi Arabia just had to tap the bond market for financing for the first time ever to avoid raiding the sovereign wealth funds.
Plus, what’s up with the blank lines from Libya and Nigeria in the report? This is important. I mean, Nigeria produces 1.9 million barrels a day and Libya produces 250k barrels a day. Do they just get a free ride? Nigerian production is down 15% yoy due to domestic issues with terrorist blowing up pipelines and such. If they just got back to their normal rate of 2.3 million barrels, that would negate the Saudi cut. Libya, before all hell broke loose, would produce 1.3 million barrels on a good day.
Anyway, the short term effect worked. Hopefully, these exporters are out their locking in all their sales for next year at the higher prices, because I can tell you, in the next 6 months, this won’t matter. Why? First, US Shale oil power is rising. Geologist just found THE LARGEST NEW RESERVE EVER in the US.
The Midland Basin of the Wolfcamp Shale area in the Permian Basin is now estimated to have 20 billion barrels of oil and 1.6 billion barrels of natural gas, according to a new assessment by the USGS.
Plus, Exxon Mobil found a large find in Nigeria, with 500 million to a 1 billion barrels. Oh, and they found a big one in Guyana as well (right next to Venezuela btw), for another potential 1.4 billion barrels. Exxon Mobil is not in OPEC nor is the United States for our oil novices.
The move can be seen on the Pre and Post Announcement Crude Oil curve below. Front dated oil moved up significantly. This is where the futures traders and speculators mainly play. However, it seems producers used this as an opportunity to lock in higher prices. The longer dated part of the curve is actually lower post OPEC. Likely they used the volume in the market to their benefit.
The power of Shale has provided the US what years of Middle East invasions, US supported dictators, and arms sells could not. The US is now essentially energy independent. Without a society of people to care for with our oil revenues, the US can plow the earnings from oil back into making our drilling technologies more efficient, cleaner, and more cost effective. Plus, with a plethora of private US producers, investment allocations can be made in extremely rational manner, not by some State Oil gorilla like PDVSA, Saudi Aramco, or Petrobras which tend to breed popular mistrust and corruption. US producers will find a way to squeeze down the marginal production cost of oil.
Anyway, all I’m saying is, I’m cynical on another major boost in oil prices. I don’t necessarily think there will be a big drop again either, I just think its dead money for now. If you can make money at $30 a barrel, then do that investment. If you are counting on $60 or $70, stay away. Demand for oil is weak due to slow global growth and rising fuel efficiency standards (most of the major auto companies plan to release electric vehicles in the next 5 years). China fed the great oil rally from 2003 to 2012. Now with their own debt overhang, they won’t likely be the ones to grow global oil demand. Perhaps India could, but they don’t have the infrastructure to support a car for every citizen. That is years away.
Supply is abundant, and we have some cracked out countries desperate for more US Dollar revenue to support their regimes. The fact is, OPEC countries, to some degree, support a society of people dependent on oil. See this chart which shows the fiscal dependence of Oil countries.
These countries have failed to provide education and job opportunities. They’ve propped up ruling dynasties by handing out subsidies to vast swaths of the population. Without profits from crude oil, they are toast. Their promises cannot be trusted and their motives are simple. Support prices and try to maintain control of your population. With US Shale now a global force in the oil market, the Cartel's soft power is significantly eroded. The stone age didn’t end with the world running out of stones. The oil age will not end with it running out of oil. Buyer beware.
Over the weekend, both the NY Times and the WSJ reported on capital flows into and out of China. The NY times reports on the Shenzen Connect, which is a system that makes it much easier for global investors to invest in the Chinese equivalent of the NASDAQ. Meanwhile, the WSJ reported on new capital controls that makes it harder for money to leave. “Targeted for particular scrutiny by the pending measure are “extra-large” foreign acquisitions valued at $10 billion or more per deal, property investments by state-owned firms above $1 billion and investments of $1 billion or more by any Chinese company in an overseas entity unrelated to the investor’s core business,” according to the WSJ Report.
This is a pretty easy jigsaw puzzle to piece together. China is encouraging money to come into the country and discouraging money to leave the country. China is trying to solve for the fact that the country is living in a bubble of magnanimous proportions. Onshore equity markets carry nose bleed valuations. Real Estate markets continue to visit new highs, reversing a cooling off period in 2015. With banks in the region offering low returns on deposits, there are few places in China for rational money to park. Plus, with the corruption crackdown and threats to punish non-conforming citizens, any respectable multi-millionaire would feel safer with his money in a country such as the US with good rule of law.
As the below figure shows, Chinese foreign buyers are increasingly the largest group purchasing homes in the US. Over the weekend, I had a conversation with a well-connected Chinese American who says Chinese buyers are desperate for high end real estate in the US, which they see as both a store of value and potentially as a crash pad should they need to leave the country. Hostile rhetoric from President-Elect Trump will not help this situation. China is trying to stop the flow of money out of the country and increase the flow into the country. It’s unlikely that international investors will take the bait. The Shenzen Composite index trades at a 45 P/E ratio and offers a measly .68% dividend yield, compared to a 31 P/E and 1.24% dividend for the NASDAQ. Throw in better safeguards for intellectual property, rule of law, and 200 plus years of democracy, and its easy to see why the US looks more appealing to the Chinese investors than their own market.
Figure 1: From the WSJ
Today's US employment cost index showed a significant gain for Q1 of 2015, at 2.6% YoY. Labor markets are getting tighter and we are seeing this show up in wage inflation. Better late than never. In addition, US yield curves are finally reacting to this trend. Still, 10 year yields look rich vs the risk of higher inflation driven by wage gains.
Interesting long term study of the affects of activism linking it to returns of stocks.
Hedge Fund Activism, Corporate Governance, and Firm Performance
Alon Brav, Wei Jiang, Frank Partnoy, and Randall Thomas*
Using a large hand-collected dataset from 2001 to 2006, we find that activist hedge funds in the U.S. propose strategic, operational, and financial remedies and attain success or partial success in two thirds of the cases. Hedge funds seldom seek control and in most cases are nonconfrontational. The abnormal return around the announcement of activism is approximately 7%, with no reversal during the subsequent year. Target firms experience increases in payout, operating performance, and higher CEO turnover after activism. Our analysis provides important new evidence on the mechanisms and effects of informed shareholder monitoring.
The capital raising environment for hedge funds is as challenging as ever, and hedge funds that are looking to attract institutional investors (currently the largest source of investor dollars) will have to develop the institutional qualities that institutional investors are looking for. The regulatory environment is also more onerous than ever, and a hedge fund that is of institutional quality will be in a better position to successfully navigate the ever increasing regulatory burdens.
The term “institutional quality” is used to describe a hedge fund (and the hedge fund manager (“HFM”) that manages the hedge fund) that has a mix of characteristics that institutional investors require before making an allocation. These characteristics include: (i) a well-developed investment management infrastructure; (ii) a robust compliance regime; (iii) a robust operational platform that meets international standards; (iv) top service providers; and (v) a strong risk management program.
Investors will use the operational due diligence (“ODD”) process at the beginning (and during the life of the relationship) to determine whether a hedge fund is of institutional quality. Similarly, regulators will use the exam process to determine whether a HFM has the correct processes and controls in place to manage the associated risks in running their business and to ensure that the hedge fund is compliant with the relevant regulatory rules of the jurisdictions in which they are domiciled and transact in. Investment The failure to pass either of these tests will significantly inhibit the HFM’s ability to raise capital. Thus, one of the most important responsibilities of the HFM is to ensure that it can effectively and efficiently meet the requirements imposed on it by investors (the continuing ODD process) and regulators (the inevitable exam process).
This one powerful trend could lower personal and corporate tax rates in America, help balance budgets, keep corporations onshore, and limit the power of Russian and Sunni Extremist.
In today's NY Times, Thomas Friedman writes:
The way you defeat such an enemy is by being “crazy like a fox,” says Andy Karsner, the former assistant energy secretary in the last Bush administration and now the C.E.O. of Manifest Energy. “We have one bullet that hits both of them: bring down the price of oil. It’s not like they can suddenly shift to making iWatches.” We are generating more oil and gas than ever, added Karsner, and it’s a global market. Absurdly, he said, the U.S. government bans the export of our crude oil. “It’s as if we own the world’s biggest bank vault but misplaced the key,” added Karsner. “Let’s lift that export ban and have America shaping the market price in our own interest.”
But that must be accompanied by tax reform that puts a predictable premium on carbon, ensuring that we unite to consistently invest in clean energies that take us beyond fossil fuels, increase efficiency and address climate change. Draining our enemies’ coffers, enhancing security, taxing environmental degradation — what’s not to like? And if we shift tax revenue to money collected from a carbon tax, we can slash income, payroll and corporate taxes, incentivize investment and hiring and unleash our economic competitiveness. That is a strategy hawks and doves, greens and big oil could all support.
To read the whole article, go to http://www.nytimes.com/2014/09/07/opinion/sunday/tom-friedman-leading-from-within.html?smid=tw-share
Learning from a true maverick. Michael Burry gives great advice to the class of 2014 about learning and trust. Worth the 20 minutes.
For those that need to know pretty much everything about hedge fund investing, check out this manual published by AIMA and DB. This is required reading in our firm.
The WSJ writes that Africa is showing more promise as an investment destination for fixed income investors as democraticly elected governments and western economic policies sweep through the region.
High growth, high interest rates attract investors put off by low growth and low rates in the developed and increasinly emerging market world.
Seeders and managers are advocating smaller funds as candidates for outperformance in the current markets, at a time the industry's largest managers are handing back money to investors.
Jeroen Tielman, CEO and founder of hedge fund incubator IMQubator, highlighted research from data monitors PerTrac showing small funds with assets of under $100m have outperformed rivals holding over $500m in 13 of the last 16 years.
Additionally, funds started within two years of a measurement point had cumulative returns of 827% since 1996, far outpacing the 350% from funds that were more than four years old.
In my reading this weekend, I found some very interesting articles on deposit flight in the EU. The below chart looks at Target 2 imbalances within the EU. I'm not going to go into detail about what these are, but generally, they represent the movement of capital from peripherial countries to the core, namely Germany.
The Mastricht Treaty allows for the free flow of goods, labor, and capital through the EU. The cheapest form of insurance an EU citizen outside of Germany can buy to protect themselves is to move their money out of the weak countries into the strong countries. This helps them avoid risks that their bank becomes insolvent and that their deposits get redenominated into new currencies other than the euro.
This material is from the FT. To read more, go to http://blogs.ft.com/gavyndavies/2012/05/20/the-anatomy-of-the-eurozone-bank-run/#axzz1vVX27kRH
Also, Wolfgang Manchau has a great post about these issues as well. http://www.ft.com/intl/cms/s/0/5d7ff324-a0e6-11e1-9fbd-00144feabdc0.html#axzz1vVWqEfZm. Proposed solutions to these problems include:
A) A eurowide deposit insurance scheme which separates the bank risk from the national risk. Spanish banks are suffering due to the preceived risk of the Spanish Government Guarnantee. If you were to mutualize the risk, meaning that all the EU guarantees the deposits rather than just the national governments, this could slow the deposit flight.
B) The ideal situaiton would be to inject equity into all the "Too Big to Fail" European banks. I think following the US playbook on this would make sense. Force all the banks to take equity in the form of a Mandatory Preferred issued to the EFSF or ESM or both. Give the banks some breathing room to earn back some capital and pay back the preferreds over time when/if the system is more stable.
The key issue here is that the banking system is broken, like late 2008 in the US. If the plumbing isn't working, the whole system risks coming to a stop. European leaders must address this issue now or risk a severe financial accident.
We intend to use this as a resouce for us to share interesting material we find relavent to our investment process.