Friday, June 29, 2012
Duties morality and short-selling: Part 2
Only one person suggested I watch reruns of the Godfather for advice.
Does it change your mind if the crooked advisor is mafia?
What if there is only a 5 percent chance of him being mafia?
What if you plain do not know?
Disclosure: a journalist is going to do it for me - or at least sound the victim out. Seems safer that way. At least for me.
Thursday, June 28, 2012
Duties, morality and short selling
I am involved in a short that has mostly collapsed. Take it as read that the company and its accounts were almost entirely fraudulent.
The stock however squeezed a fair bit along the way. Had you "played" the stock you could have made considerable money. But you had to understand that when it spiked it was a short-squeeze and short-squeezes are made to be sold.
The short squeeze happened when an elderly man who was rich from a successful mid-sized business started buying the stock aggressively. He purchased over 10 percent of the company - and more than 20 percent of the float. His purchases were well in excess of 10 million dollars - and on market value now he would be down $8-9 million (having been up considerably along the way).
Given this was a fairly easily determined fraud there was a large short interest - and some of those shorts were so big in the stock they had to buy back as the stock went up (short positions alas get larger as they go against you). So the shorts lost some. Short squeezes do that.
The old man lost, and some short sellers lost. Almost all the longs lost too. The only winners were a few short sellers with positions small enough to sit out the squeeze (which fortunately in this case includes Bronte), a few "players", and of course the insiders. Fidelity was a big loser losing tens of millions of dollars.
The insiders were crooks who sold stock more or less continuously. The insiders carved out something like 40 million of neat profit. All fraudulently obtained. Victims included the old man and Fidelity.
I did a fair amount of research into this elderly man. He wasn't usually a big-swinging stock player - instead he was an investor who had been successful in his normal line of business (a form of retailing) and took his (excessive) confidence into the stock market. Much worse though - he was being privately advised by someone who had previously accepted a ban from the securities industry for selling pump-and-dump securities to his own clients. The old man was being advised by a crooked advisor.
However only recently - and after the old man had lost most of his life savings - did I work out the advisor was a crook. Telling the old man now will just deepen his sadness. On paper he has $1-2 million worth of the shares left - but they are not saleable. If he tried to sell them the stock price would collapse to below a penny. He could - if lucky - get out 50 thousand dollars on the way down.
I know what it is in my interest to do. That is follow the crooked advisor to his next victim and short that stock too.
But I don't know what it is my moral duty to do. Do I tell the old man he has been had (and risk retribution from the advisor)? Do I hope he can salvage the last 50 thousand dollars from what was his 10 million plus dollar life savings? I told the regulators but nothing much has been done. (They don't tend to follow leads like that from short sellers. They perceive we have an interest in telling stories.)
I have now more or less covered the stock. I do not have any particular interest in future moves in this security which already trades well below $1.
Should I ring the old man? Would you?
Tuesday, June 26, 2012
Coronado Biosciences is not exactly kosher
Coronado Biosciences - now listed on the Nasdaq - is researching a treatment for Crohn's (and possibly a few other autoimmune diseases including the big-daddy of them MS). The technology is all licensed. To quote the original prospectus:
All of our product candidates were in-licensed from third parties. Under the terms of our license agreements, the licensors generally have the right to terminate such agreement in the event of a material breach by us. Our licenses require us to make annual and milestone payments prior to commercialization of any product and our ability to make these payments depends on our ability to generate cash in the future. These agreements generally require us to use diligent and reasonable efforts to develop and commercialize the product candidate. In the case of CNDO-201, the company from which we sublicense CNDO-201, OvaMed, licenses CNDO-201 from a third party, UIRF, in exchange for annual and milestone payments, patent cost reimbursement, royalties based on sales and diligence obligations. Our rights to CNDO-201 are, therefore, also subject to OvaMed’s performance of its obligations to UIRF, certain of which are outside of our control. For example, upon our acquisition of this license from Asphelia, we paid certain overdue patent cost reimbursement obligations to UIRF.So the stock holders (those that participated in the recent capital raise) get to fund the development of someone else's drug and have to make milestone payments based on the success of that development.
I will leave it to readers to work out the nuances of that disclosure.
I am more interested in the treatment. Here is how it is described in their latest prospectus:
TSO, or CNDO-201, is a biologic comprising Trichuris suis ova, the microscopic eggs of the porcine whipworm, for the treatment of autoimmune diseases, such as Crohn’s disease, or Crohn’s, ulcerative colitis, or UC, and multiple sclerosis, or MS.
The treatment comes from porcine whipworm - that is a worm that lives in pig intestines.
That is an obscure ingredient. You would think they breed pigs for it - but no a subcontractor of OvaMed breeds the pigs and CNDO pays OvaMed for that. This is the same OvaMed they are licensing the drug from. Here is the disclosure:
We have contracted with OvaMed to produce and supply us with all of our requirements of TSO. OvaMed’s contractor inoculates young pathogen-free pigs with T. suis from a master ova bank and harvests the ova which are incubated to maturity and are processed to remove any viruses and other pathogens. Ova then are processed and extensively tested to assure uniformity. They are then used to repopulate the master ova bank and are processed further by OvaMed into a final formulation of the drug product that is a clear, tasteless and odorless liquid. OvaMed manufacturing is conducted at one facility in Germany.This disclosure leaves out the really funny detail. Here it is:
Mature T. suis produce ova that exit the porcine host with the stool, however, ova are not infective until incubating in the soil for several weeks, thereby preventing direct host-to-host transmission.
So get this - Coronado Biosciences is a company testing a drug to treat a disease prevalent amongst New York Orthodox Jews where the drug is extracted from pig stools.
And you get the messy relationship with OvaMed thrown in for free.
It is not exactly Kosher.
Either this does not work or the Old Testament God does not exist or, if the Old Testament God does exist he has a wicked sense of humour.
*There are other inherited autoimmune disorders linked to people with other origins. Coeliac disease is of Anglo-Celtic origin. Behçet's disease is sometimes called Silk Road disease and has higher incidence in people of Turkish and Middle Eastern origin.
Monday, June 25, 2012
China and the shiny stuff
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.
Friday, June 22, 2012
Follow up to the China kleptocracy post
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...
*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.
Tuesday, June 19, 2012
Distractions: winter in Sydney
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.
Sunday, June 10, 2012
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.
Wednesday, June 6, 2012
SEFE, balloons and other spark attracting bubbles
No further comment but I expect comment from my readers.
Disclosure: short - but the borrow is so tight that being short is hardly worthwhile...
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Monday, June 4, 2012
How business decisions are made in a boom: Fortescue Metals edition
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:
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...)
*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.
Saturday, June 2, 2012
Weekend diversions (which I think you may need after a Friday in the markets like that...)
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):
Gulfport Energy and Wexford Capital Part VII: The independence of reserve assessment
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).
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.
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