Saturday, January 31, 2009

Crashology 101

In the 2000 stock crash, which began to accelerate in fall of that year, the market bottomed in late 2002. That's about two full years, peak to trough. For the 1973 crash, the market began its slide in January and bottomed out in December of 1974. Again, about two years.

Here is a great Wall Street Journal page on stock crashes in general:

Overall, stock crashes in the United States always seem to last about two years, peak to trough, even in the Great Depression. As Warren Buffett described that episode: “During the Depression, the Dow hit its low, 41, on July 8, 1932. Economic conditions, though, kept deteriorating until Franklin D. Roosevelt took office in March 1933. By that time, the market had already advanced 30 percent.”

By this crude, two-year yardstick, the current market peaked in October of 2007, and we can expect it to recover sometime in late 2009.

Throughout this crash, I have realized why so many smart investors often end up with inferior results. The reason is two-fold: when the market is richly-valued, they accept small or nonexistent discounts in price relative to value. And then they become fearful or unable to purchase deep value securities when the market is in a state of chaos. It seems ridiculously obvious to say this, but we see distinguished investors falling into such traps nearly every day.

We’ve seen many examples of the first reason; there was no shortage of aggressive buyers in the markets for stocks, commercial real estate, and private equity in 2006 and 2007. And now, with investors fearful of macroeconomic disaster, they’re making decisions to do things like pile into gold at a thirty-year high.

As for the stock market, Buffett also wrote:

“Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.

“You might think it would have been impossible for an investor to lose money during a century marked by such an extraordinary gain. But some investors did. The hapless ones bought stocks only when they felt comfort in doing so and then proceeded to sell when the headlines made them queasy.”

While I do believe that sharp macroeconomic vicissitudes will continue over the coming years – and, for that matter, throughout our lives – many stocks probably have already bottomed. And, as Buffett says, we will probably see a sharp advance in the market before the economy improves.

When I look over all the potential global-macro trades – commodities, currencies, fixed income, whatever – the best opportunities that I see, in terms of risk and reward, are currently in the stock market.

Friday, January 30, 2009

Jim Rogers on Global Finance

Here is an interesting presentation given by Jim Rogers. My only criticism is that Rogers repeats many of the same points lately, yet his logic is beginning to sound more dogmatic and convoluted than was the case five or ten years ago. For example, he presented a rock-solid case for commodities investment at that time. Yet, with his current criticisms of letting the banks fail as opposed to bailing them out, Rogers doesn't provide much reasoning for critics, especially those who've cited contrary examples such as Lehman Brothers. Additionally, you have to question what biases he's currently bringing to the table. In light of his commodities index, asking what asset class in which to invest is like asking the barber if you need a haircut.

Thursday, January 29, 2009

Einhorn on Inflation

David Einhorn is now buying gold, the yen, and calls on long-term interest rates. In fact, he sounds a lot like Jim Rogers nowadays – the Fed is going to debase the currency, Ben Bernanke is obsessed with money printing, and so on.

But there are a couple of problems with this line of reasoning.

First, it’s not at all what we’re seeing. The risk of a depression is higher than the risk of hyperinflation, at least right now, so to a large degree the Federal Reserve is doing the right thing. They contracted the money supply and didn’t support banks after 1929, and the result is well known.

Second, gold is a horrendous investment under all other scenarios except for high inflation. The supply of gold is massive – there is more gold available now than ever before in history – and demand has dwindled to basically nothing more than use as an inflation hedge. It is one of the most inferior commodities in terms of fundamentals.

If inflation does not occur as predicted, you have no margin of safety. You are left holding a nonproductive lump of metal. In buying gold at current prices, roughly the highest in thirty years, there is not much room for error.

Yet it sounds much more reasonable to tell your investors that you’re holding gold, as opposed to sugar futures or lead futures or whatever else. The fact is that Einhorn’s investors may be better served if he simply held the Rogers Index instead.

Third, higher inflation appears to be turning into a consensus view, and the consensus view is rarely correct. You have to question why investors like Einhorn would even get into these big macro questions, and what competitive advantage they have there.

Incidentally, here are some of my views on inflation. I have held similar views to what Einhorn is currently expressing, since early 2006. But now I am playing the devil’s advocate even with my own reasoning.

The interest rate trade definitely makes sense: coming out of this crisis, rates must rise. Moreover, the yen will continue to strengthen as the carry trade continues to unwind; but it seems that Einhorn is a little late to this party as well, as the yen was probably a better trade in 2008 than it will be in 2009.

I am with Buffett in saying that you’re going to do a lot better with picking great businesses than you will in trading macro events. The latter are just way too difficult to predict.

Wednesday, January 28, 2009

Einhorn on Stocks

David Einhorn's Greenlight Capital Reinsurance, a new venture, recently reported results:

It is interesting to note that Einhorn is still very bearish on financials. Moreover, he appears to be interested in European markets recently, both stocks and fixed-income, which may be rooted in skepticism about the U.S. dollar.


Reinsurance company Greenlight Capital Re (GLRE.O) is betting that some large financial companies' shares will fall further even though its portfolio is now more conservatively positioned than it was a few weeks ago, its chairman said on Wednesday.

"The portfolio is more net long than it was at the beginning of October," said David Einhorn, Greenlight Capital Re's chairman of the board. Einhorn also runs a New York-based hedge fund called Greenlight Capital and is well known for having questioned the health of investment bank Lehman Brothers before it filed for bankruptcy in September.

Einhorn told Greenlight Capital Re's shareholders on a conference call that mistakes in the portfolio have hurt the company.

Greenlight Capital Re reported on Tuesday a net loss of $117.8 million, or $3.29 per share loss, in the third quarter. Its share price was up 7.7 percent in morning trading on Wednesday to $13.45, curbing its year-to-date stock losses to around 40 percent.

Einhorn reminded shareholders that he never reveals his exact trading strategies but said the portfolio is still short large financial companies whose balance sheets remain exposed to the fallout from the current financial crisis.

The hedge fund manager also said the company is betting against companies that rely on consumers spending a lot of money, a trend researchers say is changing as growth slows and unemployment rises.

Looking back, Einhorn said the company miscalculated on how short positions would protect the protect the portfolio. "We should have been more conservatively positioned," Einhorn said, adding that the long side of the portfolio also suffered from "analytical errors in a few names."

Einhorn said the company's portfolio was hurt by a bet that carmaker Volkswagen AG's (VOWG.DE) shares would sink while they rose dramatically.

People who are familiar with Einhorn's hedge fund portfolio and the reinsurance company's portfolio say they are often very similar.

Tuesday, January 27, 2009

Bill Ackman's Great Expectations

In Bill Ackman's Q3 letter to investors, he laid out his approach to investing in high-risk, high-reward scenarios:

"We occasionally are willing to invest a small amount of fund capital in situations which offer the potential for a many-fold profit at the risk of a large or near-total loss of capital invested. I typically call these investments mispriced options."

Not long ago, while discussing credit default swaps in an interview, Ackman explained how an investment in these instruments presented such an opportunity before the credit crisis hit, where 2% of your portfolio could return "ten times — the portfolio." Ackman went on to say that John Paulson "made a fortune this way," with his historic bet against subprime MBS and other weak credits.

What Ackman is really saying is to make investments where you have a high expected value. This means analyzing the size of potential gains and losses, adjusted for the respective probabilities that such gains or losses will be realized. Here is how to define it, in the language of elementary statistics:

In words, it is the sum of all possible gains and losses multiplied by their relative probabilities. This type of reasoning is commonly used by skilled gamblers, and you can look over some basic examples on this gambling webpage.

This is the essence of what Ackman is talking about with "mispriced options"; a small position that will either expire worthless or be worth a fortune. In fact, with stock prices devastated by panic selling, Ackman appears to be using this logic quite often nowadays.

One current example might be General Growth Properties (NYSE: GGP), a beleaguered REIT facing bankruptcy. But whatever the case is with General Growth, it seems that another Ackman holding, Borders Group (NYSE: BGP), might be a safer bet.

This month,
Pershing Square installed both a new CEO and non-executive chairman, which you can read about here, essentially giving Pershing full control of the company. At the very least, it is clear that Ackman is committed to Borders as a going concern.

And while the probabilities inherent in a potential General Growth bankruptcy filing are anyone's guess, Pershing Square's ongoing commitment to Borders can be interpreted that the odds are tilted in stockholders' favor.

Borders' current share price is roughly 53 cents. This is down from over $20 before the credit crisis began. Given that Ackman started buying at the latter price, we might assume that he believes the company is worth much more.

Indeed, going by what Ackman said at the time, in late 2006, the shares might be worth about $36 each. But since then, we must also assume that value has been destroyed, from the economic malaise as well as a dilutive emergency financing, which granted Ackman warrants to purchase additional shares at $7 each.

Let us assume that Borders' intrinsic value is $10.60 for our example, or twenty times the current market price. This is less than a third of Ackman's original estimate, but a price that puts his warrants in the money. Thus, we have a possible gain of $10.07 and a possible loss of $0.53, on a per share basis. But what is the probability of such a gain or loss?

Setting up the expected value problem the same way as before, but using these new assumptions, we find that Borders' current market price implies a 5% probability that Borders will survive and return to our $10.60 price. For the mathematically inclined, this probability is derived as follows: ($10.07x) - ($0.53)(1-x) = 0, and thus x = ($0.53)/($10.60) = 5%.

But, given Pershing Square's continued commitment to Borders, you might assess that the market is mispricing these odds and there is a greater than 5% chance that Borders will survive and return to our $10.60 stock price.

By Ackman's definition of a "mispriced option," as set forth above, Borders fits the bill. This is an opportunity that could provide a tremendously outsize return, if one is willing to accept the chance of a total loss of capital invested.

Let me be clear: this is an illustration, not a recommendation. Borders' stock does not trade for 53 cents because it is a risk-free proposition. The company faces an onerous debt burden and, depending what happens with the economy, still might not make it through these hard times.

Moreover, such a situation is clearly inappropriate for investment of more than even a few percent of one's portfolio. This is not a situation analogous to Warren Buffett's famous 1964 investment in American Express, where he bet roughly 40% of his partnership's capital on the stock. In that case, Buffett had high confidence that his chance of loss was near zero, with a company that is immensely stronger than Borders is.

This illustrates a current opportunity cost that investors must weigh: Should you accept a relatively lower gain, although still handsome by most standards, with near certainty? Or should you shoot for truly eye-popping gains, but with a risk of permanent loss?

Moreover, how do you gauge your confidence level and accuracy in assessing such risks? Should you attempt to create a portfolio across the risk spectrum, with a small amount of capital in Borders-type stocks and a larger amount in American Express-type stocks?

These are questions that only you can answer.

Monday, January 26, 2009

Short-Term Capital Mismanagement

It almost strikes me that Ken Lewis is trying to make it appear as if he's taking aggressive action, to make his own botched deals look better – first Countrywide Financial, now Merrill Lynch. I particularly love this line: “Recent reports that Mr. Thain had spent $1.2 million to redecorate his office caused Mr. Lewis to further question Mr. Thain's judgment, according to a person close to Mr. Lewis.”

Do you think that Warren Buffett does his questioning about managers after the fact? Wouldn't you want to be sure of a person's judgment before closing a larger-than-life deal?

The fact with John Thain, like Stan O'Neal before him, is that he's a product of the past era on Wall Street, of egregiously-high, wage labor. They've built their lives around receiving flagrant "bonus" checks, so even in a time of total crisis, it almost appears bizarre how desperate they are to get them.

The alignment of interests is all-important. John Thain has a gold-standard résumé – Harvard MBA, Goldman Sachs executive, CEO of the NYSE – and it would be very easy to talk up his abilities. In fact, he is probably an extremely smart, excellent manager. The only problem is that John Thain's interests are aligned with John Thain, and not shareholders.

Even more, he probably has no sense of attachment that comes from building anything, aside from his résumé or loose loyalties to Goldman Sachs. This makes a huge difference in terms of how someone manages a business.

This type of manager will make decisions to do acquisitions at high prices, or sell assets (like the CDO portfolio) at rock-bottom prices to appease Wall Street or manage the share price and work to build a corporate empire at the expense of shareholder value. And, of course, they will pay themselves outrageous compensation packages, also at the expense of shareholders.

I believe that the BAC-Merrill deal supports my theory of management determinism. I would bet that Ken Lewis' prime reason for this deal was the “Merrill Lynch franchise” – one of the most storied Wall Street names, and “the thundering herd” (no pun intended, that's really what they call their brokers).

But Ken Lewis flat-out admits to placing no emphasis on management, as if it didn't matter at all and he fully expected Thain to be gone within a short period of time. It appears that he made a $50 billion purchase with the same standards that other people would use for a $50 purchase.

Lo and behold, it is already looking like another trainwreck deal. It's looking like AOL-Time Warner, which was announced in January of 2000 – at the apex of the tech bubble – and then merged a year later. This was one of the most value-destroying transactions ever undertaken. My favorite line from the deal was: “One of the creative breakthroughs was in the valuation.”

The experience with an owner-operated business, where the CEO has huge economic and emotional interests – Steve Jobs at Apple, Buffett at Berkshire – will almost always be a superior investment, relative to some bureaucratic behemoth run by hired MBA operators. It is the difference between night and day.

Thursday, January 22, 2009

Water Scarcity: The Real Food Crisis

Here is a different side of the agricultural debate, by British writer Fred Pearce, in a journal at
Yale University, which emphasizes water as another key element in our handful of global crises — energy, food, water and global warming, all of which are interlocked and self-reinforcing.

After decades in the doldrums, food prices have been soaring this year, causing more misery for the world’s poor than any credit crunch. The geopolitical shockwaves have spread round the world, with food riots in Haiti, strikes over rice shortages in Bangladesh, tortilla wars in Mexico, and protests over bread prices in Egypt.

The immediate cause is declining grain stocks, which have encouraged speculators, hoarders, and panic-buyers. But what are the underlying trends that have sown the seeds for this perfect food storm?

Biofuels are part of it, clearly. A quarter of U.S. corn is now converted to ethanol, powering vehicles rather than filling stomachs or fattening livestock. And the rising oil prices that encouraged the biofuels boom are also raising food prices by making fertilizer, pesticides, and transport more expensive.

But there is something else going on that has hardly been mentioned, and that some believe is the great slow-burning, and hopelessly underreported, resource crisis of the 21st century: water.

Climate change, overconsumption and the alarmingly inefficient use of this most basic raw material are all to blame. I wrote a book three years ago titled When The Rivers Run Dry. It probed why the Yellow River in China, the Rio Grande and Colorado in the United States, the Nile in Egypt, the Indus in Pakistan, the Amu Darya in Central Asia, and many others are all running on empty. The confident blue lines in a million atlases simply do not tell the truth about rivers sucked dry, for the most part, to irrigate food crops.

We are using these rivers to death. And we are also pumping out underground water reserves almost everywhere in the world. With two-thirds of the water abstracted from nature going to irrigate crops — a figure that rises above 90 percent in many arid countries — water shortages equal food shortages.

Consider the two underlying causes of the current crisis over world food prices: falling supplies from some of the major agricultural regions that supply world markets, and rising demand in booming economies like China and India.

Why falling supplies? Farm yields per hectare have been stagnating in many countries for a while now. The green revolution that caused yields to soar 20 years ago may be faltering. But the immediate trigger, according to most analysts, has been droughts, particularly in Australia, one of the world’s largest grain exporters, but also in some other major suppliers, like Ukraine. Australia’s wheat exports were 60 percent down last year; its rice exports were 90 percent down.

Why rising demand? China has received most of the blame here — its growing wealth is certainly raising demand, especially as richer citizens eat more meat. But China traditionally has always fed itself — what’s different now is that the world’s most populous country is no longer able to produce all its own food.

A few years ago, the American agronomist and environmentalist Lester Brown wrote a book called Who Will Feed China?: Wake Up Call for a Small Planet. It predicted just this. China can no longer feed itself largely because demand is rising sharply at a time when every last drop of water in the north of the country, its major breadbasket, is already taken. The Yellow River, which drains most of the region, now rarely reaches the sea, except for the short monsoon season.

China's once-great Yellow River often no longer reaches the sea, as much of it is drawn off for power and agriculture.

Some press reports have recently suggested that China is being sucked dry to provide water for the Beijing Olympics. Would that it were so simple. The Olympics will require only trivial amounts of water. China’s water shortages are deep-seated, escalating, and tied to agriculture. Even hugely expensive plans to bring water from the wetter south to the arid north will only provide marginal relief.

The same is true of India, the world’s second most populous country. Forty years ago, India was a basket case. Millions died in famines. The green revolution then turned India into a food exporter. Its neighbor Bangladesh came to rely on India for rice. But Indian food production has stagnated recently, even as demand from richer residents has soared. And the main reason is water.

Even this elaborate hand-dug well in the Indian state of Tamil Nadu is dry, a result of over-pumping the underground aquifers.

Underground water is pumped for irrigation in Bengal, India, a practice that is increasing as surface water dries up.

With river water fully used, Indian farmers have been trying to increase supplies by tapping underground reserves. In the last 15 years, they have bought a staggering 20 million Yamaha pumps to suck water from beneath their fields. Tushaar Shah, director of the International Water Management Institute’s groundwater research station in Gujarat, estimates those farmers are pumping annually to the surface 100 cubic kilometers more water than the monsoon rains replace. Water tables are plunging, and in many places water supplies are giving out.

“We are living hand-to-mouth,” says D.P. Singh, president of the All India Grain Exporters Association, who blames water shortages for faltering grain production. Last year India began to import rice, notably from Australia. This year, it stopped supplying its densely populated neighbor Bangladesh, triggering a crisis there too.

More and more countries are up against the limits of food production because they are up against the limits of water supply. Most of the Middle East reached this point years ago. In Egypt, where bread riots occurred this spring, the Nile River no longer reaches the sea because all its water is taken for irrigation.

A map of world food trade increasingly looks like a map of the water haves and have-nots, because in recent years the global food trade has become almost a proxy trade in water — or rather, the water needed to grow food. “Virtual water,” some economists call it. The trade has kept the hungry in dry lands fed. But now that system is breaking down, because there are too many buyers and not enough sellers.

According to estimates by UNESCO’s hydrology institute, the world’s largest net supplier of virtual water until recently was Australia. It exported a staggering 70 cubic kilometers of water a year in the form of crops, mainly food. With the Murray-Darling Basin, Australia’s main farming zone, virtually dry for the past two years, that figure has been cut in half.

The largest gross exporter of virtual water is the United States, but its exports have also slumped as corn is diverted to domestic biofuels, and because of continuing drought in the American West.

The current water shortages should not mark an absolute limit to food production around the world. But it should do three things. It should encourage a rethinking of biofuels, which are themselves major water guzzlers. It should prompt an expanding trade in food exported from countries that remain in water surplus, such as Brazil. And it should trigger much greater efforts everywhere to use water more efficiently.

On a trip to Australia in the midst of the 2006 drought, I was staggered to see that farmers even in the most arid areas still irrigate their fields mostly by flooding them. Until the water runs out, that is. Few have adopted much more efficient drip irrigation systems, where water is delivered down pipes and discharged close to roots. And, while many farmers are expert at collecting any rain that falls on their land, they sometimes allow half of that water to evaporate from the surfaces of their farm reservoirs.

For too long, we have seen water as a cheap and unlimited resource. Those days are coming to an end — not just in dry places, but everywhere. For if the current world food crisis shows anything, it is that in an era of global trade in “virtual water,” local water shortages can reverberate throughout the world — creating higher food prices and food shortages everywhere.

Wednesday, January 21, 2009

Buffett on Macro

We will continue to ignore political and economic forecasts,
which are an expensive distraction for many investors and
businessmen. Thirty years ago, no one could have foreseen the
huge expansion of the Vietnam War, wage and price controls, two
oil shocks, the resignation of a president, the dissolution of
the Soviet Union, a one-day drop in the Dow of 508 points, or
treasury bill yields fluctuating between 2.8% and 17.4%.

But, surprise - none of these blockbuster events made the
slightest dent in Ben Graham's investment principles. Nor did
they render unsound the negotiated purchases of fine businesses
at sensible prices. Imagine the cost to us, then, if we had let
a fear of unknowns cause us to defer or alter the deployment of
capital. Indeed, we have usually made our best purchases when
apprehensions about some macro event were at a peak. Fear is the
foe of the faddist, but the friend of the fundamentalist.

Warren E. Buffett, 1995

El-Erian on Banking

From the Financial Times:

We have to bring the banking sector back to life
By Mohamed El-Erian

There was a time when US banks were like the high-priced properties on a Monopoly board: expensive to buy yet very profitable, especially once you added houses and hotels. This is no longer the case. Banks increasingly resemble the utilities on the board: cheap to buy, with low revenue potential and limited ability to leverage.

The transformation of the banking system into a utility model has become inevitable in light of the risks that banks’ damaged balance sheets pose for the broader economy. The process is being driven by both market- and government-related factors and the implications are huge. In the weeks ahead, look for bold government initiatives, even greater fiscal spending and a further subordination of equity holders. The longer-term impact is even more consequential and threatens to erode the dynamism and growth potential of the US economy.

Banks play an important role in any economy – so much so that, by efficiently channelling funds to productive uses, they can meaningfully improve prospects for employment and wealth creation. Yet, if they run into difficulties, they become sources of turmoil and painful contraction in economic activity.

Emerging economies are familiar – in some cases too familiar – with this binary phenomenon; so are some of the small and medium-sized industrial countries. Until recently, however, large industrial countries had not experienced the downside since the 1930s. Now they are doing so.

For the reasons set out in my Financial Times article of September 25, we are in the midst of a historic consolidation of the banking system. This follows a period of over-expansion in balance sheets and overreach in business plans.

Banks were particularly ill prepared for the abrupt change in global liquidity conditions that took place last year, and they are ill prepared for the global economic contraction that is still building momentum. With fresh capital essentially sidelined by uncertainties and losses, weaker banks have become highly distressed sellers. In a very public manner, they are forced to dispose of assets and business lines into illiquid and unreceptive markets.

The results inevitably fall short of what is needed. Moreover, as the Bank of America-Merrill Lynch case vividly illustrates, the alternative of institutional consolidations offers no panacea. It simply results in the weaker partner contaminating the stronger one.

It should therefore come as no surprise that, returning to the Monopoly analogy, banks’ balance sheet rehabilitation efforts have not moved meaningfully beyond “Go”, and this notwithstanding the fact they have received billions of dollars of capital injections from the government. Instead, the banking system remains a huge liability for the overall economy.

Over the next few weeks, the US government will be forced to do more. Further capital injections are likely to be supplemented by ambitious attempts to remove in one swoop the overhang of toxic assets. This can be done by aggregating them into a new government-supported institution that benefits from abundant and permanent capital. The institution would liquidate the toxic assets in a gradual and orderly fashion. This sensible approach is costly to the taxpayer and it can be sustained only if accompanied by meaningful steps to ensure that banks do not return to their bad habits – thereby accelerating the government-inspired march towards a “de-risked” and slimmed-down financial system. Governments will be more than strict regulators; they will be meddling partial owners.

Under the utility model, banks will perform narrow functions within well-defined and constrained leverage. They will be less risky, but also less innovative and less able to lend imaginatively. This will inevitably reduce the speed limit for medium-term economic growth in the US and beyond. It is too late to stop the transformation of banks into utilities. But it is not too late to start working on a subsequent reinvigoration in the context of a more effective regulatory structure. Let us hope the Obama administration includes this in the long list of “must-dos” it has just inherited. Otherwise, both my and my daughter’s generation will face the higher tax bills in the context of a muted ability to generate revenues.

The writer is chief executive of Pimco and author of When Markets Collide: Investment Strategies for the Age of Global Economic Change, winner of the 2008 FT/Goldman Sachs business book of the year award

Monday, January 19, 2009

Goldman Sachs Predicts Oil Rebound

In today’s Bloomberg News:

Goldman Sachs commodity analyst Jeffrey Currie predicts that oil will close the year at $65 per barrel, a “swift and violent rebound” of 88% over today’s price of roughly $34.50. We may be entering a “new bull market” in oil, Currie says.

“Thirty dollar oil reflects the same imbalances that got us to $147 oil … The problems haven’t gone away. We still believe the day of reckoning is to come … This is not 1982-1983 all over again … The supply picture’s radically different, the demand picture’s radically different,” Currie says.

“The key difference is that today there are no large-scale next generation projects that are going to save the world,” he added. “Commodity demand is exponentially higher than it was.”

This is a compelling argument, especially in light of the experience in oil over the past decade. But, as I have said before, it is important to approach such situations with a healthy degree of skepticism. One should look to, as investor Bruce Berkowitz puts it, “kill” one’s ideas, rather than giddily pump money into them.

Investing is possibly the most competitive game on earth. And if winning such epic stakes relied on parroting widely known information that has prevailed for a decade, in such a huge and liquid market as in oil, then anyone could become wildly rich. Despite being an investor in the commodities market since 2002, I became very skeptical in 2008.

At that time, when crude oil traded only a little beneath its peak, Goldman Sachs analyst Arjun Murti put out a report claiming that oil would surge through the $200 per barrel mark. He arrogantly mocked the idea that speculation played any part in the run up in prices; and spoke for his firm in saying: “Unfortunately, we do not think the energy crisis will be solved by finding and punishing the big, bad speculator.”

Of course, the fact that Goldman released this information to the public shows how valuable it was to them. And it gave the speculators, who were the cause of the spike, even more enthusiasm in aggressively bidding up prices, without asking any questions. If the venerable Goldman Sachs says it, then it must be true. And then the market caved in and oil sank like a stone to $30 a barrel.

In other words, after Goldman’s advice was wrong and made at the peak of a bubble – as it has been so many times before – the new advice is to be a “value investor” and buy low. They’ve got advice for all seasons, even after destroying the people who listened to them last time.

My personal view is that one should be skeptical in venturing into the oil market, remaining cognizant of how many other people are currently eying the same asset. Back in 1999, when the oil market truly bottomed, or even in 2003 when it bottomed again, virtually no one was looking at it. Commodities werent featured in the news or discussed by pundits.

I also question the assumptions that are built into these analysts’ models. For example, one assumption that is virtually certain is economic growth in China running at above 7% or 8% per annum, and strong growth in many other emerging markets. This was a major factor driving up oil prices from 1999 to 2008.

Indeed, there is possibly no greater dogma than strong, continued growth in China. But what if China and the emerging markets simply don’t resume this kind of growth for several years? If the bubble in United States consumerism has popped, and Asian economies are reeling, then why would anyone expect China to be exempt and continue its rapid export-driven growth? What effect does this have on oil demand?

Events never materialize as the vast majority of people expect. For example, the only people who predicted the credit crisis were gloom & doomers (who only ever have one view) and obscure traders from the high-yield space. If Kenneth Griffin at Citadel, far and away one of the smartest people in finance, got slammed with a 50% loss, that sizes up most peoples’ chances of predicting macro events.

Yet no one seems to be approaching the commodities market or national economies with similar sobriety and skepticism. The irony is, what should be more difficult, predicting the trajectories of subprime CDOs and hugely-leveraged mortgage companies, or the trajectories of entire nations and world trade?

Sunday, January 18, 2009

John D. Rockefeller

"Financier's Fortune in Oil Amassed in Industrial Era of 'Rugged Individualism'."

Here is the New York Times obituary of John D. Rockefeller; a historical document that is slightly difficult to read, yet it contains many invaluable insights. Similar to Benjamin Franklin or Warren Buffett, you can always find witticism and wisdom in Rockefeller's words:

"One of the swiftest toboggans I know of is for a young man just starting in life to get into debt."

Saturday, January 17, 2009

Agricultural Commodities 101

This is far and away the best primer and concise presentation on the agricultural commodities market that I've seen, given at my alma mater, Cornell University. This is crucial viewing for anyone who is interested agricultural commodities investment; and in fact investment in any commodity, whether crude oil or even gold. The professor essentially breaks down the anatomy of a bull market. Absolutely fascinating.

His predictions will surprise you:

Thursday, January 15, 2009

(un)Hot Commodities?

Energy Key Stats 2008

Above you will find the International Energy Agency's Key World Energy Statistics report for 2008. A few statistics that jumped out at me are the following:

On Page 6 (of the document, not the PDF viewer),

In 1973, 46.1% of our energy came from oil.

In 2006, 34.4% came from oil, down by over 25%.

Page 24,

Look at how electricity generated from oil has dwindled over this time period, 1973 to 2006, from 24.7% to a mere 5.8%, down by over 76%. Whereas the nuclear segment has grown by nearly 350%. In fact, world nuclear production as a whole is up nearly fourteen fold.

Page 33,

In 1973, 45.4% of world oil consumption was used in transportation.

In 2006, 60.5% was used in transportation, up 33%, with industrial use down by over 50%.

In other words, possibly the most crucial part of the transition away from oil use will be an economically-viable engine that does not run on refined products like gasoline and diesel. This will fundamentally change the world's supply and demand for crude oil.

As for making investments in crude oil futures contracts (or an ETF proxy), consider the fact that the world energy supply has trended up since about 2001, as is visible in the attached report. According to the International Energy Agency:

“Global oil demand is now expected to contract in 2008 for the first time since 1983…with the total this year revised down to 85.8 million barrels per day. World oil supply growth slowed in November, averaging 86.5 million barrels per day.”

In other words, supply exceeds demand – leading to lower prices – which will probably continue or roughly balance over the coming years. As I discuss in a recent article, capacity and supply have been ramped-up dramatically over the past few years, in response to record prices, which is reflected in the IEA's current world energy assessment.

One of my concerns is that higher oil prices have become the consensus view. Investors like Jim Rogers or Matthew Simmons are now guru figures, whereas they were virtually unheard of back in 2000. (Back then, dot-com gurus dominated the news and published books.) The consensus view is never correct; or at least for very long, until it ends poorly.

My current view is that we will undoubtedly go through another "tight" period where oil either reaches or exceeds its old highs; but this could be five years from now, comparable to what happened in the 1970s.

In 1973, the Yom Kippur War caused oil prices to skyrocket. But then oil didn't reach its peak again until 1979. For the intermediate period, 1974 to 1978, oil traded flat at roughly $13 per barrel.

Indeed, even in the middle of a secular bull market, oil can prove to be a bad trade for fairly extended periods of time. And when it does heat up, like all commodities, it tends to come in the form of a sharp boom and bust.

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This work by Nicholas E. Radice is licensed under a Creative Commons Attribution-No Derivative Works 3.0 United States License.