China and the shiny stuff

In my kleptocracy post I described how the range of investments available to the median Chinese family is limited. They can't take their money offshore (unless they are rich enough to afford casino junkets). The local stock market is rigged. There is no worthwhile mutual fund market. They can own see-through apartments. But their main saving mechanism is bank accounts and life insurance contracts (life insurance being a bank account proxy).

Rates are regulated - low. Inflation is high and ex-ante the return to Chinese savers is negative.

Despite negative real returns Chinese save in huge quantity. This may be because of the "four grandparent policy" as described in the kleptocracy post or because of gender imbalance (as described in the follow up post).

Whatever: in China we have huge quantities of savings at ex-ante negative real returns in some sense compelled by local social and political structures.

This pool of savings (part of what Ben Bernanke once described as the "excess of global savings") has global implications - and these will be explored in a forthcoming posts.

But here I state the obvious.

If you were forced to save huge amounts of money at negative real rates of return wouldn't gold look attractive?

There is no data I would trust on how much gold has been socked away by middle-income Chinese. Being a kleptocracy where government officials expropriate land, hydro dams and any other private assets they take a fancy to, the gold buried under the house is hardly going to be declared to official statistics collectors.

But it is there in some quantity.

Gold is a market I have studiously taken very little interest in. I agree with Warren Buffett - that it has no real return over very long periods and is thus unattractive. But in China no-real-return is a good return and until recently I had not thought about that clearly.

If people have a decent knowledge of the non-official gold-market in China please leave it (anonymously if you wish) in the comments.

Observations on gold demand in China now and in the future

I have no knowledge of the specifics of middle income people trading gold in China.

But I do note that inflation in China (with regulated low interest rates) is likely to be strongly positively correlated to gold demand in China.

Inflation in China is clearly declining right now (which is very bad for Chinese gold demand). However I do not think that falling inflation in China is likely to be sustained. Low inflation would result in the collapse of many State Owned Enterprises (and probably the regime) - and the regime is the hand that holds the printing press so to some extent inflation is a choice for the regime. They will print. And print. Their very lives depend on it.



John

Follow up to the China kleptocracy post

The China kleptocracy post has received a lot of comment - mostly favourable. It was my first post to get 100 thousand views. I would like to thank all that commented on it (especially Paul Krugman who was good for about 35 thousand page views).

Only a few of those views are from China. My post was blocked by the Great Chinese firewall.* That said, within China the people who have been in business there for more than a decade were mostly in agreement. The people who have been there a couple of years were less in agreement. Bill Bishop (who I read and respect) was in the less in agreement group.

I will not name the people in agreement because many have to live in China.

My thesis was

(a). The savings rate in China was abnormally high driven by the one-child policy,
(b). The options for investing those savings for most the population were extremely limited - mostly bank deposits.
(c). The bank deposit market was rigged so that deposit rates were consistently below the inflation rate.
(d). That repressed interest rates were mainly used to subsidize state owned enterprises and that
(e). This funded the widespread looting of State Owned Enterprises by party officials.

Demographics is outside my field of expertise and I received (and expected) most criticism on the demographic point. The first bit came from my business partner who thought that the high savings rate and the property boom came in part from the (extreme) gender imbalance in China. The gender imbalance is another artefact of the one-child policy - where selective abortion and infanticide produce a large shortage of female babies and (later) eligible women to marry. This drives male preening behaviour - and the most successful preening behaviour for a man is to be rich and to own property. This is an extension of the men-will-do-anything-for-sex argument - and in this case "anything" is own apartments and big (negative return) bank balances.

Unknown to me this was the subject of a serious academic paper by Shang-Jin Wei - a professor of finance and economics at Columbia University who supports the men-will-do-anything-for-sex argument with lots of fancy econometrics.

There was little objection to my argument about limited options for saving in China. That seemed self-evident - however those limited options are being undermined by capital flight. The Chinese are washing an incredible amount of money through Macau. That money is being saved outside the Chinese banking system - and is thus not subject to extreme financial repression.

There is also little objection to my suggestion that bank deposit rates are rigged below the inflation rate. China dropped the regulated bank deposit rate recently as the inflation rate declined. However - and it was the point of my post - negative real interest rates are declining in China because inflation is declining.

The fourth point - that the repressed interest rates are the main source of subsidy for Chinese State Owned Enterprises was backed up very strongly by Michael Pettis. There are other sources of subsidy. For instance tobacco is largely provided by a State Owned monopoly and tobacco use is not subject to much social sanction making the tobacco company unbelievably profitable (and hence able to pay very high salaries and benefits to senior staff). Indeed Michael Pettis points to a Mainland think-tank - Unirule which suggests that monopoly and direct subsidies have accounted for as much as 150 percent of the profitability of the State Owned Enterprises over the last decade. Pettis himself calculates that repressed interest rates may have accounted for another 400 to 500 percent of total profitability over this period.

Monopoly profits and financial repression are a subsidy from the household sector. Pettis thus states the obvious - five hundred to six hundred and fifty percent of SOE profits come from a subsidy from the household sector.

Absent subsidy the SOEs are staggeringly unprofitable. In a market economy a business that goes from making X per year to losing X per year usually fails or closes pretty quickly. A business that goes from making X per year to losing 5X per year crashes and burns very rapidly.

Absent the subsidies the whole SOE sector with its current expense base crashes and burns very quickly. By far the biggest subsidy is the subsidy of being allowed to borrow at repressed interest rates.

This of course leads to the fifth part of my argument. That was that the expense base of the SOEs was the (looted) income of Communist Party apparatchiks. Here surprisingly the New York Times came to my rescue with an article about the difficulty of economic reform in China. Reform in this article really meant reform of State Owned Enterprises. The difficulty was that:

Publicly controlled enterprises have become increasingly lucrative, generating wealth and privileges for hundreds of thousands of Communist Party members and their families.

That is - of course - precisely my point. And the Times goes on to say that the Government is moving to stifle debate on anything that challenges this status-quo.

Deflation of course will challenge the status-quo anyway. If 400-500 percent of the profitability of SOEs comes from financial repression then the end of financial repression will result in the collapse of the State Owned sector and the collapse of the wealth and privilege led by "hundreds of thousands of Communist Party members and their families". I suspect that the centre would find it increasingly hard to control their regional elites and the regional elites would revolt. [Revolution is almost always an affair of the second-tier elite versus the first-tier elite - the masses rarely drive it. This would be no exception.]

However in the face of that the centre would do anything to keep the inflation rate high. Ben Bernanke might not literally be prepared to throw dollars out of helicopters. The Central Committee - they might go there...



John

*I have been informed by someone that blogger is always blocked in China. The Chinese people who were telling me they can't get the blog usually get it via a virtual private network.

Distractions: winter in Sydney

It is mid winter in Sydney - and the surf has been too big and the water a little cold for me. But the sun was out and I went to Cape Solander to watch. Cape Solander is the notorious surf break also known as "ours".

This was the wave of the day:



I do not know who the surfer is.

A little less plausibly the small-wave surfers have had some fun in Sydney Harbour:




Here is a little bigger at Cape Solander. I showed this video (and similar) to a surfing hedge fund manager. His response in two words: no bid.













John

The Macroeconomics of Chinese kleptocracy

China is a kleptocracy of a scale never seen before in human history. This post aims to explain how  this wave of theft is financed, what makes it sustainable and what will make it fail. There are several China experts I have chatted with – and many of the ideas are not original. The synthesis however is mine. Some sources do not want to be quoted.

The macroeconomic effects of the Chinese kleptocracy and the massive fixed-currency crisis in Europe are the dominant macroeconomic drivers of the global economy. As I am trying a comprehensive explanation for much of the world's economy in less that two thousand words I expect some kick-back.

China is a kleptocracy. Get used to it.

I start this analysis with China being a kleptocracy – a country ruled by thieves. That is a bold assertion – but I am going to have to assert it. People I know deep in the weeds (that is people who have to deal with the PRC and the children of the PRC elite) accept it. My personal experience is more limited but includes the following:

(a). The children and relatives of CPC Central Committee members are amongst the beneficiaries of the wave of stock fraud in the US,

(b). The response to the wave of stock fraud in the US and Hong Kong has not been to crack down on the perpetrators of the stock fraud (so to make markets work better). It has been to make Chinese statutory accounts less available to make it harder to detect stock fraud.

(c). When given direct evidence of fraudulent accounts in the US filed by a large company with CPC family members as beneficiaries or management a big 4 audit firm will (possibly at the risk to their global franchise) sign the accounts knowing full well that they are fraudulent. The auditors (including and arguably especially the big four) are co-opted for the benefit of Chinese kleptocrats.

This however is only the beginning of Chinese fraud. China is a mafia state – and Bo Xilai is just a recent public manifestation. If you want a good guide to the Chinese kleptocracy – including the crimes of Bo Xilai well before they made the international press look at this speech by John Garnaut to the US China Institute.

China has huge underlying economic growth from moving peasants into the modern economy

Every economy that has moved peasants to an export-orientated manufacturing economy has had rapid economic growth. Great Britain industrialized at about 1 percent per annum. It was slow because all the technology needed to be invented for the first time. During the 19th Century US economic growth – once started – ran about twice the rate of the UK. They copied the technology which was faster than inventing it. Later economies (eg Japan, Malaysia, Thailand, Korea) went later and faster. As a general rule the later you industrialized the faster you went – as the ease of copying went up. In the globalized internet age copying foreign manufacturing techniques and seeking global markets is easier than ever – so China is growing faster than any prior economy.

This fast economic growth – which would happen in a more open economy – is creating the fuel for the Chinese kleptocracy.

The one-child policy drives massive savings rates

The other key fuel for kleptocracy is a copious supply of domestic savings to loot. The reason Chinese savings levels are so high is the one-child policy.

In most developing countries the way that people save is they have multiple children hopefully to generate a gaggle of grandchildren all of whom are trained to respect their elders. Given most people did not live to old age if you did you became a treasured (and well cared for) family member.

This does not work in China. Longevity in China is increasing rapidly and the one-child policy results in a grandchild potentially having four grandparents to look after. The “four grandparent policy” means the elderly cannot expect to be looked after in old age. Four grandparents, one grand-kid makes abandoning the old-folk looks easy and near certain.

Nor can the elderly rely on a welfare state to look after them. There is no welfare state.

So the Chinese save. Unless they save they will starve in old age. This has driven savings levels sometimes north of fifty percent of GDP. Asian savings rates have been high through all the key industrializations (Japan, Korea, Singapore etc). However Chinese savings rates are over double other Asian savings rates – this is the highest savings rate in history and the main cause is the one-child policy.

Low and middle income Chinese have very limited savings options

The Chinese lower income and middle class people have extremely limited savings options. There are capital controls and they cannot take their money out of the country.  So they can't invest in any foreign assets.

Their local share market is unbelievably corrupt. I have looked at many Chinese stocks listed in Shanghai and corruption levels are similar to Chinese stocks listed in New York. Expect fraud.

What Chinese are left with is bank deposits, life insurance accounts and (maybe) apartments.

Bank deposits and life insurance as a savings mechanism in China

Bank deposits rates are regulated. You can't get much different from 1 percent in a bank deposit. Life insurance contracts (a huge savings mechanism) are just rebadged bank deposits – attractive because the regulated rate is slightly higher.

This is a lousy savings mechanism because inflation has been between 6 and 8 percent (but is now lower than that and is falling fast). At almost all times (except during the height of the GFC) the inflation rate has been higher – often substantially higher – than the regulated bank deposit (or life insurance contract) rate.

In other words real returns for bank accounts are consistently negative – sometimes sharply negative.

You might ask why people save with sharply negative returns. But then you are not facing starvation in your old age because of the “four grandparent policy”. Moreover because of the underlying economic growth (moving peasants into a manufacturing economy) there are increasing quantities of these savings every year. This is the critical point – the negative return to copious and increasing Chinese bank deposits drives a surprising amount of the global economy and makes sense of many things inside and outside China.

The Chinese property market as a savings mechanism

Chinese people have very few savings mechanisms. The major ones (bank deposits and their life-insurance contract twins) have sharp and consistently negative real returns.

Beyond that they have property.

Bank deposits have sometimes 5 percent negative returns. If you got 1 percent negative returns from  property – well – you would be doing well. Buying an empty apartment and leaving it empty will do fine provided you can sell the property at some stage in the future.

It is commonplace amongst Western investors to view the see-through apartment buildings of China as insane. And they may be a poor use of capital. But from the perspective of the investors – well they look better than bank deposits.

Negative returns on bank deposits and the Chinese kleptocracy

Most Chinese savings however are not invested in see-through apartment buildings. Bank deposits still dominate. The Chinese banks are the finest deposit franchises in human history. They can borrow huge amounts at ex-ante negative real returns.

And those deposits are mostly lent to State Owned enterprises.

The SOEs are the center of the Chinese kleptocracy. If you manage your way up the Communist Party of China and you play your politics really well may wind up senior in some State Owned Enterprise. This is your opportunity to loot on a scale unprecedented in human history.

Us Westerners see the skimming arrangements. If you want to sell kit (say high-end railway control equipment) to the Chinese SOE you don't sell it to them. You sell it to an intermediate company who on-sell it in China. From the Western perspective you pay a few percent for access. From the Chinese perspective – this is just a gentle form of looting.

And it is not the only one. The SOEs are looted every way until Tuesday. The Business insider article on the spending at Harbin Pharmaceutical is just a start. The palace pictured in Business Insider would make Louis XIV of France (the Sun King) proud. This palace shows the scale (and maybe the lack of taste) of the Chinese kleptocracy.

A normal business – especially a State Owned dinosaur run by bureaucrats – would collapse under this scale of looting. But here is the key: the Chinese SOEs are financed at negative real rates.

A business – even a badly run business – can stand a lot of looting if it is (a) large and (b) funded at negative real rates.

Those negative real rates are only possibly because there are copious bank deposits available at negative real rates to State controlled banks.

The cost of funds in China and the willingness to hold foreign bonds

The Chinese Government (and the banks are part of the government even though they are listed) has access to seemingly unlimited bank deposits at negative real costs.

When you have copious funds at a negative cost a lot of investments that look stupid under some circumstances suddenly look sensible. US Treasuries look just fine. Don't think the Chinese are going to stop holding Treasuries. The Treasuries yield far more than they pay the peasants. The Chinese make a positive arbitrage on holding low rate US bonds.

Monetary threats to the Chinese establishment

The Chinese kleptocracy – and indeed several major trends in the global economy – depend on copious quantities of savings at negative expected rates of return by middle and lower income Chinese.

There are two core threats to this system – one widely discussed – one undiscussed.

Inflation (widely discussed) is known to produce riots and demonstrations in China – and is considered by Westerners to be bad news for the Chinese establishment. And there are good reasons why the Chinese riot with inflation – the poor who save because they are going to starve – get their savings taken away from them.

But ultimately the Chinese establishment like inflation – it is what enables their thievery to be financed.

The more serious threat is deflation – or even inflation at rates of 1-3 percent. If inflation is too low then the SOEs – the center of the Chinese kleptocratic establishment will not generate enough real profit to sustain the level of looting. These businesses can be looted at a negative real funding rate of 5 percent. A positive real funding rate - well that is a completely different story.

The real threat to the Chinese establishment is that the inflation rate is falling - getting very near to the 1-3 percent range.

Low Chinese inflation rates will mean reasonable returns on savings for Chinese lower and middle income savers. Good news for peasants perhaps.

But that changing division of the spoils of economic progress will destroy the Chinese establishment (an establishment that relies on a peculiar and arguably unfair division of the spoils). The SOEs will not be able to pay positive real returns to support that new division of spoils. The peasants can only receive positive real returns if the SOEs can pay them - and paying them is inconsistent with looting.

If the SOEs cannot pay then the banks are in deep trouble too.

All because the inflation rate is dropping. Maybe they can stop it dropping. The Chinese establishment has a vested interest in getting the inflation rate up in China. Because if they don't all hell will break loose.

Unless the Chinese can get the inflation rate up expect a revolution.



John

SEFE, balloons and other spark attracting bubbles

I am a collector of peculiar stock market press releases. I cannot read this release (by far this year's best) without tears of laughter welling in my eyes...

No further comment but I expect comment from my readers.

John

Disclosure: short - but the borrow is so tight that being short is hardly worthwhile...

-------------------------------------------------------

SEFE, Inc. (OTCBB/OTCQB: SEFE), a sustainability company engaged in offering innovative, pioneering solutions for the world’s energy needs, today provides the following letter to its stockholders and the investment community from its CEO, Don Johnston.

To our valued Shareholders:

I’d like to update you on the status of the company’s technological developments and operational changes. We’ve made much progress in the last four years, taking a seemingly impossible concept and developing it into a solution with many applications in different industries. We call our system the Harmony III.

Briefly, the Harmony III utilizes the phenomena of atmospheric corona discharge by a proprietary collection element held in the air by a balloon. The earth’s natural electrical field drives the discharge, and ions in the lower atmosphere provide a sink for the current. The solution is a high voltage and relatively low current technique by nature and requires a careful approach to handling the power.

Our engineering team has been extremely busy, and we’ve filed for patents on many of the aspects of this unique energy gathering system. The last 90 days have been very productive, and we’d like to share the results with you.

We’ve filed for a patent on our strain reduction system that uses an elastic bungee between a balloon and the tether attached to the balloon. As wind pushes on the balloon, the immediate pressure is absorbed by the elastic bungee rather than the balloon or the tether. This reduces the immediate force and tension, protecting critical components from damage.

Additionally, we’ve filed for patent protection on our tether contact system. The tether contact system is designed to minimize the electrical path length on the power tether. The system uses a proprietary mechanism to complete the power circuit, removing the unused power tether from the path. This system functions in tandem with the dynamic electrical converter and the electrostatic motor-generator as an efficiency booster. This allows for the same hardware to be used no matter what the flight elevation of the aerostat (the technical name for the balloon) may be.

We’ve also filed for patent protection on our system for detecting the concentration of atmospheric ions in the lower atmosphere at varying elevations. The charge detection system will play a critical role in broadening SEFE’s client base, allowing us to quickly determine how to best deliver the required amount of power to the client.

As our research and methodologies have progressed, we’ve realized we need a better balloon launch and retrieval system. So our engineers came up with the “Balloon Launch Assist” system, which uses a secondary stabilizing balloon on top of the primary lift balloon. This invention allows the balloon to be launched and retrieved in a simple manner, without a need for the extra manpower usually associated with the initial launch of a balloon. The secondary balloon provides upward lift and prevents the primary balloon from tipping over, ensuring stability during the critical stages of initial balloon deployment as well as during retrieval. The invention is currently in the patent application process with the U.S. Patent and Trademark Office. A patent-pending number has not yet been issued.

We’re also in the process of designing an electrostatic motor that operates as a generator when supplied with a high voltage-low current power source. This motor will be a key piece of the electrical generation hardware for our Harmony III system. It is designed to work side-by-side with our electrical converter to produce usable AC power directly for immediate consumption, delivery to an electrical grid, or stored for later use.

Our engineers have modified the original ion detector design for a more flight suited geometry which we are calling our “Cubic Wire Detector.” The IP for this technology has been categorized as a "continuation-in-part" application, adding a variation to SEFE's patent-pending application for Collection of Atmospheric Ions while claiming priority based on the original patent, which was filed with the U.S. Patent and Trademark Office on May 12, 2011. The variation employs an open-frame cubic box with alternating wires rather than parallel plates to collect atmospheric ions. The Cubic Wire Detector provides valuable insight into where the most abundant source of atmospheric charge is located.

We believe the cubic wire geometry is more suited to the flight environment and in its second iteration will also be able to capture directionality, depletion, and charge mobility measurements. The alternating wires are held at a high voltage and the ions that pass between the wires are accelerated by the high voltage and measured as a current. The team has developed a custom software routine to automate the data collection and allow for the test operator to adjust test parameters in flight. The software has gone through several iterations over the past year and is currently performing as expected in laboratory tests utilizing an ion source.

As you can see, our engineers are very busy developing Harmony III so it can become a huge success. Our operational staff has adeptly kept pace with several important developments, as well.

While we continue our efforts to advance the capabilities of the Harmony III system, we are working the marketing side at the same time. We’ve launched Revmodo to keep investors and the public up to date on developments in clean energy and the clean energy business. Revmodo has created an online presence that is geared toward driving potential new business to SEFE through community outreach initiatives and education of the public about the growing clean technology space.

Shea Gunther and Michael d’Estries, two award-winning green marketing veterans whose experience ranges from Glamour to Forbes, and from the Huffington Post to the Mother Nature Network and GE’s ecomagination.com, built the site for us and we are very pleased with their efforts. We feel that Revmodo will provide us with unique opportunities to foster new clean energy concepts, and believe it will also enable access to a wide variety of potential business partners that will bolster our company’s commercial opportunities. If you have not yet viewed the Revmodo site, I encourage you to do so.

Earlier this year, we moved our headquarters to Boulder, Colorado. We believe our Boulder facility provides us with an optimal setting for continued testing and perfection of our Harmony III system. We’re also pursuing a partnership with the University of Colorado’s Department of Electrical and Computer Engineering. We plan to work with both the Colorado Center for Power Electronics and the Center for Environmental Technology to perform research and development related to the physics and engineering of the Harmony III system. We believe the University will be a valuable partner in our efforts to further advance the development of our atmospheric energy technology.

Finally, we have set the following milestones on the path toward commercializing the Harmony III:

• Completing the data collection to determine how much electricity can be generated and stored by each unit over a period of time based on location, altitude, weather, and other factors;
• Securing contracts with mining organizations and/or utility companies;
• Implementation of the communications, monitoring methodologies, and security for each unit through our Network Operations Center (NOC) where applicable.

Please feel free to contact us with any questions you may have. We very much appreciate the continued support of our investors and are committed to delivering long-term shareholder value to all of you.

Sincerely,

Donald C. Johnston, CEO
SEFE, Inc.
4700 Sterling Drive
Boulder, CO 80301
T: (303) 444-0584
F: (303) 444-0571

About SEFE, Inc.

SEFE focuses on pushing the boundaries of what’s possible, embracing innovation and employing the cutting-edge to solve problems, and offering sustainable solutions to a world hungry for invention, direction and leadership. SEFE is technology- and solutions-driven, focusing on developing inventions that provide a real-world impact and true profitability. So, success is measured by both a sustainable return on investment, as well as a project’s sustainability from an environmental perspective.  

How business decisions are made in a boom: Fortescue Metals edition

The Australian boom - the one that leaves foreigners gobsmacked when see our housing prices, debt levels and general economic cheeriness - has been powered by iron ore and (to a lesser extent) coal.

These are the components of steel - and steel is the foundation metal of infrastructure - bridges, skyscrapers, gas pipelines and rail. Coal and (especially) iron ore are the raw material for the great Chinese construction and infrastructure build-out.

Below I demonstrate just how extreme the iron ore boom is by extracting BHP revenue and EBIT margin by commodity from BHP's last annual report:

I want to draw attention to the critical lines. Iron ore revenue (in millions of USD) progresses from 10,048 to 11,139 to 20,412 in 2009 to 2011 inclusive.

Underlying EBIT from iron ore was 13,328 million in 2011.

That is a 65.3 percent EBIT margin. These margins would make a luxury goods maker salivate. LVMH (the iconic luxury goods powerhouse) had an EBIT margin of about 23 percent. To make the margin for LVMH equal the margin from BHP's iron ore operation you need to exclude all selling costs (by far the bulk of costs) from LVMH's accounts.

You get the idea this is profitable. Breathtakingly profitable.

But it has not always been. Back in 2000 BHP made 2.5 billion EBIT on 21 billion of revenue. BHP only made that because its operations were about the lowest cost in the world.

The numbers above (almost 32 billion of EBIT) reflect the powerful commodities cycle.

For an Australian investor (or an investor in the large Australian mining stocks) the (literally) sixty four billion dollar question is what is the normalized profit of iron ore companies? At the moment (in what might be the tail-end of a wild boom) the profit situation reflects two things (i) an historically very high iron ore price and (ii) historically high costs (especially labour) incurred to get the stuff out of the ground.

The end price of iron ore is going to depend on global cost curves. Some very dicey mines are getting funding (for example Alderon financed by Liberty Mutual who are going to waste their policy-holder funds)*. I do not know the shape of cost curves but it seems unlikely to me that iron ore will remain as profitable on a cost-of-goods-sold basis (and three times as profitable all up) as selling luxury goods.

Whatever happens - BHP's mines will remain operational though. They are very high grade (mostly over 60 percent iron content and with acceptable impurities) and with good transport infrastructure in place. The only iron ore operation that is competitive is RIO - where the grades are a little higher still.

Fortescue - an aggressive miner somewhere in the middle of the cost curve

BHP and RIO are the very best iron ore operations in the world. Vale is clearly pretty good too (but further from China where the demand is strongest).

There are some very marginal iron ore operations getting funding (see Alderon as linked above). Also there newly developed large mixed-quality operations (particularly on the West Coast of Africa). The competition is rising.

I don't know (nor does anyone else really) where the cost curve will be - but it is likely that Fortescue Metals Group will be somewhere in the middle. At the moment it is certainly a better-than-average mining operation - it is hemetite (rather than a low-grade iron ore that needs extensive pre-processing before shipping) but the grades are typically about 57 percent. Fortescue exports some mildly processed ore (fines etc) with higher grades for higher prices.

These are good iron ore properties. They are just not as good as the BHP and RIO ones.

You can see this in the accounts too. Here are the last half:

Gross profit is 1426 million on 3357 million in sales - an eye-watering 42 percent margin. After administration costs margins are little thinner.

These margins are still salivating-good - but they are twenty percentage points worse than BHP. This is a modestly inferior mining operation that is stupendously profitable because iron ore prices are very high.

Fortescue tell us their vision:

They want to be the "lowest cost, most profitable iron ore producer". And whilst they are frighteningly profitable they are a long way from being the lowest cost producer and given the difference in grades it is unlikely they can ever close that gap.

Some calculation of profit versus iron ore price

The average price realized during the last half (the half with the P&L above) was USD139 per tonne.

If I take $20 per tonne off that price Fortescue is a darn good business. Better than the P&L above indicates because they have mega-large reserves and the volumes are expanding very fast.

But if the iron ore price drops by $50 this is very difficult and if it drops by $60 this is disastrous.

If you take $60 off the iron ore price from last half levels then BHP remains profitable (albeit much less profitable than it is now).

I note that iron ore briefly touched prices in the 60s during the GFC - but prices ramped up with Chinese infrastructure spend almost immediately.

One observation though: at a price in the 110 to 120 range BHP and RIO remain more profitable than Louis Vuitton. This just remains an outrageously attractive business.

Just how big are the expansion plans of Fortescue

Fortescue might lack 20 points of margin against BHP. But they want to make that up in volume. Seldom have I seen a company that keen on capital expenditure. They do so much of it that they have wiped their liabilities under Australia's resource rent tax (at least for next few years).

The capital expenditure is well illustrated in this video from the company:





It can also be seen in the balance sheet - where the company has come through this enormously powerful iron ore boom with ever increasing volume and ever increasing debt.

Yes - you do see that balance sheet right. Exploration, evaluation and development assets of USD5 billion (give or take a little) and debt of USD6 billion.

And it can all be paid if the iron ore price remains high.

But if the commodity cycle goes back to the dark days when BHP's margin was around 10 percent this one is pushing up daisies. They have 20 percentage points less margin than BHP and with a commodity crunch like their margin will go negative and the debt will not be able to be serviced.

Jim Chanos (the noted shortseller best-known for picking on Enron) has publicly stated as much.

Of course the management don't see it that way. They have a view of iron ore prices consistent with their business. Indeed I can't imagine how long anyone bearish on iron ore prices would remain around Fortescue. Having a less than sanguine view of iron ore prices would be about as sensible at Fortescue as trying to be a proselytizing moral conservative working at the bar in a swingers club. You are not going to keep your job.

Still iron ore prices were covered in this amazing interview of Nev Power (Fortescue CEO) by Alan Kohler:

ALAN KOHLER: Now, you must be feeling a bit nervous about what's going on in Europe at the moment. About a week ago your chairman Andrew Forrest said it's all a storm in a teacup beaten up by the media. Do you still think that?

NEV POWER: I think the issues in Europe have had a very strong effect around the global economies, and probably far more than what you would expect, so the difficulty there is that yes, they are in trouble over there in those economies, but if you take the sum total of the impact of those economies, say, on China and Australia, they're relatively small.

But the equity markets have been hit very, very hard in comparison to that effect, so what Andrew was talking about was the fact the equity markets have been spooked by Europe far greater than the actual physical impact.

ALAN KOHLER: But what matters to you of course is the iron ore price.

NEV POWER: Yes.

ALAN KOHLER: What price have you got in your forward planning, in your budgeting?

NEV POWER: Well, we see in the short term that it'll trade in that range of $130-$150 a tonne and it has been very resilient over the last 12 months or so trading around that range. But looking forward we've allowed the forecast to drop down to around $110 a tonne and done all our modelling around that, so we see that long term that'll be the sustainable price.

ALAN KOHLER: But in the 2008 crisis it got down to as low as $55 a tonne, so if there's another crisis - this is what I'm talking about you feeling a bit nervous - if there's another crisis, Spain collapsing, Greece or whatever, you could see the price go down to that level again.

NEV POWER: Well, Alan, it did go down to around a little under $60 a tonne but that was for a fleeting moment and it recovered to over $100 a tonne within weeks - and that was a global financial crisis, that was a real global crisis.

ALAN KOHLER: But the reason it recovered so quickly the Chinese economy recovered so quickly and right now it's slowing.

NEV POWER: Well Alan, the Chinese economy is going through a short-term fluctuation, but overall it's growing very strongly. It's growing in that 7 to 8 per cent range which reflects back to a 4 to 5 per cent growth in steel which we see as a really strong growth and something I think a lot of countries would aspire to.

ALAN KOHLER: Thanks very much for joining us, Nev Power.

NEV POWER: Thank you, Alan. It's good to be here.

Get this: they have modelled around a price ($110 per tonne) which is high enough to keep BHP earning far better margins than Louis Vuitton. As if BHP has a god-given right to make Louis Vuitton look marginally profitable.

Those are prices that might even make the Alderon project cited above borderline viable.

Whatever: Nev Power is sure - simply sure - that the price registered in the GFC was an aberration. To view it otherwise means that he could not possibly hold a senior position at Fortescue.

And I am sure Nev Power is a rational man - but I methinks he has succumbed to the capitalist version of rationality. Whatever makes you a dollar (or in this case for the senior people at Fortescue a few billion dollars) is what is rational (and moral too).

If I were not short this I would wish them good luck with that. As it is I have a small bet against Mr Power and Fortescue. (But then maybe I am just hedging my Australia risk...)


John

*Disclosure: I am short less than 10 thousand dollars worth of Alderon Iron Ore. The project is silly - but the stock is too illiquid and the borrow is too tight to stay short. But it would be a much better short than Fortescue if you could borrow and sell it in quantity. I am also short other marginal iron ore properties. They too are - I think - better shorts than Fortescue.

Weekend diversions (which I think you may need after a Friday in the markets like that...)

You know you are getting old when the librarian at your child's school (Amanda Brown) was in a band you idolized when young.

I give you the Go Betweens (still my all time favourite Australian band with the Triffids a close second).






And for something more recent (Lissie and one of the best covers of a Bob Dylan song done on a single guitar I have ever seen):









John

Gulfport Energy and Wexford Capital Part VII: The independence of reserve assessment

Having got into a spat with everyone and their dog (including more than one client) about the ethics and conflicts of interest in investment banking I thought I would go back to just old-fashioned hot-chair-job-swapping conflicts.

And my old flame - Gulfport Energy and the many conflict-ridden relationships they have entered.

This is a conflict as old as industry: who do you get to assess your reserves and are they truly independent?

Oil and gas companies are meant to have independent and competent parties assess their reserves. This is critical because what you as a shareholder are buying is future production and reserves are the basis for future production.

In this light I want to explore who is involved in assessing the reserves of Gulfport Energy.

To quote the 10K:

There are numerous uncertainties associated with estimating quantities of proved reserves and in projecting future rates of production and timing of expenditures. The reserve information herein represents estimates prepared by Netherland, Sewell & Associates, Inc., or NSAI, with respect to our WCBB, Hackberry and Niobrara fields at December 31, 2011, with respect to our WCBB and Niobrara fields at December 31, 2010, and with respect to our WCBB field at December 31, 2009; by Ryder Scott Company L.P., or Ryder Scott, at December 31, 2011, and by Pinnacle Energy Services, LLC, or Pinnacle, at December 31, 2010 and 2009, with respect to our assets in the Permian Basin in West Texas; and by our personnel with respect to our overriding royalty and non-operated interests at December 31, 2011 and with respect to our Hackberry fields, overriding royalty and non-operated interests at December 31, 2010 and 2009.

I have highlighted the critical bit. The reserves with respect to the Permian Basin are assessed by Pinnacle Energy Services LLC. This has been the case for many years - dating back at least to the 2008 annual report. Specifically the reserves were last assessed in 2010 and were assessed in 2009.

These reserves are over half the stated reserves of Gulfport in the last 10K.

In the first post I quoted the Gulfport's proxy stating that Windsor Energy (which is controlled by Wexford) is the operator all Gulfport's assets in the Permian basin.

Who are Windsor Energy?

Well apart from being controlled by Wexford we know very little about them. They have a website - but it is dead. More precisely the site is "under construction". Corporation Wiki gives a list of officers. But our best clue comes from archive.org - and the "way-back machine". On archive.org we can find how the WindsorEnergy.com website looked a few years ago. The site isn't "under construction" as described - it has been removed and replaced with an "under construction" page.

Anyway the old site contains some CVs and I have pulled one which you can find here (click the world "impatient" at the bottom right hand corner of the linked page).

Lance Galvin
Vice President and Chief Operating Officer 

Mr. Galvin was appointed Chief Operating Officer in July 2008. Prior to this appointment he served as Vice President, Operations and Engineering for Windsor Energy since February 2008. Mr. Galvin worked as a consulting petroleum engineer for Pinnacle Energy Services, LLC from 2003 to 2008. Mr. Galvin started his career in the oil and gas industry in 1980 with Marathon Oil Company serving in various locations and capacities. He served as Engineering Manager for Marathon Oil Company’s Oklahoma City business unit from 1996 to 2001. Prior to this 1996, Mr. Galvin served in various engineering and operations roles for Marathon in Houston, Wyoming and Alaska. Mr. Galvin graduated from Colorado School of Mines in 1980 with a bachelor's degree in Petroleum Engineering and is a Professional Engineer in the state of Oklahoma.

This CV was valid in 2009. I do not think the CV is currently valid because Lance Galvin no longer appears on their dial-by-name phone directory of Windsor. Thus I presume he no longer works there. He did work there during the period that Pinnacle assessed Windsor's reserves. Remember Windsor's reserves were assessed by Pinnacle in 2009.

And that is notable. According to the above CV, Lance Gavin, the former Chief Operating Officer and VP of Windsor Energy used to work as a "consulting engineer" for Pinnacle Energy Services LLC immediately prior to working Windsor Energy.

When accountants do that - going from audit firm to their clients - it raises eyebrows because it raises issues of independence. But it is not illegal. Its the sort of soft-conflict you get used to on Wall Street - surprising, but not very surprising.

I was however very surprised when I googled Mr Galvin's name. You see the first hit was his CV at Pinnacle Energy Services. I note that Lance Galvin is the second most senior listed employee at Pinnacle. The following was downloaded in May 2012 and is still on the web at the time of posting.

Lance J. Galvin began working part-time for Pinnacle Energy Services, LLC as a consulting petroleum engineer in 2003 and joined the company full-time in 2005. 

In 2001 Lance purchased a small manufacturing business in Oklahoma City and continues to be involved in that business. 

From 1996 to 2001, Lance was Engineering Manager for Marathon Oil Company’s Oklahoma City business unit. His duties included managing a multi-disciplined Business Development Team responsible for identifying, evaluating and completing acquisitions and divestitures, managing several multi-disciplined Asset Teams responsible for development and exploitation of the business unit’s reserve base. These responsibilities included properties located in Michigan, Wyoming, and Oklahoma. Lance was also responsible for engineering personnel development, reserve reporting and budget compilation. 

From 1992 to 1996, Lance held the position of Operations Engineering Manager reporting to the Vice President of onshore operations for Marathon Oil Company in Houston, Texas. He was responsible for overseeing all engineering functions in business units located in Midland, Texas; Oklahoma City, Oklahoma and Cody, Wyoming. Lance managed development of asset optimization strategies, implementing corporate change agendas, engineering personnel development, SEC reserve reporting, and corporate financial planning. 

From 1990 to 1992, Lance was Operations Manager for Marathon Oil International’s Damascus, Syria operation. His responsibilities included evaluating well performance, developing economics, preparing a Plan of Development, managing drilling and completion operations, government negotiations and facility design oversight.
From 1988 to 1990, Lance held the position of Reservoir Engineering Supervisor for Marathon Oil International in Houston, Texas. He was responsible for managing all reservoir engineering activities for properties in Ireland, Norway, The Netherlands, Tunisia, Egypt, Indonesia, and Australia. These duties included detailed technical well analysis, reservoir simulation, preparing drilling proposals, economic evaluations, preparing Development Plans, interfacing with government officials and reserve reporting.
From 1980 to 1988, Lance held various production and reservoir engineering assignments with Marathon Oil Company in Casper, Wyoming and Anchorage, Alaska. His responsibilities included field operations supervision, well completion and facility design for oil and gas fields in New Mexico, Utah, Colorado, and Wyoming. He prepared economic evaluations, reservoir simulations, field-wide reservoir studies and reserve reports for fields and reservoirs in Utah, Colorado, New Mexico, Nebraska, Wyoming and the Cook Inlet. 

Lance graduated from Colorado School of Mines in 1980 with a bachelor's degree in Petroleum Engineering.

There are several issues with this CV vis the CV on Windsor Energy's site. For a start Lance is described as a full time employee of Pinnacle since 2005 - somewhat more involvement than a "consulting engineer". The CV's don't match.

But again I suspect the CV is temporarily incorrect. I rang Pinnacle and despite the current web page stating that Lance is a full time employee his name does not appear in the Pinnacle phone directory. It is also possible to find other entities which Lance has been an employee of during this time - so the page stating he is a full time employee of Pinnacle may be old or not updated.

Still Gulfport Energy is laced with conflicts of interest: conflicts have been the point of this series. And conflicts of interest are not often illegal but the law generally requires disclosure. Moreover as my Facebook series shows reasonable people often argue about the ethics of conflicts.

Moreover, the disclosure at Gulfport is generally pretty good - but I had to work a little harder to find this conflict.

And I thought the process amusing.



John

Diversions: Greetings to the New Brunette

Complete diversion here...

Brad Delong complained recently that Siri was interpreting "surely" as "Shirley". He doesn't even know anyone called Shirley.

And in the perverse way my brain works I was thinking back to a 1987 show by Billy Bragg at the Coogee Bay Hotel and him singing Greetings to the New Brunette. (It is a song about a relationship with "Shirley".)

Due to the magic of YouTube I could find a live recording of the same song from the same tour (this time in Wellington New Zealand).

There is no video - but headphones make it worthwhile:

The Epicurean Dealmaker replies to my Facebook post

The Epicurean Dealmaker (TED) has replied to my Facebook post. As usual TED is worth reading.

The Epicurean Dealmaker: As Long as the Right People Get Shot

His argument comes down to the IPO discount being a cost of doing business.

However I would like to turn this into a real estate deal. I go to a real estate agent and ask her to sell my property at the best price.

I enter into a contract which obliges the real estate agent to sell at the best price.

She sells it at less than the best price - as she always does.

She has a queue of buyers willing to buy because she always sells at the best price.

In this case I would think she is a shonk more concerned with her own franchise (her queue of buyers) than my best price and her legal and moral obligations.

I think precisely that of investment bankers. Always have.

My view of the morality of this trade differs from TED's view. And I would like to explain how I think that TED has got to his strange position.

To do that I need to look at this transaction from Morgan Stanley's viewpoint

Morgan Stanley (at least on this deal) appear to have broken the cardinal rule of investment banking. The cardinal rule of investment banking is to look after the investment bank (in the hope that at bonus time they will look after you).

Morgan Stanley's interests are clearly damaged by the Facebook IPO. Their ability to do more IPOs of scale is somewhat limited. Their ability to do future deals is contingent on a reasonably predictable IPO discount.

In my post I defended Michael Grimes (the Morgan Stanley investment banker) as he did what the law and ethics required of him. He looked after the client. I stand by that moral assessment.

Michael Grimes should most certainly NOT be investigated by the SEC for this.

But here my deeply cynical side comes out: Michael Grimes should be fired by Morgan Stanley for this deal. He broke the cardinal rule of investment banking which is the investment bank's interests come before the client interests. By selling too much Facebook at too high a price he has damaged the franchise of the investment bank. That is untenable.

People get fired in investment banking for lesser infractions.

So where does the Epicurean Dealmaker's moral position come from

TED is an investment banker. His background is M&A.

Morality for him is defined by the cardinal rule of investment banking. After all that is what you have to do. It is the moral pact of everyone who works in investment banking.

Indeed it is a moral pact that almost all humans make. What feeds you becomes (in your eyes at least) moral.

This was the very point of my post. People's morality is defined not around what is right and just but what they need to do to make a buck. We are human. Even TED.

Investment bankers learn to rip of clients. That is what they need to do to get by.

And the Epicurean Dealmaker - and everyone else in the industry - has accepted that as the new fair and just.

Its not the Epicurean Dealmaker is a bad man. (I like and respect his blog. I think I would like and respect the man.) It is just that circumstances make the morals.




John