The gritty potential of Fire Ice – Saviour or Scourge?

The gritty potential of Fire Ice – Saviour or Scourge?

400dpiLogo

Macro Letter – No 80 – 30-06-2017

The gritty potential of Fire Ice – Saviour or Scourge?

  • Estimates of Methane Hydrate reserves vary from 10,000 to 100,000 TCF
  • 100,000 TCF of Methane Hydrate could meet global gas demand for 800 years
  • Cost of extraction is currently above $20/mln BTUs but may soon fall rapidly
  • Japan METI estimate production costs falling to $7/mln BTUs over the next 20 years

On June 6th Japan’s Ministry of Economy, Trade and Industry (METI) announced the Resumption of the Gas Production Test under the Second Offshore Methane Hydrate Production Test this is what they said:-

Concerning the second offshore methane hydrate production test, since May 4, 2017, ANRE has been advancing a gas production test in the offshore sea area along Atsumi Peninsula to Shima Peninsula (Daini Atsumi Knoll) using the Deep Sea Drilling Vessel “Chikyu.” However, on May 15, 2017, it decided to suspend the test due to a significant amount of sand entering a gas production well.

In response, ANRE advanced an operation for switching the gas production wells from the first one to the second one for which a different preventive measure against sand entry is in place. Following this effort, on May 31, 2017, it began a depressurization operation and, on June 5, 2017, confirmed the production of gas.

Sand flowing into the well samples has been a gritty problem for the Agency for Natural Resources and Energy – ANRE since 2013. They continue to invest because Japan relies on imports for the majority of its energy needs, especially since the reduction in nuclear capacity after the Tōhoku earthquake and tsunami in 2011. It has been in the vanguard of research into the commercial extraction of Methane Hydrate or ‘Fire Ice’ as it is more prosaically known.

Methane hydrates are solid ice-like crystals formed from a mixture of methane and water at specific pressure in the deep ocean or at low temperature closer to the surface in permafrost. For a primer on Methane Hydrate and its potential, this November 2012 article from the EIA – Potential of gas hydrates is great, but practical development is far off – may be instructive but a picture is worth a thousand words:-

Methane Hydrate diagram - EIA

Source: US Department of Energy

During the last two months there have been some important developments. Firstly the successful extraction of gas by the Japanese, albeit, they have run into the problem of sand getting into the pipes again, which poses an environmental risk. Secondly China has successfully extracted gas from Methane Hydrate deposits in the South China Sea. This article from the BBC – China claims breakthrough in mining ‘flammable ice’ provides more detail. The Chinese began investment in Fire Ice back in 2006, committing $100mln, not far behind the investment commitments of Japan.

Japan and China are not alone in possessing Methane Hydrate deposits. The map below, which was produced by the US Geological Survey, shows the global distribution of deposits:-

Methane_Hydrate_deposits_-_USGS_-_2011

Source: US Geological Survey

For countries such as Japan, South Korea and India, Methane Hydrate could transform their circumstances, especially in terms of energy security.

Estimates of global reserves of Methane Hydrate range from 10,000 to 100,000trln cubic feet (TCF). In 2015 the global demand for natural gas was 124bln cubic feet. Even at the lower estimate that is 80 years of global supply at current rates of consumption. This could be a game changer for the energy industry.

The challenge is to extract Methane Hydrate efficiently and competitively. Oceanic deposits are normally found at depths of around 1500 metres. Even estimating the size of deposits is difficult in these locations. Alaskan and Siberian permafrost reserves are more easily assessed.

Japan has spent $179mln on research and development but last week METI announced that they would now work in partnership with the US and India. The Nikkei – Japan joining with US, India to tap undersea ‘fire ice’ described it in these terms, the emphasis is mine:-

Under the new plan, Japan will end its lone efforts and pursue cooperation with others. The country has been spending tens of millions of yen per day on its tests. By working with other nations, it seeks to reduce the cost.

A joint trial with the U.S. to produce methane hydrate on land in the state of Alaska is expected to begin as early as next year. Test production with India off that country’s east coast may also kick off in 2018.

The new blueprint will define methane hydrate as an alternative to liquefied natural gas. Based on the assumption that Japan will be paying $11 to $12 per 1 million British thermal units of LNG in the 2030s to 2050s, the plan will set the target production cost for methane hydrate over the period at $6 to $7.

In the shorter term METI hope to increase daily production from around 20,000 cubic metres/day to around 56,000 cubic metres/day which they believe will bring the cost of extraction down to $16/mln BTUs. That is still three times the price of liquid natural gas (LNG).

Here is the latest FERC estimate of landed LNG prices/mln BTUs:-

LNG_prices_-_May_17_FERC

Source: Waterborne Energy, Inc, FERC

You might be forgiven for wondering why the Japanese, despite being the world’s largest importer of LNG, are bothering with Methane Hydrate, but this chart from BP shows the evolution of Natural Gas prices over the last two decades:-

bp-statsreview

Source: BP

Japan was squeezed by rising fuel costs between 2009 and 2012 only to be confronted by the Yen weakening from USDJPY 80 to USDJPY 120 from 2012 to 2014. If Abenomics succeeds and the Yen embarks upon a structural decline, domestically extracted Methane Hydrate may be a saviour.

Cooperating internationally also makes sense for Japan. The US launched a national research and development programme in 1982. They have deep water pilot projects off the coast of South Carolina and in the Gulf of Mexico as well as in the permafrost of the Alaska North Slope.

Technical challenges

As deep sea drilling technology advances the cost of extraction should start to decline but as this 2014 BBC article – Methane hydrate: Dirty fuel or energy saviour? explains, there are a number of risks:-

Quite apart from reaching them at the bottom of deep ocean shelves, not to mention operating at low temperatures and extremely high pressure, there is the potentially serious issue of destabilising the seabed, which can lead to submarine landslides.

A greater potential threat is methane escape. Extracting the gas from a localised area of hydrates does not present too many difficulties, but preventing the breakdown of hydrates and subsequent release of methane in surrounding structures is more difficult.

And escaping methane has serious consequences for global warming – recent studies suggest the gas is 30 times more damaging than CO2.

Given the long term scale of the potential reward, it may seem surprising that the Japanese have only invested $179mln to date, however these projects have been entirely government funded.  Commercial operators are waiting for clarification of the cost of extraction and size of viable reserves before entering the fray. Most analysts suggest commercial production is unlikely before 2025. With the price of Natural Gas depressed, development may be delayed further but in the longer term Methane Hydrate will become a major global source of energy. Like the fracking revolution of the past decade, it is only a matter of when.

The history of fracking can be traced back to 1862 and the first patent was filed in 1865. In the case of Fire Ice, I do not believe we will have to wait that long. Deep sea mining and drilling technologies are advancing quickly in several different arenas. The currently depressed price of LNG is only one factor holding back the development process.

Conclusions and investment opportunities

Predicting the timing of technological breakthroughs is futile, however, the US energy sector is currently witnessing a resurgence in profitability. In their June 16th bulletin, FactSet Research estimated that Q2 profits for the S&P500 will rise 6.5%. They go on to highlight the sector which has led the field, Energy, the emphasis is mine:-

At the sector level, nine sectors are projected to report year-over-year growth in earnings for the quarter. However, the Energy sector is projected to report the highest earnings growth of all eleven sectors at 401%.

This sector is also expected to be the largest contributor to earnings growth for the S&P 500 for Q2 2017. If the Energy sector is excluded, the estimated earnings growth rate for the index for Q2 2017 would fall to 3.6% from 6.5%.

The price of Brent Crude Oil has been falling but the previous investment in technology combined with some aggressive cost cutting in the recent past has been the driving force behind this spectacular increase in Energy Sector profitability. Between 2014 and 2016 Energy Sector capital expenditure fell nearly 40%. I expect a rebound in capex over the next couple of years. It may be too soon for this to spill over to commercial investment in Methane Hydrate, but developments in Japan and China during the past two months suggest a breakthrough may be imminent. The next phase of investment may be about to begin.

Russia – Will the Bear come in from the cold?

400dpiLogo

Macro Letter – No 67 – 9-12-2016

Russia – Will the Bear come in from the cold?

  • In 2015/16 the Russian economy suffered in the sharpest recession since 2008/09
  • The RTSI Stock Index, anticipating a recovery, is up 78% from its January lows
  • Russian government bonds traded at 8% in August down from 16% in December 2014
  • The Ruble has stabilised after the devaluation of 2014/2015 and inflation is still falling

Since January many emerging equity and bond markets have staged a spectacular recovery. Russia has been among the winners, buoyed by hopes of an end to international sanctions and a, relative, rapprochement with the new US administration. A near-virtuous circle is achieved when combined with the country’s strengthening trade relationship with China and the rising oil price, stemming from the first OPEC production agreement in eight years.

Looking at the RTSI Index, a lot of this favourable news is already in the price:-

rtsi_2016_-_moscow_exchange

Source: Moscow Exchange

Since January the RTSI has rallied by 78% and, at 1082 is close to the highs of May 2015 (1092) from whence it broke down to the lows of January (607). Is it too late to join the party? A longer-term chart lends perspective:-

rtsi-1995-2016

Source: Tradingview

By a number of other metrics Russian stocks still look inexpensive. The chart below compares stock market capitalisation to GDP:-

russia-mktcap-to-gdp-guru-focus

Source: Guru Focus

The current ratio is 20%, the average over the period since 2000 is 65% – return to mean would imply a 19.25% annual return for Russian stocks over the next eight years. That would equate to a compound return of 409%.

The table below shows the P/E Ratios of four Russian ETFs as of 8th December:-

Symbol Name P/E Ratio
RSXJ VanEck Vectors Russia Small-Cap ETF 6.07
ERUS iShares MSCI Russia Capped ETF 7.33
RBL SPDR S&P Russia ETF 7.72
RSX VanEck Vectors Russia ETF 8.73

Source: EFTdb.com

For comparison, the iShares MSCI BRIC ETF (BKF) currently trades on a PE of 10 times.

Bonds, Inflation and the Ruble

Russian inflation has been declining rapidly this year as the sharp devaluation of 2014/2015 feeds through. The two charts below shows the USDRUB (black – RHS) and Russian CPI (blue – LHS) and Russian 10 year Government bonds (blue – LHS) versus CPI (black – RHS):-

russia-inflation-cpi-and-usdrub-1-1-14-to-8-12-16

Source: Trading Economics

russia-government-bond-yield-and-cpi-1-1-14-to-8-12-16

Source: Trading Economics

Whilst the Ruble has stabilised at a structurally higher level than prior to the annexation of the Crimea, the inflation rate has been brought back under control by the hawkish endeavours of the Central Bank of Russia. The benchmark one-week repo rate remains at 10%, down from 17% in December 2014 but still well above the rate of inflation – which the Central Bank of Russia forecast to fall to 4% by the end of next year. The yield curve remains inverted but that has not always been a structural feature of the Russian market. The chart below compares the one week repo rate (black – RHS) versus 10yr Government bonds (blue – LHS):-

russia-government-bond-yield-vs-interest-rate-2003-2016

Source: Trading Economics

Economics and Politics

The IMF WEO – October 2016 revised its GDP forecast for Russia in 2017 to +1.1% (versus +0.1% in July) although they revised their 2016 estimate to -0.8% from +0.4%. Focus Economics poll of analysts, forecast 1.2%, whilst Fathom Consulting’s Global Economic Strategic asset Allocation Model (GESAM) is predicting +0.8. Between 1996 and 2016 the average rate of GDP growth was 3.08%. As the chart below shows, the growth rate has been volatile and, like many countries globally, the post 2008/2009 period has been more subdued:-

russia-gdp-growth-annual

Source: Trading Economics, Federal Statistics Service

Oil and Gas

Russia’s largest export markets are Netherlands 11.9%, China 8.3% and Germany 7.4%. Their main exports are oil and gas. The chart below shows the price of Russian gas at the German border over the last 15 years:-

russian_gas_15_year-indexmundi

Source: Indexmundi

Whilst this may be good news for European consumers it has led to considerable political tension. Russia is developing a new gas pipeline – Nord Stream 2 – which will double Russia’s gas export capacity and avoid the geographic obstacle of the Ukraine. It is scheduled to be operational in 2019.

However the EU is developing another gas pipeline – the Southern Gas Corridor, avoiding Russian territory, which is scheduled to be operational in 2020 – to diversify their sources of supply. The Carnegie Moscow Centre – Gazprom’s EU Strategy Is a Dead End – December 6th 2016 takes up the story:-

The EU points out that Ukraine has never violated its gas transit obligations, while Russia shut off the tap during some of the coldest days in 2006 and 2009, and then sharply cut the volume of exports to Europe in late 2014, each time for political reasons. Brussels believes that the real threat to European energy security is not Ukraine but rather the unpredictability of Russian authorities.

US LNG exports are slowly increasing but producers are expected to focus on meeting demand from Japan and other parts of Asia, where prices are higher, first. The Colombia SIPA Center on Global Energy Policy – American Gas to the Rescue – September 2014 – made the following observations which still hold true:-

Although US LNG exports increase Europe’s bargaining position, they will not free Europe from Russian gas. Russia will remain Europe’s dominant gas supplier for the foreseeable future, due both to its ability to remain cost-competitive in the region and the fact that US LNG will displace other high-cost sources of natural gas supply. In our modeling we find that 9 billion cubic feet per day (93 billion cubic meters per year) of gross US LNG exports results in only a 1.5 bcf/d (15 bcm) net addition in global natural gas production. 

By forcing state-run Gazprom to reduce prices to remain competitive in the European market, US LNG exports could have a meaningful impact on total Russian gas export revenue. While painful for Russian gas companies, the total economic impact on state coffers is unlikely to be significant enough to prompt a change in Moscow’s foreign policy, particularly in the next few years.

Oil is a more global market and the 29th November OPEC production agreement, the first that OPEC members have signed in eight years, should help to stabilise global prices – that is assuming that OPEC members do not cheat. Russia, although not a member of OPEC, agreed to reduce production by 300,000 bpd. Russia had just achieved record post-soviet production of 11.1mln bpd in September, they have room to moderate their output:-

rusian-oil-production-2005-2016-bloomberg-energy-ministry

Source: Bloomberg, Russian Energy Ministry

Prospects for 2017

In 2015 tax from oil and gas amounted to 52% of Russian receipts – a stabilisation of the oil price will be a significant fiscal boost next year. Russia has been far from profligate since 2008, it runs a trade and current account surplus and, although the government is in deficit to the tune of 2.6% of GDP this year, the government debt to GDP ratio is a very manageable 17.17%.

Looking ahead to 2017 Brookings – The Russian economy inches forward – highlights a number of features which support optimism for the future:-

…the country seems to have turned the corner and growth is expected to be positive in 2017-2018. One key reason is that over the last two years, the government’s policy response package of a flexible exchange rate policy, expenditure cuts in real terms, and bank recapitalization—along with tapping the Reserve Fund—has helped buffer the economy against multiple shocks.

…The banking sector has also now largely stabilized. The consolidated budget of regional governments even registered a surplus in the first eight months of 2016. Indeed, on the back of projected rising oil prices, we expect the economy to enter positive territory in 2017 and 2018, reaching 1.5-1.7 percent.

With a growing federal fiscal deficit (3.7 percent of GDP by end 2016), one proactive step the government has taken is to reintroduce a three-year, medium-term fiscal framework, which proposes to cut the deficit by about 1 percent each year ultimately leading to a balanced budget by 2020. The budget is conservatively costed at a $40 per barrel oil price, and cuts are driven mostly by a reduction in expenditures in mostly defense/military and social policy. If adhered to, this medium-term framework will be an important step toward reducing overall policy uncertainty. 

China (and India)

In the longer term a major focus of Russian economic policy has, and continues to be, the development of trade with China. The first Russo-Chinese partnership agreements were signed in 1994 and 1996, followed by the Treaty of Friendship and Cooperation in 2001 and the Strategic Partnership in 2012 which was superseded by a further agreement in 2014 – signed by President Xi. Ratified shortly after the annexation of the Crimea and imposition of sanctions by the US and EU, the latest agreement has substance. Here are some of the more prominent deals which have emerged from the closer cooperation:-

  • Gazprom and China National Petroleum Corporation (CNPC) announced a 40 year gas supply deal, including plans to build the “Power of Siberia” gas pipeline.
  • Rosneft agreed to supply CNPC with $500bln of oil, potentially making Russia, China’s largest supplier of oil, surpassing Saudi Arabia. The Eastern Siberia-Pacific Ocean oil pipeline will be connected to Northeast China next year and a pipeline linking Siberia’s Chayandinskoye oil and gas field to China comes online in 2018.
  • The Central Bank of Russia signed a RUB 815bln swap agreement with the PBoC to boost bilateral trade. They had previously contracted business in US$.

The Diplomat – Behind China and Russia’s ‘Special Relationship’ – investigates the impact this new cooperation is beginning to have:-

…Russia has become one of the five largest recipients of Chinese outbound direct investment in relation to the Chinese government’s Belt and Road Initiative (BRI) connecting Asia with Europe. Meanwhile, China was Russia’s largest bilateral trade partner, in 2015; in spite of declining overall bilateral trade in U.S. dollar terms (mainly due to sharp declines in the ruble as well as the yuan), relative to 2014, trade flows continued to expand in terms of volume.

In this context, it was significant that Russia’s exports of mechanical and technical products to China rose by about 45 percent over the course of 2015 possibly signifying an important trend in the diversification and competitiveness of Russia’s non-energy sector in terms of bilateral trade prospects with China.

The Diplomat goes on to highlight the improved and increasing importance of Russian trade with India:-

The Russia-India-China (RIC) trilateral grouping is considered by its participants as an important arrangement in securing political stability, both globally and in the region. India and Russia’s relations have remained strong for several decades, with Russia being India’s largest defense and nuclear energy partner. However, while China’s and Russia’s relations have clearly improved in the last few years, the China-India relationship has somewhat lagged the development of the other two legs of the triangle. Consequently, Russia has played a role in bringing both sides closer together through its interactions in the RIC grouping.

The Trump Card?

US pre-election rhetoric from the Trump campaign suggested a less combative approach to Russia. Trump said he would “look into” recognising Crimea and removing sanctions, however, Republican hawks in Congress will want to have their say. Syria may be the key to a real improvement in relations – don’t hold your breath.

Conclusion and Investment Opportunities

The Ruble has stabilised and whilst Russia has some external debt the amount is not excessive. The effect of the devaluation of 2014/2015 has run its course and inflation is forecast to decline further next year. It may weaken against the US$ in line with other countries but is likely to be range-bound, with a potential upward bias, against its major trading partners.

The Central Bank of Russia has maintained tight grip short term interest rates, leaving it room to reduce rates, perhaps, as soon as Q1 2017. Russian government bond yields halved since their highs of 16% in late 2014, but have risen by around 60bp since August following the trend in other global bond markets. With short term interest rates set to decline, the inversion of the yield curve is likely to unwind, but this favours shorter dated, lower duration bonds – there is also a risk of forced liquidation by international investors, if US and other bond markets should decline in tandem.

The Russian stock market has already factored in much of the positive economic and political news. The OPEC deal took shape in a series of well publicised stages. The “Trump Effect” is unlikely to be as significant as some commentators hope. The ending of sanctions is the one factor which could act as a positive price shock, however, the Russian economy has suffered a severe recession and now appears to be recovering of its own accord. The VanEck Vectors Russia Small-Cap ETF (RSXJ) has very little exposure to oil and gas and therefore reflects a less commodity-centric aspect of the Russian economy. The chart below covers the five years since 2011. It has risen further than the major indices since January yet still trades at a lower PE ratio:-

rsxj-index-yahoo

Source: Yahoo Finance

Like the RTSI Index the small-cap ETF looks over-bought, however, the economic recovery in Russia appears to be broad-based, Chinese growth, in response to further fiscal stimulus, has increased and the oil price has (at least for the present) stabilised around $50/bbl. If you do not have exposure to Russia, you should consider an allocation. There may be better opportunities to buy, but waiting for trends to retrace can leave you feeling like Tantalus. The last two bull-markets – January 2009 to March 2011, and July 2004 to May 2008 – saw the RTSI Index rally 315% and 382% respectively. In the aftermath of the Russian crisis of 1998 the index rose from 61 to 755 in less than six years (1,138%). Don’t be shy but also keep some power dry.

Saudi Arabian bonds and stocks – is it time to buy?

400dpiLogo

Macro Letter – No 64 – 28-10-2016

Saudi Arabian bonds and stocks – is it time to buy?

  • Saudi Arabia issued $17.5bln of US$ denominated sovereign bonds – the largest issue ever
  • Saudi Aramco may float 5% of their business in the largest IPO ever
  • The TASI stock index is down more than 50% from its 2014 high
  • OPEC agreed to cut output by 640,000 to 1,140,000 bpd

The sovereign bond issue

The Saudi Arabia’s first international bond deal raised $17.5bln. They tapped the market across the yield curve issuing 5yr, 10yr and 30yr bonds. The auction was a success – international investors, mostly from the US, placed $67bln of bids. The issues were priced slightly higher than Qatar, which raised $9bln in May, and Abu Dhabi, which issued $2.5bln each of 5yr and 10yr paper in April.

The Saudi issue appears to have been priced to go, as the table below, showing the basis point spread over US Treasuries, indicates. According to the prospectus the Kingdom of Saudi Arabia (KSA) want to tap the US$ sovereign bond market extensively in the future, raising as much as $120bln; attracting investors has therefore been a critical aspect of their recent charm offensive:-

Issuer 5yr Spread 10yr Spread 30yr Spread Bid to Cover
Saudi Arabia 135 165 210 3.82
Qatar 120 150 210 2.56
Abu Dhabi 85 125 N/A 3.4

Source: Bloomberg

The high bid to cover ratio (3.8 times) enabled the Kingdom to issue $2.5bln more paper than had been originally indicated: and on better terms – 40bp over, higher rated, Qatar rather than 50bp which had been expected prior to the auction.

The bonds immediately rose in secondary market trading and other Gulf Cooperation Council (GCC) issues also caught a bid. The Saudi issue was also unusual in that the largest tranche ($6.5bln) was also the longest maturity (30yr). The high demand is indicative of the global quest for yield among investors. This is the largest ever Emerging Market bond issue, eclipsing Argentina’s $16.5bln offering in April.

The Aramco IPO

Another means by which the Kingdom plans to balance the books is through the Saudi Aramco IPO – part of the Vision 2030 plan – which may float as much as 5% of the company, worth around $100bln, in early 2018. This would be four times larger than the previous record for an IPO set by Alibaba in September 2014.

An interesting, if Machiavellian, view about the motivation behind the Aramco deal is provided by – Robert Boslego – Why Saudi Arabia Will Cut Production To Achieve Vision 2030:-

As part of the implementation of this plan, Saudi Aramco and Shell (NYSE:RDS.A) (NYSE:RDS.B) are dividing up their U.S. joint venture, Motiva, which will result in Saudi’s full ownership of the Port Author refinery. Aramco will fully own Motiva on April 1, 2017, and has been in talks of buying Lyondell’s Houston refinery.

I suspect Motiva may also purchase U.S. oil shale properties (or companies) that are in financial trouble as a result of the drop in prices since 2014. According to restructuring specialists, about 100 North American oil and gas companies have filed for bankruptcy, and there may be another 100 to go. This would enable Aramco to expand market share as well as control how fast production is brought back online if prices rise.

By using its ability to cut production to create additional spare capacity, Aramco can use that spare capacity to control prices as it wishes. It probably does not want prices much above $50/b to keep U.S. shale production to about where it is now, 8.5 mmbd. And it doesn’t want prices below $45/b because of the adverse impact of such low prices on its budget. And so it will likely adjust its production accordingly to keep prices in a $45-$55/b range.

Conclusions

Although I authored a series of articles stating that OPEC was bluffing (and it was), I now think that Saudi Arabia has formulated a plan and will assume the role of swing producer to satisfy its goals. It can and will cut unilaterally to create excess spare capacity, which it needs to control oil prices.

This will make the company attractive for its IPO. And by selling shares, Aramco can use some of the proceeds to buy U.S. shale reserves “on the cheap,” not unlike John D. Rockefeller, who bankrupted competitors to acquire them.

The Saudi’s long-term plan is to convert Aramco’s assets into a $2 trillion fund, which can safely reside in Swiss banks. And that is a much safer investment than oil reserves in the ground subject to external and internal political threats.

Whatever the motives behind Vision 2030, it is clear that radical action is needed. The Tadawul TASI Stock Index hit its lowest level since 2011 on 3rd October at 5418, down more than 50% from its high of 11,150 in September 2014 – back when oil was around $90/bbl.

As a starting point here is a brief review of the Saudi economy.

The Saudi Economy

The table below compares KSA with its GCC neighbours; Iran and Iraq have been added to broaden the picture of the oil producing states of the Middle East:-

Country GDP YoY Interest rate Inflation rate Jobless rate Gov. Budget Debt/GDP C/A Pop.
Saudi Arabia 1.40% 2.00% 3.30% 5.60% -15.00% 5.90% -8.2 31.52
Iran 0.60% 20.00% 9.40% 11.80% -2.58% 16.36% 0.41 78.8
UAE 3.40% 1.25% 0.60% 4.20% 5.00% 15.68% 5.8 9.16
Iraq 2.40% 4.00% 0.20% 16.40% -2.69% 37.02% -0.8 35.87
Qatar 1.10% 4.50% 2.60% 0.20% 16.10% 35.80% 8.3 2.34
Kuwait 1.80% 2.25% 2.90% 2.20% 26.59% 7.10% 11.5 3.89
Oman -14.10% 1.00% 1.30% 7.20% -17.10% 9.20% -15.4 4.15
Bahrain 2.50% 0.75% 2.60% 3.70% -5.00% 42.00% 3.3 1.37

Source: Trading Economics

In terms of inflation the KSA is in a better position than Iran and its unemployment rate is well below that of Iran or Iraq, but on several measures it looks weaker than its neighbours.

Moody’s downgraded KSA in May – click here for details – citing concern about their reliance on oil. They pointed to a 13.5% decline in nominal GDP during 2015 and forecast a further fall this year. This concurs with the IMF forecast of 1.2% in 2016 versus 3.5% GDP growth in 2015. It looks likely to be the weakest economic growth since 2009.

The government’s fiscal position has deteriorated in line with the oil price. In 2014 the deficit was 2.3%, by 2015 it was 15%:-

saudi-arabia-government-budget-1970-2016

Source: Trading Economics, SAMA

Despite austerity measures, including proposals to introduce a value added tax, the deficit is unlikely to improve beyond -13.5% in 2016. It is estimated that to balance the Saudi budget the oil price would need to be above $79/bbl.

At $98bln, the 2015 government deficit was the largest of the G20, of which Saudi Arabia is a member. According to the prospectus of the new bond issue Saudi debt increased from $37.9bln in December 2015 to $72.9bln in August 2016. Between now and 2020 Moody’s estimate the Kingdom will have a cumulative financing requirement of US$324bln. More than half the needs of the GCC states combined.  Despite the recent deterioration, Government debt to GDP was only 5.8% in 2015:-

saudi-arabia-government-debt-to-gdp-1999-2016

Source: Trading Economics, SAMA

They have temporary room for manoeuvre, but Moody’s forecast this ratio rising beyond 35% by 2018 – which is inconsistent with an Aa3 rating. Even the Saudi government see it rising to 30% by 2030.

The fiscal drag has also impacted foreign exchange reserves. From a peak of US$731bln in August 2014 they have fallen by 23% to US$562bln in August 2016:-

saudi-arabia-foreign-exchange-reserves-2010-2016

Source: Trading Economics, SAMA

Reserves will continue to decline, but it will be some time before the Kingdom loses its fourth ranked position by FX reserves globally. Total private and public sector external debt to GDP was only 15% in 2015 up from 12.3% in 2014 and 11.6% in 2013. There is room for this to grow without undermining the Riyal peg to the US$, which has been at 3.75 since January 2003. A rise in the ratio to above 50% could undermine confidence but otherwise the external debt outlook appears stable.

The fall in the oil price has also led to a dramatic reversal in the current account, from a surplus of 9.8% in 2014 to a deficit of 8.2% last year. In 2016 the deficit may reach 12% or more. It has been worse, as the chart below shows, but not since the 1980’s and the speed of deterioration, when there is no global recession to blame for the fall from grace, is alarming:-

saudi-arabia-current-account-to-gdp

Source: Trading Economics, SAMA

The National Vision 2030 reform plan has been launched, ostensibly, to wean the Kingdom away from its reliance on oil – which represents 85% of exports and 90% of fiscal revenues. In many ways this is an austerity plan but, if fully implemented, it could substantially improve the economic position of Saudi Arabia. There are, however, significant social challenges which may hamper its delivery.

Perhaps the greatest challenge domestically is youth unemployment. More than two thirds of Saudi Arabia’s population (31mln) is under 30 years of age. A demographic blessing and a curse. Official unemployment is 5.8% but for Saudis aged 15 to 24 it is nearer to 30%. A paper, from 2011, by The Woodrow Wilson International Center – Saudi Arabia’s Youth and the Kingdom’s Future – estimated that 37% of all Saudis were 14 years or younger. That means the KSA needs to create 3mln jobs by 2020. The table below shows the rising number unemployed:-

saudi-arabia-unemployed-persons-2008-2016

Source: Trading Economics, Central Department of Statistics and Economics

If you compare the chart above with the unemployment percentage shown below you would be forgiven for describing the government’s work creation endeavours as Sisyphean:-

saudi-arabia-unemployment-rate-2000-2016

Source: Trading Economics, Central Department of Statistics and Economics

Another and more immediate issue is the cost of hostilities with Yemen – and elsewhere. Exiting these conflicts could improve the government’s fiscal position swiftly. More than 25% ($56.8bln) of the 2016 budget has been allocated to military and security expenditure. It has been rising by 19% per annum since the Arab spring of 2011 and, according to IHS estimates, will reach $62bln by 2020.

The OPEC deal and tightness in the supply of oil

After meeting in Algiers at the end of September, OPEC members agreed, in principle, to reduce production to between 32.5 and 33mln bpd. A further meeting next month, in Vienna, should see a more concrete commitment. This is, after all, the first OPEC production agreement in eight years, and, despite continuing animosity between the KSA and Iran, the Saudi Energy Minister, Khalid al-Falih, made a dramatic concession, stating that Iran, Nigeria and Libya would be allowed to produce:-

…at maximum levels that make sense as part of any output limits.

Iranian production reached 3.65mln bpd in August – the highest since 2013 and 10.85% of the OPEC total. Nigeria pumped 1.39mln bpd (4.1%) and although Libya produced only 363,000 bpd, in line with its negligible output since 2013, it is important to remember they used to produce around 1.4mln bpd. Nigeria likewise has seen production fall from 2.6mln bpd in 2012. Putting this in perspective, total OPEC production reached a new high of 33.64mln bpd in September.

The oil price responded to the “good news from Algiers” moving swiftly higher. Russia has also been in tentative discussions with OPEC since the early summer. President Putin followed the OPEC communique by announcing that Russia will also freeze production. Russian production of 11.11mln bpd in September, is the highest since its peak in 1988. Other non-OPEC nations are rumoured to be considering joining the concert party.

Saudi Arabia is currently the largest producer of oil globally, followed by the USA. In August Saudi production fell from 10.67mln bpd to 10.63mln bpd. It rebounded slightly to 10.65mln bpd in September – this represents 32% of OPEC output.

There are a range of possible outcomes, assuming the OPEC deal goes ahead. Under the proposed terms of the agreement, production is to be reduced by between 1.14mln and 640,000 bpd. Saudi Arabia, as the swing producer, is obliged to foot the bill for an Iranian production freeze and adjust for any change in Nigerian and Libyan output. The chart below, which is taken from the Federal Reserve Bank of Dallas – Signs of Recovery Emerge in the U.S. Oil Market – Third Quarter 2016 make no assumptions about Saudi Arabia taking up the slack but it provides a useful visual aid:-

opec-secenario-dallas-fed

Source: EIA, OPEC, Dallas Fed

They go on to state in relation to US production:-

While drilling activity has edged up, industry participants believe it will be awhile before activity significantly increases. When queried in the third quarter 2016 Dallas Fed Energy Survey, most respondents said prices need to exceed $55 per barrel for solid gains to occur, with a ramp-up unlikely until at least second quarter 2017.

Assuming the minimum reduction in output to 33mln bpd and Iran, Nigeria and Libya maintaining production at current levels, Saudi Arabian must reduce its output by 300,000 bpd. If the output cut is the maximum, Iran freezes at current levels but Nigeria and Libya return to the production levels of 2012, Saudi Arabia will need to reduce its output by 623,000 bpd. The indications are that Nigeria and Libya will only be able to raise output by, at most, 500,000 bpd each, so a 623,000 bpd cut by Saudi Arabia is unlikely to be needed, but even in the worst case scenario, if the oil price can be raised by $3.11/bbl the Saudi production cut would be self-financing. My “Median” forecast below assumes Nigeria and Libya increase output by 1mln bpd in total:-

OPEC Cut ‘000s bpd KSA Cut ‘000s bpd KSA % of total OPEC Cut Oil Price B/E for KSA/bbl
Max 1,140 623 54.68% +$3.11
Median 890 422 47.41% +$2.06
Minimum 640 300 47.07% +$1.45

Source: OPEC

Many commentators are predicting lower oil prices for longer; they believe OPEC no longer has the power to influence the global oil price. This article by David Yager for Oil Price – Why Oil Prices Will Rise More And Sooner Than Most Believe – takes a different view. His argument revolves around the amount of spare capacity globally. The author thinks OPEC is near to full production, but it is his analysis of non-OPEC capacity which is sobering:-

…RBC Capital Markets was of the view oil prices would indeed rise but not until 2019. RBC says 2.2 million b/d of new non-OPEC production will enter the markets this year, 1.3 million b/d next year and 1.6 million b/d in 2018. Somehow U.S. production will rise by 900,000 b/d from 2017 and 2019 despite falling by 1.1 million b/d in the past 15 months and with rigs count at historic lows. At the same time RBC reported the 124 E&P companies it follows will cut spending another 32 percent in 2016 from 2015, a $US106 billion reduction.

…The Telegraph ran it under the title, “When oil turns it will be with such lightning speed that it could upend the market again”. Citing the lowest levels of oil discoveries since 1952, annual investment in new supplies down 42 percent in the past two years and how the International Energy Agency (IEA) estimates 9 percent average annual global reservoir depletion, the article stated, “…the global economy is becoming dangerously reliant on crude supply from political hotspots”. “Drillers are not finding enough oil to replace these (depletion) barrels, preparing the ground for an oil price spike and raising serious questions about energy security”.

Depletion of 9 percent per year is about 8.6 million b/d. Add demand growth and you’re approaching 10 million b/d. How do the crystal ball polishers of the world who see flat oil prices for the foreseeable future figure producers can replace this output when others report $US1 trillion in capital projects have been cancelled or delayed over the rest of the decade?

The last ingredient in the oil price confusion in inventory levels. OECD countries currently hold 3.1 billion barrels of oil inventory. That sounds like lot. But what nobody reports is the five-year average is about 2.7 billion barrels. Refinery storage tanks. Pipelines. Field locations. Tankers in transit. It’s huge. The current overhang is about 6 days of production higher than it has been for years, about 60 days. So inventories are up roughly 10 percent from where they have been.

Obviously this is going to take a change in the global supply/demand balance to return to historic levels and will dampen prices until it does. But don’t believe OECD inventories must go to zero.

…The current production overhang suppressing markets is only about 1 million b/d or less depending upon which forecast you’re looking at. Both the IEA (Paris) and the EIA (Washington) see the curves very close if they haven’t crossed already. Neither agency sees any overhang by the end of the next year.

…OPEC has no meaningful excess capacity. Non-OPEC production is flat out and, in the face of massive spending cuts, is more likely to fall than rise because production increases will be more than offset by natural reservoir depletion.

Since this article was published OECD inventories have declined a fraction. Here is the latest EIA data:-

  2014 2015 2016 2017
Non-OPEC Production 55.9 57.49 56.84 56.94
OPEC Production 37.45 38.32 39.2 40.07
OPEC Crude Oil Portion 30.99 31.76 32.45 33.03
Total World Production 93.35 95.81 96.04 97.01
OECD Commercial Inventory (end-of-year) 2688 2967 3049 3073
Total OPEC surplus crude oil production capacity 2.08 1.6 1.34 1.21
OECD Consumption 45.86 46.41 46.53 46.6
Non-OECD Consumption 46.69 47.63 48.8 50.07
Total World Consumption 92.55 94.04 95.33 96.67

Source: EIA

Whether or not David Yager is correct about supply, the direct cost to Saudi Arabia, of a 623,000 bpd reduction in output, pales into insignificance beside the cost of domestic oil and gas subsidies – around $61bln last year. Subsidies on electricity and water add another $10bln to the annual bill. These subsidies are being reduced as part of the Vison 2030 austerity plan. The government claim they can save $100bln by 2020, but given the impact of removing subsidies on domestic growth, I remain sceptical.

The Kingdom’s domestic demand for crude oil continues to grow. Brookings – Saudi Arabia’s economic time bomb forecast that it will reach 8.2mln bpd by 2030. By some estimates they may become a net importer of oil by their centenary in 2032. Saudi oil reserves are estimated at 268bln bbl. Her gas reserves are estimated to be 8.6trln M3 (2014) but exploration may yield considerable increases in these figures.

The Kingdom is also planning to build 16 nuclear power stations over the next 20 years, along with extensive expansion of solar power generating capacity. Improvements in technology mean that solar power stations will, given the right weather conditions, produce cheaper electricity than gas powered generation by the end of this year. This article from the Guardian – Solar and wind ‘cheaper than new nuclear’ by the time Hinkley is built – looks longer term.

According to EIA data US production in July totalled 8.69mln bpd down from 9.62mln bpd in March 2015. A further 200,000 bpd reduction is forecast for next year.

The table below, which is taken from the IEA – Medium Term Oil Market Report – 2016suggests this tightness in supply may last well beyond 2018:-

iea_mtomr_-_global_balance_2016

Source: IEA – MTOMR 2016

According to Baker Hughes data, US rig count has rebounded to 443 since the low of 316 at the end of May, but this is still 72% below its October 2014 peak of 1609. This March 2016 article from Futures Magazine – How quickly will U.S. energy producers respond to rising prices? Explains the dynamics of the US oil industry:-

Crude oil produced by shale made up 48% of total U.S. crude oil production in 2015, up from 22% in 2007 according to the Energy Information Administration (EIA), which warns that the horizontal wells drilled into tight formations tend to have very high initial production rates–but they also have steep initial decline rates. Some wells lose as much as 70% of their initial production the first year. With steep decline rates, constant drilling and development of new wells is necessary to maintain or increase production levels. The problem is that many of these smaller shale companies do not have the capital nor the manpower to keep drilling and keep production going.

This is one of the reasons that the EIA is predicting that U.S. oil production will fall by 7.4%, or roughly 700,000 barrels a day. That may be a modest assessment as we are hearing of more stress and bankruptcies in the space. The EIA warns that with the U.S. oil rig count down 76% since the fall of 2014, that unless capital spending picks up, the EIA says that U.S. oil production will keep falling in 2017, ending up 1.2 million barrels a day lower than the 2015 average at 8.2 million barrels a day.

The bearish argument that shale will save the day and keep prices under control does not fit with the longer term reality. When more traditional energy projects with much slower decline rates get shelved, there is the thought that the cash strapped shale producers can just drill, drill. Drill to make up that difference is a fantasy. The problem is that while shale may replace that oil for a while, in the long run it can never make up for the loss of projects that are more sustainable.

OPEC might just have the whip hand for the first time in several years.

The chart below, taken from the New York Federal Reserve – Oil Price Dynamics Report – 24th October 2016 – shows how increased supply since 2012 has pushed oil prices lower. Now oversupply appears to be abating once more; combine this with the inability of the fracking industry to “just drill” and the reduction in inventories and conditions may be ripe for an aggressive short squeeze:-

ny-fed-oil-supply-demand-imbalance-oct-24th-2016

Source: NY Federal Reserve, Haver Analytics, Reuters, Bloomberg

But, how sustainable is any oil price increase?

Longer term prospects for oil demand

commodity-crude-oil-9-92014-to-18-10-2016

Source: Trading Economics

In the short term there are, as always, a plethora of conflicting opinions about the direction of the price of oil. Longer term, advances in drilling techniques and other technologies – especially those relating to fracking – will exert a downward pressure on prices, especially as these methods are adopted more widely across the globe. Recent evidence supports the view that tight-oil extraction is economic at between $40 and $60 per bbl, although the Manhattan Institute – Shale 2:0 – May 2015 – suggests:-

In recent years, the technology deployed in America’s shale fields has advanced more rapidly than in any other segment of the energy industry. Shale 2.0 promises to ultimately yield break-even costs of $5–$20 per barrel—in the same range as Saudi Arabia’s vaunted low-cost fields.

These reductions in extraction costs, combined with improvements in fuel efficiency and the falling cost of alternative energy, such as solar power, will constrain prices from rising for any length of time.

Published earlier this month, the World Energy Council – World Energy Scenarios 2016 – The Grand Transitionpropose three, very different, global outlooks, with rather memorable names:-

  1. Modern Jazz – digital disruption, innovation and market based reform
  2. Unfinished Symphony – intelligent and sustainable economic growth with low carbon
  3. Hard Rock – fragmented, weaker, inward-looking and unsustainable growth

They go on to point out that, despite economic growth – especially in countries like China and India – global reliance on fossil fuels has fallen from 86% in 1970 to 81% in 2014 – although in transportation reliance remains a spectacular 92%. The table below shows rising energy consumption under all three scenarios, but an astonishing divergence in its rise and source of supply, under the different regimes:-

Scenario – 2060 % increase in energy consumption % reliance on oil Transport % reliance on oil
Modern Jazz 22 50 67
Unfinished Symphony 38 63 60
Hard Rock 46 70 78

Source: World Energy Council

The authors expect demand for electricity to double by 2060 requiring $35trln to $43trln of infrastructure investment. Solar and Wind power are expected to increase their share of supply from 4% in 2014 to between 20% and 39% dependent upon the scenario.

As to the outlook for fossil fuels, global demand for coal is expected to peak between 2020 and 2040 and for oil, between 2030 and 2040.

…peaks for coal and oil have the potential to take the world from stranded assets predominantly in the private sector to state-owned stranded resources and could cause significant stress to the current global economic equilibrium with unforeseen consequences on geopolitical agendas. Carefully weighed exit strategies spanning several decades need to come to the top of the political agenda, or the destruction of vast amounts of public and private shareholder value is unavoidable. Economic diversification and employment strategies for growing populations will be a critical element of navigating the challenges of peak demand.

The economic diversification, to which the World Energy Council refer, is a global phenomenon but the impact on nations which are dependent on oil exports, such as Saudi Arabia, will be even more pronounced.

Conclusion and investment opportunities

As part of Vision 2030 – which was launched in the spring by the King Salman’s second son, Prince Mohammed bin Salman – the Saudi government introduced some new measures last month. They cancelled bonus payments to state employees and cut ministers’ salaries by 20%. Ministers’ perks – including the provision of cars and mobile phones – will also be withdrawn. In addition, legislative advisors to the monarchy have been subjected to a 15% pay cut.

These measures are scheduled to take effect this month. They are largely cosmetic, but the longer term aim of the plan is to reduce the public-sector wage bill by 5% – bringing it down to 40% of spending by 2020. Government jobs pay much better than the private sector and the 90/90 rule applies –that is 90% of Saudi Arabians work for the government and the 10% of workers in the private sector are 90% non-Saudi in origin. The proposed pay cuts will be deeply unpopular. Finally, unofficial sources claim, the government has begun cancelling $20bln of the $69bln of investment projects it had previously approved. All this austerity will be a drag on economic growth – it begins to sound more like Division 2030, I anticipate social unrest.

The impact of last month’s announcement on the stock market was unsurprisingly negative – the TASI Index fell 4% – largely negating the SAR20bln ($5.3bln) capital injection by the Saudi Arabian Monetary Agency (SAMA) from the previous day.

Saudi Bonds

Considering the geo-political uncertainty surrounding the KSA, is the spread over US Treasuries sufficient? In the short term – two to five years – I think it is, but from a longer term perspective this should be regarded as a trading asset. If US bond yield return to a more normal level – they have averaged 6.5% since 1974 – the credit spread is likely to widen. Its current level is a function of the lack of alternative assets offering an acceptable yield, pushing investors towards markets with which many are unfamiliar. KSA bonds do have advantages over some other emerging markets, their currency is pegged to the US$ and their foreign exchange reserves remain substantial, nonetheless, they will also be sensitive to the price of oil.

Saudi stocks

For foreign investors ETFs are still the only way to access the Saudi stock market, unless you already have $5bln of AUM – then you are limited to 5% of any company and a number of the 170 listed stocks remain restricted. For those not deterred, the iShares MSCI Saudi Arabia Capped ETF (KSA) is an example of a way to gain access.

Given how much of the economy of KSA relies on oil revenues, it is not surprising that the TASI Index correlates with the price of oil. It makes the Saudi stock exchange a traders market with energy prices dominating direction. Several emerging stock markets have rallied dramatically this year, as the chart below illustrates, the TASI has not been among their number:-

saudi-arabia-stock-market-1994-2016

Source: Saudi Stock Exchange, Trading Economics

Oil

Tightness in supply makes it likely that oil will find a higher trading range, but previous OPEC deals have been wrecked by cheating on quotas. Longer term, improvements in technology will reduce the cost of extraction, increase the amount of recoverable reserves and diminish our dependence on fossil fuels by improving energy efficiency and developing, affordable, renewable, alternative sources of energy. By all means trade the range but remember commodities have always had a negative real expected return in the long run.

US growth – has the windfall of cheap oil arrived or is there a spectre at the feast?

400dpiLogo

Macro Letter – No 53 – 22-04-2016

US growth – has the windfall of cheap oil arrived or is there a spectre at the feast?

  • Oil prices have been below $60/bbl since late 2014
  • The benefit of cheaper oil is being felt across the US
  • Without lower oil prices US growth would be significantly lower
  • Increasing levels of debt are stifling the benefits of lower prices

In this letter I want to revisit a topic I last discussed back in June 2015 – Can the boon of cheap energy eclipse the collapse of energy investment? In this article I wrote:-

The impact of the oil price collapse is still feeding through the US economy but, since the most vulnerable states have learnt the lessons of the 1980’s and diversified away from an excessive reliance of on the energy sector, the short-run downturn will be muted whilst the long-run benefits of new technology will be transformative. US oil production at $10/barrel would have sounded ludicrous less than five years ago: today it seems almost plausible.

This week the San Francisco Fed picked up the theme in their FRBSF Economic Letter – The Elusive Boost from Cheap Oil:-

The plunge in oil prices since the middle of 2014 has not translated into a dramatic boost for consumer spending, which has continued to grow moderately. This has been particularly surprising since the sharp drop should free up income for households to use toward other purchases. Lessons from an empirical model of learning suggest that the weak response may reflect that consumers initially viewed cheaper oil as a temporary condition. If oil prices remain low, consumer perceptions could change, which would boost spending.

Given the perceived wisdom of the majority of central banks – that deflation is evil and must be punished – the lack of consumer spending is a perfect example of the validity of the Fed’s inflation targeting policy; except that, as this article suggests, deflations effect on spending is transitory. I could go on to discuss the danger of inflation targeting, arguing that the policy is at odds with millennia of data showing that technology is deflationary, enabling the consumer to pay less and get more. But I’ll save this for another day.

The FRBSF paper looks at the WTI spot and futures price. They suggest that market participants gradually revise their price assumptions in response to new information, concluding:-

The steep decline in oil prices since June 2014 did not translate into a strong boost to consumer spending. While other factors like weak foreign growth and strong dollar appreciation have contributed to this weaker-than-expected response, part of the muted boost from cheaper oil appears to stem from the fact that consumers expected this decline to be temporary. Because of this, households saved rather than spent the gains from lower prices at the pump. However, continued low oil prices could change consumer perceptions, leading them to increase spending as they learn about this greater degree of persistence.

In a related article the Kansas City Fed – Macro Bulletin – The Drag of Energy and Manufacturing on Productivity Growth observes that the changing industry mix away from energy and manufacturing, towards the production of services, has subtracted 0.75% from productivity growth. They attribute this to the strength of the US$ and a decline in manufacturing and mining.

…even if the industry mix stabilizes, the relative rise in services and relative declines in manufacturing and mining are likely to have a persistent negative effect on productivity growth going forward.

The service and finance sector of the economy has a lower economic multiplier than the manufacturing sector, a trend which has been accelerating since 1980. A by-product of the growth in the financial sector has been a massive increase in debt relative to GDP. By some estimates it now requires $3.30 of debt to create $1 of GDP growth. A reduction of $35trln would be needed to get debt to GDP back to 150% – a level considered to be structurally sustainable.

Meanwhile, US corporate profits remain a concern as this chart from PFS group indicates:-

corporate-profits-peak

Source: PFS Group, Bloomberg

The chart below from Peter Tenebrarum – Acting Man looks at whole economy profits – it is perhaps more alarming still:-

saupload_4-whole-economy-profits

Source: Acting Man

With energy input costs falling, the beneficiaries should be non-energy corporates or consumers. Yet wholesale inventories are rising, total business sales seem to have lost momentum and, whilst TMS-2 Money Supply growth remains solid at 8%, it is principally due to commercial and industrial lending.

US oil production has fallen below 9mln bpd versus a peak of 9.6mln. Rig count last week was 351 down three from the previous week but down 383 from the same time last year. Meanwhile the failure of Saudi Arabia to curtail production, limits the potential for the oil market to rally.

From a global perspective, cheap fuel appears to be cushioning the US from economic headwinds in other parts of the world. Employment outside mining and manufacturing is steady, and wages are finally starting to rise. However, the overhang of debt and muted level of house price appreciation has dampened the animal spirits of the US consumer:-

US-house-prices-_Federal_Housing_Finance_Agency

Source: Global Property Guide, Federal Housing Finance Agency

According to the Dallas Fed – Increased Credit Availability, Rising Asset Prices Help Boost Consumer Spendingthe consumer is beginning to emerge:-

A combination of much less household debt, revived access to consumer credit and recovering asset prices have bolstered U.S. consumer spending. This trend will likely continue despite an estimated 50 percent reduction since the mid-2000s of the housing wealth effect— an important amplifier during the boom years.

…Since the Great Recession, the ratio of household debt-to-income has fallen back to about 107 percent, a more sustainable—albeit relatively high—level.

…The wealth-to-income ratio rose from about 530 percent in fourth quarter 2003 to 650 percent in mid-2007 as equity and house prices surged. Not surprisingly, consumer spending also jumped.

The conventional estimate of the wealth effect—the impact of higher household wealth on aggregate consumption—is 3 percent, or $3 in additional spending every year for each $100 increase in wealth.

…Recent research suggests that the spendability, or wealth effect, of liquid financial assets—almost $9 for every $100—is far greater than the effect for illiquid financial assets, which explains why falling equity prices do not generate larger cutbacks in aggregate consumer spending. Other things equal, higher mortgage and consumer debt significantly depress consumer spending.

…The estimated housing wealth effect varies over time and captures the ability of consumers to tap into their housing wealth. It rose steadily from about 1.3 percent in the early 1990s to a peak of about 3.5 percent in the mid- 2000s. It has since halved, to about the same level as that of the mid-1990s. During the subprime and housing booms, rising house prices and housing wealth effects propagated and amplified expansion of consumption and GDP.

During the bust, this mechanism went into reverse. High levels of mortgage debt, falling house prices and a reduced ability to tap housing equity generated greater savings and reduced consumer spending. Fortunately, house prices have recovered, deleveraging has slowed or stopped, and consumer spending is strong, even though the housing wealth effect is only half as large as it was in the mid-2000s.

Countering the positive spin placed on the consumer credit data by the Dallas Fed is a recent interview with  Odysseas Papadimitriou, CEO of CardHub by Financial Sense – Credit Card Debt Levels Reaching Unsustainable Levels:-

In 2015, we accumulated almost $71 billion in new credit card debt. And for the first time since the Great Recession, we broke the $900 billion level in total credit card debt so we are back on track in getting to $1 trillion.

total-consumer-credit-outstanding

Source: Bloomberg, Financial Sense

Another factor which has been holding back the US economy has been the change in the nature of employment. Full-time jobs have been replaced by lower paying part-time roles and the participation rate has been in decline. This may also be changing, but is likely to be limited, as the Kansas City Fed – Flowing into Employment: Implications for the Participation Rate reports:-

After a long stretch of declines, the labor force participation rate has risen in recent months, driven in part by an increase in the share of prime-age people flowing into employment from outside the labor force. So far, this flow has remained largely confined to those with higher educational attainment, suggesting further increases in labor force participation rate could be relatively limited.

…Overall, the scenarios show that while more prime-age people could enter the labor force in the coming years, the cyclical improvement in the overall participation rate may be limited to the extent only those with higher educational attainment flow into employment. In addition, the potential increase in the participation rate could be constrained by other factors such as an increase in the share of prime-age population that reports they are either retired or disabled and a limited pool of people saying they want a job, even if they have not looked recently. Thus, while higher NE flow indicates the prime-age participation rate could increase further, it will likely remain lower than its pre-recession rate.

Conclusion

At the 2015 EIA conference Adrian Cooper of Oxford Economics gave a presentation – The Macroeconomic Impact of Lower Oil Prices – in which he estimated that a $30pb decline in the oil price would add 0.9% to US GDP between 2015 and 2017. If this estimate is correct, lower oil is responsible for more than a quarter of the current US GDP growth. It has softened the decline from 2.9% to 2% seen over the last year.

I would argue that the windfall of lower oil prices has already arrived, it has shown up in the deterioration of the trade balance, the increase in wages versus consumer prices and the nascent rebound in the participation rate. That the impact has not been more dramatic is due to the headwinds on excessive debt and the strength of the US$ TWI – it rose from 103 in September 2014 to a high of 125 in January 2016. After the G20 meeting Shanghai it has retreated to 120.

According to the March 2015 BIS – Oil and debt report, total debt in the Oil and Gas sector increased from $1trln in 2006 to $2.5trln by 2015. The chart below looks at the sectoral breakdown of US Capex up to the end of 2013:-

US CAPEX by sector

Source: Business Insider, Compustat, Goldman Sachs

With 37% allocated to Energy and Materials by 2013 it is likely that the fall in oil prices will act as a drag on a large part of the stock market. Energy and Materials may represent less than 10% of the total but they impact substantially in the financial sector (15.75%).

Notwithstanding the fact that corporate defaults are at the highest level for seven years, financial institutions and their central bank masters will prefer to reschedule. This will act as a drag on new lending and on the profitability of the banking sector.

The table below from McGraw Hill shows the year to date performance of the S&P Spider and the sectoral ETFs. This year Financials are taking the strain whilst Energy has been the top performer – over one year, however, Energy is still the nemesis of the index.

Sector SPDR Fund % Change YTD % Change 1 year
S&P 500 Index 2.86% 0.10%
Consumer Discretionary (XLY) 2.23% 5.05%
Consumer Staples (XLP) 4.16% 6.83%
Energy (XLE) 10.20% -19.16%
Financial Services (XLFS) -2.49% 0.00%
Financials (XLF) -1.22% -2.85%
Health Care (XLV) -1.01% -3.31%
Industrials (XLI) 6.41% -0.07%
Materials (XLB) 8.45% -5.78%
Real Estate (XLRE) 1.98% 0.00%
Technology (XLK) 3.60% 5.19%
Utilities (XLU) 10.74% 7.08%

Source: McGraw Hill

The benefit of lower oil and gas prices will continue, but, until debt levels are reduced, anaemic GDP growth is likely to remain the pattern for the foreseeable future. In Hoisington Investment Management – Economic Review – Q1 2016 – Lacy Hunt makes the following observation:-

The Federal Reserve, the European Central Bank, the Bank of Japan and the People’s Bank of China have been unable to gain traction with their monetary policies…. Excluding off balance sheet liabilities, at year-end the ratio of total public and private debt relative to GDP stood at 350%, 370%, 457% and 615%, for China, the United States, the Eurocurrency zone, and Japan, respectively…

The windfall of cheap oil has arrived, but cheap oil has been eclipsed by the beguiling spectre of cheap debt.

Will Nigeria be forced to devalue the naira?

Will Nigeria be forced to devalue the naira?

400dpiLogo

Macro Letter – No 50 – 26-02-2016

Will Nigeria be forced to devalue the naira?

  • The Nigerian government met the World Bank to discuss its deficit – loan pending
  • The Bank of Nigeria cut rates in November – bond prices suggest further cuts are imminent
  • Foreign Exchange controls tightened further in December
  • President Buhari states he won’t “kill the naira”

I last wrote about Nigeria back in early June – Nigeria and South Africa – what are their prospects for growth and investment? My favoured investment was long Nigerian bonds – then trading around 13.7%. They rose above 16% as naira exchange controls tightened. Here is a chart showing what happened next:-

nigeria-government-bond-yield

Source: Trading Economics, Central Bank of Nigeria

The catalyst for lower yields was an unexpected interest rate cut by the Central Bank of Nigeria. This is how it was reported by Reuters back on 25th November:-

Nigeria’s central bank cut benchmark interest rate to 11 percent from 13 percent on Tuesday, its first reduction in the cost of borrowing in more than six years.

…The stock market, which has the second-biggest weighting after Kuwait on the MSCI frontier market index , erased seven days of losses to climb to 27,662 points following the rate cut. The index has fallen 20.4 percent so far this year.

“On the back of the reduction in policy rates … investors are reconsidering investment in the equities market to earn higher return,” said Ayodeji Ebo, head of research at Afrinvest. “We anticipate further moderation in bond yields.”

He expected stocks in the industrial sector such as Dangote Cement and Lafarge Africa to gain from the liquidity surge as infrastructure projects boom. Ebo said the rate cut may hurt bank earnings as consumer firms reel from dollar shortages.

Yield on the most liquid 5-year bond fell 264 basis points to a five-year low of 7 percent while the benchmark 20-year bond closed 150 basis points down at 10.8 percent on Wednesday, traders said.

Bond yields had traded above 11 percent across maturities prior to Tuesday’s rate decision, with the 2034 bond trading at 12.30 percent.

The central bank has been injecting cash into the banking system since October in a bid to help the economy. Banking system credit stood at 290 billion naira ($1.5 bln) as of Wednesday, keeping overnight rates as low as 0.5 percent .

…The rate cut also weakened the naira on the unofficial market, which fell 0.8 percent to 242 to the dollar. The currency is pegged at 197 naira on the official market.

Non-deliverable currency forwards, a derivative product used to hedge against future exchange rate moves, indicated markets expected the naira’s exchange rate at 235.56 to the dollar in 12 months’ time – the strongest level in five months – and compared to 245.25 at Tuesday’s close

“Our economists still believe a devaluation will happen in a couple of quarters but I think they have had opportunities,” said Luis Costa, head of CEEMEA debt and FX strategy at Citi.

Here is a chart showing the naira spot and three month forward rate – a good surrogate for the differential between the official and black market rate:-

Naira spot vs forwards

Source: Bloomberg

December saw a further tightening of exchange controls, the FT – Capital controls curtail spending of Nigeria’s jet set elaborates:-

Nigeria’s central bank introduced currency controls last spring as the naira came under pressure after the collapse in the price of oil, the country’s main export and the lifeblood of its economy.

As well as in effect banning imports of goods from rice to steel pipes to protect dwindling foreign exchange reserves, the central bank has also enforced spending limits on foreign currency-denominated Nigerian bank cards, much to the chagrin of Nigeria’s well-heeled travellers. These are needed, it says, to curb black market activity such as “arbitraging”: when a customer turns a quick profit by withdrawing foreign exchange from an overseas ATM to sell on the black market back home.

Another less publicised aim of the controls, according to one senior official, is to limit the flight of billions of dollars suspected to have been fraudulently obtained and then hoarded in cash by business people and officials under the former government of Goodluck Jonathan.

Last month, the central bank extended the policy by banning the use of naira-denominated debit cards altogether for overseas transactions or withdrawals. The central bank has said it will not lift the restrictions until foreign reserves, which have fallen to $29bn from $34.5bn a year ago, are restored.

There is speculation among economists about the true level of foreign exchange reserves – suffice to say $29bln is regarded as an overestimate.

The January Central Bank of Nigeria Communiqué looked back to the rate cut in November but left rates unchanged, here are some of the highlights:-

Output

…Domestic output growth in 2015 remained moderate. According to the National Bureau of Statistics (NBS), real GDP grew by 2.84 per cent in the third quarter of 2015, almost half a percentage point higher than the 2.35 per cent recorded in the second quarter. However, third quarter expansion remained substantially below the 3.96 and 6.23 per cent in the first quarter of 2015 and corresponding period of 2014, respectively. The major impetus to growth continued to come from the non-oil sector which grew by 3.05 per cent compared with the growth of 3.46 per cent posted in the preceding quarter. The major drivers of expansion in the non-oil sector were Services, Agriculture and Trade.

…The economy is expected to continue on its growth path in the first quarter 2016, albeit less robust than in the corresponding period of 2015. This expectation is predicated on the current low global oil price trend which is projected to hold low over the medium-to long term, and with attendant implications for government revenue and foreign exchange earnings. Other downside risks to growth in 2016 include: capital flow reversal, high lending rates, sluggish credit to private sector and bearish trends in the equities market.

Prices

…Core inflation declined for the third consecutive month to 8.70 per cent in November and December from 8.74 per cent in October 2015, while food inflation inched up to 10.32 per cent from 10.13 and 10.2 per cent over the same period.

Monetary, Credit and Financial Markets Developments

Broad money supply (M2) rose by 5.90 per cent in December 2015, over the level at end-December 2014, although below the growth benchmark of 15.24 per cent for 2015. Net domestic credit (NDC) grew by 12.13 per cent in the same period, but remained below the provisional benchmark of 29.30 per cent for 2015. Growth in aggregate credit reflected mainly growth in credit to the Federal Government by 151.56 per cent in December 2015 compared with 145.74 per cent in the corresponding period of 2014. The renewed increase in credit to government may be partly attributable to increased government borrowing to implement the 2015 supplementary budget.

Committee’s Considerations

The Committee observed that the last episode of low oil prices in 2005 lasted for a maximum period of 8 months. However, the current episode of lower oil prices is projected to remain over a very long period.

At the end of January, President Buhari stated that he would not “kill the naira” – this prompted some commentators to question the independence of the central bank. It also suggests that foreign exchange controls will remain in place, despite pressure from the IMF for their removal.

Conclusion and Investment Opportunities

Whilst foreign exchange controls remain in place it is difficult to access the Nigerian markets: stubbornly high inflation remains a concern which these controls will only exacerbate – see chart below:-

nigeria-inflation-cpi

Source: Trading Economics, Nigerian Statistics Bureau

In this, high inflation, environment, it is difficult to envisage much further upside for government bonds. If you have been long I would take profit before the currency comes under renewed pressure. On 21st January Nigeria’s finance minister Kemi Adeosun announced that the government would borrow $5bln from international agencies to plug the shortfall in tax receipts, she has since then been in talks with the AfDB and the World Bank – after all, oil represents 95% of exports and more than two thirds of government revenue.

Stocks have fallen by more than 45% since their July 2014 highs, but further devaluation looks likely. The non-oil sector will outperform in the current environment but should the central bank “throw in the towel” it will be the energy sector which benefits in the short-term. According to Knoema, Nigerian oil production offshore is around $30/bbl whilst the smaller on-shore production is nearer $15/bbl. Other estimates suggest that only 16% of Nigerian oil reserves are worth exploiting at prices below $40/bbl. A 20% to 40% decline in the naira will reduce the break-even immediately. I remain side-lined until the valuation of the naira has been resolved.

As for the naira – a prolonged period of low oil prices will see the three month forward rate return towards NGNUSD 250 – a break towards 280 could represent a capitulation point. I believe this offers value, being 40% above the official rate. Will it happen? Yes, I think so.

Central Banks – Ah Aaaaahhh! – Saviours of the Universe?

400dpiLogo

Macro Letter – No 48 – 29-01-2016

Central Banks – Ah Aaaaahhh! – Saviours of the Universe?

Flash-Gordon-flash-gordon-23432257-1014-1600

Copryright: Universal Pictures

  • Freight rates have fallen below 2008 levels
  • With the oil price below $30 many US producers are unprofitable
  • The Fed has tightened but global QE gathers pace
  • Chinese stimulus is fighting domestic strong headwinds

Just in case you’re not familiar with it here is a You Tube video of the famous Queen song. It is seven years since the Great Financial Crisis; major stock markets are still relatively close to their highs and major government bond yields remain near historic lows. If another crisis is about to engulf the developed world, do the central banks (CBs) have the means to avert catastrophe once again? Here are some of the factors which may help us to reach a conclusion.

Freight Rates

Last week I was asked to comment of the prospects for commodity prices, especially energy. Setting aside the geo-politics of oil production, I looked at the Baltic Dry Index (BDI) which has been plumbing fresh depths this year – 337 (28/1/16) down from August 2015 highs of 1200. Back in May 2008 it touched 11,440 – only to plummet to 715 by November of the same year. How helpful is the BDI at predicting the direction of the economy? Not very – as this 2009 article from Business Insider – Shipping Rates Are Lousy For Predicting The Economy – points out. Nonetheless, the weakness in freight rates is indicative of an inherent lack of demand for goods. The chart below is from an article published by Zero Hedge at the beginning of January – they quote research from Deutsche Bank.

BDI_-_1985_-_2016 (4)

Source: Zerohedge

A “Perfect Storm Is Coming” Deutsche Warns As Baltic Dry Falls To New Record Low:

…a “perfect storm” is brewing in the dry bulk industry, as year-end improvements in rates failed to materialize, which indicates a looming surge in bankruptcies.

The improvement in dry bulk rates we expected into year-end has not materialized.

…we believe a number of dry bulk companies are contemplating asset sales to raise liquidity, lower daily cash burn, and reduce capital commitments. The glut of “for sale” tonnage has negative implications for asset and equity values. More critically, it can easily lead to breaches in loan-to-value covenants at many dry bulk companies, shortening the cash runway and likely necessitating additional dilutive actions.

Dry bulk companies generally have enough cash for the next 1yr or so, but most are not well positioned for another leg down in asset values.

China

The slowing and rebalancing of the Chinese economy may be having a significant impact on global trade flows. Here is a recent article on the subject from Mauldin Economics – China’s Year of the Monkees:-

China isn’t the only reason markets got off to a terrible start this month, but it is definitely a big factor (at least psychologically). Between impractical circuit breakers, weaker economic data, stronger capital controls, and renewed currency confusion, China has investors everywhere scratching their heads.

When we focused on China back in August (see “When China Stopped Acting Chinese”), my best sources said the Chinese economy was on a much better footing than its stock market, which was in utter chaos. While the manufacturing sector was clearly in a slump, the services sector was pulling more than its fair share of the GDP load. Those same sources have new data now, which leads them to quite different conclusions.

…Now, it may well be the case that China’s economy is faltering, but its GDP data is not the best evidence.

…To whom can we turn for reliable data? My go-to source is Leland Miller and company at the China Beige Book.

…China Beige Book started collecting data in 2010. For the entire time since then, the Chinese economy has been in what Leland calls “stable deceleration.” Slowing down, but in an orderly way that has generally avoided anything resembling crisis. 

…China Beige Book noticed in mid-2014 that Chinese businesses had changed their behavior. Instead of responding to slower growth by doubling down and building more capacity, they did the rational thing (at least from a Western point of view): they curbed capital investment and hoarded cash. With Beijing still injecting cash that businesses refused to spend, the liquidity that flowed into Chinese stocks produced the massive rally that peaked in mid-2015. It also allowed money to begin to flow offshore in larger amounts. I mean really massively larger amounts.

Dealing with a Different China

China Beige Book’s fourth-quarter report revealed a rude interruption to the positive “stable deceleration” trend. Their observers in cities all over that vast country reported weakness in every sector of the economy. Capital expenditures dropped sharply; there were signs of price deflation and labor market weakness; and both manufacturing and service activity slowed markedly.

That last point deserves some comment. China experts everywhere tell us the country is transitioning from manufacturing for export to supplying consumer-driven services. So if both manufacturing and service activity are slowing, is that transition still happening?

The answer might be “yes” if manufacturing were decelerating faster than services. For this purpose, relative growth is what counts. Unfortunately, manufacturing is slowing while service activity is not picking up all the slack. That’s not the combination we want to see.

Something else China Beige Book noticed last quarter: both business and consumer loan volume did not grow in response to lower interest rates. That’s an important change, and probably not a good one. It means monetary stimulus from Beijing can’t save the day this time. Leland thinks fiscal stimulus isn’t likely to help, either. Like other governments and their central banks, China is running out of economic ammunition.

Mauldin goes on to discuss the devaluation of the RMB – which I also discussed in my last letter – Is the ascension of the RMB to the SDR basket more than merely symbolic? The RMB has been closely pegged to the US$ since 1978 though with more latitude since 2005, this has meant a steady appreciation in its currency relative to many of its emerging market trading partners. Now, as China begins to move towards full convertibility, the RMB will begin to float more freely. Here is a five year chart of the Indian Rupee and the CNY vs the US$:-

INR vs RMB - Yahoo

Source: Yahoo finance

The Chinese currency could sink significantly should their government deem it necessary, however, expectations of a collapse of growth in China may be premature as this article from the Peterson Institute – The Price of Oil, China, and Stock Market Herding – indicates:-

A collapse of growth in China would indeed be a world changing event. But there is just no evidence of such a collapse. At most there is suggestive evidence of a mild slowdown, and even that is far from certain. The mechanical effects of such a mild decrease on the US economy should, by all accounts, and all the models we have, be limited. Trade channels are limited (US exports to China represent less than 2 percent of GDP), and so are financial linkages. The main effect of a slowdown in China would be through lower commodity prices, which should help rather than hurt the United States.

Peterson go on to suggest:-

Maybe we should not believe the market commentaries. Maybe it was neither oil nor China. Maybe what we are seeing is a delayed reaction to the slowdown in the world economy, a slowdown that has now gone on for a few years. While there has been no significant news in the last two weeks, maybe markets are only realizing that growth in emerging markets will be lower for a long time, that growth in advanced economies will be unexciting. Maybe…

I think the explanation is largely elsewhere. I believe that to a large extent, herding is at play. If other investors sell, it must be because they know something you do not know. Thus, you should sell, and you do, and so down go stock prices. Why now? Perhaps because we have entered a period of higher uncertainty. The world economy, at the start of 2016, is a genuinely confusing place. Political uncertainty at home and geopolitical uncertainty abroad are both high. The Fed has entered a new regime. The ability of the Chinese government to control its economy is in question. In that environment, in the stock market just as in the presidential election campaign, it is easier for the bears to win the argument, for stock markets to fall, and, on the political front, for fearmongers to gain popularity.

They are honest enough to admit that economics won’t provide the answers.

Energy Prices

The June 2015 BP – Statistical Review of World Energy – made the following comments:-

Global primary energy consumption increased by just 0.9% in 2014, a marked deceleration over 2013 (+2.0%) and well below the 10-year average of 2.1%. Growth in 2014 slowed for every fuel other than nuclear power, which was also the only fuel to grow at an above-average rate. Growth was significantly below the 10-year average for Asia Pacific, Europe & Eurasia, and South & Central America. Oil remained the world’s leading fuel, with 32.6% of global energy consumption, but lost market share for the fifteenth consecutive year.

Although emerging economies continued to dominate the growth in global energy consumption, growth in these countries (+2.4%) was well below its 10-year average of 4.2%. China (+2.6%) and India (+7.1%) recorded the largest national increments to global energy consumption. OECD consumption fell by 0.9%, which was a larger fall than the recent historical average. A second consecutive year of robust US growth (+1.2%) was more than offset by declines in energy consumption in the EU (-3.9%) and Japan (-3.0%). The fall in EU energy consumption was the second-largest percentage decline on record (exceeded only in the aftermath of the financial crisis in 2009).

The FT – The world energy outlook in five charts – looked at five charts from the IEA World Energy Outlook – November 2015:-

Demand_Growth_in_Asia

Source: IEA

With 315m of its population expected to live in urban areas by 2040, and its manufacturing base expanding, India is forecast to account for quarter of global energy demand growth by 2040, up from about 6 per cent currently.

India_moving_to_centre

Source: IEA

Oil demand in India is expected to increase by more than in any other country to about 10m barrels per day (bpd). The country is also forecast to become the world’s largest coal importer in five years. But India is also expected to rely on solar and wind power to have a 40 per cent share of non-fossil fuel capacity by 2030.

A_new_chapter_in_Chinas_growth_story

Source: IEA

China’s total energy demand is set to nearly double that of the US by 2040. But a structural shift in the Asian country away from investment-led growth to domestic-demand based economy will “mean that 85 per cent less energy is required to generate each unit of future economic growth than was the case in the past 25 years.”

A_new_balancing_item_in_the_oil_market

Source: IEA

US shale oil production is expected to “stumble” in the short term, but rise as oil price recovers. However the IEA does not expect crude oil to reach $80 a barrel until 2020, under its “central scenario”. The chart shows that if prices out to 2020 remain under $60 per barrel, production will decline sharply.

Power_is_leading_the_transformation

Source: IEA

Renewables are set to overtake coal to become the largest source of power by 2030. The share of coal in the production of electricity will fall from 41 per cent to 30 per cent by 2040, while renewables will account for more than half the increase in electricity generation by then.

The cost of solar energy continues to fall and is now set to “eclipse” natural gas, as this article from Seeking Alpha by Siddharth Dalal – Falling Solar Costs: End Of Natural Gas Is Near? Explains:-

A gas turbine power plant uses 11,371 Btu/kWh. The current price utilities are paying per Btu of natural gas are $3.23/1000 cubic feet. 1000 cubic feet of natural gas have 1,020,000 BTUs. So $3.23 for 90kWh. That translates to 3.59c/kWh in fuel costs alone.

A combined cycle power plant uses 7667 Btu/kWh, which translates to 2.42c/kWh.

Adding in operating and maintenance costs, we get 4.11c/kWh for gas turbines and 3.3c/kWh for combined cycle power plants. This still doesn’t include any construction costs.

…The average solar PPA is likely to go under 4c/kWh next year. Note that this is the total cost that the utility pays and includes all costs.

And the trend puts total solar PPA costs under gas turbine fuel costs and competitive with combined cycle plant total operating costs next year.

At this point it becomes a no brainer for a utility to buy cheap solar PPAs compared to building their own gas power plants.

The only problem here is that gas plants are dispatchable, while solar is not. This is a problem that is easily solved by batteries. So utilities would be better served by spending capex on batteries as opposed to any kind of gas plant, especially anything for peak generation.

The influence of the oil price, whilst diminishing, still dominates. In the near term the importance of the oil price on financial market prices will relate to the breakeven cost of production for companies involved in oil exploration. Oil companies have shelved more than $400bln of planned investment since 2014. The FT – US junk-rated energy debt hits two-decade lowtakes up the story:-

US-High Yield - Thompson Reuters

Source: Thomson Reuters Datastream, FT

The average high-yield energy bond has slid to just 56 cents on the dollar, below levels touched during the financial crisis in 2008-09, as investors brace for a wave of bankruptcies.

…The US shale revolution which sent the country’s oil production soaring from 2009 to 2015 was led by small and midsized companies that typically borrowed to finance their growth. They sold $241bn worth of bonds during 2007-15 and many are now struggling under the debts they took on.

Very few US shale oil developments can be profitable with crude at about $30 a barrel, industry executives and advisers say. Production costs in shale have fallen as much as 40 per cent, but that has not been enough to keep pace with the decline in oil prices.

…On Friday, Moody’s placed 120 oil and gas companies on review for downgrade, including 69 in the US.

…The yield on the Bank of America Merrill Lynch US energy high-yield index has climbed to the highest level since the index was created, rising to 19.3 per cent last week, surpassing the 17 per cent peak hit in late 2008.

More than half of junk-rated energy groups in the US have fallen into distress territory, where bond yields rise more than 1,000 basis points above their benchmark Treasury counterpart, according to S&P.

All other things equal, the price of oil is unlikely to rally much from these levels, but, outside the US, geo-political risks exist which may create an upward bias. Many Middle Eastern countries have made assumptions about the oil price in their estimates of tax receipts. Saudi Arabia has responded to lower revenues by radical cuts in public spending and privatisations – including a proposed IPO for Saudi Aramco. As The Guardian – Saudi Aramco privatisation plans shock oil sector – explains, it will certainly be difficult to value – market capitalisation estimates range from $1trln to $10trln.

Outright energy company bankruptcies are likely to be relatively subdued, unless interest rates rise dramatically – these companies locked in extremely attractive borrowing rates and their bankers will prefer to renegotiate payment schedules rather than write off the loans completely. New issuance, however, will be a rare phenomenon.

Technology

“We don’t want technology simply because it’s dazzling. We want it, create it and support it because it improves people’s lives.”

These words were uttered by Canadian Prime Minister, Justin Trudeau, at Davos last week. The commodity markets have been dealing with technology since the rise of Sumer. The Manhattan Institutes – SHALE 2.0 Technology and the Coming Big-Data Revolution in America’s Shale Oil Fields highlights some examples which go a long way to explaining the downward trajectory in oil prices over the last 18 months – emphasis is mine:-

John Shaw, chair of Harvard’s Earth and Planetary Sciences Department, recently observed: “It’s fair to say we’re not at the end of this [shale] era, we’re at the very beginning.” He is precisely correct. In recent years, the technology deployed in America’s shale fields has advanced more rapidly than in any other segment of the energy industry. Shale 2.0 promises to ultimately yield break-even costs of $5–$20 per barrel—in the same range as Saudi Arabia’s vaunted low-cost fields.

…Compared with 1986—the last time the world was oversupplied with oil—there are now 2 billion more people living on earth, the world economy is $30 trillion bigger, and 30 million more barrels of oil are consumed daily. The current 33 billion-barrel annual global appetite for crude will undoubtedly rise in coming decades. Considering that fluctuations in supply of 1–2 MMbd can swing global oil prices, the infusion of 4 MMbd from U.S. shale did to petroleum prices precisely what would be expected in cyclical markets with huge underlying productive capacity.

Shipbuilding has also benefitted from technological advances in a variety of areas, not just fuel efficiency. This article (please excuse the author’s English) from Marine Insight – 7 Technologies That Can Change The Future of Shipbuilding – highlights several, I’ve chosen five:-

3-D Printing Technology:…Recently, NSWC Carderock made a fabricated model of the hospital ship USNS Comfort (T-AH 20) using its 3-D printer, first uploading CAD drawings of ship model in it. Further developments in this process can lead the industry to use this technique to build complex geometries of ship like bulbous bow easily. The prospect of using 3-D printers to seek quick replacement of ship’s part for repairing purpose is also being investigated. The Economist claims use this technology to be the “Third Industrial Revolution“.

Shipbuilding Robotics: Recent trends suggest that the shipbuilding industry is recognizing robotics as a driver of efficiency along with a method to prevent workers from doing dangerous tasks such as welding. The shortage of skilled labour is also one of the reasons to look upon robotics. Robots can carry out welding, blasting, painting, heavy lifting and other tasks in shipyards.

LNG Fueled engines

…In the LNG engines, CO2 emission is reduced by 20-25% as compared to diesel engines, NOX emissions are cut by almost 92%, while SOX and particulates emissions are almost completely eliminated.

…Besides being an environmental friendly fuel, LNG is also cheaper than diesel, which helps the ship to save significant amount of money over time.

…Solar & Wind Powered Ships:

…The world’s largest solar powered ship named ‘Turanor’ is a 100 metric ton catamaran which motored around the world without using any fuel and is currently being used as a research vessel. Though exclusive solar or wind powered ships look commercially and practically not viable today, they can’t be ruled out of future use with more technical advancements.

Recently, many technologies have come which support the big ships to reduce fuel consumption by utilizing solar panels or rigid sails. A device named Energy Sail (patent pending) has been developed by Eco Marine Power will help the ships to extract power from wind and sun so as to reduce fuel costs and emission of greenhouse gases. It is exclusively designed for shipping and can be fitted to wide variety of vessels from oil carrier to patrol ships.

Buckypaper: Buckypaper is a thin sheet made up of carbon nanotubes (CNT). Each CNT is 50,000 thinner than human air. Comparing with the conventional shipbuilding material (i.e. steel), buckypaper is 1/10th the weight of steel but potentially 500 times stronger in strength  and 2 times harder than diamond when its sheets are compiled to form a composite. The vessel built from this lighter material would require less fuel, hence increasing energy efficiency. It is corrosion resistant and flame retardant which could prevent fire on ships. A research has already been initiated for the use of buckypaper as a construction material of a future aeroplane. So, a similar trend can’t be ruled out in case of shipbuilding.

Shipping has always been a cyclical business, driven by global demand for freight on the one hand and improvements in technology on the other. The cost of production continues to fall, old inventory rapidly becomes uncompetitive and obsolete. The other factor effecting the cycle is the cost of finance; this is true also of energy exploration and development. Which brings us to the actions of the CBs.

The central role of the central banks

Had $100 per barrel oil encouraged a rise in consumer price inflation in the major economies, it might have been appropriate for their CBs to raise interest rates, however, high levels of debt kept inflation subdued. The “unintended consequences” or, perhaps we should say “collateral damage” of allowing interest rates to remain unrealistically low, is overinvestment. The BIS – Self-oriented monetary policy, global financial markets and excess volatility of international capital flows – looks at the effect developed country CB policy – specifically the Federal Reserve – has had on emerging markets:-

A major policy question arising from these events is whether US monetary policy imparts a global ‘externality’ through spillover effects on world capital flows, credit growth and asset prices. Many policy makers in emerging markets (e.g. Rajan, 2014) have argued that the US Federal Reserve should adjust its monetary policy decisions to take account of the excess sensitivity of international capital flows to US policy. This criticism questions the view that a ‘self-oriented’ monetary policy based on inflation targeting principles represents an efficient mechanism for the world monetary system (e.g. Obstfeld and Rogoff, 2002), without the need for any cross-country coordination of policies.

…Our results indicate that the simple prescriptions about the benefits of flexible exchange rates and inflation targeting are very unlikely to hold in a global financial environment dominated by the currency and policy of a large financial centre, such as the current situation with the US dollar and US monetary policy. Our preliminary analysis does suggest however that an optimal monetary policy can substantially improve the workings of the international system, even in the absence of direct intervention in capital markets through macro-prudential policies or capital controls. Moreover, under the specific assumptions maintained in this paper, this outcome can still be consistent with national independence in policy, or in other words, a system of ‘self-oriented’ monetary policy making.

Whether CBs should consider the international implications of their actions is not a new subject, but this Cobden Centre article by Alisdair Macleod – Why the Fed Will Never Succeed – suggests that the Fed should be mandated to accept a broader role:-

That the Fed thinks it is only responsible to the American people for its actions when they affect all nations is an abrogation of its duty as issuer of the reserve currency to the rest of the world, and it is therefore not surprising that the new kids on the block, such as China, Russia and their Asian friends, are laying plans to gain independence from the dollar-dominated system. The absence of comment from other central banks in the advanced nations on this important subject should also worry us, because they appear to be acting as mute supporters for the Fed’s group-think.

This is the context in which we need to clarify the effects of the Fed’s monetary policy. The fundamental question is actually far broader than whether or not the Fed should be raising rates: rather, should the Fed be managing interest rates at all? Before we can answer this question, we have to understand the relationship between credit and the business cycle.

There are two types of economic activity, one that correctly anticipates consumer demand and is successful, and one that fails to do so. In free markets the failures are closed down quickly, and the scarce economic resources tied up in them are redeployed towards more successful activities. A sound-money economy quickly eliminates business errors, so this self-cleansing action ensures there is no build-up of malinvestments and the associated debt that goes with it.

When there is stimulus from monetary inflation, it is inevitable that the strict discipline of genuine profitability that should guide all commercial enterprises takes a back seat. Easy money and interest rates lowered to stimulate demand distort perceptions of risk, over-values financial assets, and encourages businesses to take on projects that are not genuinely profitable. Furthermore, the owners of failing businesses find it possible to run up more debts, rather than face commercial reality. The result is a growing accumulation of malinvestments whose liquidation is deferred into the future.

Macleod goes on to discuss the Cantillon effect, at what point we are in the Credit Cycle and why the Fed decided to raise rates now:-

We must put ourselves in the Fed’s shoes to try to understand why it has raised rates. It has seen the official unemployment rate decline for a prolonged period, and more recently energy and commodity prices have fallen sharply. Assuming it believes government unemployment figures, as well as the GDP and its deflator, the Fed is likely to think the economy has at least stabilised and is fundamentally healthy. That being the case, it will take the view the business cycle has turned. Note, business cycle, not credit-driven business cycle: the Fed doesn’t accept monetary policy is responsible for cyclical phenomena. Therefore, demand for energy and commodities is expected to increase on a one or two-year view, so inflation can be expected to pick up towards the 2% target, particularly when the falls in commodity and energy prices drop out of the back-end of the inflation numbers. Note again, inflation is thought to be a demand-for-goods phenomenon, not a monetary phenomenon, though according to the Fed, monetary policy can be used to stimulate or control it.

Unfortunately, the evidence from multiple surveys is that after nine years since the Lehman crisis the state of the economy remains suppressed while debt has continued to increase, so this cycle is not in the normal pattern. It is clear from the evidence that the American economy, in common with the European and Japanese, is overburdened by the accumulation of malinvestments and associated debt. Furthermore, nine years of wealth attrition through monetary inflation (as described above) has reduced the purchasing power of the average consumer’s earnings significantly in real terms. So instead of a phase of sustainable growth, it is likely America has arrived at a point where the economy can no longer bear the depredations of further “monetary stimulus”. It is also increasingly clear that a relatively small rise in the general interest rate level will bring on the next crisis.

So what will the Fed – and, for that matter, other major CBs – do? I look back to the crisis of 2008/2009 – one of the unique aspects of this period was the coordinated action of the big five: the Fed, ECB, BoJ, BoE and SNB. In 1987 the Fed was the “saviour of the universe”. Their actions became so transparent in the years that followed, that the phase “Greenspan Put” was coined to describe the way the Fed saved stock market investors and corporate creditors. CEPR – Deleveraging? What deleveraging? which I have quoted from in previous letters, is an excellent introduction to the unintended consequences of CB largesse.

Since 2009 economic growth has remained sluggish; this has occurred despite historically low interest rates – it’s not unreasonable to surmise that the massive overhang of debt, globally, is weighing on both demand pull inflation and economic growth. Stock buy-backs have been rife and the long inverted relationship between dividend yields and government bond yields has reversed. Paying higher dividends may be consistent with diversifying a company’s investor base but buying back stock suggests a lack of imagination by the “C” Suite. Or perhaps these executives are uncomfortable investing when interest rates are artificially low.

I believe the vast majority of the rise in stock markets since 2009 has been the result of CB policy, therefore the Fed rate increase is highly significant. The actions of the other CBs – and here I would include the PBoC alongside the big five – is also of significant importance. Whilst the Fed has tightened the ECB and the PBoC continue to ease. The Fed appears determined to raise rates again, but the other CBs are likely to neutralise the overall effect. Currency markets will take the majority of the strain, as they have been for the last couple of years.

A collapse in equity markets will puncture confidence and this will undermine growth prospects globally. Whilst some of the malinvestments of the last seven years will be unwound, I expect CBs to provide further support. The BoJ is currently the only CB with an overt policy of “qualitative easing” – by which I mean the purchasing of common stock – I fully expect the other CBs to follow to adopt a similar approach. For some radical ideas on this subject this paper by Professor Roger Farmer – Qualitative Easing: How it Works and Why it Matters – which was presented at the St Louis Federal Reserve conference in 2012 – makes interesting reading.

Investment opportunities

In comparison to Europe– especially Germany – the US economy is relatively immune to the weakness of China. This is already being reflected in both the currency and stocks markets. The trend is likely to continue. In the emerging market arena Brazil still looks sickly and the plummeting price of oil isn’t helping, meanwhile India should be a beneficiary of cheaper oil. Some High yield non-energy bonds are likely to be “tarred” (pardon the pun) with the energy brush. Meanwhile, from an international perspective the US$ remains robust even as the US$ Index approaches resistance at 100.

US_Index_-_5_yr_Marketwatch

Source: Marketwatch

US Growth and employment – can the boon of cheap energy eclipse the collapse of energy investment?

400dpiLogo

Macro Letter – No 38 – 19-06-2015

US Growth and employment – can the boon of cheap energy eclipse the collapse of energy investment?

  • Last year’s oil price falls are still feeding through to the wider economy
  • Oil producing states have remained resilient despite the continued lower price of WTI
  • The wider economy has rebounded after the slowdown in Q1
  • Stock earnings growth is regaining upward momentum

At the end of last year I became cautious about the prospects for the US stock market. The principal concern was the effect a sustained decline in the price of oil was likely to have on the prospects for employment and economic growth.

The Texan Experience

Oil rich Texas represents a microcosm of the effect lower energy prices may be having on employment and growth. This article from December 2014 by Mauldin Economics – Oil, Employment, and Growth – neatly sums up my concerns at the end of last year:-

…we need to research in depth as we try to peer into the future and think about how 2015 will unfold. In forecasting US growth, I wrote that we really need to understand the relationships between the boom in energy production on the one hand and employment and overall growth in the US on the other. The old saw that falling oil prices are like a tax cut and are thus a net benefit to the US economy and consumers is not altogether clear to me. I certainly hope the net effect will be positive, but hope is not a realistic basis for a forecast. Let’s go back to two paragraphs I wrote last week:

Texas has been home to 40% of all new jobs created since June 2009. In 2013, the city of Houston had more housing starts than all of California. Much, though not all, of that growth is due directly to oil. Estimates are that 35–40% of total capital expenditure growth is related to energy. But it’s no secret that not only will energy-related capital expenditures not grow next year, they are likely to drop significantly. The news is full of stories about companies slashing their production budgets. This means lower employment, with all of the knock-on effects.

As we will see, energy production has been the main driver of growth in the US economy for the last five years. But changing demographics suggest that we might not need the job-creation machine of energy production as much in the future to ensure overall employment growth.

…The oil-rig count is already dropping, and it will continue to drop as long as oil stays below $60. That said, however, there is the real possibility that oil production in the United States will actually rise in 2015 because of projects already in the works. If you have already spent (or committed to spend) 30 or 40% of the cost of a well, you’re probably going to go ahead and finish that well. There’s enough work in the pipeline (pardon the pun) that drilling and production are not going to fall off a cliff next quarter. But by the close of 2015 we will see a significant reduction in drilling.

Given present supply and demand characteristics, oil in the $40 range is entirely plausible. It may not stay down there for all that long (in the grand scheme of things), but it will reduce the likelihood that loans of the nature and size that were extended the last few years will be made in the future. Which is entirely the purpose of the Saudis’ refusing to reduce their own production. A side benefit to them (and the rest of the world) is that they also hurt Russia and Iran.

Employment associated with energy production is going to fall over the course of next year. It’s not all bad news, though. Employment that benefits from lower energy prices is likely to remain stable or even rise. Think chemical companies that use natural gas as an input as an example.

I am, however, at a loss to think of what could replace the jobs and GDP growth that the energy complex has recently created. Certainly, reduced production is going to impact capital expenditures. This all leads one to begin thinking about a much softer economy in the US in 2015.

Last month’s employment report suggests we may have avoided the downturn from cheaper oil, but uncertainty remains. Earlier this month the Dallas Fed – Robust Regional Banking Sector Faces New Economic Hurdles whilst focusing on the health of the banking sector, worried that the effect of lower oil prices, combined with higher interest rates, may yet wreak havoc in the Eleventh District. Here are some of the highlights:-

Not only have district banks achieved greater profitability than their counterparts nationwide, but their loan portfolios also have grown twice as fast. District banks returned to lending sooner than banks in the rest of the country and experienced more rapid loan growth due to the region’s economic strength.

…Possibly reflecting banks’ quest for yield in a low-interest-rate environment, the so-called three-year asset/ liability gap has been growing, particularly for district banks. This measure subtracts liabilities with maturities greater than three years (certificates of deposit, for example) from loans and securities with maturities greater than three years and divides the difference by total assets. A bigger gap means that banks would be hurt by rising interest rates because their assets are tied up for a longer time relative to their liabilities. Consequently, when interest rates rise, banks’ funding costs could rise while interest income remains stagnant, squeezing profitability.

…The other big concern is potential fallout from recent dramatic oil and gas price declines, which affects Texas banks in particular. In July 2014, the West Texas Intermediate (WTI) spot price exceeded $105 a barrel; by March, it had tumbled to below $50 before bouncing back to near $60 at the start of May. The size and rapidity of the decline raised concerns about the impact on the Texas economy and Texas banks, especially given the experiences of the energy and financial collapses of the 1980s. While the state’s economy has become more diverse and thus less reliant on the oil and gas industry, the price drop has still negatively affected the Texas economy and labor market. Some pockets of the state remain heavily dependent on the energy sector, making local industries vulnerable to spillover effects. And because of community banks’ close ties to the areas they serve, they are more exposed than large banks.

…One measure of potential distress is the so-called Texas ratio, the book value of an institution’s nonperforming assets as a percent of its tangible equity capital and its loan-loss reserves. Essentially, the Texas ratio compares an institution’s bad assets to its available capital. A Texas ratio above 1 (expressed as 100 percent) indicates that probable and potential losses exceed an institution’s immediate loss-absorbing cushion, putting it at greater risk of bankruptcy. There have been two instances of dramatic oil price declines since 1980; one gives rise to concern and the other to hope.

Between June 1980 and September 1986, the WTI price declined 74 percent in real (inflation-adjusted) terms. Roughly 20 percent of all Texas institutions had a Texas ratio greater than 100 percent by year-end 1988. A staggering 706 Texas banks and thrifts failed—including nine of the 10 largest banking institutions—between September 1986 and year-end 1990.9

A more recent oil price decline, in the second half of 2008 and early 2009, was also dramatic, but in a different way. Over a nine-month period beginning in June 2008, the price fell more than 71 percent. Yet less than 1 percent of Texas banks had a Texas ratio exceeding 100 percent and only seven failed in 2008–09. The slight pickup in bank troubles in 2010 is likely attributable to generally difficult financial and economic conditions that year.

From June 2014 through March 2015, the price of WTI fell 58 percent. Nevertheless, not one Texas bank had a Texas ratio greater than 100 percent as of the first quarter and only one bank had failed as of March.

The bottom line: The persistence of low oil prices seems to matter more for banks than the magnitude of falling prices. A precipitous, but short-lived, decline is likely to have only a minor impact on the banking industry. Even a longer-term decline similar to that seen in the 1980s is unlikely to provoke the same scope of disruption now as it did then.

…Mitigating factors also make Texas banks better able to weather falling oil prices. Memories of the 1980s crisis linger, and the 2008–09 financial crisis is also fresh in the minds of bankers and regulators. Apart from regulatory changes, Texas bankers manage their risks more prudently, using better risk diversification. The Shared National Credit (SNC) program is one example. Generally, large loans are held by multiple institutions through the SNC program, allowing individual institutions to spread the risk of large credit exposures. While the SNC program has been around since 1977, it has grown in importance and coverage. SNC industry trends by sector show that commodities credits, including those tied to the oil and gas industry, increased from $395 billion in 2002 to $798 billion in 2014. Regulatory filings and investor conference calls suggest that energy exposure at the larger banks in Texas is now predominantly through these shared credits.

…The low-interest-rate environment and a flat yield curve with relatively little difference in interest rates across various maturities have pressured bank earnings over the past five years. Banks have responded by extending their maturity profile in an attempt to generate more robust returns. As interest rates normalize, regulators will need to monitor banks’ ability to restructure their maturity profiles and adapt to the new environment.

The impact of recent oil price declines on banks also bears watching, particularly in Texas. While banks appear to be managing their energy exposure well—and a relatively short spell of low energy prices is not expected to have a severe, adverse effect on local banks—the importance of energy in certain regions points to the possibility of relatively large localized disruptions. The banking system has navigated a post crisis path to recovery. Conditions have improved markedly, but the industry must remain vigilant to potential risks to its financial health and stability.

According to the Dallas Fed – Texas Economic Indicatorspublished on 4th June, the region is showing mixed performance:-

Region Employment Growth
Austin 7.70%
Dallas 2.20%
El Paso 3.30%
Houston 0%
San Antonio -0.50%
Southern New Mexico -0.90%

Source: Dallas Federal Reserve

For the state as a whole, April employment was 1% higher versus the US +1.9%. The largest fall was seen in Oil and Gas Extraction (-14.4%) followed by Manufacturing (-4%) and Construction (-2.6%). Leisure and Hospitality led employment increases (5.3%) Information (4.6%) Education and Health (2.6%) and Trade, Transportation and Utilities (2.3%).

The importance of Oil and Gas to Texas, from an employment perspective, is small– only 2.5% of the workforce – but the sector’s impact on the rest of the region’s economy is much greater. Many ancillary sectors, including manufacturing, banking and finance rely on energy. The most encouraging aspect of the data above is the 2.3% increase in Trades, Transportation and Utilities. As an employer this sector amounts to 20.2% of the total. For this sector, lower energy prices are like the tax cut John Mauldin alluded back in December.

The Energy Complex and US growth

The recent energy technology boom has increased the oil and gas sector’s importance – please revisit Manhattan Institute – New Technology for Old Fuels – my personal favourite essay on this subject. The share of oil and gas in total employment peaked in the early 1980s at 0.8% it’s now back to 0.5%. Its share of GDP followed a similar path, falling from 4% in the 1980’s to less than 1% at the start of the millennium; it’s now back around 2%. Energy self-sufficiency remains elusive – the US is still a net oil importer and therefore benefits from lower oil prices. The Energy Information Administration (EIA) estimates a $700 per household saving from the decline in gasoline prices in 2015. This should also spur an increase in capital investment. The traditional estimate of a halving of output has increased dramatically; meanwhile energy efficiency has significantly improved. The fall from $105 to $60 – assuming the market remains around the current level – will probably add 0.4% to GDP.

As one might expect, the direct impact of cheaper oil on the energy sector has been negative. The US rig count fell by 850 between December 2014 and March 2015. Many energy exploration firms have reduced headcount and cut capital expenditure. I don’t believe the benefits of technology have been exhausted by the energy exploration firms, especially the shale-industry. The Manhattan Institute – Shale 2.0 – takes up the story and go on to make some policy recommendations:-

John Shaw, chair of Harvard’s Earth and Planetary Sciences Department, recently observed: “It’s fair to say we’re not at the end of this [shale] era, we’re at the very beginning.” He is precisely correct. In recent years, the technology deployed in America’s shale fields has advanced more rapidly than in any other segment of the energy industry. Shale 2.0 promises to ultimately yield break-even costs of $5–$20 per barrel—in the same range as Saudi Arabia’s vaunted low-cost fields.

The shale industry is unlike any other conventional hydrocarbon or alternative energy sector, in that it shares a growth trajectory far more similar to that of Silicon Valley’s tech firms. In less than a decade, U.S. shale oil revenues have soared, from nearly zero to more than $70 billion annually (even after accounting for the recent price plunge). Such growth is 600 percent greater than that experienced by America’s heavily subsidized solar industry over the same period.

Shale’s spectacular rise is also generating massive quantities of data: the $600 billion in U.S. shale infrastructure investments and the nearly 2,000 million well-feet drilled have produced hundreds of petabytes of relevant data. This vast, diverse shale data domain—comparable in scale with the global digital health care data domain—remains largely untapped and is ripe to be mined by emerging big-data analytics.

Shale 2.0 will thus be data-driven. It will be centered in the United States. And it will be one in which entrepreneurs, especially those skilled in analytics, will create vast wealth and further disrupt oil geopolitics. The transition to Shale 2.0 will take the following steps: 1.Oil from Shale 1.0 will be sold from the oversupply currently filling up storage tanks. 2. More oil will be unleashed from the surplus of shale wells already drilled but not in production. 3. Companies will “high-grade” shale assets, replacing older techniques with the newest, most productive technologies in the richest parts of the fields. 4. And as the shale industry begins to embrace big-data analytics, Shale 2.0 begins.

Further, if the U.S. is to fully reap the economic and geopolitical benefits of Shale 2.0, Congress and the administration should: 1. Remove the old, no longer relevant, rules prohibiting American companies from selling crude oil overseas. 2. Remove constraints, established by the 1920 Merchant Marine Act, on transporting domestic hydrocarbons by ship. 3. Avoid inflicting further regulatory hurdles on an already heavily regulated industry. 4. Open up and accelerate access to exploration and production on federally controlled lands.

Nonetheless, in the near-term, states which benefitted from $100+ crude oil and the energy related innovations it spawned, are now feeling the effects of what appears to be a sustained period of lower energy prices. The EIA predicts WTI crude will average $60 over the course of 2015.

The CFR – Energy Brief – October 2013 – predicted that a 50% oil price fall would affect the employment prospects of eight states in particular:-

State Fall in Employment
Alaska -1.70%
Louisiana -1.60%
North Dakota -2%
New Mexico -0.70%
Oklahoma -2.30%
Texas -1.20%
West Virginia -0.70%
Wyoming -4.30%

Source: Council for Foreign Relations

So far, if Texas is any guide, the negative effects of the oil price decline have failed to materialise.

The effect of a 25% rise in crude oil prices is also worth considering:-

State Employment Change State Employment Change
Wisconsin -0.74 Ohio -0.61
Minnesota -0.73 Missouri -0.6
Tennessee -0.72 Illinois -0.59
Rhode Island -0.71 Massachusetts -0.59
Florida -0.71 Delaware -0.58
New Hampshire -0.7 South Dakota -0.57
Idaho -0.69 New York -0.57
Nevada -0.69 California -0.56
Arizona -0.68 Alabama -0.56
Indiana -0.68 DC -0.5
Nebraska -0.67 Kentucky -0.48
Vermont -0.66 Pennsylvania -0.47
Iowa -0.66 Utah -0.38
New Jersey -0.65 Kansas -0.35
Washington -0.64 Mississippi -0.35
Maryland -0.64 Arkansas -0.34
Georgia -0.64 Montana -0.31
Michigan -0.64 Colorado -0.15
Virginia -0.64 New Mexico 0.36
South Carolina -0.64 West Virginia 0.36
Oregon -0.64 Texas 0.6
Connecticut -0.63 Louisiana 0.78
Maine -0.62 Alaska 0.87
North Carolina -0.62 North Dakota 1.01
Hawaii -0.61 Oklahoma 1.16
Wyoming 2.14

Sources: CFR, U.S. Bureau of Labor Statistics and the Wall Street Journal

The effect on the US as a whole is estimated at -0.43%. In other words, a fall in crude oil is good for employment and should also act as a cathartic stimulus to GDP growth.

A final measure of the vulnerability of the US economy to the recent oil price decline is shown by the next table. This shows the substantial diversification away from the energy sector seen in every one of the major oil producing states since the 1980’s:-

Share of Oil and Gas Extraction as a % of GDP
1981 2000 2010
Alaska 49.5 15.1 19.1
Louisiana 35.5 11.1 9.7
New Mexico 26.1 5.2 5.1
North Dakota 20.3 0.9 4.3
Oklahoma 21.6 4.8 9.1
Texas 19.1 5.8 7.8
West Virginia 2.4 1 1.5
Wyoming 37.1 9.8 18.5

Source: CFR, U.S. Bureau of Economic Analysis

Looking at how unemployment has changed across the 51 states over the last 12 months:-

State April April 12-month net change
2014 2015
Alabama 7.1 5.8 -1.3
Alaska 6.9 6.7 -0.2
Arizona 6.9 6 -0.9
Arkansas 6.3 5.7 -0.6
California 7.8 6.3 -1.5
Colorado 5.4 4.2 -1.2
Connecticut 6.8 6.3 -0.5
Delaware 5.9 4.5 -1.4
DC 7.8 7.5 -0.3
Florida 6.4 5.6 -0.8
Georgia 7.3 6.3 -1
Hawaii 4.5 4.1 -0.4
Idaho 4.9 3.8 -1.1
Illinois 7.4 6 -1.4
Indiana 6 5.4 -0.6
Iowa 4.4 3.8 -0.6
Kansas 4.5 4.3 -0.2
Kentucky 7 5 -2
Louisiana 5.7 6.6 0.9
Maine 5.8 4.7 -1.1
Maryland 5.9 5.3 -0.6
Massachusetts 5.8 4.7 -1.1
Michigan 7.5 5.4 -2.1
Minnesota 4.2 3.7 -0.5
Mississippi 7.8 6.6 -1.2
Missouri 6.3 5.7 -0.6
Montana 4.7 4 -0.7
Nebraska 3.4 2.5 -0.9
Nevada 8.1 7.1 -1
New Hampshire 4.5 3.8 -0.7
New Jersey 6.7 6.5 -0.2
New Mexico 6.7 6.2 -0.5
New York 6.5 5.7 -0.8
North Carolina 6.4 5.5 -0.9
North Dakota 2.7 3.1 0.4
Ohio 5.9 5.2 -0.7
Oklahoma 4.7 4.1 -0.6
Oregon 7 5.2 -1.8
Pennsylvania 6 5.3 -0.7
Rhode Island 8.1 6.1 -2
South Carolina 6.1 6.7 0.6
South Dakota 3.4 3.6 0.2
Tennessee 6.5 6 -0.5
Texas 5.2 4.2 -1
Utah 3.8 3.4 -0.4
Vermont 4 3.6 -0.4
Virginia 5.3 4.8 -0.5
Washington 6.2 5.5 -0.7
West Virginia 6.8 7 0.2
Wisconsin 5.5 4.4 -1.1
Wyoming 4.3 4.1 -0.2

Source: Bureau of Labor Statistics

Only Louisiana (+0.9%) North Dakota (+0.4%) and West Virginia (+0.2%) of the top oil producing states, have witnessed increased levels of unemployment. South Dakota (+0.2%) and South Carolina (+0.6%) were the only other states in the union to see unemployment rise. This is not the picture of a faltering economy.

The Federal Reserve Leading Index, whilst it hit a low point of +0.9% in January – down from +2% in July 2014 – has rebounded – April +1.12% – and has remained in positive territory since August 2009. The Conference Board Leading Economic Index increased 0.7% in April to 122.3, following a +0.4% in March, and a -0.2% February. The Conference Board commented:-

April’s sharp increase in the LEI seems to have helped stabilize its slowing trend, suggesting the paltry economic growth in the first quarter may be temporary. However, the growth of the LEI does not support a significant strengthening in the economic outlook at this time. The improvement in building permits helped to drive the index up this month, but gains in other components, in particular the financial indicators, have been somewhat more muted.

The outlook appears steady rather than robust but this has been the pattern of the economic recovery ever since the first round of quantitative easing (QE) in November 2008.

Conclusion and Equity Investment Opportunities

The US economic recovery remains intact. The long run economic benefits of structurally lower energy prices and energy security are slowly feeding through to the wider economy. This is good for the US and, as long as the US continues to run a trade deficit with the rest of the world, it’s good for the US main trading partners too.

After a sharp correction in October 2014 the S&P500 recovered. Since its January lows the market has ground slowly higher:-

S&P500 - 1yr

Source: Barchart.com

The table below shows a series of additional valuation measures:-

Indicator Ratio Date Start of Data
Trailing 12 month P/E 20.53
Mean 15.54
Min 5.31 Dec 1917
Max 123.73 May 2009 1875
Shiller Case P/E 27.1
Mean 16.61
Min 4.78 Dec 1920
Max 44.19 Dec 1999 1885
Price to Sales 1.81
Mean 1.4
Min 0.8 Mar 2009
Max 1.81 Jun 2015 2001
Price to Book 2.89
Mean 2.75
Min 1.78 Mar 2009
Max 5.06 Mar 2000 2000

Source: multpl.com

On most of these metrics the market looks relatively expensive but the current level of interest rates is unprecedented. JP Morgan Asset Management predict average corporate earnings to grow by 4% in 2015 – stripping out energy stocks this rises to 11%. They also remind investors that the S&P has seen 10 bear markets since 1926. Eight occurred as a result of economic recessions or commodity price shocks (price increases not decreases) and extreme valuations were a contributing factor only on four occasions. They go on to refute the idea that interest rate increases by the Federal Reserve will derail the bull market, pointing to the positive correlation between rising interest rates and rising equity prices when interest rates start from a low point. They make the caveat that the initial reaction to interest rate increases is negative but in the longer term stocks tend to rise.

At the risk of uttering that most dangerous of phrases – “this time it’s different” – I believe the majority of the rise in equity prices was a function of the reduction in the level of interest rates since 2008. This had two effects; investors switched from interest bearing securities to equities, hoping that capital appreciation would offset the declining income from bonds: and corporations, faced with negative real interest rates, decided to raise dividends and buy back stock, rather than make capital investments when interest rates were artificially low. The chart below shows US 10yr Government Bond yields since 1790:-

US 10 yr Bond Yield Global Financial Data

Source: Global Financial Data

The chart ends in 2013, since when yields have plumbed new depths. Ignoring the inflation shock of the 1970’s and 1980’s it would be reasonable to expect US Treasuries to yield around 3% but that was before the Federal Reserve moved from a stable price target – i.e. around zero – to a 2% inflation target. I think it is reasonable for corporates to assume a long-term cost of finance based on a 3% real yield for US Treasuries plus an appropriate credit spread. Is it any wonder that corporates continue to buy back stock?

The impact of the oil price collapse is still feeding through the US economy but, since the most vulnerable states have learnt the lessons of the 1980’s and diversified away from an excessive reliance of on the energy sector, the short-run downturn will be muted whilst the long-run benefits of new technology will be transformative. US oil production at $10/barrel would have sounded ludicrous less than five years ago: today it seems almost plausible.

US stocks are not cheap, but Q1 earnings declines have been reversed and, whilst growth is muted, the longer term benefits of lower energy prices are just beginning to feed through. At the beginning of the year I was cautious and considering reducing exposure to the US market. Now, I am still cautious, but, if earnings start to improve, today’s valuations will prove justified and further upside may be well ensue. The US bond market is doing the Fed’s work for it – 10yr yields have risen from a low of 1.64% in January to 2.30% today. Whilst the first rise in official rates is likely to act as a negative for stocks, the market will recover as long as the momentum of earnings growth remains positive and energy prices remain subdued.