Oil, Gold, Equities and Huaxi - February 13th, 2011
The London Brief
Oil, Gold, Equities and Huaxi
February 13th, 2011
Equity indices pushed to new highs this week. Oil prices trended lower, even with the uncertainties in Egypt, which should help mute inflation trends. Unemployment is edging lower and the statistics are positive. European sovereign risks still exist but there has been consistent activity within the EU to develop an end solution, even if they are moving frustratingly slow. The Economist's top story was about printing technology that could revolutionize manufacturing and lower costs dramatically for the world.
There is much more ebullience in general and people are taking more risk. People who did not take risk early are feeling left behind.
However, inflation remains the chief risk to the market today. Although oil's drop this week is constructive, the medium to long-term is still risky.
I had an interesting lunch with someone involved in the exploration of oil and gas fields last weekend. He is part of an engineering consultancy who the majors bring in when trying to tap a lesser field to increase production. Currently he does a lot with Shell in the North Sea.
He believes one thing that doesn't garner enough attention is the amount of oil it takes to extract oil. Venezuelan heavy crude takes enormous amounts of energy to extract. Tar sands too. The massive under-water fields in Brazil will be pumped from miles under water. These off-shore fields don't have enough data to tell if the oil they extract will definitively be light. If it ends up being a heavy oil, the economics of the whole project could come in to question.
The energy it takes to get the oil out should be included in oil demand, but it appears that the IEA (International Energy Agency) does not do so in their projections. It is difficult to measure, but there should be a model for incremental oil demand caused by extracting these harder to develop fields.
My friend in Lugano also highlighted the following from Wikileaks about the Saudi's fields:
...Sadad al-Husseini, a geologist and former head of exploration at the Saudi oil monopoly Aramco, met the US consul general in Riyadh in November 2007 and told the US diplomat that Aramco's 12.5m barrel-a-day capacity needed to keep a lid on prices could not be reached. According to the cables, which date between 2007-09, Husseini said Saudi Arabia might reach an output of 12m barrels a day in 10 years but before then – possibly as early as 2012 – global oil production would have hit its highest point. This crunch point is known as "peak oil". Husseini said that at that point Aramco would not be able to stop the rise of global oil prices because the Saudi energy industry had overstated its recoverable reserves to spur foreign investment. He argued that Aramco had badly underestimated the time needed to bring new oil on tap. One cable said: "According to al-Husseini, the crux of the issue is twofold. First, it is possible that Saudi reserves are not as bountiful as sometimes described, and the timeline for their production not as unrestrained as Aramco and energy optimists would like to portray." It went on: "In a presentation, Abdallah al-Saif, current Aramco senior vice-president for exploration, reported that Aramco has 716bn barrels of total reserves, of which 51% are recoverable, and that in 20 years Aramco will have 900bn barrels of reserves. "Al-Husseini disagrees with this analysis, believing Aramco's reserves are overstated by as much as 300bn barrels. In his view once 50% of original proven reserves has been reached … a steady output in decline will ensue and no amount of effort will be able to stop it. He believes that what will result is a plateau in total output that will last approximately 15 years followed by decreasing output." The US consul then told Washington: "While al-Husseini fundamentally contradicts the Aramco company line, he is no doomsday theorist. His pedigree, experience and outlook demand that his predictions be thoughtfully considered." Seven months later, the US embassy in Riyadh went further in two more cables. "Our mission now questions how much the Saudis can now substantively influence the crude markets over the long term. Clearly they can drive prices up, but we question whether they any longer have the power to drive prices down for a prolonged period." A fourth cable, in October 2009, claimed that escalating electricity demand by Saudi Arabia may further constrain Saudi oil exports. "Demand [for electricity] is expected to grow 10% a year over the next decade as a result of population and economic growth. As a result it will need to double its generation capacity to 68,000MW in 2018," it said. It also reported major project delays and accidents as "evidence that the Saudi Aramco is having to run harder to stay in place – to replace the decline in existing production."
I've heard the same things mentioned in other pro "peak oil" circles. No one independently audits the Saudi reserves. Even if they are being truthful and achieve their target production, the IEA and OPEC have under-stated the increase in demand.
In the short term, however, the market will fixate on OPEC's pronouncement that it has a higher than expected capacity in reserve if prices increase above its target range. This could see oil trading in the low $80s WTI. It seems like an interesting level to invest in oil stocks.
The gold and silver market are showing signs of backwardation, which means that traders are speculating that prices will fall in late 2011 and 2012. The thesis is that the Federal Reserve, the ECB and the Bank of England will start to raise interest rates in late 2011/early 2012. Yet despite the view on interest rate policy, there are a couple things supporting the gold market.
First, precious metals traders cited by the FT saw "unbelievable" demand from the Chinese over the last month. They estimate China imported 200 tons of gold in three months. PBOC advisor Xia Bin told the Economic Information Daily that China should increase its holdings of gold, silver and other precious metals. Gold and silver can help with the yuan’s international status by increasing China’s “final payment capacity”. Gold bars were cited at a premium of $4 per ounce in Hong Kong to spot London prices. A dealer in Singapore said, “My clients offered to buy gold bars at a $5 premium, but I have no gold. Nowadays, gold is booked and sold even before they leave the refinery”.
Second, JP Morgan announced last week that from now on they will accept physical gold bullion as collateral for loans. It may signal that JP Morgan is having difficulty in securing gold bullion in volume and is trying to attract gold deposits. JP Morgan is the custodian for many of the gold and silver exchange traded funds. They will not accept ETF trust gold as collateral interestingly.
Finally, there may have also been technical reasons for the sell-off a few weeks ago. The WSJ had reported that a bullish bet of $850 million by SHK Asset Management on gold went wrong (they only had assets of $10 million). The contracts were worth 10% of the U.S. futures market, or the equivalent of South Africa's entire gold production. The manager said the dollar amount "was very small, it was just a lot of contracts." The number of contracts on the Comex dived more than 81,000 to about 500,000, the biggest single reduction in history. A usual daily move is only about 3,000 to 4,000 contracts according to the WSJ.
Currently, China is providing the back-stop bid to gold right now. If China were to have a hard landing, gold will probably have a severe price correction. Chinese people buy gold because it has appreciated at a faster rate than the low interest rates on their deposits. Since China is a risky bet, perhaps that makes gold a risky investment. But China only raised interest rates by 0.25%, and continues to move slowly on its tightening efforts. I continue to think China's policy makers will attempt to avoid a "hard landing".
Yet it is difficult for gold to increase unless there is a tail event (unlikely in the near term) or inflation. Other commodities, like platinum, may be more in favour in the months ahead as the market feels inflation trends are muted.
JP Morgan believes the U.S. is the best place for equities and has made it their largest regional allocation in their private bank portfolio. Even though input costs are rising, U.S. labour is priced low. The result are high margins for companies. In addition, S&P 500 revenues over the last fifteen years have been linked more to world GDP growth than to U.S. GDP growth. Global GDP is expected to grow in excess of 4% in 2011 (although there would be a sharp downward adjustment if China had a hard landing). This sets up U.S. equities in a favourable position for 2011. U.S. banks are close to the minimum levels required under Basel III and should reach "well-capitalized" levels through retained earnings before the capital requirements are phased in.
Europe also got a tentative upgrade on the basis that existential problems have declined, meaning European equities should be priced on the basis of earnings. Considering the discount the market has placed on many equities, things could be quite interesting for the remainder of this year in Europe.
Ireland stoked a bit of worry during the week in front of elections. Brian Lenihan, the current finance minister, said, "We put the 20 billion [of senior debt outside of a government guarantee] on the table in the EU/IMF negotiations but the ECB ruled it out, but it's still there in debate and we're pressing for a substantial discount and for burden sharing". Claude Trichet vehemently came out against haircuts. He said, "Modern markets are made of investors that are long and investors that are short. The investors that are long, private sector investors, are losing money when you practice this haircut you have mentioned. Those investors who are short are making money, so this is also something that one must have in mind when reflecting on this very, very important issue". Instead of fixing Ireland's problems to make their debts sustainable, he's worried about short sellers making money?
One of my friends sent me this on China's richest village that I thought was insightful, but also quite worrying.
* Huaxi (华西村) is China’s richest village. It is two notches down from the county-level city of Jiangyin in administrative ranking or four notches below its parent province of Jiangsu. Every family in Huaxi has had a net worth of more than RMB1m since 2005. The village enterprise is a company listed on the Shenzhen Stock Exchange with a current market cap of more than RMB7.3bn or USD1.1bn. Many of the former village farmers are large shareholders of the village enterprise, Jiansu Huaxicun Co Ltd (ticker 000936.SZ). The company runs a wide-range of businesses that include polyester chip manufacturing, commercial trading and electricity generation and sales. * For a place with just 30,000 inhabitants, Huaxi’s ambitions seem extraordinary. In addition to its existing 328-meter building (ranked the world’s 15th tallest in 2010), it is planning to build a new 128-storey, 638 meter skyscraper, which when completed will be the second tallest building in the world. Moreover, the village plans to have a fleet of 20 airplanes by 2015, a prime example of its continued ambition.
* Every village ex-farmer is a millionaire, thanks to its A-share listing in 1999. 200 of the richest village residents put down RMB10mn each or RMB2bn to build the 328 meter tall tower.
Statistical data shows that after such a building is constructed, the market crashes soon after. Luckily, the building is not expected to complete until after 2012 leaving at least a few years of ebullience.
London, February 13th, 2011