The End of Black Gold? (Part I)

Take a look at this info-graphic for a moment:

It chronicles the history of the tallest skyscrapers ever built on earth. Now, look at the years they were completed. Notice anything interesting? Here's a hint: historically, each new skyscraper coincided with the end of an economic boom associated with it... a hallmark that signifies the end of an era. The completion of the Chrysler Building and the Empire State Building both coincided with the end of the 1920s boom in the US, signifying the start of the infamous Great Depression of the 1930s. The Petronas Towers in Kuala Lumpur was completed after the Asian Financial Crisis of 1997 broke out, after many Asian economies experienced a period of strong GDP growth rates and a financial boom...

This is what The Economist calls the "Skyscraper Effect" (for more information about it, the Mises Institute has some interesting thoughts).

Now, Saudi Arabia is building the world's tallest skyscraper. Known as the Jeddah Tower, it would be at least 170m higher than the Burj Khalifa in next door Dubai and at least 3 times higher than the Chrysler Building in New York. Costing about US$ 1.5 billion, it is estimated to be completed in 2018/2019, and will be surrounded by a supersized mall and an artificial lake (which brings adds another US$ 20 billion to the development tab). The CEO of the project, Mounib Hammoud, says that "it's a statement of power, of economic growth, of success."

Courtesy of the Wall Street Journal:

Would the Jeddah Tower once again mark the end of a cycle? Or is the skyscraper effect just plainly a mere coincidence? Too some however, the skyscraper effect makes economic sense. Historically, the development projects were drawn up during a period of prosperity, in times of great optimism. The actual construction takes a long period of time to play out before its final completion. By the time the new development is completed, the "boom" and all the accompanying euphoria has evaporated. 

Now with the above being mentioned, let's turn our attention back to the current state of affairs.

Since the start of the fall of 2014 when crude oil prices have plunged from above US$100/barrel to below US$30/barrel in early 2016 (they are currently hovering above US$40/barrel), OPEC nations have maintained and even increased their production amount, with the Saudis leading the pack in an attempt to drive higher-cost producers out of business (such as those cowboys in North America).

However, their attempts to crush the North American marginal producers may have backfired. In the mid-1980s, the Saudis expanded production to drown out their US competitors (which worked beautifully back then). When the damage has been done, the Saudis cutback output to tighten supplies, sending crude oil prices soaring back up.

However, this time round, US crude oil production remain surprisingly resilient. Despite a slight slowdown in output, many producers in the US have opted to maintain and even increase their production. The US Department of Energy's data still indicates that production remains close to 9 million barrels daily.

And this is despite the following developments (to the dismay of oil bulls):

The amount of petroleum freight carloads according to the Association of American Railroads has declined -36.3% from its 2014-highs, indicating that energy production from shale rock formations did slow down (rail freight is one better way to track production activity among shale energy producers as railroads had to step up to fill the gap created as domestic production outpaced existing pipeline capacity during the shale energy boom).

Rig count data tracked and compiled by Baker Hughes has fallen substantially in North America, but that has not led to a further cut in output - the white line being the rig count, which currently stands around 340, at multi-year lows and at a quarter of its 2014 peak.

There are several possible reasons for the continued expansion of oil production in the US:

• the energy sector is heavily reliant on credit. When times were good, credit flooded the sector, allowing many producers, including the non-conventional shale companies to ramp up output. In fact, Canada's oil sands' boom was largely built on credit. An entire industry fueled by cheap credit is difficult to end, as producers have to continue producing to service their debt obligations in order to keep the credit taps flowing and to stay in business. The Saudis may have miscalculated, and did not anticipate the effect of the cheap credit cycle on the North American energy industry. The Bank of International Settlements (BIS) have actually reported on this, commenting that the crude oil market is so broken that low prices may actually make the supply glut worse.
• the costs of producing a barrel of crude oil varies widely in various areas of the the US (based on initial costs of exploration and production, as well as financing and maintenance costs). Some of the recent output has actually been generated from "stripper" wells, which were once abandoned sites that are seeing new life thanks to advanced production techniques, and these wells are profitable at current prices. Additionally, some of the rigs that have been sidelined, thereby contributing to the fall in aggregate rig counts, were either "newer" sites or less efficient operations
• Some producers may be better off maintaining output as they may incur more losses if they shut operations down. The high cost of terminating and restarting may even spur them to produce more now and store the surplus, ready to deploy their reserves the minute crude oil prices rebound sufficiently higher. Inventories at Cushing, Oklahoma are at decade highs!

Meanwhile, data from the International Energy Agency indicated that total stockpiles among OECD countries are also at multi-year highs, presenting a huge headache for anyone hoping for a strong lasting rebound in crude oil prices (unless stockpiles dwindle, high crude oil prices may be unsustainable as supplies are dumped to capture price increases):

While Wood Mackenzie reported that indeed some cutbacks have been made in onshore fields in Canada, as well as aging North Sea fields, OPEC producers in the Middle East have kept the taps on and contributed to the current global glut... So this essentially is terrible news to the Saudis in their attempt to regain market share since they started this painful campaign of attrition.

Let's digress once more, and think from a game-theory perspective.

Many of us have played poker before. Professional poker players and experts will tell you that it's all a game of probability and odds. Winning at poker essentially requires a superior understanding of the odds and playing your hand well, and also being proficient at reading or anticipating the motives of the players you're up against.

To better understand the current dynamic of the crude oil market, it would thus be wise and even imperative to consider what the Saudis are doing at this moment:

• they have set up a whopping US$ 2 trillion investment fund in an attempt to diversify their economy away from hydrocarbons and to generate alternative revenue streams over the next 5 - 10 years
• they have cut expenditures in latest budget adjustments, and tapped the debt markets for a portion of their financing requirements. Via Bloomberg: "the country's ratio of debt to economic output, the world's lowest in 2014, is expected to increase to over 25% by 2017, according to the International Monetary Fund, which said in October that the kingdom risked wiping out its financial reserves in 5 years"
• they have even decided to overhaul their military in the process! (this is despite their ongoing military operation in Yemen)

And these developments above are done by the "smartest of the smart money" of the global crude oil industry. If there exists any form of "insider-info" in the industry, then the Saudis are probably the guys who know them best - and this smart money is boldly preparing to hunker down for a prolonged period of low oil prices. Doesn't this send a troubling signal to anyone who is optimistic that crude oil prices could recover higher and also stay higher?

The investment community seems not to agree. Even after the failure of the recent Doha talks, crude oil prices have risen, with both WTI and Brent crude prices above US$40 per barrel. Open interest futures positioning by speculators (black line) and the hedgers (yellow line) seems to suggest that the speculative community is betting on a rebound in crude oil prices:

Additionally, there is the sticky problem of Iran's reintegration into the global economy. The Iranians have vowed to only enter high-level negotiations and summits only after they have regained their former market share of the crude oil export market. And look at how the Saudis reacted to them at the recent Doha talks? To the geopolitical observer, the animosity between these 2 rivals in the Gulf is no surprise.

All of the above leads us to this chain of logic:

-> "Strategy of drowning out the competition is taking longer-than-expected, but it would be worse to give up now, let's continue to produce and finish the job!
-> If the strategy will take longer than expected to work out, we have to prepare and hunker down for as long as it takes!
-> No negotiations or concessions for any of my rivals until the strategy works out! Antagonise and block any bids for new market share! (the Saudis have openly talked about their extra 1 million barrels/day output potential openly and have promised to use it)"

Considering this chain of logic with the understanding that the crude oil industry is Saudi Arabia's lifeblood makes it all the more frightening - they have every reason to execute their current game plan to the end as the whole game involves their existence on this planet.

Now that the facts have been laid above, the fundamentals clearly show that the odds to the fate of crude oil prices remain to the downside, and any upward spike or rebound may not be sustainable at all.

Stay tuned for Part II!

P.S.: Remember our new Jeddah Tower mentioned earlier? Would it perhaps mark the end of Black Gold.. perhaps, as Mercenary Trader puts it: an R.I.P. marker/tombstone for the hydrocarbon age?

When Will The BOJ Commit Seppuku?

During the last days of the horrendous and tragic period known as the Second World War (WWII), Japan remained the sole Axis power (after Nazi Germany fell in May 1945) still fighting on against the Allied Nations, led by Great Britain, the United States and the Soviet Union.

As General Eisenhower triumphantly declares Victory in Europe, US forces in the Pacific are on their relentless advance to Japan in the summer of 1945, with the Marines already engaging Imperial Japanese troops on Okinawa. Back then, and of course with some benefit of hindsight, it was clear to everyone that Japan has already lost the war.

Her war industries were devastated by Allied bombings and her logistics systems crippled by the loss of key areas of the empire. There was a lack of sufficient food as well as resources to continue the war effort, and the population was extremely war weary after fighting a war in Asia since the 1930s. It was only a matter of time before Japan would be defeated.

However, there was a denial of reality within the minds of the Japanese government. Their Bushido spirit wouldn't allow them to accept failure. Failure meant shame and dishonour, and it is better to die than to be dishonoured. According to the historian Tsuyoshi Hasegawa, policy-makers (of those who favour continued war against the Allies) in 1945 began to silent dissension and impose strict controls of the country, making all efforts to continue supporting the war.

It is not until the combination of 2 devastating nuclear bombs and the Soviet Union's entry into the Pacific theater (the USSR and Japan maintained a non-aggression treaty during WWII) that the Japanese decided to accept the Potsdam declaration and unconditional surrender (and this is of course, only after the Emperor sided with the peace party according to Hasegawa). Tragically, only after hundreds of thousands of innocent lives and huge collateral damage did WWII in Asia-Pacific came to its final conclusion.

And humanity lived on, hoping to learn from the lessons of this dark period in history.

In Japan however, this Bushido spirit has surreptitiously lingered and lived on till today.

Remember the frothy times of the 1980s in Japan? After the Nikkei and the Japanese real estate bubble popped, the country entered a deflationary cycle, and the government decided to support the sectors and industries that have been devastated by the collapse of the bubble, leading to the result of what many call "zombie banks." It took many years for the idea of "reform" to enter into Japan, and many of her politicians have tried and failed since the 1990s.

In November 2012, Mr Shinzo Abe became the Prime Minister of the country. He proposed a shock-and-awe package of reforms in the hopes of defeating deflation once and for all, involving monetary easing, fiscal packages as well as corporate reforms. His sidekick, the Bank of Japan (BOJ), under the leadership of Mr Kuroda, unleashed an extremely aggressive strategy of monetary easing, and for a while in 2013 and 2014, "Abenomics" seem to have made progress. Japanese equity and bond markets rallied, and the Yen got crushed, bringing the USDJPY pair all the way to 120.

However and unfortunately, since the third quarter of 2015, the tide seemed to have turned against Mr Abe and his gang of reformers:

(1) The Yen's weakness has reversed (the USDJPY pair continues to fall below levels not seen since October 2014)

(2) Inflation is almost non-existent (deflationary pressures still exist)

(3) The BOJ's stimulus programme via asset purchases seems to be nearing its limits (what else could they buy?)

Volatility has risen to 10 year highs in the Japanese government bond market (JGB), and according to a recent report by Bloomberg, it seems that the market's functioning is starting to breakdown as the BOJ gets too big in the market for its own good. Recall what superinvestor George Soros once said: "short term volatility is greatest at turning points, diminishing as a new trend becomes established." It seems that an inflection point could be developing in Japan, and foreign investors (crucial to Mr Abe's plan) have been net sellers of Japanese equities, disillusioned with "Abenomics".

If boosting inflation, getting Japanese corporates to increase capex, getting Japanese consumers to spend instead of hoarding cash are the BOJ's goals, it seems that they are hopelessly failing as of the present moment - when capex is muted and more Japanese households are holding more cash (measured via M2 supply).

It also seems that every attempt to fulfill their goals makes things worse, as policy-makers fail to account for the fact that markets are dynamic and that there could be huge consequences for mistakes. Imposing a negative interest rate policy shows the desperation of the BOJ - considering the fact that NIRP screws up your rapidly aging and retiring populace and the banks and insurance sector that supports the whole country.

Then there is also the law of unintended consequences. An NIRP and continued QQE by the BOJ has pushed everyone out further the risk curve, causing at present, a boom in the real estate market. Some of the richly-valued real estate developers (via EV/EBITDA) globally can be found in Japan at present. Courtesy of Bloomberg, the Japanese REIT space has been red hot and has surged since the BOJ announced its policy of tiered negative deposit rates back in January (green arrow):

Whether or not this "boom" in Japan's real estate market is genuine or sustainable remains to be seen. If incomes do not rise fast enough as property assets, don't they become debt?

Clearly, as was the case of the military government back in the last days of WWII, Abe and co. have failed in their objectives but will not admit defeat. Policy-makers may have realised that they have no way out, no back out option. Too much has been wagered on this blitzkrieg.. honour is at stake. Hence, they will do what they can in an attempt to salvage the situation. They will keep at it until the whole, ugly and terrible reality of failure starts to sink in... and perhaps collateral damage starts to surface... a JGB market breakdown? Possible default by the Japanese government (given their high debt to GDP levels)? A massive devaluation of the Yen/ a new reissue of the currency? A long benign and obedient population fed-up with the government causing social/civil unrest?

So the question comes to mind: When Will The BOJ Commit Seppuku?

Possible action:

Shorting "Hedged Equity ETFs", or Japanese equity ETFs that have their underlying equity exposure hedged to the USD seems to be an interesting proposition at this juncture. These ETFs were designed with the intention to preserve a foreign investor's returns in Japanese stocks as the Yen's weakness drives the stock market goes up. However, when the Yen strengthens, the Japanese stock market goes down.

As selling pressure in Japanese equities continue, equity prices go down and the Yen strengthens against many currencies - delivering double whammies to an investor who's long such a Japanese Hedged Equity ETF. Someone who's short such an ETF could benefit if the current trend continues and a vicious cycle of a strengthening yen and plunging stock market begets more selling and more redemption, which leads to a further strengthening of the Yen as Yen shorts are scaled back (so far, technical price action has been favourable to an investor who is short such ETFs like the DXJ).

However, always be nimble and trade with caution. When policy-makers become desperate, one can never know what they can come up with...

The "Decade of the Central Banks"

Throughout the history of financial markets, various colourful and interesting personalities are known to dominate various cycles, appearing as 'wizards' or narrative icons of various powerful market trends.

Think about the 1980s for a moment. Both Ronald Reagan and Margaret Thatcher were sworn into office in the United States and in Great Britain and both advocated deregulation and free trade policies, enabling a boom in financial assets in the Western developed markets. The late John Gutfreund and Lewis Ranieri were running Salomon Brothers, and it was the "Greed is Good" era, where the narrative was fed by Michael Milken, Ivan Boesky, Martin Zweig, and the image of the flamboyant and outspoken investment banker in Winchesters and suspenders became synonymous with Wall Street culture - the archetype being Gordon Gekko.

During the days of the late 1990s and the Tech Bubble, the zeigeist and animal spirits of that time were lifted by characters like Henry Blodget, Jack Grumman, Frank Quattrone and Mary Meeker. Back then, the techno-preneurs like Paul Graham, Elon Musk, Peter Thiel and Larry Page were working hard on their projects and startups, and are now successful Venture Capitalists or business owners in their own right.

Then there were the days of the 2000s. The decade between 2000 to 2010 saw 2 huge booms (or bubbles depending on how one views them), one in the US housing market, which led to the collapse in subprime mortgages, and the other, the famous commodity boom. The housing bubble era was fostered by the likes of Louis Cavalier and Abby Joseph Cohen. The emerging markets/commodity boom narrative were led by Jim O'Neil (who coined the term BRICs), Jim Rogers, Marc Faber, T.Boone Pickens, Peter Schiff and Eric Sprott.

Fast forward to the present day, and we get a whole new host of icons in the present cycle. Only this time, they are leading academics and economists, and are running (or advising) various central banks around the world. This new narrative of omnipotence are led by the likes of Paul Krugman, Ben Bernanke, Mark Carney, Haruhiko Kuroda, Janet Yellen and Mario Draghi. These powerful figures have an almost all-encompassing presence and influence in the global financial markets as we speak.

We initially started this decade with the belief that central banks could solve the issue of a lethargic and slow economy since the 2008-2009 global financial crisis. And everyone relied on these leading policy-makers.

Perhaps, the current narrative could be the real truth, and these characters could continue to be the trend guardians. However, the frightening truth is what if the narrative does not play out in the way they expect it to be?

Already, we are seeing some signs of central bankers losing their grips over the markets. In Europe and Japan, the imposition of a negative interest rate policy on deposits park at their respective central banks' facilities have not had the desired effect that policy-makers desire for (perhaps we need more time, but how long more?).

Consider that in both the European continent as well as Japan, both the Euro and the Japanese Yen currencies have been strengthening relative to their trade partners. Additionally, European banks are parking more money at the European Central Bank (ECB) despite them having to pay more on those deposits. In Japan, consumers and households are hoarding cash instead of investing or spending, which is entirely against what the Abe-regime hopes for.

At the same time, the US Federal Reserve seems to be backtracking on its expected path of tightening via hikes in the benchmark Fed Funds rates - perhaps to soften the US dollar and to alleviate concerns of the international community. And the Fed seems to have internal dissent as well, with several more 'hawkish' members of the committee expressing their concerns on a deviation from the central bank's targets.

What and how do we make of this?

It is entirely possible that we are at an inflection point in this decade - that central banks may be facing a 'crisis' and that more people increasingly do not buy the fact that central bankers are really in control.

Some time in the future, we may look back in history and characterize this decade as the "Central Bank Decade"...

The Saudi Riyal Peg - Sustainable For Now?

The hefty plunge in crude oil prices since the second half of 2014 have wrecked countries heavily reliant on energy-related exports, leading to GDP downgrades by economists and contraction of growth since then. Emerging markets like Russia, Nigeria and Venezuela are probably some of the most-affected, and the impact is clearly evident from the sharp depreciation of their respective currencies vis-à-vis hard currencies like the US Dollar.

This development has raised concerns over the economic health of Saudi Arabia - clearly (and still) the world's most important crude oil exporter and the somewhat-defacto leader of the OPEC cartel. With lower oil revenues, the kingdom has cut expenditures and raise funds (via tapping the bond market or digging into its sovereign wealth entities) in order to maintain the current status quo. News that Saudi Aramco, the state-owned oil giant, is going public has also gotten market participants curious and looking beyond the veil in their attempt to ascertain the state of finances and affairs of the Middle Eastern kingdom.

One key issue that came up was whether the kingdom could maintain its currency peg against the US Dollar. Where it once was an unquestionable fact the past 3 decades, the markets are now speculating on the sustainability of the current level of the Riyal's peg against the US Dollar - which currently stands at 3.75 (USD/SAR).

Policy-observers, market cynics and analysts have cited that both trade and budget deficits are increasing pressures on the kingdom, after being used to years of running surpluses. Forward contracts in December 2015 and early 2016 show that the market expects a downward adjustment of the SAR against the USD (although the recent rebound in crude oil prices have tapered expectations), and betting against the SAR is cheap and contains an asymmetric risk/reward profile (expected upside more than downside), making the trade attractive.

To understand the probability of this event, it is imperative to analyse the possible outcomes, and to examine its possible effects to the Saudis. Should a devaluation occur (whether it's through a gradual downward adjustment of the currency peg or a total abandonment):

(i) short-term relief on the state's finances and improve the balance of payments, since most of the government's expenses are denominated in SAR while their revenues are USD-denominated (like oil receipts). It could also increase export-competitiveness. However, this is not a long term strategy as import costs will surge, and this could lead to high imported inflationary pressures reducing purchasing power as the kingdom relies heavily on imports!

(ii) capital outflows could accelerate as markets question once again if a lower rate is sustainable. A drastic change to the USD peg would require deliberate planning and communication and a reliable monetary policy framework to gain confidence and credibility.

With the above understanding, the probability of maintaining the peg is still high (at least > 80%) until end-2017 given that a devaluation may not be in their best interests. The Saudis are also taking measures to revamp and modernize their economy (which is way less diversified than Canada and even Russia). The kingdom is also in the midst of planning and implementing structural changes to their budget and fiscal plans.

Moreover, they still have the resources and leeway to adjust themselves to the new reality and the current environment. Saudi Arabia is not in a similar state like the United Kingdom was in 1992 during the Sterling Crisis when the country was forced out of the Exchange Rate Mechanism (ERM). Foreign exchange reserves are still relatively large, and they have time to adapt - consider:

(i) as of end-2015, M2 supply was USD 421 billion (SAR 1.58 trillion), against reserves of USD 604 billion - making the coverage ratio 1.41 - sufficient to maintain the peg.

(ii) the government is expected to shift towards higher debt financing, exploring the options of raising external debt in both international loan and capital markets. Domestic commercial banks will probably be incentivised to hold a larger share of sovereign bonds.

Additionally, there is the troubling geopolitical state of affairs to consider at this current juncture. With Iran now being reintegrated into the global economy, the country is ramping up its crude oil exports, and their main rival in the region is Saudi Arabia. This makes the Saudis reluctant to give up defending their market share in crude oil exports, keeping in mind the surprising resiliency of the US shale energy industry at the moment.

Tensions remain elevated in the Middle East, with traditionally peaceful countries like Jordan and the United Arab Emirates (UAE) actually deploying armed forces to troubled areas like Syria and eastern Libya, and the United States of America (USA) desperate to retain its declining influence over the region while erstwhile supporting Israel. There is a possibility that US policy-makers could arrange a swap agreement with the Saudis (their ally) to allow them to maintain the currency peg should they find themselves unable to do so, as social or civil unrest in the kingdom following high inflation from a Riyal devaluation could lead to chaos in Saudi Arabia, which could possibly lead to a decrease of America's influence in the region.

Unlike the British in 1992, the Saudis could actually choose when to adjust the Riyal's peg should they wish to. If any, an abandonment of the current level remains a grey swan event.

At least for now ...