Wednesday 4 March 2015

Deindustrialization: What it means for China, India, and Africa

This post reflects a few thoughts on a book, a paper, and my priors. The book is William Easterly's, The Tyranny of Experts: Economists, Dictators, and the Forgotten Rights of the Poor. The paper is Dani Rodrik's, Premature Industrialization. And my priors are that when it comes to economic development there has to be some lessons to learn from the very few that have pulled off the feat successfully: South Korea, Taiwan, Singapore, and currently China.

Economic development, measured by poor people getting richer (and usually freer), is in my opinion the most important thing going. Obviously, the simple outcome is as complex as a problem gets, but we do have a relatively flushed out highlevel roadmap. Agrarian - Industrial - Post-Industrial.

Perhaps two of the best examples of this phenomenon in recent history have been South Korea and Taiwan. Both took cues from Japan, who went through a similar climb towards the end of the 19th century (the post WWII climb, along with others in Europe, isn't as interesting given the war was an economically exogenous impact, institutions needed to be recreated rather than reimagined).

The book.

I picked up Easterly's book mostly looking forward to getting his take on the East Asian development story. I have to admit to being disappointed. It's not that I strongly disagree with anything. I just don't think he dug in deep enough.

The books is largely a takedown of, 'so called experts'. In this case development professionals that typically try to exert, well intentioned, exogenous forces on the developing world, while failing to recognize (or advocate) the best method of development: getting the hell out of the way.

In the Chinese context this is almost certainly true. South Korea and Taiwan also achieved high income status by increasing the market's hold on the country and it's resource allocation.

So maybe I just picked up a book looking for something that it wasn't. The book clearly and convincingly (disclosure: it confirms my priors in this regard) that freedom is, itself, an end goal. That, at the very least, policy should require a push in this direction (or a very convincing explanation why it doesn't).

But, it seems to me, there is a case to be made for gradualism. In this case, the interesting questions are a). When should China embrace more economic/political freedom? And, b). How best can India (sustain/improve) and Africa (begin) to emulate Chinese economic progress?

After reading Studwell, I talked about this here, as it relate to China the path seems relatively consistent. South Korea and Taiwan acted first to stabilize, then push the agricultural portion of their economies into surplus conditions (via land reform, incentive structuring, increasing market conditions, etc.). Some form of financial repression and/or corruption based incentive structures enticed a significant build up in capital investment that pushed the industrialization of the country forward. Then a loosening of these controls pushing the country into fairly free and democratic entities.

The key difference between the countries that succeeded in making the leap to high income countries and those that stagnated and/or slid back to low-income status (most of SE Asia) was the ability of these countries to push the right sort of industry. This took the form of a difficult balance between market based and expressly anti-market policy.

The reforms that led to the gains and stability at each step were certainly to make them more market based. The surplus agrarian conditions enabled a steady surplus of crop that both freed individuals to migrate to areas with capital accumulation, while also building a savings pool that could be exploited via financial repression to subsidize the investment required in capital accumulation. I think Easterly needs to wrestle with how that financial repression enabled a higher level of development.

The creative destruction of capitalism having a socially sub-optimally high level of capital as it pushed into industrialization (in a fairly market competitive nature) might have added in a level of redundancy that increased the chances of success.

Market and economy sized changes typically happen best at the margins and so aggregate iteratively. This sequential development has been successful because the redundancies that it builds in don't require big perfect pushes to succeed. It requires many gradual trial and errors.

Perhaps if the World Bank and development professionals at large could figure out a way to create a market disciplined pool of excess capital for entrepreneurs to employ in these markets to recreate this financial repression the East Asian model could be exported. Good luck with that.

The paper.

Which brings me to the paper. Rodrick's contention is that the push from industrialization to post-industrialization economies (that also roughly coincided with the final democratization in Taiwan and South Korea) is occurring at an earlier stage of development than we have previously seen.

IF this is true (the case seems compelling, although I wonder if social media and the ability for developing country citizens to see how the richer countries live might push for sub-optimally early reforms; where sub-optimal refers to long run gdp level), and if this is simply a function of changing technology and consumption preferences, then we are forced to consider the implication for those who have yet to achieved developed standards; ie. what does this mean for the poor people we want to see get rich?

My hope has always been that the simple act of moving labor intensive industrial production of 'items' from high income countries to low income countries would move on from China's newly minted (trending towards) high income eastern coast inland to the low income secondary cities. From there, they'd migrate to India. And from there, to Africa. Simplistic certainly, but that's a high, high, level trent that I could simply hope for.

Industrialization certainly doesn't guarantee a result of high income status. But coupled with increasing levels of economic and (hopefully) political freedom; as we've seen in China, it does seem to be the best bet in moving from VERY low income levels, to simply low or middle income status. The catch up process is fairly simple to implement. The quantity of human capital required is huge and the quality of human capital required is low. That's ideal for this initial transition.

But what if China's eastern coast doesn't get to a level of income that sustainably establishes it as an importer of labor intensive goods? What growth model can India and Africa look towards (I know, I know, referring to Africa as one political entity doesn't make sense, I'm just using it to refer to a large mass of people I'd like to see become richer)?

Rodrik points out that growth/development is becoming more and more dependent on capital inflows, transfers, or commodity booms. He suggests this brings sustainability into question. More specifically it takes alot of the onus off the country and places it on exogenous factors, namely those with excess capital; ie. the rich world.

The conclusion.

Which ties this all together. The more existing growth models require exogenous factors, these developing countries will become more and more reliant on the whims of the rich. Often in the guise of the experts (well intentioned or not) that Easterley skewers.

It's hard to say how this dynamic will play out, but it adds to the already intriguing development/reform story going on in China.

Friday 6 February 2015

Has Putin Already Won???

Front Page Magazine

With Merkel and Hollande meeting with Putin shortly to discuss a ceasefire, media coverage has been speculating as to the possible out comes. But in looking through a few of these accounts I'm struck by the notion that Putin already has won. Here's what I mean:


The Telegraph.

The Wall Street Journal.

The Guardian.

Notice it? Crimea? No?

It's not in there. Was the eastern conflict (which Russia isn't officially involved in of course) simply a way for Putin to consolidate his hold on Crimea?

The whole world: Vladamir, we need to stop the fighting in the Ukraine. They are a sovereign country and your border seems awfully porous when it comes to both people and weapon movements. We want to remove these sanctions but until the killing stops, we simply can't.

Vladamir: Ok, Ok. Because I'm so reasonable and such a nice guy I will step up and help solve this eastern Ukraine crisis which I have no part in but you western softies can't handle.

The whole world: Rejoice, remove sanctions, no more killing, we really diplomacied the shit out of Putin!

Two months later...

The whole world: Remember when we bullied Putin with sanctions until he caved? Wait, what ever happened with that Crimea thing?

It's almost like a reverse Assad moment, where Putin got the 'win' in the media, but really he went and made his ally give up all of his chemical weapons. The outcome was exactly what Obama had wanted.

If Russia is able to consolidate it's hold on Crimea, while having sanctions removed, does that not get Putin the outcome that makes the most sense?

Thursday 29 January 2015

Maclean's Racism Story: Am I a racist?

I'm finally getting around to this story. The Maclean's article: Welcome to Winnipeg: Where Canada's racism problem is at its worst, has pretty much gone viral and has spawned corrections, responses, counter-responses, and so on. I'm going to skip over most of that. Going back to the original article I'll outline my opinions on it and the race conversation in it's entirety.

First, the reason it took me so long to get to this article is that this entire conversation has long been uninteresting to me. Not because racism isn't an issue in Canada, or is an important issue to me, but because the issue is stale. I feel like I've been on all sides of all arguments, and I just don't see any tangible progress being made. When all options are on the table, and a real honest conversation is taking place, I'd happily take an active role in the process. That time is not now. Articles like this help reinforce that.

Maybe I'm mis-defining what stereotyping means, but I use it as a 'judge a book by it's cover' type of term. Now, I've never understood why this term carries a negative connotation. If you go into a book store. Do you grab a book at random, read the entire thing through, then decide if you should buy it? No, you gather as much information as you can from the covers and form a judgements of their viability.

Based on those judgements of that cover, you might be able to make a selection. But if your requirements are more stringent, you take the information you've gathered and flip open the jacket and read the summary. Perhaps you read the jacket reviews, or perhaps you quickly flip to amazon and read some customer reviews. The point is, you gather information every step of the way to a level sufficient enough to fill your criteria. There is no objective 'right' level of scrutiny required, but simply, a subjective 'right' level given time and personal preferences.

My point is that useful information can, and should be made, when little knowledge is at hand. An honest discussion about it's use and how to improve upon how we upgrade our priors would be much more useful than simply calling it racism and wiping our hands of it.

On to the article.

My first problem: The use of polling 

I clicked through the CIIM link, but after three clicks of trying to find the study that the figures were drawn from, I lost interest. How do you rely on figures and not make them easy to access?

Citing that, 'one in three Prairie residents believe that "many racial stereotypes are accurate" or that, '52 per cent of Prairie residents agree that Aboriginals' economic problems are "mainly their fault."' as proof of racism seems to carry a pretty significant explanation. We don't get it.

Let's consider racial stereotypes. Thought experiment: random white person vs. random asian person; math contest... who would you bet on? (full disclosure: as a half white and half asian person I can make this comparison). One more? Random white person vs. random asian person; driving contest... who do you bet on?

Now, the failure to update your bet upon acquiring further information, may stem from prejudice or from poor gambling skills, whatever motivates that that decision (to me) would determine if a person is racism or not. But to suggest that holding an opinion based racial identity as 'racist', kind of dilutes the term to the point of being worthless. This is where I believe discussions find themselves now.

If someone called me up and said: do you think most racial stereo types are true, I'd say, yes I'm a pretty effective stereo typer. Am I racist? Depends how you define it. I make a pretty qualitative difference, and as a good bayesian, I update my priors as often as possible and as objectively as possible. Simple race based information is largely useless next to good info.

So, perhaps asking about what the author believes to be racial stereotypes, specifically would be useful. And then asking what how that stereotype impacts their view of a random person would be useful. But a vague yes or no to a vague question about a vague topic? Useless (this of course assumes that is how the data was collected, which the article didn't really present readily, and in the internet age, that seems inexcusable).

In terms of the 'their fault' result. First, what are Aboriginals' economic problems? I really hope a more specific set of questions were asked, but again, I don't care enough to dig through website links. Likely, this pushes another vague concept: 'economic', and reports a yes or no answer.

Life is a sum of our choices. Not graduating high school? A choice. Not going to University? A choice. Doing illegal activities and running the risk of a criminal record? A choice. These are all significant factors in determining economic outcomes. I'd answer yes, it is 'mainly their fault' with the caveat that these choices are ultimately up to the individual but they stem from a complex web of interconnected occurrences both involving individual choices and non-individual surroundings and influences. Those surroundings, largely out of the control of the individual will often pre-dispose them towards making choices, if they don't maximize the probability of economic successes then the blame does not solely fall on the individual. Ultimately, a choice is a choice. But there is a lot going on in those choices. Again though, the implication is I'm a racist.

I'll even leave the 'hearing negative comment' poll alone (did they ask about intent?).

My Second Problem: Causation vs. Correlation

Drawing causal inferences from observed outcomes is difficult in almost any circumstances. That's why one handed economists are so often longed for (... but on the other hand). But that exists for a reason. Simply taking an out come, and observation, seeing the correlation and chalking the observation up as the causal factor is troubling even with a decently flushed out theoretical underpinning.

This article takes as given that 'racism' is both an observable and casual factor in social and economic outcomes without explaining the linkages. I'm not even saying it isn't a factor here, I'm saying that it's a lazy and uninteresting way to make an argument.

I remember back during my undergrad hockey playing days (at St. Lawrence University) one of the deans was giving the atheletes a lecture on racial sensitivity and, using the hockey team as an example, said (paraphrased): as a black man, if I were on the hockey team, I'd have to wonder where the diversity is.

Now, my brother (also on the team) and I are very much visible minorities and were both laughing. The implication that the outcome: no black folks on the team. Equated to a bias: against black hockey players. Seemed laughable to us then, and still to me now. Do you know how many black kids played hockey in Canada when I was growing up, probably about the same as there was asian kids (like myself, who was often 'stereotyped?' as being aboriginal). You know how many black NCAA hockey players there were when I was in college? Probably about the same as there was asian NCAA hockey players when I was in college. IS that racism? Or were there more good white hockey players to choose from? Is it racism to have the people best suited for an outcome, get that outcome? Depends how you define it I suppose.

When it comes to more serious issues like health, education, criminal, and economic outcomes the implication that correlation equates causality along these simple racial lines isn't laughable, but it should be met with a pretty healthy dose of skepticism and context.

Murdered teens, elevated incarceration rates, elevated poverty rates, these are outcomes that are used to show us that racism persists. For racism to be the cause shouldn't we find a better control group? What about other races with comparable levels of education, from comparably broken homes, and people in as high of risk factor settings.

Certainly, proportionally aboriginals find themselves in higher risk situations, but addressing these situations instead of assessing how racist the outcomes are seems like a different conversation all together. Am I mistaken here?

The author clearly states that a number of risk factors are more prevelant in the aboriginal communities, but doesn't offer an explanation about why it's simply 'racism' to blame.

If the risk of getting murdered as a teenage girl goes up in the presence of: growing up in a broken home, travelling alone in a city, substance abuse (self inflicted and the presence of it), and sex trafficking, is race the dominant factor? My assumptions are clear, that these factors do increase the risk of ending up murdered. But to conclude that race is the dominant factor you'd have to assume that race is the primary cause of these factors. I'm not even saying that this is false. I'm just saying that it should have been explored in this article.

Were these outcomes perpetrated on the victims by people with racist intent? I haven't heard if racially motivated people perpetrated the murders, abuses, or neglect. If that is so, I am all for addressing that. This article doesn't flush any of that out.

Instead the author observes the correlation (not causation) between race and these risk factors. Then points to these risk factors and the victim. Then draws the line between race and the victim; without justifying the other steps. Outcome. Correlation. Conclusion. Outcome. Correlation. Conclusion.

It just seems lazy.


Look, Racism is a despicable act that needs to be addressed whenever, and wherever it rears up. But I don't think that outcomes falling disproportionately on a race equate racism. Racism, to me, is when opinions, beliefs, and MOST importantly actions and policy can only be justified on racial terms. I abhor this absolutely (or sex, or religion, or sexual orientation) but that isn't what the author is after.

If school funding is the problem (as implied, but my knowledge on the topic is basically nil), go after whoever is in charge of that and insist that they justify it without using race (is it net tax flows? is there something in the treaties?). If they can't? It might be racism.

If native deaths are being neglected, go after the investigators and insist that they justify it without using race (neglect across the board? higher incidence rate?). If they can't? It might be racism.

Is this unreasonable? I don't know, it doesn't seem so to me.

Policy addressing these 'racial' issues need not be justified in racial terms. If you're disadvantaged, we'll help. If you're in a high risk situation, we'll help. Income redistribution? I'm actually for it (despite my largely libertarian bend), but I don't understand why race need be involved in that discussion. Same rules for everyone makes sense to me.

If you're comparing social outcomes of two groups wouldn't the obvious place to start looking be how each group is represented legally and making them the same? I don't get it, and I'd love for someone to fill me in. This article doesn't do that.

And this is largely why I simply abstain from this whole mess of a conversation, and why nothing will change. I'm usually told it's a legal issue with treaties and all that good stuff. That may very well be so. I don't know. I don't care. The whole conversation shifts from looking for the best possible outcome, to justifying ones priors. I'll leave that to politicos and the lawyers. I don't find that interesting. So I move on.

The bottom line is that there is a huge discrepancy in outcomes that I'd love to play a part in addressing. I just don't think all of the options are on the table. They aren't. But broadly painting outcome differences as simply 'racist' doesn't seem helpful. Writing articles as sloppy as this doesn't seem helpful either. Everyone gets to reaffirm their priors and the conversation sits exactly where it's been.

Thursday 22 January 2015

China's 2014 GDP Miss

Important context for the Chinese slowdown provided by the Economist:
China joined an exclusive club last year: its economic output exceeded $10 trillion, making it only the second country to achieve that feat (America reached this level in 2000). At market exchange rates, China’s economic output was $10.3 trillion last year, more than five-times bigger than a mere decade ago, when it was $1.9 trillion.
It almost feels like commentators lose sight of the fact that we're talking about a slowdown in GROWTH  rather than an aggregate decline. The article goes on to mention that lower growth rates of a larger base still adds more additional demand than the staggering growth rates up to the most recent years (when the base was sufficiently large).

The article also points to the changing composition of the growth where consumption and services are playing a more prominent role (as constantly pushed by external and internal reform minded folks as a needed rebalance alike). I've long said that China has recognized this need and should be given the benefit of the doubt in achieving them at their own pace given their track record over the past couple of decades, so I'll focus on the second point made:
Second, healthy wage growth means that labour’s share of China’s economic output rose last year, another critical part of tilting the country towards greater consumption. After controlling for inflation, incomes increased 8% last year, three-fifths of a percentage point faster than the economy as a whole. Importantly, this income growth probably also resulted in a mild improvement in income equality within China because it was rural citizens, poorer than their urban counterparts, who did particularly well. Rural incomes increased 9.2% last year on average, while urban incomes rose 6.8%. The gap between urban and rural incomes peaked at a ratio of 3.3-to-1 in 2009; it fell to about 2.9 last year.
China is adding jobs, increasing income, all while undertaking structural reforms. We've seen the Shanghai and Shenzhen stock markets finally gain traction over the last year (up 55% and 42% respectively) as these markets have slowly been opened to foreign money.

The bottom line is growth does not equal growth does not equal growth. China isn't undertaking the Shock Therapy type of timeline that apparently most people want them to undertake, but why does this surprise anyone?

Again, it comes down to where the benefit of the doubt should lie. I still have to side with the Xi and the rest of the party leaders over media 'experts' on this front. Missing their growth target could have been bad, had they maintained the status quo. Missing their growth target while undertaking some pretty massive, if not too gradual, reforms. I'd chalk it up as a win.

Friday 16 January 2015

The Supply Side: Cracks showing?

IEA Revises Production Down for 2015

The IEA's revision of non-OPEC supply growth in January's Open Market Report hints at the supply side destruction I've speculated about previously.

While they point to a 175k bopd revision in Columbia, they also show a 95k bopd in the US and 80k bopd in Canada. The article speculates that price may not turn quickly, but these low prices aren't likely to achieve any sort of steady state equilibrium (emphasis is my own):
The most tangible price effects are on the supply front. Upstream spending plans have been the first casualty of the market's rout. Companies have been taking an axe to their budgets, postponing or cancelling new projects, while trying to squeeze the most out of producing fields. For the most part the supply effects will not be felt immediately, but further down the road, through project delays and faster decline rates. Nevertheless, expectations of non-OPEC supply growth for 2015 have already been downgraded, with growth for the year adjusted downwards by 350 kb/d since last month's Report and more steeply so for 2H15. Colombia and Canada lead the declines. Expectations of US light, tight oil production growth have also been revisited, but so far the cuts do not exceed 80 kb/d compared with our already conservative previous estimates, as many producers appear to be well hedged against short-term price drops. 
There's alot of meat in that, but I think this is a question of market interpretation. To me, when I read that, I see high cost oil as being the intuitive easy casualty. But with Canadian oil growth coming from the oil sands it merely gets pushed back a time period.

The light tight oil game is where the action will be. Production won't drop in the short term due to price hedging.Which makes sense. But what happens when those hedges need to be renewed? What happens when the financing used to drill the wells coming on line need to be re-upped on the next wells?

LTO Decline Rates

I keep harping on this, but it just seems like the story to me: faster decline rates. It's almost worth subscribing to these IEA reports just to get the more detailed version, but that's a huge differentiator.

Accepting the premise that the US LTO is the marginal barrel of oil (ie. that it's incredible production growth has largely led to the supply glut we're seeing) then the implication of it's behavior and sensitivity to these market conditions is paramount. Decline rates are important because they need to be replaced with new production before growth can occur. That LTO has achieved that so far is incredible. And according to my premise has been the most impactful development in terms of this supply glut/price gutting.

Market Implications

Remember, markets move on expectations. Sure, the current real time conditions (price obtained, quantity produced, etc.) matter, and arguably matter the most, in forming those expectations. But when these companies go to market for financing they will be faced with financiers concerned with the price obtained in the future and the quantity produced in the future. Both of which get murkier by the day. Uncertainty requires price premiums.

Remember, saying that someone is well hedged also means that someone hedged them unprofitably. Did they adequately price in the possibility of sub $50 oil when the contracts were written? I'm guessing they didn't. So if there were any wells deemed marginally economic with these contracts locking in the well hedged prices, they likely won't be any longer even if price rebounds to $100.

The players writing those hedges may exit the market altogether or they may re price those hedges. The point is that this past 6 months has to materially impact expectations (for the majority of us that didn't see sub-$50 oil coming), risk premiums, and general participation rates.

That is strictly on the hedging side. But the same applies to financing. What was the range of price used in sensitivity testing? My assumption is p ($50) last summer was tiny if even considered. Will it remain that way if oil prices rise back up to $100+ by this summer? There is no way. Again, as financing gets more expensive or dries up previously marginal economic wells aren't drilled.

Aggregate Impact

The physical properties of LTO being high initial production (IP) into a steep decline places a greater importance of these wells continuously being drilled. Aggregate production from a play depends on it, I've referred to this previously as the need to increasingly increase drilling activity. Particularly if you consider the creaming effect (cream rises to the top, top prospects are drilled first) and a maturing LTO play.

So again, if prices remain low I think we'll see the IEA consistently revise this US projection number down.

I look forward to next month to see if I'm full of shit or not!

Wednesday 14 January 2015

"Islamophobia" - Am I a bigot? Am I racist?

In the wake of Charlie Hebdo we're seeing, what seems to me, another wasted opportunity to address the real issue here. Stupid ideas. In this case, 'my' being offended justifies my action of killing you. Stupid idea.

Rather then asking: how did these idiots arrive at this decision? We focus on the outcome. We call it radicalization and wipe our hands of it. They are crazy! Irrational! You can't reason with them! Look at most Muslims they do good stuff. Therefore, these idiots aren't 'true' Muslims.

So we look past their stated motivation. Even worse, people like me who say: "they are telling us why they did it, it's their religious conviction" get branded as an islamophobe and conversation shuts down. "He's a bigot, he's a racist (?!?), bigot's and racists don't have anything useful to say, so he doesn't have anything useful to say!"

First, lets knock that shit off. It's clearly not racism. By definition. Next, Islamophobia. Is it 'bigoted"? What is Islamophobia? What is bigotry? Some definitions to start off. Here's Google:
an extreme or irrational fear of or aversion to something.
And of course bigot:
a person who is intolerant toward those holding different opinions.
Ok, so there probably is a fairly significant overlap between those irrationally afraid of Muslim's and those who are bigots. But am I a bigot? Do I have an irrational fear of Islam?

It's worth defining what the Islam in Islamophobe is. Because really, who the hell knows? I've read the Bible, and I've read parts of the Quran. It's the same basic stuff. You can read it any which way you want. 'Nice' people take nice stuff from it. 'Shitty' people take shitty things from it (remember Abraham, who's willing to murder his kid because god told him to? Well 'shitty' people might think a voice in their head is justification enough to kill someone. Where as 'nice' people.... wait, how would a nice interpretation of that story go?).

Mea Culpa: I'm scared of shitty people who take their direction from other shitty people who take direction from a book written centuries ago. This is materially different then my intellectual disagreement with nice people taking their direction from other nice people who take direction from a book written centuries ago.

But, let me be clear: I'm scared of any shitty person, who takes their direction from other shitty people, especially when they take their direction from a book written centuries ago. Particularly if your conviction is strong enough for you to employ this direction in the physical world and impact others (if you just think it, I still think you're an idiot, but also believe in (and will defend) your right to think like an idiot). I don't care what else you believe, how you look, how old you are, your race, etc.

I'm also Bayesian by nature, so this fear has zero impact on my life because I know the vast majority of people who disagree with me out there, simply disagree with me and (like me) often find these disagreements make for the best conversations! "Am I going to get killed" would be so far down the list of questions I ask myself upon meeting a Muslim that it's essentially irrelevant. But I still think that it's worth pursuing the implications of this intellectually.

Here's the truth: I am more afraid of the shitty Muslims folks who take their actions from other shitty Muslim folks, then I am of shitty Christian folks who take their actions from other shitty Christian folks. Is this 'Islamophobia'? I guess you could define it as such if you want.

But why? I think that relative fear is rational. 'Shitty' Christians in this day in age try to prevent gay people from getting married and want to change school curriculums. The logic behind these actions are just as stupid as the logic behind the more violent perpetrated by 'Shitty' people in the Islamic world, but the outcomes are clearly less worse (but still terrible). Now neither of these fears are nearly enough to impact my day to day. Is that a phobia? It doesn't seem so. But it's all semantics. If you put me up on a split screen with a 20 second summary of my thoughts it might be labeled so.

And I'm not saying one religion is better or more 'true' then any others. I'm saying the outcomes that stem from some are currently better then other. Not always were, not will be in the future, but at this point in time the out comes are better. The simple truth is that I think no justification for any action should ever be faith based. I just think that reevaluating all laws, social constructs, etc. in a manner that says "not good enough" when someone says, "it's what we believe", or "it's always been done this way", would make this world a better place.

Don't think women should be allowed to drive? Justify it. Don't think two dudes should be allowed to have sex? Justify it. Don't think girls should be allowed to go to school? Justify it. Don't use "it's what we believe", or "it's always been this way" and justify it. I'm actually curious, and all ears. I've never heard an argument that made any sense under these requirements.

Anyone that knows me, knows I don't have alot of patience for 'faith'. I think this is a good place to define that term. From Google:
complete trust or confidence in someone or something.
"this restores one's faith in politicians"
strong belief in God or in the doctrines of a religion, based on spiritual apprehension rather than proof.
My problem with faith has to do with the combination of both points of the definition. A complete trust or confidence and the absence of proof. In fact, that's typically how I define faith, I rid it of any religious connotation. Faith: belief in or of something, in the absence of proof. It just seems like a dumb way to justify something. I believe it because I believe it. Now, the counter argument is, well you have faith that faith is a bad way to arrive at a decision. If you see those as symmetrical in their dogma. We'll have to agree to disagree.

Faith takes many different forms, and results in many different actions. I'd probably even argue that the vast majority of these faith based actions result in positive outcomes (although I think better justification for those actions are redily available, like helping out a poor person because you care for their well being not because your mandated by faith).

The problem is that the justification for those perpetrating the action resulting in a positive outcome, is the exact same justification as those who perpetrate the action resulting in a negative outcome.

In simplified terms: the little old lady who volunteers down at the soup kitchen 'because of her faith' employs the same logic as the guy who doesn't eat bacon "because of his faith", or lets kids think their friends (who don't share their faith) are going to roast in hell for ever "because of their faith", and the guy who thinks his daughter deserved stoning for hurting his feelings (I never really got honour killings) "because of his faith".

My point is that unless you're willing to look at the underlying reason behind ALL of these actions. You'll never properly address the underlying reason behind ANY specific action.

Until I hear an honest conversation on this front. I'll just keep rolling my eyes at these commentators explaining Charles Hebdo, Al Shabab, Boko Haram, etc., etc.  and hope that tomorrow's story in the world of idiocy is about school curriculums and legal rights, and not about honour killings and terrorist attacks.

Thursday 8 January 2015

2015 Tight Oil's Big Test

There (May) Be Blood

I've been wrong about tight oil production in the US. Or, more accurately, the folks that I think make the most sense on the topic (hence, are much smarter then I) have been wrong about tight oil production in the US. Namely, that the high decline rates of these tight oil wells combined with the 'creaming effect' (that the cream rises to the top so the 'best' areas get drilled up first) would result in a steep decline in production once the production peaked. 

The specific numbers thrown around, guessing the peak level, have been surpassed. But the overall trend described still makes sense to me. What we are seeing now with the collapse in oil prices is certainly going to put this basic notion to the test.

Again, the basic logic: when wells decline quickly (relative to 'traditional' wells) growth in production MUST come from GROWTH in the number of wells being brought on line. That is key, growth comes from an ever increasing INCREASE in wells. Not an increase in over wells in aggregate, since there is a need to replace the rapid run off.

The story described above held that once the best areas of these finite oil plays were drilled up, the production rates of individual wells would fall, requiring either an increase to the increasing increase in wells (think about it) brought on line, or a leveling of production into a steep decline in production (relative to the long slow tailing off of production in traditional oil plays).

So in this story, the price of oil remaining high was assumed. The production decline was motivated by the inability to continually increase growth in new wells (ie. the market for drilling rigs would be at capacity) and/or the decline in production of new wells relative to older wells (the creaming effect).

Now, consider that this story is strictly about physical properties (although the rig capacity might be construed more as a financial property). This doesn't take into account the financial constraints that producing companies are under. For companies that are highly levered, and assuming the financial institutions had based their lending on future cashflows that took status quo production behavior (ie. not considering the creaming effect or the increasing increases effect (I need a name for that)) then if either of these two factors moved in any direction besides positive-positive, we'd likely see forced liquidation into a market that would then be pricing in the new (not positive-positive) understanding of future cashflows.

For anyone to really be an awesome prognosticator they'd have to have seen the 50% drop in oil prices. I don't think anyone has really nailed this. However, this drop in prices exogenously imposes this reduced revenue condition on companies (and their lenders) that would have resulted from a deterioration of the positive-positive scenario.

Forward Guidance: The Saudi's as Oil's Central Bank?

What should we watch for? The biggest wildcard is how long the depressed price of oil should last. Any marketish monetarist (like myself) will tell you that a central bank's best tool in enacting monetary policy is simply stating what you will do in the future. The market reacts to what it thinks is being said, and how credible that is. So the ECB (and the FED to a lesser extend) has constantly undershot the stated 2% inflation target (despite having a dual mandate that should require overshoot in the FED case). So the market basically prices that in. This is why FED statements are so heavily analyzed (we're beyond what they say, but how they say, what mood were the trying to express, etc. etc.). The market is saying: Ok we see what you're doing now, but what are you likely to do in the future. How will that impact the market (This is why a price level of NGDP level target makes the most sense to me, but that's another story for another day).

The interesting choice by the Saudi's to simply say: we're pumping this oil out period. Is that the market gets to weigh: can the physically do it? and, will they actually do it? Well physically, yes, they can produce oil profitably at whatever price the market wants (as far as a best guess goes). They have the cheapest large deposits of oil anywhere. The only corollary to that is in the "budget break even oil price" stat you see trotted out. Ignore that, it doesn't apply here. Will they actually do it? They need the market to think so. They have an example where they didn't do it (in the 70s) where they got screwed over by OPEC (the Saudi's were the only producer to cut).

My guess is they won't do it long term. But from their perspective it makes the most sense to convince the market that they are doing this on a going forward basis. If the market was to price in a Saudi production reduction, or if the Saudi's were to announce a price range they'd like to see oil at, the market would either price that into current prices or, perhaps more importantly for American tight oil, would discount future cashflow accordingly.

And that is the kicker. Now that the market isn't so wildly optimistic about shale, how will this impact drilling. If there is a drop off in drilling, according to the story told above (and the best guesses that I think are the best, best guesses (think about it)) any slowdown in the increasing increase of new wells, will exert strains on future cashflows (the upfront capex savings offsets some portion of the loss in revenue, but again, it depends on the leverage piece).

Are Cracks Starting to Show?

This article from the New York Times (via the Economic Times) identifies a couple cracks starting to show:
The national rig count had remained surprisingly resilient over recent months even as oil prices dropped by more than 50 percent since June, and it still tops the count of a year ago as domestic production continues to surge. 
But an announcement on Wednesday by Helmerich & Payne, the giant contract rig company, that it planned to idle up to 50 rigs over the next month sent shudders through the industry. And that came on top of 11 rigs that it has already mothballed, meaning that in just a few weeks, its shale drilling activity will be reduced by about 20 percent. 
Again, oil producers rely on increasing increases to maintain tight oil projection trajectory. What will happen if the increasing increase of wells drilled/completed stagnates or declines? Well certainly a decrease in production. Since the tight oil of the US (and the Oil Sands of Canada) are likely the greatest contributor to the global supply glut, we'll likely see the markets equilibrate to a higher price level.

Under this umbrella of assumptions. And all else equal, we would expect these tight oil producers to shut in wells until price rebounds. But all else isn't equal here. If a company is highly leveraged or if they've locked themselves into production quotas (for pipeline/rail space contracts) they may be forced to sell into a depressed market.

Access to finance is typically constrained by cashflow, expected cashflow, and equity. 

Here's Nick Cunningham on, in this article he outlines all of the bearish downgrades being issued on oil companies. This stripping away of equity, in a cashflow constrained environment is a company killer if they have debt to roll over.

This article from Market Watch looks at the highyield junk bond market. You can see that Energy has been the largest player since around 2005 with a whole wack of high yield debt. The article outlines the precarious nature of high-yield markets;
There’s “no question” that for energy companies with a riskier debt profile the high-yield debt market “is essentially shut down at this stage,” and there are signs that further pain could hit the sector, Heckman said.

For energy companies with weaker credit, debt spreads are around 800 basis points over Treasurys, he said. 
“We are getting to the point that it is becoming very concerning, “ he said. “In the last few days we’ve seen a further selloff in energy names.” 
For the high-yield debt specifically, there’s a threat to liquidity, and the high-yield market is “very, very sensitive to liquidity.” Liquidity for energy issuers in the high-yield market is gone, and it’s very difficult to be a seller, Heckman said. If liquidity dries up further, the high-yield market would extend the selloff, he said. 
Junk-bond expert Martin Fridson, chief investment officer at Lehmann Livian Fridson Advisors, argued that energy companies aren’t so much shut out of the high-yield market as they may be unwilling to tap it under current conditions. 
He notes that around 30% of the bonds in a key junk-bond index are trading at “distressed” levels, defined as more than 1,000 basis points above U.S. Treasurys, with some sporting yields of around 20%.
The exposure level in the high yield market from the same article is here:


At the end of the day, it's going to be an interesting time for light tight oil. It takes money to make money is about as true as a saying gets. With high capex needed in this space to get wells producing, lots of money is needed to make lots of money.

While things aren't uniform (texas has better existing infrastructure for example). The physical properties and resulting production/decline profiles of the wells are similar across LTO and materially different from conventional oil reserves. How these characteristics aggregate to the entire play remain to be seen. Logically, or mathamatically, it looks fairly obvious. The unknown is when the tipping point will occur.

While I had been really curious to see if and when the physical charactersitics of this type of oil production would find the tipping point, this recent price collapse might just accelerate the process exogneously.

Either way, it's going to be interesting to watch and find out what happens.