Tuesday 9 December 2014

A Follow Up On Supply Side Destruction

I posted here about how I believe markets will behave. My particular emphasis was on the precarious nature of the status quo. Namely, that it's unstable; because current output levels can not be maintained in this current price environment.

It seems to me that the Saudi's need to convince the market that their strategy is the new status quo. Period. We will produce oil if it's economical, our oil is economical down to $x, so good luck with your oil! Similar to forward guidance in monetary policy, the swing producer can only move markets with words if their actions (or more specifically, their communicated future actions) are deemed credible.

Arguments against the credibility of this new non-price supportive strategy seem to hinge on the 'break-even' fiscal story (which gets mentioned all the time and I largely ignore when it comes to KSA). However, in terms of sheer economics, market share, market power, geo-political and regional balances of power, alternative fuel viability, the KSA seems likely to pursue their market grab. At the very least we need to consider it credible until proven otherwise.

Implications of Lower Prices

Although we hear it discussed more and more, I still believe the heterogenous nature of oil market is underreported. First, defining oil is inherently difficult, what we call 'oil' is crude oil, the EIA summarizes the variety here where oil is classified according two qualitative variables: density (API) and sulfur content (sour/sweet). Sweet oil is good (less refining required to get useable product). Mid density is good (the heavier the oil the more 'energy' is contained in the carbon chain, it's a balance between energy content and difficulty in cracking it in the refining process).

The second differentiator is the price differential. In Canada we know all about this. These differentials are driven by the local quality of the oil, but also the ability of that oil to get to markets that want them. The EIA article above outlines that globally. In this article from Bloomberg describes inter-regional price differentials. Which is where things start to get a bit more interesting. First let me set this up a bit.

This article by Euan Mearns on Seeking Alpha points sketches out where the 'new oil' is coming from. Namely, Canada and the United States:

Figure 2 Global production of conventional crude oil and condensate has not changed since May 2005 despite a prolonged spell of record high oil price. All of the growth has come from expensive LTO and tar sands. The toxic mix of high debt and losses in the LTO industry that are in the making may short circuit the global banking system again.
Here, LTO refers to the Light Tight Oil that is typically referred to as shale oil (not to be confused with oil shale). This is the Bakken, The Eagle Ford, the multi-stage fracks, all that good stuff.

So that's the set up. Why these sources of oil have been prolific is something we'll skip over (how much is ingenuity, how much is the recent steady state of $100+ oil?). But where this gets interesting is when you consider the variation in production costs.

Prices and Production Costs

Again, this is an incredibly difficult figure to make sense of. These costs vary with the factors mentioned above. The regulatory and transportation frameworks are also key. But aggregated I think we can fairly make some interesting and relevant inferences.

Decline Rates: By definition, if decline rates increase, the number of new wells that need to be brought online to maintain production levels also increases. This isn't controversial. How quickly wells decline is another difficult thing to be accurate on, however, it isn't controversial to suggest that LTO wells have significantly higher decline rates.

It will be interesting to watch how oil sands and LTO production behave if oil prices continue to hover in this lower range for a significant portion of time. You'll see capex budgets slashed in Alberta, without any real production decline (rather a reduction in growth), but how will LTO production behave?

It will depend on the fiscal health of these companies and the duration of $70ish oil, but since LTO requires drilling activity to maintain production levels, and increased drilling activity to produce the production growth we've seen, any hiccup in capex will have a much larger impact then we'd see in any other oil play.

Costs vs. Prices: Let me butcher Econ 101 here: shut down isn't justified simply when operations are cashflow negative. Rather, you have to make a few considerations. The future behaviour of both costs and price. Costs have both a sunken and operating portion, where the sunken portion are more long run (infrastructure, regulatory, exploratory, etc.) and operating costs refer more to the actual production and transportation of oil to markets.

Again, with high decline rates comes more drilling, comes more regulatory issues, comes more infrastructure (increased production points). And these decisions happen in real time. Oil sands projects have massive upfront costs. They also have high operating costs (relatively speaking). The difference is in how the economics impact production volume.

LTO companies can immediately cut the sunken costs by reducing drilling activity. How long it takes to work through the backlog of well sites ready to go (with significant sunken costs) remains to be seen. But I have to believe that if low prices stretch through this drilling season into next year's drilling season, we're bound to find out.

Oilsands production might stagnate, but remember that massive upfront investment also results in fewer individual decisions.

Duration: Steep decline rates also mean that when a new LTO well is brought into production is more important to the lifecycle economics of the project. Rune Likvern has done alot of interesting work on decline rates and the subsequent economics. While, his overall production predictions have not come to fruition, the underlying logic still remains solid (in my eyes). In this follow up posted on Peak Oil Barrel, Rune makes some interesting points.

Most relevant here is the notion that the leverage that has enabled this massive drillout of the LTO plays in the United States are likely also conditional on the high price of oil. Now we have pressure from both the strict cost and benefit economics of the oil well, but also, the exogenously determined credit conditions. Being in the finance game I know that when some guy in some office some where gets freaked out about a negative trend, the tap can turn on and off pretty quick. Might the tap turn off quick here? It likely depends on the expected duration of these low oil prices.

Remember, LTO producers are firms, they have no access to printing presses. They dividend out their earnings. They are accountable to quarterly reports. They are not national oil producers. This makes for the most efficient model when it comes to exploiting economic plays. But when they become uneconomic? Well... we might just find out.


I believe we will see supply reduction and prices rebound. Over what time frame? No idea. But if the KSA won't take on the entire burden. The first domino to fall will be the US Shale producers. They've had the greatest impact on global oil production. But the nature of the oil production and the debt factor will necessitate blinking first.

Wednesday 3 December 2014

Supply Side Destruction

As discussed here, OPEC's latest (last?) decision to not reduce production in order to arrest the recent fall in price, has lead to alot of speculation about what we're likely to see come out of this.

Now, I should start by confessing to being totally wrong on this type of occurance happening. While I'm not quite convinced that I need to scrap my overwall Peak Oil Dynamic world view (explained here), this certainly has caught me by surprise.

One of the key factors of the Peak Oil Dynamic world view was that the conventional cheap oil is shrinking both in aggregate and proportionally to expensive and/or unconventional sources. That logic led me to believe that the offshore oil market would be strong going forward and we'd see oscillating prices around that $100 mark for awhile but likely a steady secular rise in prices until someone figured out renewables.

Obviously, the oscillation didn't happen. Why? This is a supply side phenomenon.

From the IEA
Demand growth may not be as rapid, but it is still growing. And despite what all the hippies are saying, there is no viable replacement on the horizon.

So the collapse in price must be supply side.

Where that supply is coming from is interesting. I'd think about this 'new oil' in two seperate categories: expensive oil and cheap oil. Basically, expensive oil is the oil that was made available due to the $100+ price of oil (and SOME technological improvements, but don't kid yourself it was mostly the price), and the cheap oil is the production that is from conventional legacy sources that for political reasons have not operated at or near full capacity in some time. Think Libya, Iraq, Iran, etc.

Now, price certainly has an impact on cheap, politically sensitive oil production levels. But those effects are typical complex and to entangled in secondary and tertiary political/social/economic effects and so I will leave them be.

The more interesting of these two sub-sections of 'new oil', the expensive stuff, are where things will get interesting and where marginal barrells will be taken off the market if an exogenous supply reduction is not imposed.

In terms of simple Econ 101, suppliers will either make due at the lower price level, or we would expect the marginal producers (those requiring $70-$100+ oil to maintain operations) will drop off.

In oil's case, things are complicated by the wide divergence in a number of factors, a few of which are: 1). the sunk cost of different production methods, 2). the decline rates of different production methods, 3). what market the oil is sold into, 4). the firm's fiscal health, 5). the firm's hedging strategy.

Again, mix, oil, politics, and big business, and all you can do is make guesses. Popular opinion seems to be fairly mixed, with a number of folks suggesting that the wheels will fall off the shale boom and other suggesting they've all hedged out any risk.

This piece in the Telegraph has a few interesting items:
US producers have locked in higher prices through derivatives contracts. Noble Energy and Devon Energy have both hedged over three-quarters of their output for 2015. 
Pioneer Natural Resources said it has options through 2016 covering two- thirds of its likely production. “We can produce down to $50 a barrel,” said Harold Hamm, from Continental Resources. The International Energy Agency said most of North Dakota’s vast Bakken field “remains profitable at or below $42 per barrel. The break-even price in McKenzie County, the most productive county in the state, is only $28 per barrel.”
So those are the headline numbers, but this of course begs the questions: how do you determine the break even cost? Is that break even on existing production? Is that break-even to maintain current production levels? Is that break even to maintain current growth rates in production levels?

And all credit to this article for taking the time to wade into this discussion but I have to disagree with the following quote from Ed Morse at Citigroup:
Mr Morse says the “full cycle” cost for shale production is $70 to $80, but this includes the original land grab and infrastructure. “The remaining capex required to bring on an additional well is far lower, and could be as low as the high-$30s range,” he said. 
Critics of US shale may have misunderstood its economics. There is a fast decline in output from new wells but this is offset by a “long-tail phase” for a growing number of legacy wells. The Bakken field has already reached 1.1m bpd, and this is expected to double again over the next five years.
I don't believe we know too much about how these legacy wells will behave. Also, we need to remember that these growth rates, in the context of fast production decline, are necessarily the result of increased drilling.

Now, to maintain drilling, you need to maintain acerage and the expansion of infrastructure IF prices remain depressed beyond what drill sites have been allocated. Beyond that then the full cycle cost is back in play.

Another items to consider is that the best portions of an oil play typically get drilled up first. Of course, a play isn't known in it's entirety from the get go, but it's not unrealistic to expect that the 'sweet spots' are more likely have played a starring role in the ramp up in production.

Also, remember that when companies are talking about break even costs in the media they also have stock prices to maintain. Any highly leveraged play gets increasing leveraged when stock prices dip. That combined with a reduction in cash flow (even if most of it's hedged) is a dangerous game to play.

So you want to watch for a couple of items: a reduction in drilling activity and a reduction in the per well production rates.

This article in Reuters showed a reduction in drilling permits issued dropped over 40% in November, which is a bit of an eye opener. But to be honest with you, I don't have a clue about the typical fluctuations in permits so I took it with a grain of salt.

The author also cites Allen Gilmer at Drilling Info who suggested that this was mostly due to companies wishing to avoid tapping new sweet spots in this depressed price environment. So the exact opposite of what I said above.

Who the hell knows. But it should be interesting to watch.

Sunday 30 November 2014

Chinese Malinvestment

Former White Elephant Investment: Pudong 1990 vs. 2010

We're in the midst of another round of Chinese 'Ghost City' malinvestment chatter in the news. Most recently, it was a report out of China citing an eye catching $6.8 trillion figure as the amount squandered.

The paper came from a couple of Chinese academics (Xu Ce and Wang Yuan) at the National Development and Reform Commission. As usual, I couldn't find the source material so I'll run through a couple of summary pieces in our media.

Here's  Jamil Anderlini at FT:
“Ghost cities” lined with empty apartment blocks, abandoned highways and mothballed steel mills sprawl across China’s landscape – the outcome of government stimulus measures and hyperactive construction that have generated $6.8tn in wasted investment since 2009, according to a report by government researchers...
Misallocation of capital and poor investment decisions are not the only explanation for the enormous waste in China’s economy. A significant portion of China’s post-crisis stimulus binge was simply stolen by Communist Party officials with direct responsibility for boosting growth through investment, according to separate estimates by Chinese and overseas economists. 
From Mike Bird at Business Insider:
The Chinese economy has wasted $6.8 trillion (£4.3 trillion) in investment during the last four years...
Even in the enormous Chinese economy, that's practically half of the investment between 2009 and 2013, the period covered by the investigation. This is likely to have pretty grim effects on Chinese economic growth in the years ahead.
This is sort of one of those sniff test statements. Does it really seem plausible? Recall this study that made the rounds a year or so back. The media typically summarized a summary of the study that they didn't bother to, or couldn't understand the nuances of; and drove conclusions far beyond the scope of the paper (which to my eye had already stretched their conclusions a bit given their own numbers).

In that paper, the authors make a claim (based on some weak assumptions) that 5.5 years of life were being lost, to Chinese living in the northern parts of the country, due to air pollution.

Again, an eye catching number. It seemed to fit the dominant China narrative. But the sniff test should have been, if you add 5.5 years to the life expectancy of northern Chinese how old would they then live? Beijingers would be living to 87+ years if they had the same air pollution levels as southern Chinese. Again, does that make sense? Of course not. Unless you're comfortable with the assertion that besides air pollution China does better at maximizes life expectancy then pretty much everywhere else in the world (in 2012 Japan's overall life expectancy was 1st in the world at 84.6 years).

So with this huge malinvestment number, the questions should be: what data were they using? and compared to what? And do two factors combine to produce the type of clear conclusions being drawn in the media?

The economist picks this apart pretty well here:
So how exactly do Mr Xu and Ms Wang arrive at their numbers? Their method is to compare China’s capital efficiency in the 1980s and 1990s with the past decade; they treat any decline in efficiency as evidence of wasted investment.
So, at a glance we can see that this is a fairly dubious way to seek the conclusions we're reading in the popular media. It's not to say that this study isn't useful. Measuring the diminishing returns to capital, or even parsing apart the theoretical divide between malinvestment and the more secular diminishing returns to capital you'd expect, would be incredibly useful. However, using the number derived from this method as a measure of malinvestment seems beyond an overreach.

At which point I notice that Paul Krugman has addressed this on his blog, better than I was going to.
What the paper does is look at the ratio of capital added to economic growth — the so-called incremental capital output ratio. It finds that the ICOR has been lower in recent years than it was in the past, and attributes all of the shortfall to waste. 
But what if there were no waste at all? What if China were simply engaged in capital deepening? What would we expect to see in that case? The answer is, exactly what we do see. The ICOR data say nothing at all about waste.
So again, this paper is looking at the capital efficiency in a more esoteric sense. The news papers a more literal sense. Playing on the ghost city, communist country narrative is all to easy. Which isn't to say that all investment is done 'efficiently'. Surely it is not. But the Chinese know that, and have been methodically going about remedying that over the past year.

Once again, I think Xi and the Communist Part of China have earned the benefit of the doubt on managing this process.

Thinking About OPEC's Meeting

 Photo: Via. Google Search

OPEC's meeting concluded with a resounding shrug of the shoulders. At the end of the day it was the Saudi's decision. I had suspicions that they'd communicate price support at some level; but in hindsight why would they? At the end of the day, I can't think of any particular self interested reason for them to do so.

The interesting thing about this meeting, and given the complexity of modern finance, I was curious to see how price would react to OPEC's (the Saudi's?) communication; and specifically so. Forward guidance, is pretty well understood to be the dominant tool of central banks.

When credibly made the bulk of a centrals banks adjustment is done by markets inline with their expectations. So, if a central bank continuously targets 2% inflation and continuously undershoots it. The market prices in the undershoot. If a central bank announces the injection of funds on a short term basis, the markets price this in and money neutrally basically holds.

Would the Saudi's be able to achieve price support, simply by communicating a target? Would the world believe them?

We certainly saw markets react to OPEC's shoulder shrug, WTI quickly shot from $74 USD down to about $66, similarly Brent plummeted from about $73 to $70.  And I suppose we'll never really know if it's reaction would have been symmetrical (asymmetrically interesting to me).

Why would the Saudi's enable OPEC?

Had the production cuts been proportionately felt across OPEC members, it might make sense. If Russia had indicated that they would also be willing to curtail production in pre-meeting talks, then it might have made sense. But if the Saudi's have to bear the entire burden, why would they?

Vox's Brad Plummer outlines this point here. The key is probably in this Reuters article linked to in this article describing who would be bearing the brunt of that production decline:
With world markets awash in oil, Saudi Arabia embarked on a strategy of defending prices, which at the time were largely set by exporters rather than the nascent futures market. The kingdom slashed its own output from more than 10 million barrels per day in 1980 to less than 2.5 million bpd in 1985-86. 
Other producers failed to follow suit, however, both within the Organization of the Petroleum Exporting Countries and among new petroleum powers such as Britain and Norway. Prices fell into a years-long slump, leading to 16 years of Saudi budget deficits that left the country deeply in debt.
Plummer also links to this often cited look at government budgetary break even price of oil for OPEC countries. I still see this as apples to oranges.
OPEC breakeven prices
No only do I believe that the Saudi's along with the rest of the gulf states likely set budgets according to revenue more then they raise revenue according to their budget. But the ruling regime does not hold the tenuous position, politically or economically then the other major exporters (of course including Russia which is not in OPEC).

With both Russian and Mexican officials meeting with Venezuela and Saudi Arabia pre-OPEC this probably presented a crucial test of price support viability. Between Russia and the Saudi's a joint strategy, would have significant market power due to not just their high level of production (Russia at 10.5 mm/bopd and KSA at 11.6 mm/bopd) but also their relatively low consumption levels (Russia at 3.3 mm/bopd and KSA at 2.9 mm/bopd) in contrast with the USA who, despite a huge upswing in production remains a massive importer on global markets.  It's these net available exports that are the interesting barrels to me on the market place.

Russia's Part in all of This.

But it's hard to imagine Russia artificially reducing production (as opposed to some new projects becoming uneconomic at low price levels) with the sanction package biting down on the economy. This article estimates that effect of oil and sanctions at $90-100B and $40B respectively.

This could make for an interesting winter. As far as I can tell, besides an escalation of the war, Putin's only real leverage would be physically delivery (mutually destructive) and a huge stockpile of nuclear material and know how. That or Putin backs down physically and rhetorically.

Market Share... At Who's Expense?

With no price support OPEC (KSA) made a clear statement that it would let markets dictate things going forward. It was always a fractious bunch and with the only partner, with both the production levels and political leeway to do anything but maximize oil revenue (the Gulf Emeritus would have the ability, but not the gross quantities), unwilling to cut production. OPEC basically isn't.

As for the Saudi's motivation, it may be a fight for market share by way of undercutting the more expensive marginal barrels on the market. From OPEC's official release:
"world oil demand is forecast to increase during the year 2015, this will, yet again, be offset by the projected increase of 1.36 mb/d in non-OPEC supply.  The increase in oil and product stock levels in OECD countries, where days of forward cover are comfortably above the five-year average, coupled with the on-going rise in non-OECD inventories, are indications of an extremely well-supplied market."
If the Saudi's are going for market share the obvious play to target is the rapid build up in tight oil production in the US. Not only is it fairly expensive (estimates oscillate in aggregation, to say nothing of the wide variation in per well/per location costs) but it's also typified by relatively steep decline rates.

How This Might Impact The US

You have to remember that once the investment in discovery, drilling, and establishing the production infrastructure, not in maintaining existing infrastructure and production. With increasing decline rates on each well any interruption in those initial capital outlays result in a much steeper drop in oil production.

Tyler Cowen links to this article by William Watts on Marketwatch that makes an interesting point:
At the same time, analysts have also noted that for many shale producers, a large chunk of production costs - acquiring acreage, contracting wells, etc. - have already been spent. As a result, the more important figure might be "half-cycle" production costs which analysts at Citi last week pegged at between $37 to $45 a barrel"
Eric Lee who is one of the Citi analysts on the report in Platts:
a “full capex cycle” shale project might have a per barrel cost of $70/b or more, but one that is a “half cycle” project, where a lot of the costs are already sunk, could be down into the high 30’s. Overall his conclusion is that a $70 basis WTI price could slow the roughly 1-million b/d growth rate in shale by 25%. “It looks like you would need about a reduction in rigs of 40% to 50% to really flatten production growth, and to do that you’d need about $50 oil,” he said. Overall then, the impact of the price fall on US production growth will be “soft.” (Morse noted that Citi has not changed its robust projections for higher US output.) 
I couldn't find the Citi report. It would be interesting to see how they got to these numbers. But we'll have to settle with for the author's synopsis. I'd be pretty curious to see the timeframe the author is speaking of. Certainly that full capex cycle number increases in importance as time rolls.

Bottom Line

I effectively read this as OPEC being no more. If there was a deal to be made, it would have been made between Russia and the KSA. There's an alliance to watch for. Maybe not until sanctions end. Maybe if sanctions intensify. Maybe never.

The things I'll be watching beyond the price of oil: Russia/Euro sanction negotiations, Russia in the Middle East (and Iran), Chinese oil consumption.

Monday 24 November 2014

A Suprise Monetary Policy Development in China.

Chinese Monetary Policy

It's been an interesting set of events over the past week at the PBOC where a surprise monetary policy move last Friday jump started markets and was a welcomed surprise for me. With a 40 basis point cut on the one year and a rise on the deposit rate ban (the bank sets a target, currently 3% and banks are allowed to offer rates within a ban around this target) from 10% to 20% this move is a nice measured step down the liberalization path.

A New Direction for the PBOC?

Chinese monetary policy has long been exceedingly interesting and exceedingly boring. Most of the intrigue stems from it's complete lack of substance, direction, or really anything. I've been curious about when/if the role of monetary policy would expand as the ambitious transformation program takes hold in China.

We've all heard countless discussions about how there is a need to increase consumption levels relative to investment levels in order to establish a sustainable growth trajectory. Of course this is true at some level. In our western way, we typically preech doom and gloom and the coming cliff of 'whatever's around the corner'. This doesn't appear so for China (in my minority view). Yes growth is decreasing and debt levels are rising. But like the structural reform package there remains alot of low hanging fruit. Monetary policy seems to hold promise.

The economist has a good outline of the bank here:
Sudden shifts in the value of the yuan always bear the central bank’s fingerprints, but are infrequently explained. The motto for the People’s Bank of China (PBOC) should be: “If you know what we did, we must have done it wrong”.
... Yet real interest rates have climbed to more than 8% for industrial companies, since the prices at which they sell their wares are actually declining. That, in turn, makes debts much harder to service than anticipated. Cutting interest rates while enforcing capital rules to prevent banks from issuing a gusher of new loans would be a better way to rein in debt.
Reducing that real debt burden is consistent with standard monetary policy of adjusting the base in accordance to more standard aggregate goals like inflation, employment, and GDP levels. Moves have been made this year, in targeted moves, in an attempt to re-allocate funds. Sectoral specific cuts in the reserve requirement ratio to encourage lending in the agriculture and smaller sized businesses was welcome. But beyond this, the PBOC still often fell into more fiscal styled actions (like the program with the Development Bank mentioned in the Economist article above).

While China's main concern should certainly be on the structural reforms mentioned above, monetary policy can and should play a central role. With the fiscal stimulus pumps set to push the infrastructure and investment based spending that risks exasperating the current imbalance, the government needs to be wary of turning on the fiscal taps.

The danger with monetary policy is that the financial system has long been set to push funds towards the SOEs that risk compounding problems as well.

I have been curious to see when the PBOC would begin more traditional monetary policy because I believe that this will indicate the state of progress in the financial system in the CPC's eyes. This is an important step.

Central to the reform package outlined at last year's Third Plennum (previous posts, here and here) was the notion that funds need to find their way into the hands of small and mid sized firms. Consumption habits would benefit from the liberalization of deposit rates. The ability for micro sized entrepreneurs to gain access to a larger pool of assets, akin to our small business lending facilities at our banks, would again push the reform goals in a manner that would also balance out bank portfolios and reduce dependence on the more murky portions of China's shadow banking sector.

A Surprise Move and More to Come?

PBOC's surprise move friday, described here, after big days Friday and Monday in Shanghai, Shenzhen and Hong Kong, it is clear that the markets hadn't price this move in. Perhaps more surprisingly, articles like this one are popping up discussing the likelihood of another rate cut:
"Top leaders have changed their views," said a senior economist at a government think-tank involved in internal policy discussions. 
The economist, who declined to be named, said the People's Bank of China had shifted its focus toward broad-based stimulus and were open to more rate cuts as well as a cut to the banking industry's reserve requirement ratio (RRR), which effectively restricts the amount of capital available to fund loans.
This is one aspect of the low hanging monetary fruit, and I believe is under appreciated in the most reports on China. Let's not forget that their falling economic growth is falling. It's not negative. Let's also not forget the scale of transformation going on here.

Over the past 5 years, due to both internal and external factors exports have fallen in importance. Chinese consumption of natural resources have fallen as the infrastructure mega projects that defined years of growth have taken a less prominent role in growth. Industrial and manufacturing weakness have been present for the past few years. All set against a background of a weak global economy.

Despite all the wisdom of the all the western experts, one thing must be noted: the scale of this purposeful transition has never been achieved before. Transitions are usually painful and externally imposed.

And of course, despite all the wisdom of all the western experts, another thing must be noted: the scale and uniqueness of China's success (as outlined by Summers & Pritchett here along with my thoughts). Leaves me with the feeling of: who better to attempt this restructure?

Assuming that the internal allocation mechanisms are improving, consistent with the rest of the reform agenda (I don't think we have any reason to believe they aren't), then reductions in the reserve requirements, liberalization of deposit rates, and a fall in official bank rates towards more western levels are an 'easy' path to a more standardized monetary policy regime.

This should be entertaining to watch unfold.

Sunday 23 November 2014

Thoughts on a Book: Don't Even Think About It

Don't Even Think About It

I had this book by George Marshall recommended to me recently. It's written by an environmentalist involved in the PR game. The author takes man made climate change as his base assumption. From there he seeks an answer to why no one cares about it enough to make any changes. Essentially it asks why people ignore it. My summary would be: energy consumption is awesome. People will justify it's consumption in whatever manner works or them. Simple as that.

I find this approach useful. The eco movement struggles on two fronts: convincing people that there is a problem and then convincing them to implement a solution. But they never truly recognize how much people enjoy consuming energy.

So my take on global warming: yeah there's an issue that we should be addressing, but until we have a replacement for all of that awesome energy we consume, we won't address it. Simply put, people know there is a problem, and don't care enough about it to do anything about it. I say 'know' there is a problem because the evidence is so overwhelming. I say that no one (even among those that 'know' there is a problem) do anything about it, because all you have to do is not consume the products, and everybody consumes the products.

This book doesn't necessarily conclude similarly, but that narrative is woven into the story line. Not surprisingly my viewpoint aligned with Daniel Kahnemen (of 'Thinking, Fast and Slow', which would be on my short list of my favorite books):
"No amount of psychological awareness will overcome people's reluctance to lower their standard of living. So that's my bottom line: There is not much hope..."
I liked that this book wrestled with the basic idea that people don't care enough about climate change/global warming to sacrifice anything close to what's needed. I take this as fact, and so I don't often find discussions and books on the topic terribly interesting.

My base assumption, for anything in life, is that people are idiots. And while I say it that way for effect, I think it's obviously true. Of course, the follow up question should be: How do you define idiots? And the answer, for the most part, comes from the aforementioned Daniel Kahnemen and Thinking, Fast and Slow. We simply aren't wired optimally for this world we've created. And yet, we're incredibly confident that we are. I call that idiocy. I also spend alot of time trying to identify and address my own idiocy.

We're built for reflexive decision making meant to keep us alive, healthy, and happy in the now.

Climate change is the perfect problem to demonstrate this. It's a long run problem. Sure we have pretty solid evidence that current weather phenomenon are being magnified by these long run trends. But our brain is wired to construct a narrative to explain things that inconvenience us in the now. These events are far away, it could be natural cycles, there have been hurricanes/tornados/droughts always, who's to say these are any worse?

And I think this is the key, that this book points out (alright, alright, I take some liberty with the interpretation), but is a bit light on in it's conclusion: it's not about getting the message out, everyone basically knows what the problem. Sure they say they don't, but they do.

It's like evolution. Everyone basically knows it, but accepting it doesn't matter enough to people to go through the mental work to sort out the cognitive dissonance of competing religious/science, consumption/science world views.


Where this book is lacking, in my opinion, is it's failure to address the vast difference in energy consumption across borders. The book reads like it was written by a rich white guy to inform the debate in countries populated by rich white people. There isn't anything wrong with that. But that discussion is an extension of the "energy consumption is awesome" line of reasoning that I think is entirely lacking in the typical discussion. While it's present here, how do you not it extend it beyond borders?

Parse out some relevant stats on India's energy consumption habits (or lack thereof), as described in this article:
“India is going to use coal because that’s what it has,” said Chandra Bhushan, deputy director of the Delhi-based Center for Science and Environment, a prominent environmental group. “Its strategy is ‘all of the above,’ just like in the U.S.” 
Each Indian consumes on average 7 percent of the energy used by an American, and Indian officials dismiss critics from wealthy countries. 
“I don’t want to use the word ‘pontificate’ when talking about these people, but it would be reasonable to expect more fairness in the discussion and a recognition of India’s need to reach the development of the West,” Mr. Goyal said with a tight smile.
Being rich is awesome. Rich people consume lots of energy. Poor people want to get rich (since being rich is awesome). One result is that they will need to consume more energy. Therefore, as current options are, that increase in energy consumption will exasperate climate change dynamics. There is no way around that. Particularly given that the vast majority of people are incredibly poor (from my Canadian lens of reference).

So again, if we accept that we need to consume less energy derived from fossil fuels. And if we have no economically viable option to replace that energy with renewable/clean energy. Then we, by definition, need to reduce energy consumption levels.

Since, really poor people consume so much less energy then rich people, and if you accept (as I do) that poor people getting richer (and enjoying all of the benefits that accompany that) should be our greatest hope, than we can't expect them to bear the burden of that reduction.

Therefore, the burden would fall on rich people to carry the burden of marginally lower consumption rates that would still be far beyond the reach of those billions of poor people increasing their consumption levels.

How is this not fair/realistic/obvious? But we can't even bring our own energy consumption levels down from their ridiculous heights. We've made strides to clean it up a bit and we pat our selves on the back for some stagnation/reductions (instead of admitting that the economic meltdown and terrible job we've done implementing rebound policy was the cause).

This book doesn't really address this, and I think is the worse for it. Someone explain to me how you'd justify telling really poor people who consume way less energy then us, to consume less. I've yet to hear a logical argument.


So the basic argument that most environmentalists face (or think they face) is two fold: explaining the problem, and getting buy in on a policy set that addresses the problem.

The eco-movement's problem (to me) is that often they think the first part of that problem is objective. It's the future, it's not objective, and it's not uniform. Pointing to past data and saying: therefore, in 40 years this will happen. Is a guess, by definition. Which is fine, but not at least acknowledging that is problematic.

The other issue is a bit more subtle: a). environmentalists often conflate not buying into their second argument (policy changes, future predictions, etc.) with not buying into the first argument (that there is a serious issue) and b). they often don't have any real answer to the second problem that is at all feasible (thus taking things back to point a).

This book reinforced my habit of ignoring conversations on this topic that don't, as a central topic, address how awesome consuming energy is.

Monday 17 November 2014

Cold Shouldering Putin and Opec's Big Meeting

A couple of interesting developments over the weekend at the G20's in Brisbane with Putin bailing out early got me thinking about end goals and strategic thinking. Naturally, with thinking about Russia comes thinking about oil. With thinking about Oil comes thinking about the Saudi's and the up coming OPEC meeting.


The interesting thing about all of this is trying to parse out the end goals of key players. So we'll start with the G-20 and work our way back. While everyone has basically condemned Russia's behaviour in Crimea and eastern Ukraine, Cameron, Abbot and my own Canada's Stephen Harper lined up to get their very public digs in. My question is why? Ok, maybe 'why' is the wrong question. These statements are meant to play to their domestic audience, to make everyone feel like they are doing their part, standing up to the bully, etc. etc.. I get that. But perhaps questioning what these types of statements might actually accomplish is appropriate.

Is Putin going to say: "oh I didn't realize Stephen Harper doesn't want me in the Ukraine... shit, get me a phone and we'll pull funding/troops/tanks/whatever out... my bad". Or do you think he's more likely to dig in? Putin remains popular, ibut that popularity is dropping according to numbers cited from Leada in this article which also shows that the average rating out of 10 given to Putin by Russians was 7.33 (this in a time of capital flight, economic sanctions, tanking crude prices, and invasion of a non-threatening neighbour). Might backing him in a corner, help him drum up domestic support the old fashioned nationalistic (ie. they are bullying Russia... and so we bomb) way? I don't know. And Putin probably doesn't either. But I wouldn't bet that he'd opt for a passive reaction to blustery headline grabbing. When his constituents are convinced his current path is a positive one.

Also remember, that although many of the big multi-natinoal companies have dollar denominated debt that sanctions will prevent being rolled over; they and Russia in totality itself aren't too bad on this front. Also remember that since the Ruble has tanked, and oil is priced in USD this acts as a slight mitigant to price declines domestically. 

This article from the telegraph gives us a great summary of events in this post (found after I started).

I think they overstate the case that the global economy needs Russia more then Russia needs the global economy. But there is truth in it. Especially as fall turns to winter and the importance of energy supplies grow. I think the EU is feeling a bit more confident in their position as Brent trades near 5 year lows. Is that sustainable?

A potentially interesting bit in this article is the discussion on how prepared Russia is to hunker down. Alluding to the national sacrifice historical narrative, it does seem like Putin has a better chance of talking his Russian electorate into a winter of sanctions then Merkel would have talking her's into a self imposed winter of intermittent supply or inflated prices on their natural gas. Should Putin decide to retaliate in this manner (notice that Merkel didn't work as hard as the leaders mentioned above to grab headlines while still maintaining a critical position).

Despite letting the Ruble float (and subsequently tank), Russia has significant reserves (over $400B USD) and was wise to not stand it's ground so early. It won't be a couple weeks or likely even a couple of months until economic pressure is so significant that Putin is forced into backing down. It may turn into a battle of popular political will between a sanctioning euro population and a sanctioned Russian population. Here's hoping it doesn't come to that.


The 27th could be a watershed moment. Hopefully we get some clarity on the strategic vision of the organization, or more specifically, the Kingdom of Saudi Arabia going forward. While this article does a great job of outlining the challenges faced by each of the major oil exporting countries. I think it doesn't fairly capture KSA's position. This graph that it cites from the Economist is a nice visual summary:


Like Russia, KSA has significant reserves ($745B in Sept.) so a downturn can be weathered. But articles like these assume all budgets are made independent of revenue. That doesn't seem likely in all cases (particularly KSA), where it seems more likely that they say: "hey look at all this money we're going to have, lets spend a bunch of it".

Aramco's Manifa project involves building of artificial islands to harness onshore drilling efficiencies in shallow waters.
One of Manifa's 27 Man Made Islands
At any rate, the Saudi's  legacy oil production is some of the cheapest in the world. The billion dollar question of course is what the composition of Saudi production is now, and will be going forward. By the end of this year Manifa is supposed to be producing 900,000 bopd. That's not nothing. The scale of the project, and subsequent cost might (must) impact cashflow considerations. If their production remains the cheapest in the world, they might just go for market share.

Conspiracy theories abound about the motivation behind the OPEC's willingness to crater the price of oil. It's certainly helping economies around the world, particularly a country like China where through their structural reform the addition of nearly (5.7 million bopd this October x $100 vs. $80) $100 million dollars daily has been great. From another angle, the western bloc of countries imposing sanctions on Russia couldn't have had the oil markets help them much more.

Regardless of whether they will enforce or lower the production quota, hopefully we get some direction. I suspect that markets will be on the move shortly after the Nov. 27th meeting. Similar to FED announcements I suspect forward guidance on price support would have a huge impact immediately. Perhaps there will be an asymmetrical move with the opposite announcement, but I also suspect the market is pricing in continued low prices.

We'll just have to wait and see.

Saturday 1 November 2014

Regression to the Mean: Chinese Economic Growth in Context

The latest study making it's rounds about Chinese economic growth is this paper by Larry Summers and Lant Pritchett: Asiaphoria Meet Regression to the Mean.

I have to admit to being underwhelmed by this paper. Much smarter people then I seem to be quite impressed like Tyler Cowen here. My reaction is fairly simple: Of course Chinese growth is unsustainably high over some undefined time horizon but what in this paper wouldn't have applied in 1990, 1995, 2000, 2005, and 2010?

Perhaps the author's intent is to be obvious and non-specific (this paper still has plenty of useful info in this context), but why has this become the new 'it' study on China? (mood-affiliation?)

The paper makes three basic claims:

1. Growth rates are typically persistent and low.
2. Developing world growth rates are highly volatile and regress back to global means aggressively.
3. The Asian giants (China and India) should include a rapid regression to the mean as a realistic possibility.

None of which I really disagree with. But in the conclusion there is this:
India and even more so China are into essentially historically unprecedented episodes of growth. China’s super-rapid growth has already lasted three times longer than a typical episode and is the longest ever. The ends of episodes tend to see full regression to the mean, abruptly.  
It is impossible to argue that either China or India have the kinds of “quality institutions” that have been associated with the steady dynamic of growth in the currently high productivity countries. The risks of “sudden stops” are much higher with weak institutions and organizations for policy implementation. China and India have very different modalities of this risk, but both have tricky paths to continued prosperity. 

Again, it's not that I disagree with any of this. In fact, I would say that these are almost self evident truths. But my issue is that this paper doesn't wrestle with whether China's "historically unprecedented" episode of growth does in fact mean that 'this time is different'. I believe that the author's would agree that progression towards the "quality institutions" found in successfully transitioned countries promotes growth, and that neither China nor India posses sufficiently developed institutions, would they not then conclude that this represents an opportunity to avoid said regression?

It seems to me that, while this paper describes the rate of change of GDP (and by proxy development) it doesn't give the level of GDP (and of course by proxy the level of development).

And this isn't me talking about how wise and efficient autocracy can be. To me, the greatest contribution to these unparalleled growth rates is just how effectively the CCP pre-Deng destroyed the economy. Talking about levels seems paramount. And I think GDP per capita adds that context to the discussion.

When you think of the most relevant cultural/economic performance parallels to China, you probably think Japan, Taiwan, and Korea. China, of course, is unique in it's sheer size. But what is lost on people is it's uniqueness in it's absolute poverty. China was one of the poorest countries in the world when this growth phase started and has merely (and miraculously) risen to near middle income territory. But where were the rest of these countries in per capita terms when they "regressed to the mean"?

Japan '70: $15,162 (regressed to: 3.4% growth)
Korea '91: $9,591 (regressed to: 4.42% growth)
Taiwan '94: $11,932 (regressed to 3.48%)

How about the Per Capita GDP at the start of these phases?

Japan '59: $7,752
Korea '62: $1,123
Taiwan '62: $2,263

By Contrast corresponding Per Capita Chinese GDP:

China '77: $178
China '91: $495
China '13: $3,583

Per capita GDP Data World Bank WDI 2013 Data Set. All numbers reported in constant 2005 USD. Growth numbers from S&P paper.

So here's an assumption that I'll make and not provide adequate data to cover: moving away from centralized autocratic control of a country/economy produces favourable economic results with diminishing marginal returns. Think of wealth enhancing policy as a continuum; at 0 you have North Korea and at 10 you have, well an argument, but lets just say above 7 you have a large group of market based economies with some mixture of liberal democratic institutions. This of course excludes countries abnormally dependent on exporting natural resources (I'm looking at you Norway).

Now in an unscientific approach that assumes my under-supported assumption, what would best proxy a countries location along that continuum? In my opinion it's the per capita wealth or GDP measurement. In a manner as simple as Summers and Pritchett (S&P) arguing that countries regress back to the GDP growth mean. Therefore, China starting at say a 0 or 1 on the 'wealth enhancing policy continuum' might be at a 3 or 4 now. Countries that successfully regressed to the mean maybe did so around 6 or 7. Of course this isn't rigorous. But intuitively I think it's not a bad framework to use.

I'll try to come back to this at a later date and try to flush things out at a later date in more detail because I think it's often overlooked, particularly in China and India's case because the aggregate size of their economies are so much larger then any other country (at their stage in development has ever been). These countries, on per capita terms, are very, VERY poor (India in '13 had per capita GDP of $1,165). If per capita is any sort of proxy of how much "low hanging fruit" is available to propel growth, then the slow move along the development continuum results in the possibility of sustained abnormal growth levels (which China has already demonstrated). Judging by the many headlines you ready about the need for/lack of/inability to produce reform in China, I have to assume it's fairly well accepted that the long hanging fruit is out there and fairly obvious.

I think China is doing a good job of sustainably harvesting that low hanging fruit. And their ability to do so sustainably in an unprecedented manner over the past three decades should give experts a bit more pause when making recommendations with any confidence. Everyone agrees on the direction of reform. The speed and the end result (just because the CPC wouldn't want to hit a 10 on the democracy index, it doesn't meant they don't want to go from a 3 to a 5) are a debatable, as the CPC is in rarified economic growth air, shouldn't we consider that they aren't idiots and might have some insight?

This isn't saying that China WILL continue growing rapidly. As S&P allude to in their paper, developing countries growth rates are extremely variable. I interpret this as: though there are a much greater quantity of growth promoting possibilities, there is a certain symmetry in growth destabilizing risks. This of course comes from a guy who is endlessly fascinated and impressed with the abnormally amazing economic performance of China (and to a lesser extent India) described in this paper by S & P. While the current regime inherited a low base to grow from, they've been able to avoid that highly variable growth rate and the expected regression to the mean.

Let's hope that L & S can repeat this same paper in another 5 years time.

Sunday 7 September 2014

The return of the Mackenzie Pipeline.

The truly northern northern pipeline route gained some publicity this week as a report from Canatec Associates (an arctic petroleum consultant) that was commissioned by the Albertan government last year and has just been released  (I believe found here).

I had wondered about this possibility back in December (here) after Bill C-15, which grants more control over these types of decisions to the NWT, passed. My belief was that with a strong resource development supporter at the helm, NWT would be much more likely to get pipelines through then BC; all else being equal. Of course, all else isn't equal, and that hasn't changed.

The board is appointed by the federal minister for Northern Affairs. The result is a far more streamlined approvals system that could well usher a new pipeline through in record time.
Following the release of the report, Northwest Territories Premier Bob McLeod said he was “heartened,” and that he’ll be meeting with his counterparts in Alberta to figure out the next steps.  
“We’ve always said that there are significant resources that have been stranded for 40 years and we’re not going to leave them stranded for another 40,” Mr. McLeod told the Financial Post.

I really believe the viability of the NWT assets, particularly the canol shale potential in the Central Mackenzie Valley will be the key to getting Alberta oil to Tuktoyaktuk. No one wants to simply be a transit point. Then again, without the Canol Shale development, the NWT will be in need of revenue.

And there hasn't really been alot of news on the Canol Shale this year. MGM which had explored the north in general and the Canol more specifically, was subsumed by parent company Paramount Resources after alot of money was sunk into the region with no production to show.

Outlined here, MGM president Henry Sykes talks about the region:
“Our experience has not been a positive one. Obviously we’ve spent hundreds of millions of dollars, drilled 11 wells and have nothing really to show for it today in terms of any cash flow-generating ability,” said Sykes, who predicted similar outcomes for other companies. 
“Until there’s infrastructure in the North, until people can see a clear path to investment and return on investment, I think you’re going to find activity is going to be delayed, if not eliminated altogether,” he said.
Sykes go on to state that they were sitting on billions of barrel of oil (I'm assuming that's the play at large and not MGM's holdings). The scale of which would be pretty solid motivation. However, having helmed a failed venture Sykes might be a bit bias on the potential (if only there was access to markets MGM would be kicking ass!).

At the end of the day it's good to get another viable pipeline option. The added length and variability in operating a year round facility that far north will add significantly to cost. However, one might argue that a more favorable political climate may offset that. Hopefully, the Canol will prove viable economically.

Monday 4 August 2014

Tiananmen Coverage

Google news popped this gem into my morning reads: "China's economic model dangerous", and I noticed it was from my local paper. I read through with a chuckle, surprised that it would make it's way onto a legitimate news site. After getting to work and opening up the print version, my annoyance at seeing it there on paper started to fester.

New Direction

It's been a long while. New city, new company, new job, new position, first time home owner, and on and on. The Peak Oil Dynamic requires more attention then I can give. With ISIS in Iraq, the EU threatening to increase sanctions (still skeptical that major NG related sanctions will be forth coming), Canadian pipelines seeming to stall, American tight oil maintaining production growth, times are very interesting on that front.

However, I'll be switching the name at some point and the URL and revert this thing to hopefully a weekly post on whatever it is I'm thinking.

Wednesday 16 April 2014

Thursday 10 April 2014

China: Reform Policy vs. Optimal Policy

Reacting to New Growth Model

I had a much much longer post sketching out my concern with the Chinese hard GDP and Inflation target. My worry was that the CPC would subordinate reform progress in order to the achievement of GDP targets. I'm still wandering around the Philippines and haven't been following too closely.

My hope was for a move off of a hard target. Even if just a signal from the government to set the stage for a miss. The need for China to rebalance remains priority number one in my eyes. The reaction to a perceived miss on current GDP might lead to a policy response that would be more likely to produce sub-optimal future GDP numbers (due to failure to rebalance).

Tuesday 25 March 2014

Russian Sanctions: Until China is onboard what's the point?

Just killing some time on a layover in Seattle (enroute to the Philippines for some vacation time) and this article on Bloomberg caught my eye.

It brings up a point that needs to be reconciled in order to effectively sanction Russia. Namely, the Chinese response.

The article makes a few key points that don't appear to be fully considered in the wider discussion.

Regarding the push to authorize export crude oil from the US in order to put pressure on Putin:
The U.S., even after the shale boom, must import 40 percent of its crude oil, 10.6 million barrels a day that leaves the country vulnerable to global markets.
Regarding China's past flurry of oil deals with Russia:
China already has agreed to buy more than $350 billion of Russian crude in coming years from the government of President Vladimir Putin. The ties are likely to deepen as the U.S. and Europe levy sanctions against Russia as punishment for the invasion of Ukraine.
Quoting Nicholas Redman from IISS:
“For Russia, there was an idea that Europe was something close by and it worked and it was desirable to emulate,” Redman said. “Over the years, on multiple fronts the attractions of the European model fell. It’s almost a civilizational choice the Russians have made to turn away from Europe, to stress their Eurasian rather than their European identity.”
So the obvious points: What oil is the US going to export (ie. why would Putin concern himself with the exports of the largest (more or less) importer int he world)? How steep of a discount would Putin have to entice a significant Asian demand shift? Would China risk their current rash of deals (and future supply) to enforce western sanctions? Can Putin sell the politics of a short term price discount for export diversity in the long run?

To me these questions seem to put Putin back in the driver seat. I always considered Germany and China as the two key participants to give sanctions any chance. While it seems like Merkel and the Germans are at least vocally supportive (I'm skeptical on their willingness to actually go through with them) the Chinese are noticeably staying out of this.

Another element to consider is if the west proceeds with sanctions against Russia with the knowledge that China will not back them, how this impacts future sanction participation by China and similarly developing countries.

I assume Iran is watching this round of sanction talk closely. If China balks here, will India participate in the next round of Iranian sanctions should they renege on whatever nuclear agreement gets put fourth? You have to assume the liklihood is significantly reduced. Of course if India balks on those sanctions, what do you think the reaction from China will be?

I might be looking at that all wrong. And perhaps all of this is getting hashed out behind closed doors. But significant economic sanctions still seem like a bluff to me.

That being said, Putin putting boots on the ground and actually occupying Crimea throughout this ordeal was also a surprise. So what the hell do I know?

Friday 21 March 2014

Chinese Reforms Update

Life has kept me away from the blog here but what a few weeks it's been.

China's Rorschach Reforms

Announcement after announcement, data point after data point, all providing 'evidence' for arguments as diametrically opposed as reform success to a hard landing (and everything in between).

Here are a few of the highlights:

Broadening the Yuan trading bound: The People's Bank of China (PBoC) has always set the rate at which Yuan can be exchanged for USD.  Until 2005 they maintained a hard peg (the rate is x and only x). Accepting a trading band of +/- 0.3% doesn't sound like a huge move but that 2005 action allowed some flexibility for the market to at least indicate the desired rate direction. 2007 brought the band to 0.5% and 2012 to 1%. Also, during this period, the Chinese currency appreciated significantly (graph below). The announcement this March was a doubling of the bound to 2%.

You can see that the Yuan/USD has largely been a one sided trade, meaning that the market almost by consensus believed that the Yuan was undervalued at 2005. 2014 and the 2% band marked an interesting occurrence, the markets pushed the Yuan value lower.

Directions aside, the liberalization of the Yuan is a key piece of the re-balancing reform we've heard so much about. While the appreciation since 2005 has eaten into the financial repression that has aided domestic producers to sell their excess production or domestic investment abroad (a below equilibrium exchange rate would result higher then socially optimal production levels). The undervalued Yuan also ate into domestic consumers purchasing power.

Notice that this imbalance encourages over investment and under consumption. Key items that the re-balance need to address. With the recent depreciation, the market is suggesting that perhaps the government won't get a free re-balancing lift from exchange rate liberalization but having the market find the right level will encourage help ensure that external balances don't encourage internal imbalances. This alone makes is encouraging.

Bankruptcies: With over investment embedded in the Chinese economy (via financial repression) it's quite reasonable to expect that the re-balance reform will render firms on the frontier of economic viability, insolvent. So for me, perhaps the most interesting reform development to watch will be how the Chinese economy handles unwinding these firms. Or put another way, how does Chinese internalize all of the uneconomic investment.

That Li Keqiang understands that bankruptcies are inevitable, and recognizes the magnitude of the problem is encouraging. However, the scale of this problem is yet to be revealed. Because of China's very low level of capital stock at the beginning of this growth phase it seems logical that despite the presence of financial repression high investment levels of investment, despite being sub-optimal in the current period were easily internalized and became economic with growth. However, at some point the marginal returns of this over-investment tipped into the uneconomic territory.

When did this happen? Has this happened? In which industries has it occurred? In which industries will it occur in the future?  These are the billion Yuan questions that reforms should answer for us. They are also the questions that will impact the effectiveness of reforms, and determine how the reforms should evolve going forward.

Capital Market Liberalization: China has unveiled a pilot program that should facilitate the issuance of preferred shares by certain market segments. From Reuters:
Analysts have widely predicted the first preferred shares to be included in the trial will be shares in Chinese banks. Sources told Reuters last week that major state-owned banks, which are among China's biggest index heavyweights, have already prepared share tenders. 
The second group of listed firms include those which intend to acquire or absorb their counterparts by issuing preferred shares, while the third group covers those which aim to use preferred shares to replace existing ordinary shares, the CSRC said in the statement published on its microblog.
Again, pushing market influence. Again, stopping well short of 'ideal' (which gives the critics ample room to wonder: why not extend this to x industry? why not offer x channels to debt?) but a clear first step in the direction indicated by the Chinese government in their reform outlines and a move consistent with the consumption/investment re-balance plot line.

The market allocation of resources, in my opinion, is by definition socially optimal in the vast majority of cases (particularly in determining consumption and investment habits). Thus, to my eye, this is by definition a step in the right direction (I accept that there is plenty of room for disagreement on this point). Increasing the market's influence on what is deemed a good investment, and what is 'over-investment' is a positive. That this reform seems to be incentivizing consolidation is a bit troubling. But, if this helps internalize the over-investment described above, then it might still be net positive.

Perhaps the more important benefit is that this is a positive step towards giving households access to a wider range of investment opportunities. I'm having a hell of a time finding data on the composition of household savings but this article from the Epoch Times cites a PBoC report, "Surveys conducted by The People’s Bank of China show that Chinese residents prefer saving their money in banks rather than investing in stocks, bonds, and real estate." I'd really love to read through this report but I'm having a hell of a time finding it or any more information on how households are allocating their savings.

If this is correct, and it does line up anecdotaly with the little bit of knowledge I have on the subject. But Chinese households are largely under invested in the stock market and as liberalization allows increasing numbers of companies to tap into debt markets, and an increasing number of financial institutes are able to fund these companies, and as an increasing number of products are offered to households to give them exposure to this type of equity, then I think they'll you'll see a serious shift to equities.

How far away is that? Again with the billion Yuan questions, but this does appear to be consistent with that direction.

Thursday 6 March 2014

Poll shows most Albertans favour renewable energy over coal... so what?

I love stories like this one from the Edmonton Journal:

A shocking result, people would rather have renewable energy produce their energy then coal. SHOCKING! I wish they'd link to the questions asked when stories rely on surveys. Of course, with framing effects and what not you can skew results in whichever direction you want. Then maybe authors would no the worthwhile surveys to report on and the worthless surveys to ignore.

For example how was the price point question asked?:
Commissioned by the Canadian Association of Physicians for the Environment, the poll also found that two-thirds of Albertans are willing to pay higher prices for electricity generated by wind and solar power, and that a majority are convinced there are negative health effects related to burning coal. 
For example, had the previous question been:  Burning coal has been found to contribute to four of the five leading causes of mortality in Alberta: Heart disease, cancer, stroke, and chronic lower respiratory diseases. Are you concerned by the negative health effects related to burning coal?

Then followed by: Would you be willing to pay a slightly higher price for your energy if it were to come from renewable non-polluting sources?

We don't know if that was the case, but you get the point.

But that all isn't even what makes me laugh.

Of course everyone wants renewable energy. It just isn't economically feasible YET. It will be someday. But it's not there yet. Even if you favor more government support, you'd probably want to support a carbon tax that would make non-renewables less economically competitive.

These are nuanced question topics that require aren't black and white. I don't find survey's like this provide any useful information. The more detail or prior knowledge you need to answer a question, the least likely the results of a survey based on these questions becomes.

'We should stop consuming fossil fuels' that's a legitimate position, but in and of itself it doesn't offer any value because it doesn't indicate how. To do so would require a) a plan to replace fossil fuels in our daily lives, or b) a plan that people will actually follow to change our daily life so we don't require fossil fuels.

At the end of the day my guess is that solar will be all that we need in 15-20 years time. I'm guessing some tinkerer (I'm hoping it's from some poor country) finds a breakthrough on energy storage that enables all renewables to breakthrough. Everything will probably scale up at first depending on when this break through happens. I remember reading Ray Kurzweil's The Singularity Is Near and bought into his reasoning on this.

As we nano-size processes the process most likely to utilize this trend is likely to be solar. Every time the sun is out our houses covered in solar power generating paint will be feeding into our smart grid that stores enough power for those cloudy days when our cars with solar power generating bodies run to our office buildings constructed from high efficiency solar power generating materials.

If someone called me asking if I'd prefer living in that world to one powered by non-renewables, I'd be inclined to say YES!... But so what?

China: Reform Progres

President Xi Jinping, centre, and Premier Li Keqiang arrive for the National People’s Congress opening session
Photo Credit: Associated Press
This post is motivated by Li Keqiang's recent speech, some recent Chinese Monetary Policy adventures, and a book I read last night: Avoiding the Fall: China's Economic Restructuring by Michael Pettis.

The theme here is restructuring. China needs to promote balanced growth. China needs to increase consumption. China needs to stop relying on debt fueld investment. We've all heard the headlines. 2014 should give us a good indicator of both the willingness to reform and the direction that policy makers will take it.

Premier Li and his forward guidance.

Two key numbers: Li identified targets of GDP growth at 7.5% and household consumption growth at 14.5% (China overshot GDP by .2% and undershot on HCG by 1.4% in 2013).

Following these statements Li reiterated the government's support for Investment, even stating (from this FT article), "We will take investment as the key to maintaining stable economic growth".

Interpretation of an interpretation is always a bit, well, of questionable value. But it'll be curious to see whether they will set a key target (aimed to reduce investment share) or if they will use it as an active discretionary fiscal policy tool to aid in the re-balance (which could easily be counterproductive).

If they actively target a path towards balancing the consumption/investment shares of GDP then this will, almost by definition reduce GDP growth significantly (via falling investment growth, perhaps even to negative growth). This is why the 7.5% target described earlier is a bit puzzling. Not too sure how you can have both.

Which turns me to Pettis's Avoiding the Fall.

The basic thesis of Pettis's book is that GDP growth MUST fall. The mechanism by which it will fall is not determined, nor is the timing of the fall. However, the debt servicing capacity will be reached at some point in the not so distant future (Pettis suggests as early as two or three years from now) in which case a hard landing will be forced on China.

Conceptually, framing this with an accounting identity is probably the easiest. So we have a basic GDP equation

GDP = Consumption + Investment + Government + Current Account

Alright, so remember:

- In a close economy Investment = Savings. But of course we aren't in a closed economy.
- If Investment exceeds Savings then that balance shows up as a Current Account surplus (or vice versa) which is simply the net exports. (ie. GDP that isn't consumed domestically but is consumed in foreign markets).

Now, a couple of items unique to China according to World Bank Data:

- Savings (Investment) increased from an already high 37% of GDP to 51% from 2000 to 2012
- Household Final Consumption dropped from an already low 47% of GDP to 35% from 2000 to 2012
- By comparison world averages were 22% and 60% respectively in 2012.

So the rebalance math is simple: Consumption growth > GDP growth > Investment Growth

So the trillion RMB question is how you get a relatively high GDP growth rate out of an economy that has manufactured it's growth via an expanding investment share of GDP. And this is a question that get's infinitely more complex when that investment portion is fueled by debt. Which is a key component of Pettis's argument.

A sense of urgency?

The main reason that the status quo can't last economically is Pettis's assumption that Chinese investment has at some level been misallocated, and is likely increasingly so. Pettis broadly describes misallocated investment as investment who's impact on GDP exceeds the economic wealth generated by it. This follows logically from his discussion on financial repression which I fully agree with.

Financial repression describes the subsidization of one sector at the expense of another. In this case, the simplistic description is that Chinese savers are given very low return on their assets (and few other avenues to preserve wealth) in order to provide very low rate loans to borrowers. These borrowers, with their below market debt can invest in projects that at the margin would not be economic. The longer this set up exists, the argument goes, the greater the number of uneconomic projects being undertaken.

Financial repression isn't necessarily all bad though. When a country has a very low existing capital stock the funneling of funds towards it's growth does not necessarily lead to economic missalocation (the China Development Bank story here shows the value). Countries like Japan and South Korea have utilized this method of development effectively in the past and have found themselves in the rarefied class of countries that blasted through the middle income trap.

While I might disagree, or at the very least remain agnostic, about the scale of misallocated investment I don't for a second doubt significant capital has in fact been misallocated. The Chinese government must implicitly accept this notion as well, or re-balancing would not then be required (if the economic worth of investment met or exceeded the capital outlay, then the project would be a good investment).

My divergence from Pettis's view is along the lines of timescale and urgency. I don't quite have my head around why dead limit capacity would form such a cliff. I agree that uneconomic acivities will have to be recognized at some point. I also agree that a slowdown in economic growth is inevitable. But a hard landing? I'm not convinced.

In order to avoid a hard landing, China needs to focus on two key items: recognizing and unwinding the loss generating debt and increasing the consumption share of GDP.

Chinese Loan Growth:

In January China's loan growth was shown to be the largest since the stimulus spending of 2009. What did this mean? Was it one of the many annual abberations caused by the Lunar New Year? Was it a bullish signal that the supply side is ramping back up? Was it another hail mary thrown onto the increasing mountain of debt that we hear is fueling China's growth?

February's numbers indicate another huge growth in loans. More of the same? Oliver Barron's article on Forbes illustrates the contradictory nature of some of the data:
Many of the data points released over the last two months have signaled a domestic slowdown, including the January manufacturing PMI reading at a six-month low of 50.5 and the February HSBC Flash PMI reading of 48.3, a seven-month low (a reading below 50 signals contraction). However, this data was somewhat puzzling as it contrasted with a 10% yoy growth in exports in January and a 23% yoy rise in new yuan loans, both of which suggest a relatively well-off economy.
His interpretation of these incredible loan volumes is something much simpler. And a strong indication that China's reform policy is pushing forward, while offering another indicator pointing towards a general slowdown:
As it is now emerging that the strength of bank loans can be partly attributed to off-balance sheet loans coming back on balance sheet, then the actual demand was actually much weaker than the headline figures suggest and the slowdown is confirmed.
IF this is the shadow banking system being rolled onto the balance sheet of Banks that is a solid first step towards the proper recognition of their magnitude, and also an indicator of how potential losses will be dealt with.

In the late 90's in the wake of the Asian financial crisis China addressed high levels of non-performing loans at the four state owned commercial banks by effectively transferring them out into state backed asset management companies. Is something like this possible now? It's hard to say but if we can get those assets out of the shadow banking sector and back onto the big banks balance sheets we'd at least know the scale of the problem.

 Interest Rate Liberalization:

Interest rate liberalization is typically a key to unwinding financial repression. Those incredibly high household savings rates now increase household income and capital is allocated more conservatively which reduces investment going forward.

Bloomberg reports on the progress here:
The People’s Bank of China moved toward freeing up interest rates in July by removing a floor on the rates banks can charge for loans. Three months later, the central bank started a “loan prime rate” based on weighted average costs charged to the best clients by nine major Chinese lenders and in December, it allowed banks to sell negotiable certificate of deposits with yields set by the market.
This, in conjunction with the deposit insurance indicated in the article, as well as the forward guidance on pushing for market determined interest rates should go along way to clear up current imbalances.

Hopefully, deregulation will also allow the entrance of other formal banks to cater to the many business, as described in this BBC article that are paying exorbitant rates:
Zhou Feng, the 30-year-old boss, told me that without the high-interest loans from shadow banks he couldn't take on large orders. He usually pays 24-30% for these loans, which in his case are usually for just three to five days, and give him much-needed cash.


The reason for my optimism on China is twofold.

The first, and most important, reason is that there is alot of low hanging fruit. I've stressed on this blog previously the need to disentangle the aggregate macro picture from the more nuanced micro environment. The main reason that China has been able to produce the spectacular growth numbers that they have is quite simply that they started from such a small base.

The second, and almost equally as important, is that for whatever reason. The Chinese government has done an excellent job at choosing policy through this period. Was every choice the right choice? I wouldn't think so no. But this growth story could have gone off the rails at any number of times where the 'experts' would have acted incredulously that anyone had thought this wouldn't be the case.

I was only 12 when the '97 Asian financial crisis hit, but I can only imagine that a similar line of reasoning to Pettis's could have been made. Obviously, the continuation, or even acceleration of these policies have likely compounded the problem, but still.

Or imagine asking yourself in 2006 what would happen to China's export economy if the entire developed world had a complete financial meltdown and fell into an economic recovery that bordered, and continues to border on stagnation.

No, I'm going to need to see something materially change (for example a walk back on the plenum reforms), my benefit of the doubt goes to the Chinese government.