Peak Oil - Bullish News from the Russian Bear

In an article in today's Financial Times, Carola Hoyos and Javier Blas quote a senior executive at Lukoil as stating that Russian oil production has peaked. Some of those refuting the peak oil thesis have been pointing to the vast reserves of Russia as a source of higher future production. It will be important to keep an eye on export data from the large producers over the next few years as their domestic demand continues to increase while supply stagnates.

From the article:

"Leonid Fedun, the 52-year-old vice-president of Lukoil, Russia’s largest independent oil company, told the Financial Times he believed last year’s Russian oil production of about 10m barrels a day was the highest he would see 'in his lifetime'. Russia is the world’s second biggest oil producer.

Mr Fedun compared Russia with the North Sea and Mexico, where oil production is declining dramatically, saying that in the oil-rich region of western Siberia, the mainstay of Russian output, 'the period of intense oil production [growth] is over'.

The Russian government has so far admitted that production growth has stagnated, but has shied away from admitting that post-Soviet output has peaked.

Viktor Khristenko, Russia’s energy minister who is pushing for tax cuts that could stimulate investment, said last week: 'The output level we have today is a plateau, stagnation.'

Russia was until recently considered as the most promising oil region outside the Middle East. Its rapid output growth in the early 2000s helped to meet booming Chinese demand and limited the rise in oil prices."

The trend, however, has turned, with supply dropping below year-ago levels for the first time this decade, according to the International Energy Agency, the energy watchdog."

Wachovia's "Solid Underlying Performance"

From Wachovia's earnings release this morning:

"While solid underlying performance was overshadowed by market disruption- related valuation losses of $2.0 billion..."

This just isn't genuine. In just the past quarter, the company reported a 93% increase in its provision for credit losses and net charge-offs jumped 66%. The allowance for loan losses as a percent of loans has been steadily climbing the past few quarters (1.37% this quarter, .98% last quarter, and .78% in the prior quarter). However, the allowance for loan losses as a percent of nonperforming assets has actually been falling. I'd love an explanation for this. I suspect the company is still not adequately reserved.

To his credit, CEO Ken Thompson did state that he was deeply disappointed with the results, so this certainly isn't some whitewash sugar coating. But to talk about "solid underlying performance" is misleading. The charge-offs and provisioning that the company is taking now are a reflection of bad loans the company issued in prior quarters and years. Essentially, the earnings for those prior periods were overstated. You can't just talk about how strong the business is if you ignore the bad loans. This is a bank! They make loans! That's their business!

It's like a doctor touting what a terrific surgeon he is - if you ignore all the patients who died.

Stiglitz and the Charmin Prescription

Recession Watch - Consumer Sentiment

The latest reading of the University of Michigan Consumer Sentiment Index is the lowest we've seen since the early 80's when inflation was soaring and Volcker was busy jacking up the Fed funds rate to 19%.

At least Bernanke is now talking about the chance of a recession. The talking heads are almost always behind the curve. The issue isn't whether we're in a recession but rather how long and deep it will be.

The only reason there's been any debate at all as to whether we've been in a recession is because of the manipulation of inflation statistics by the government. The real GDP figures reported by the government are overstated due to their ridiculously low calculation of inflation. The lower the inflation figure, the higher the reported real GDP.

Consumption accounts for about 70% of U.S. economic activity, and the U.S. consumer is clearly in retrenchment mode. I expect this recession will be longer and/or deeper than the consensus view. Therefore, it's likely still too early to bottom fish in the consumer discretionary sector.

Ricing Frustrations

To think, I was actually a little tweaked that the cost of my Bran Flakes was 30 cents higher on my last shopping trip.

This link offers a number of brief videos from the BBC on the global rice shortage. According to the United Nations Food and Agriculture Organisation (FAO), 37 countries are facing a food crisis, and food riots have broken out in several African countries, Indonesia, the Philippines and Haiti.

The beauty of investing in commodities is that there are relatively few variables that need to be monitored and no company-specific factors to worry about. Price boils down to supply and demand. Currently, with many agricultural commodities we are seeing demand increase due to increasing populations, a rising middle class in parts of the the developing world, and new demand for ethanol. Supply hasn't kept pace.

When we look at the US Department of Agriculture's figures for rice, we find that this supply-demand imbalance has led to a decline in global rice stocks from a peak of 130 million tonnes in 2000-2001 to 72 million tonnes in 2007-2008, the lowest level since 1983-84. According to the same report, nearly half of the world's 6.6 billion people are dependent on rice and are already eating more than is harvested yearly. The price of rice on the Chicago Board of Trade has doubled in the past year.

In response, governments are curbing rice exports in an attempt to keep prices down and bolster local supply. To the extent that they're instituting price controls they're taking away incentive for farmers to expand planting, and the limiting of exports is leading to crises in import-dependent countries like the Philippines. Consumers are hoarding rice as well, furthering the supply crisis.

Clearly, demand has been outstripping supply (as with many commodities). The key will be to look for the inflection point. There's a huge incentive these days (where prices are not constrained) to put even marginal land back into farm service. Pests, disease, and weather are always wild-cards, but the incentive to plant is there. The question is whether this will result in a narrowing of the supply-demand gap.

The fertilizer companies continue to be well-positioned and should be a key beneficiary again this year. I continue to like this space, but I'll be watching the supply figures carefully.

In the meantime, I'll be expanding my pantry and hoarding my Bran Flakes.

Mortgage Cheats

An April 9th article by Ernest Istook of The Heritage Foundation entitled "Will Your Tax Dollars Go To Mortgage Cheats?" is worth a read.

Brief excerpts:
"By some estimates, borrower fraud accounts for most of the mortgage crisis now troubling the nation. It was certainly abetted by dishonest brokers. But just as honest taxpayers should not be expected to bail out dishonest brokers, so they shouldn't be expected to bail out dishonest borrowers."

"Greater than the financial threat to America is the moral threat of a bailout. What's next? Paying off car loans for those who were 'seduced' by a glib salesman? How about those who bought a bigger TV or a more powerful stereo system than they could afford? Where will this practice end of treating dishonest or incautious consumers as victims?"

A Fed Chairman Worth Listening To

I don't agree with all of his views, but Paul Volcker is the best Federal Reserve Chairman this country has seen. He understood the role of the Fed, the importance of its independence, and he wasn't afraid to administer some much needed but politically unpopular medicine to this country as Chairman of the Fed from 1979 to 1987. Greenspan and Bernanke look like confused, spineless, political, patsies next to this guy. He's always worth a listen. The following is his April 8th speech to the Economic Club of New York:

Bloomberg Video of Volcker speech

Chocolate and Beer - Part 2

To recap Part 1, financial regulation failed miserably to recognize or prevent the current credit crisis and actually played an integral role in creating and fostering the credit bubble. Most politicians, regulators, and pundits are using this failure as an excuse to expand that which just failed - regulation. Unfortunately, our policymakers are far too busy trying to look “responsible” and “proactive” to actually expend any effort examining the role the regulators themselves played in creating the current debacle or questioning whether less regulation may actually be the better policy. I’m accustomed to being on the unpopular side of many arguments, and this one is no different.

I’ve been reading quite a bit lately from all corners that the current credit crisis is proof of the failure of free market economics. This is laughable since we’ve hardly been operating in a free market system. When it comes to the financial markets, we have many organizations involved in the regulation and manipulation of our markets, our financial institutions, our money supply, our interest rates, etc. Despite all of this, we are facing the largest financial crisis since the Great Depression. It’s important to understand that regulation has been prevalent and growing for many decades. Yet, here we are.

Then how may things have transpired in a truly free market? Most importantly, moral hazard would not be an issue if the free market had been in operation. Basically, moral hazard means that people will be less cautious if they know they’ll be bailed out. Bailing out is exactly what the Fed under Greenspan did repeatedly, and it’s exactly what the Fed under Bernanke is doing currently. It’s also what the federal government does when it passes legislation to bail out certain constituents. Financial actors aren’t stupid. Greedy? Yes. Stupid? No. They’ve realized for some time now that the Fed and government were effectively putting a floor under the financial markets (LTCM, Asian currency crisis, tech bubble). The Fed repeatedly demonstrated that it was willing to aggressively intervene during relatively modest financial dislocations. In such a world, the obvious course of action is to lever up as much as possible and swing for the fences. Heads you win, tails you don’t lose.

In a free market, the issue of moral hazard disappears because no one gets bailed out. There is no Federal Reserve, or Treasury or Congress standing ready to lower rates, print money, and use taxpayer dollars to “rescue” the imprudent. The losers fail. They go away. Long-Term Capital Management would not have been bailed out. The Fed would not have guaranteed $30 billion of questionable Bear Stearns assets. The strong prosper. The weak fail. A strong signal is sent to all market participants that there is a significant and definable downside to taking too much risk. This signaling has unfortunately been overridden by the regulators/politicians in our increasingly quasi-capitalistic system of democratic socialism.

It’s important to recognize that government and regulatory intervention in our markets has led to ever larger bubbles, misallocations of capital, and financial dislocations. Without the Fed manipulating interest rates and the money supply, ever-larger serial bubbles would not have been blown, the money supply would not have been so grossly inflated, inflation would be less of a threat (by definition), and the dollar wouldn’t be nearly so weak. We can recognize all of this, but we can’t go back and undo what’s already occurred. Given that fact and given the crisis we’re currently in, what might we expect from a free market from this point forward if regulation were magically eliminated today? The following are just a few reasonable realistic possibilities:

• Development of better risk models and more focus on risk management
• More aversion to and higher risk premia for complicated security structures
• Increased competition in the credit-rating market resulting ultimately in better analysis and modeling
• Insolvent financial institutions would be allowed to fail
• Increased financial statement disclosure
• More accountability for evaluating risk at all levels of distribution
• Credit-rating agencies being compensated by investors rather than by the companies they rate
• A strong call for financial institutions to increase their capital position
• A continuing trend of deleveraging
• Mortgage originators retaining more security exposure to better ensure adequate underwriting standards
• Opportunists taking advantage of illiquid markets to buy securities at deep discounts to their intrinsic value
• Unwinding of and more sensitivity to counterparty arrangements
• Development of more standardized derivative contracts and clearing arrangements
• A better and more symmetrical alignment of executive compensation with longer-term shareholder goals
• More critical analysis of credit insurer strength
• Clearer and more robust mortgage terms disclosure
• Fewer no-doc or low-doc mortgages and/or higher spreads on them
• Less opaque securitizations

All of these things would be healthy for the market and would lead to a strengthening of our financial system. Some variation of many of these suggestions as well as others can be expected to occur over the next 5 years without any government intervention simply due to the demands of various financial market constituents. None of this requires government intervention.

Now let’s look at just a few examples of free market success so far in this current crisis. First is the entry of Warren Buffett into the municipal bond insurance business. This is exactly what we’d expect to see - a strong player with extensive capital and an excellent reputation entering a failed industry that didn’t adequately price its insurance or assess its risk. Other individuals and firms are also exploring entering this market. Should we use taxpayer dollars to support the incumbents (for example, MBIA, SCA, and ABK) to the detriment of the newer and stronger players? No. The free market is filling the void and will be doing so with better risk modeling and a stronger capital position.

When asset prices finally start to adequately price in risk, liquidity tends to surface. For example, on April 1 Blackstone Group LP raised a record $10.9 billion to invest in property. It was also recently reported that another opportunity fund, Dallas-based Lone Star Funds, is raising up to $10 billion to invest in real estate. Lone Star managing partner John Grayken recently told the Oregon Investment Council, ``This is as good a distressed environment as we've seen in a long time. It's a race among a number of different lenders to play this.'' This week, we also learned that Citigroup is close to unloading $12 billion of bad loans to a group of private-equity firms at 90 cents on the dollar.

There are many other examples of capital being raised. UBS recently raised another $15 billion. Lehman raised $4 billion. Washington Mutual is raising $7 billion. Sovereign Wealth Funds (SWFs) have tossed about another $70 billion into investment banks over the past year. The point is that when prices fall enough to adequately (or more than adequately) discount the risk, private funding is made available. Capitalism does work (when allowed). The quicker this process unfolds the better for the financial system and the economy. The bailout efforts by the Fed and the government are simply dragging out this price-discovery process and delaying the eventual economic recovery. Of course, others could argue that this money is only forthcoming now because of the steps that the Fed has already taken. My contention, however, is that Fed actions have been hindering and delaying the price-discovery process, keeping asset prices higher than warranted, and therefore keeping further private funding from entering the market and prolonging the correction. Granted, it's impossible to know which view is correct since we can't rewind and play it twice.

We don’t need the government to “bail out” the market, but we’re going to get it, so let’s be clear about what a government bailout means. It means the government is stealing. They’re stealing from those who were prudent – those who bought a house and selected a mortgage that they could afford, those who have been living beneath or within their means, and those who decided to save versus play. The government is using these stolen funds to support/bailout/rescue/benefit/enrich those who speculated on rising home prices, those who gambled on always being able to refinance at low rates, those who took on too much debt, those who have lived beyond their means, and the millionaires running our financial institutions. If you’re in the former group, you should be irate. The government won’t be sending you a bill directly, but they will be increasing their borrowing and increasing the money supply during this bailout. You will suffer the depreciation of your dollar assets and higher inflation as a result.

What would I like to see the Fed/government do? Put their hands back in their own pockets, get out of the way, and sit down with a nice big cup of coffee and a copy of the Constitution (to be read – not to be used as a coaster). Let the market do its job - liquidate the bad debt and the imbalances that have occurred and eliminate the ubiquity of moral hazard. It’s healthy, and it’s in the long-term best interests of our country.

If only the government could bail out common sense.

Chocolate and Beer - Part 1

I admit it. The title is a little misleading. I’m actually going to discuss financial market regulation, but I wanted you to at least get past the title. Regulation is the dentist office of the financial world – nobody really wants to go there. In the mid-90’s, I was an MBA student at the University of Chicago. They have a bidding system for classes, and I was saving a bunch of points to bid on Merton Miller’s class. He was a Nobel Prize winner, and he only taught one class each year, so I was sure the class would cost me. The topic of the class was financial regulation, but he was a Nobel Prize winner! Amazingly, the class didn’t cost me a point since the class didn’t fill up – only about 20 of us signed up. So, I know that this isn’t the most exciting topic. If a Nobel Prize winner can’t fill a small class, I realize I probably lost most of you by the second sentence. No matter. I’ll soldier on if for no other reason than to spare my wife.

The chatter about the failure of the free market and capitalism has been steadily increasing as has the call for increased financial market regulation. This is hardly surprising given the news of the past six months: credit markets seizing up, rising foreclosure rates, the failure of the rating agencies, the collapse of Bear Stearns and a number of hedge funds, mortgage origination and appraisal improprieties, tumult in the “safe” muni market, etc. Furthermore, it’s an election year and you’d better show leadership and be full of ideas if you’re running for President. Time to put the baby down and draft some legislation.

So it’s no surprise that the call for increased regulation is on the rise, but I find it a bit ironic. The current credit bubble was caused, in some part, by regulation itself. Let’s start with the Federal Reserve, arguably the most prominent regulator of the financial system. Under Greenspan, the Fed rarely hesitated to cut rates in an attempt to forestall any whiff of a slowdown or financial dislocation. This came to be known as the Greenspan Put. Greenspan repeatedly and effectively placed a floor under the markets by lowering interest rates and increasing the money supply at any hint of instability (think Long-Term Capital Management and the tech bubble collapse). This encouraged risky behavior. The thinking was straightforward. If you take a big risk and you’re right, you win. If you take a big risk and you’re wrong, the Fed bails you out. It didn’t take long for folks to figure out that it paid to take risk. The Fed was distorting the real relationship between risk and reward and causing an ever greater misallocation of resources as normal market signals were subverted. This encouraged an increasing amount of risk to be taken with each cycle of easing. The low interest rates and increased money supply ultimately found its way to the housing market, resulting in the biggest housing (and credit) bubble we’ve ever seen. I’m not saying the Fed is singularly responsible for causing the bubble, but it did play an important part.

Another example of the role that regulatory interference has played in our current crisis is the effective oligopoly that the SEC (a regulator) has given to a handful of credit-rating agencies. These credit-rating agencies essentially faced no competition, and they made their money by charging fees to the very companies they were rating – an obvious conflict of interest. It’s not exactly clear to me why the SEC should even be involved in controlling the entry of new competitors. Had a free market allowed for the entry of new competitors we would have been much more likely to have seen some evolution in the relationship and incentive structure between the credit agencies, the firms they evaluate, and the investors who ultimately purchase the securities. We would also have been more likely to have seen some evolution in the risk models that somehow managed to bestow AAA ratings upon the Frankensteinian brew of mortgage-crapped securities known as collateralized debt obligations (CDOs). Eventually, people will learn that 1+1 does not equal 3. Let’s not forget that these are the same rating agencies that also managed to miss the fact that Enron, Worldcom, and Adelphia were frauds. So our regulators protected a few credit-rating firms (which had just recently shown their tremendous failings a few years prior) from contending with new competition. We need more of that?

Don’t forget about Fannie Mae and Freddie Mac. As the nation’s primary buyers and guarantors of mortgages, they had a front row seat to the excesses in the real estate market. Importantly, these two quasi-governmental agencies are highly regulated by the Office of Federal Housing Enterprise Oversight (OFHEO). According to their website, OFHEO’s mission is to “promote housing and a strong national housing finance system by ensuring the safety and soundness of Fannie Mae and Freddie Mac. OFHEO works to ensure the capital adequacy and financial safety and soundness of two housing government-sponsored enterprises (GSEs)…” Wow. Ensuring the safety and soundness? Ensure capital adequacy? In light of Freddie and Fannie’s deteriorating balance sheet and capital position, OFHEO hasn't been terribly effective. We need more of this?

Let’s not kid ourselves. There was plenty of regulation before this latest crisis. Yes, it’s true that the financial institutions were employing strategies and creating securities to move assets off-balance sheet and out of the purview of the regulators, but everyone knew that they were doing this – including the regulators. Where were all the warnings from the regulators about this? Where were the warnings from the regulators about the markets/firms/securities they did oversee? The fact is that all parties, including the regulators, knew what was going on, but everyone chose to ignore it since it seemed to be working. When it comes to derivatives, Greenspan himself had said "these instruments enhance the ability to differentiate risk and allocate it to those investors most able and willing to take it." So, seriously, had the regulators been in charge of regulating even these non-regulated instruments would anything have played out differently? The Chief Regulator himself was a fan!

The objective of this article is simply to look at just a few examples of the role the regulators have played in the current crisis. My main point is that we had plenty of regulation already, and it failed. Depending on how you look at it, it appears the regulators were either asleep at the switch, accomplices, or negligent. They failed to forestall the current crisis, and, in fact, pursued polices that (at a minimum) exacerbated it. Despite this, we’re hearing calls for more regulation. We’re hearing that existing regulation failed because there wasn’t enough of it, and it wasn’t structured properly, and it didn’t have enough bite. Do we really think that more government bureaucrats are the answer? It might help the faltering national employment figures, but is it really the solution? Don’t these folks get something like 150 days off a year? No wonder they’ve been so ineffective.

We’re also hearing that the free market failed. The fact is that we were never operating in a free market in the first place. A truly free market isn’t encumbered by all of these regulations. A truly free market doesn’t have an elite body of 12 setting short-term interest rates. A truly free market doesn’t use taxpayer dollars to bail out banks which made bad bets or homeowners who took on more of a mortgage than they could handle. A truly free market doesn’t struggle with the issue of moral hazard because it lets the losers fail. I know this may sound crazy given the current fear and fervor in the markets and political arena, but here’s my prescription – less regulation and more accountability. I’ll follow up on this in Part 2.

UBS and The Market Rally

We’re off to an interesting start to the second quarter. Swiss banking giant UBS reported that it will be taking a $19 billion write-down and about a $12 billion net loss for the first quarter. This is on top of last quarter’s roughly $12.5 billion loss. $24 billionish gone in two quarters. So how far down is the stock right now? Well, it’s actually up 14%. Sounds like a bad April Fool’s joke. Too bad they didn’t write-off $40 billion – their stock might be up 30%!

So what’s going on here? First off, they’ve announced the resignation of their Chairman. You lose $20+ billion in 6 months you should probably lose your job. More importantly, the company claims to have substantially reduced its exposure to real-estate-related assets (subprime exposure fell to $15 billion from $27.6 billion last quarter) and will create a new wholly-owned unit to hold its remaining illiquid real-estate assets. UBS also said that it will be raising $15 billion of new capital, after having just raised $13 billion in February.

What does this all mean, and why is this stock and the market moving higher? Clearly, the market wants to believe that the company (as well as the financial industry) has put the worst of the credit crisis behind it and that there will be minimal future write-offs and plenty of additional capital raised. The fact that UBS is able to raise another $15 billion is also seen as a bullish sign since this would have proven difficult (at least on reasonable terms) if their balance sheet was too ugly. Finally, the bank’s Tier 1 capital will remain at a fairly healthy level for the time being following the capital raise.

As for moving the remaining exposure to a separate wholly-owned firm, UBS may be doing this to enable it to sell the entire lot at one time to a single buyer versus piece-meal in the open market. It seems that whether that happens or not, this move will allow UBS to "focus" investors on its “core” business since these poorly-performing assets will be segregated.

With the additional news that Lehman is also raising capital and that Morgan Stanley has further reduced its exposure to bad assets, it seems investors are eager to sound the all-clear and jump back into financials and equities in general. Is the worst really behind us? Was that it? From peak to trough the S&P 500 fell about 20% in 6 months - quite a bit less than the two-year 50%ish drop following the bursting of the tech bubble and relatively mild as far as bear markets go.

This credit bubble is the biggest bubble we’ve ever seen in dollar terms and in terms of breadth. Far more people are affected by falling home prices and rising mortgage payments than falling stock prices (although the combination is pretty lethal), and far more people are more dangerously over-extended when it comes to credit now than we’ve ever seen. Little of the damage we’ve seen so far has come from the obvious slowing of the economy. We still have that to look forward to.

Furthermore, although equity valuation isn’t as rich as it was at the start of the last bear market, the current P/E on the 2008 S&P 500 estimated reported earnings is still about 20x. Future returns are rarely exciting when starting from such an elevated level. It's also very likely that earnings estimates for the balance of the year are still over-stated and need to come down, particularly given the difficulties in the financial and consumer sectors. Weak personal income growth, rising foreclosures, a struggling financial industry, higher inflation, a lack of ready access to cheap capital, rising/high commodity input prices, and high equity valuation is hardly the recipe for a new and powerful bull market.

Given all of these issues, the odds that the crisis is over appears to remain low. Even if we’ve seen the lows in the market (which I doubt), it’s hard to imagine that we’re off to the races again. Bear markets are marked by intermediate and short-term rallies. These are called dead-cat bounces and sucker rallies. Look back to the 2000-2002 period. You see a number of 10-20% rallies during that bear market. I strongly suspect that what we’re seeing lately is another dead-cat bounce, just like we saw this past November and January. As the market becomes short-term oversold on strong negative sentiment almost any news short of Armageddon gets interpreted positively. That’s in part why a $19 billion write-down can result in an 14% rise in your stock.

We’ve been due for a nice rally. Markets don’t move in just one direction. Sentiment was so bad it had to improve - at least temporarily. I wouldn’t be surprised to see this rally continue a bit, but it should face a stiff headwind as companies start reporting first quarter earnings in a couple of weeks. I expect to see fairly cautious guidance from companies on the balance of the year and earnings estimates being reined in. I would be very hesitant to chase the market during this rally. However, the long-term thesis for commodities/precious metals is still attractive, and the recent pullback in this sector is healthy and is likely providing a nice opportunity to nibble.