Category Archives: Side Effects

DYLAN GRICE: The Next Crisis Will Be Born Out Of The US Treasury Market

SocGen investment strategist Dylan Grice does not think “safe-haven” assets are very safe.

In Grice’s latest note to clients, he compares the illusion of safety created by faulty regulation before the 2008 financial crisis to the new, impending wave of financial regulation on the table like Dodd-Frank in the U.S. and Basel requirements on a global scale.

Grice warns “madness is going on in the government bond markets” today, furnishing this long term chart of US Treasury yields going back to 1800:

From the note:

The regulations which told banks that AAA-rated bonds were “risk free” were designed to make markets safer. But they created an artificial demand for such bonds, which created an incentive for issuers to dress up bonds as “risk free” when they were anything but. The regulations effectively incentivized ratings agencies to rate them as “risk free” when they clearly weren’’t. And today, the same madness is going on in the government bond markets.

It’s very difficult to see how government bonds are anything other than “risk assets” (let’s face it, all assets are). Yet insurers are buying them because they’’ve been told to “take less risk” (whatever that means) by the regulators. So they are taking more risk, and they will one day suffer the consequences. Banks in the eurozone are bust because they own so much of their local sovereigns’’ debt. But they were told it was OK to do that by the regulators. So they let their guard down.

Indeed, having told banks that they were of sound balance sheet before the crises (Lehman Brothers Tier 1 risk-weighted capital ratio was 11% five days before bankruptcy), those same regulators today scratch their heads and wonder how banks became too big to fail. It’’s all embarrassing really.

Source

Banker to the Bankers Knows the Numbers Are Lying

By Jonathan Weil
 Jun 28, 2012 5:30 PM CT

The Bank for International Settlements, which acts as a bank for the world’s central banks, should know fudged numbers when it sees them. What may come as a surprise is how openly it has been discussing the problem of bogus balance sheets at large financial companies.

“The financial sector needs to recognize losses and recapitalize,” the Basel, Switzerland-based institution said in its latest annual report, released this week. “As we have urged in previous reports, banks must adjust balance sheets to accurately reflect the value of assets.” The implication is that many banks are showing inaccurate numbers now.

Unfortunately the BIS’s suggested approach is almost all carrot and no stick. “The challenge is to provide incentives for banks and other credit suppliers to recognize losses fully and write down debt,” the report said. “Supporting this process may well call for the use of public sector balance sheets.”

So there you have it. More than four years after the financial crisis began, it’s so widely accepted that many of the world’s banks are burying losses and overstating their asset values, even the Bank for International Settlements is saying so — in writing. (The BIS’s board includes Federal Reserve Chairman Ben Bernanke and Mario Draghi, president of the European Central Bank.) It fully expects taxpayers to pick up the tab should the need arise, too.

No Change

In this respect, little has changed since the near-meltdown of 2008, especially in Europe. Spain has requested 100 billion euros ($125 billion) to rescue its ailing banks. Italy, perhaps the next in line for a European Union bailout, is weighing plans to boost capital at some of the country’s lenders through sales of their bonds to the government.

Those bank rescues almost certainly won’t be the last. All but four of the 28 companies in the Euro Stoxx Banks Index (SX7E) trade for less than half of their common shareholder equity, which tells you investors don’t believe the companies’ asset values. While it may be true that the accounting standards are weak, the bigger problem is they are often not followed or enforced.

Government bailouts might be easier for the world’s taxpayers to swallow if banks were required to be truthful about their finances, as part of their standard operating procedure. Nowhere in its report did the BIS discuss the role of law enforcement, although the last time I checked it’s against the law in most developed countries to knowingly publish false financial statements. There have been few fraud prosecutions against executives from large financial institutions in recent years, in the U.S. or elsewhere, much to citizens’ outrage.

In the BIS’s eyes, it seems that it’s enough to merely encourage or incentivize banks to come clean about their losses, by dangling the prospect of additional taxpayer support before them. For example, on the subject of how to deal with overvalued mortgage loans: “One frequently used option is to set up an asset management company to buy up loans at attractive prices, i.e., slightly above current market valuations,” the BIS report said. “Alternatively, authorities can subsidize lenders or guarantee the restructured debt when lenders renegotiate loans.”

The BIS report got this much right: The lack of transparency and credibility in banks’ balance sheets fuels a vicious cycle. When investors can’t trust the books, lenders can’t raise capital and may have to fall back on their home countries’ governments for help. This further pressures sovereign finances, which in turn weakens the banks even more. The contagion spreads across borders. There is no clear end in sight.

Propping Up

To date, the task of propping up the economies in Europe and the U.S. has fallen largely to central banks. As the BIS wrote, easy-money policies also can make balance-sheet repairs harder to accomplish.

“Prolonged unusually accommodative monetary conditions mask underlying balance sheet problems and reduce incentives to address them head-on,” the report said. “Similarly, large- scale asset purchases and unconditional liquidity support together with very low interest rates can undermine the perceived need to deal with banks’ impaired assets.”

At some point, the cycle will break, only nobody knows when. This you can count on: It will take more than subtle inducements to make banks fess up to all their losses. Prosecutors must have a role. There’s nothing like the threat of a courtroom trial to focus a bank executive’s mind. The risk just has to be real.

To contact the writer of this article: Jonathan Weil in New York at jweil6@bloomberg.net.

To contact the editor responsible for this article: James Greiff at jgreiff@bloomberg.net

Source

Natural Gas: Where Endless Money Went to Die

Wednesday, June 20, 2012 at 4:17PM

The fiasco that is playing out in the natural gas industry doesn’t happen often in a free market, and when it does happen, it’s usually short—and brutal for all involved: namely, prices that are way below production costs. In most industries, hedging strategies might get market participants through the period, while unhedged production, a money-losing activity, gets slashed. If it lasts long enough, it causes a shakeout where less efficient or poorly capitalized producers, and their investors, get wiped out. It’s all part of the capitalist system that weeds out weaker elements through occasional sweeps of creative destruction.

As shortages crop up on the horizon, prices return to sustainable levels, and occasionally spike to once again unsustainable levels. For the survivors, or for lucky new entrants, the next step in the cycle has begun.

Alas, thanks to the Fed’s zero-interest-rate policy and the trillions it has handed over to its cronies since late 2008, the sweeps of creative destruction have broken down. Instead, boundless sums of money have been searching for a place to go, and they’re chasing yield when there is none, and so they’re taking risks, any kind of risks, in their vain battle to come out ahead. The result is a stunning misallocation of capital to the tune of tens of billions of dollars to an economic activity—drilling for dry natural gas—that has been highly unprofitable for years. It’s where money has gone to die. What’s left is debt, and wells that will never produce enough to make their investors whole. For that whole debacle, read…. Capital Destruction in Natural Gas.

But the money has dried up. And drilling for natural gas is collapsing. Last week, there were only 562 rigs drilling for dry natural gas—the lowest number since September 1999. A dizzying downward trajectory:

 

Producers, if at all possible, are switching to drilling for oil and natural gas liquids (priced like oil), still a profitable activity. Thus, capital is now being channeled to where it can make money. Drilling for dry natural gas will continue to decline as the long delayed sweep of creative destruction is scouring the industry.

The largest producer, ExxonMobil, given its monumental size and worldwide focus on oil, will weather the fallout just fine. But the second largest producer, Chesapeake Energy, is struggling. It’s trying to dump assets to raise cash to deal with its mountain of decomposing debt. Other producers that haven’t diversified away from dry natural gas are in a similar quandary. And at current prices, it’s going to be bloody.

At $2.53 per million Btu at the Henry Hub, the price of natural gas is up 33% from the April low of $1.90 per million Btu—a number not seen in a decade. But even if it doubled, it would still be below the cost of production. And if it tripled, it might still be below the cost of production for most producers. That’s how mispriced the commodity has become.

Misallocation of capital, and the resulting overproduction, is only part of the problem. The other part of the problem is horizontal fracking itself—a drilling method that extracts gas from shale formations. With nasty economics. It’s an expensive method. And once drilled, the well suffers from steep decline rates; after a year or a year-and-a-half, only 10% of the original production might still come to the surface.

The breakeven price for natural gas under these conditions—and it differs from well to well—is still partially theoretical since horizontally fracked wells have not yet gone through their entire lifecycle. Here is a detailed discussion and pricing model. The short answer: over $8 per million Btu. Even if that number is off, at the current price of $2.53 per million Btu, the industry is still near its point of maximum pain.

There are consequences. Power generators, having switched massively from coal to natural gas, are driving up demand. And production has finally seen a bend, a small one, in the curve that had set new highs month after month. Now, it’s declining. There is a lag between dropping rig count and production. The rig count estimates how many new wells are being drilled. Even if it dropped to zero next week, production would not immediately be impacted because the current wells would continue to produce. Production would then taper off as a function of decline rates per well—and in fracked wells, that lag is expressed in months, not years.

While the US doesn’t yet have LNG terminals to liquefy and export natural gas—in the global markets, LNG fetches mouthwatering prices between $10 and $15 per million Btu—it does have a pipeline to Mexico. According to BENTEK Energy (via the EIA), pipeline exports to Mexico hit 1,867 million cubic feet per day, a record in the seven plus years that BENTEK has been tracking it (by comparison, Chesapeake Energy produces about 2,575 MMcf/day).

 

Rising demand and exports are slamming into declining production. What was a record amount of natural gas in storage is coming down rapidly. Fears that storage would reach capacity towards the end of the injection period in the fall, and that natural gas would have to be flared, thus reducing its price to zero, seem ridiculous now. But prices, if they stay in the current ballpark, will continue to demolish producers, drive them away from dry natural gas, and cause financial bloodshed.

Until shortages appear on the horizon. But then, production can’t be ramped up quickly, regardless of what the price might be. Expect a spike and more mayhem, but this time in the other direction.

And oil, which has experienced a phenomenal boom in drilling? In North America, the range of oil qualities and a raft of infrastructure nightmares are wreaking havoc with record price differentials, writes energy expert Marin Katusa in his excellent…. Oil Price Differentials: Caught between the Sands and the Pipelines.

Source

LOST: Law of the Sea Hearings Point to Lame Duck Passage Strategy

Brian Darling
June 14, 2012 at 10:49 am

Today, the Senate has two hearings scheduled on the Law of the Sea Treaty (LOST). The Senate will have had three hearings on the LOST after today—yet, not for the purposes of educating Senators on the flaws versus the benefits of the treaty. These hearings are a pretext for a lame duck strategy to railroad the treaty through the Senate after the November election.

The first hearing today is titled “Perspectives from the U.S. Military.” Witnesses include Admiral James A. Winnefeld, Jr, Vice Chairman of the Joint Chiefs of Staff, and representatives from other government stakeholders in navigation on the high seas. The question that these witnesses can’t sufficiently answer is, “What can’t you do today, because of the LOST, that you could do if the treaty were to be ratified?” The answer is nothing.

Heritage’s Kim Holmes, former Assistant Secretary of State for International Organization Affairs, wrote for The Washington Times last year that the navigational provisions in the treaty are not necessary.

The treaty’s navigational provisions offer nothing new. Yes, the U.S. Navy says (LOST) might improve the “predictability” of these rights, but does the Navy’s access to international waters really depend upon a treaty to which we are not even a member? The last time I checked, the U.S. Navy could go anywhere it wanted in international waters. Though redundant, the navigational provisions of (LOST) are actually pretty good. That’s why President Ronald Reagan supported them. But Reagan and others objected to the unaccountable international bureaucracy created by the treaty.

The second hearing today will include former Secretary of Defense Donald Rumsfeld, Heritage Foundation expert Steve Groves, former Deputy Secretary of State John Negroponte, and former Legal Advisor at State John B. Bellinger, III. This hearing will be an excellent opportunity for the opponents of LOST to make the case that this treaty is flawed.

The bottom line is that Senator John Kerry (D–MA) has been stacking hearings in favor of proponents of LOST. The first hearing this year included Secretary of State Hillary Clinton, Secretary of Defense Leon Panetta, and General Martin Dempsey, Chairman of the Joint Chiefs of Staff.

As I wrote in an op-ed at Townhall, opponents of the treaty made a strong case against ratification.

Sen. Bob Corker (R-Tenn.) professed to be starting from a neutral position vis a vis ratification. Directing a query to Ms. Clinton, he said, “A lot of people believe that the administration…wants to use this treaty as a way to get America into a regime relating to carbon, since it has been unsuccessful doing so domestically. And I wonder if you might respond to that.” Ms. Clinton’s response? She said she has a legal analysis that knocks down that argument. But not all Americans are willing to rely on a politically driven legal memo from the Obama Administration as a guarantee that this treaty will not empower the International Sea Bed Authority to force regulations on American business. Those seeking certainty on this vital issue would rather take a pass on the treaty than take a chance on Ms. Clinton’s promises.

Senators Mike Lee (R–UT) and Jim Risch (R–ID) expressed dissatisfaction with the Administration’s alleging that opponents of the treaty were engaging in “misinformation” and “mythology.” Risch argued that “you addressed the people who oppose ratification of the treaty, and…I hope you weren’t scoffing at us.” Proponents have engaged in name calling to avoid the central issues to be considered before ratification.

These hearings are intended to show that Senate Foreign Relations Committee Chairman Kerry allowed conservatives to have their say before the lame duck strategy is implemented. The deck has been stacked, with two hearings in favor and one with a 50–50 split between proponents and opponents. Kerry used a similar strategy the last time the Senate considered the LOST.

Make no mistake; these hearings are part of the strategy of the treaty’s proponents to wait until after the election to push through LOST—in November or December of this year when the American people have no recourse against this offense against American sovereignty.

Source

Oil Refiners Launch Counter Offensive on Obama’s ‘War on Fossil Fuels’

By Felicity Carus
Published: June 12, 2012

America’s oil refiners are preparing to intensify efforts to press the federal government to drop mandates to encourage the development of advanced biofuels and counter the Obama administration’s “war on fossil fuels.”

The Renewable Portfolio Standard requires that 36 billion gallons of renewable fuel be blended with petroleum-based products by 2022 under the Bush-era Energy Independence and Security Act of 2007.

Five years can be a very long time in US energy politics, said Charles Drevna, president of the American Fuel & Petrochemical Manufacturers, whose members include oil supermajors such as Shell, BP and Chevron.

“RFS2 was really conceived at a different time in the nation’s history even though it was only a few years ago. There was a thought permeating through Congress that we were eventually going to run out of natural resources.

Policy Tools not keeping Pace with Shifting Market Dynamics

“Since then, as a nation we fully understand we’re not an energy poor nation, we’re an energy rich nation with the advent of fracking and horizontal drilling.

“We’ve had this 4-5 year experiment going on which we believe has proved to be a failure.”

The RFS2 demonstrates how quickly the dynamics of the energy industry can outgrow policy, said Drevna, in an exclusive interview with AOL Energy.

“Policymakers haven’t kept pace [with change in the energy industry] and that’s always a problem when you have new technology and entrepreneurship being developed but when you’re forced to apply mandates and uneconomic solutions once they’re passed they’re very difficult to get amended.

“One of our major goals at AFPM is to have Congress and whatever administration it is to take a long hard look at the RFS and come to the epiphany that if we want to limit our reliance on foreign sources of crude oil the best way to do it is to develop our own resources and forget this totally anti-consumer anti-environment anti-common sense approach to national security which is mandating biofuels and renewables.”

At the end of May, Drevna warned the House Committee on Oversight and Government Reform: “The policies of the administration and EPA continue to support a war on fossil fuels that ultimately harms consumers, workers, the economy and our country’s national security.”

AFPM is a 110-year-old trade association which represents 98% of US oil refiners that process 18 million barrels of oil a day with a combined annual revenue of $725 billion.

In April, the US Energy Information Agency forecast that US gasoline demand this summer – usually a peak period – is expected to be the lowest in 11 years, partly due to rising gasoline prices at the pump and more fuel efficient vehicles.

Next month, Sunoco‘s Philadelphia refinery will become the latest in a number of refinery closures which have resulted in a 4% decline in refining capacity in the US since last year.
Overall, gasoline demand in the US declined since the 2008 spike at $147 a barrel and flattened since the subsequent global economic recession, said Drevna.

Biofuels Seen as a Small but Growing Threat

Although advanced biofuels are at de minimis levels of production this year, Raymond James equity research analysts forecast 800 million gallons of production by the end of 2013.

Meanwhile, the 133.93 billion gallons of gasoline consumed in the US last year contained about 12.87 billion gallons of ethanol, accounting for 9% of each gallon pumped into tanks.

Advanced biofuel and ethanol production are unlikely to make too much of a dent in the US liquid fuel market which is expected to sell 186 billion gallons of gasoline and diesel this year.
But AFPM sees mandates on alternative sources of liquid fuels for transportation and chemicals as a direct threat to the industry – and the American economy.

“We don’t think [biofuels] should be mandated whether it’s corn ethanol, biofuels or biodiesel until such time as those products are as efficient, reliable and abundant as gasoline and diesel produced from petroleum,” said Drevna. “Until they are able to compete head to head then let the free market decide, let the consumer decide.

…E15 goes way beyond what makes sense.” – Drevna

“The RFS was based on ideology and political science rather than reality and real science. We believe it needs to be significantly modified to prevent harm to American consumers and the economy.”

But the RFS2 has not been without its problems. Earlier this year, the EPA had to revise down its quota for cellulosic ethanol from 500 million gallons to 10.5 million gallons as advanced biofuels are still at zero commercial production. But refiners were still fined $6.8 million by the EPA – part of what Drevna said was a “hidden tax” for the consumer as costs were transferred to the consumer.

US ethanol producers last year reached saturation point of production for its domestic market as a 10% blendstock in gasoline. EPA’s decision to raise the maximum percentage blend to 15% is potentially dangerous, said Drevna.

A recent Coordinating Research Council (CRC) study found that there are at least 5 million vehicles on American roads which are at risk of failure with 15% ethanol blended fuel.

“We don’t think the EPA has the authority to bifurcate the fuel system. How much corn are we going to use to blend when we have enough oil under our own feet and off our own shores? We’re not anti-ethanol but E15 goes way beyond what makes sense.”

Source

%d bloggers like this: