Chill out on the zone – Part 2

The ECB has adamantly refused to take the single, simple step that would solve the crisis overnight: printing cash and buying sovereign debt. Last week Mario Draghi, whilst once again refusing to contemplate such steps on principle, rather cagily announced that eurozone banks could borrow effectively unlimited amounts at cheap, below market rates.

While on the surface in the tradition of his austere, ideological and rather mistaken German predecessor, this could in fact be a sly move from the recently installed Italian: for eurozone banks could use the cheap cash to buy their own nation’s debt at their own government’s auctions.

The next six months will certainly have their share of thrills. From February to April, Italy needs to borrow 150 billion euros alone, whilst over the course of next year the Zone’s total funding is 800 billion. It’s worth taking a look at the existing firepower from the ‘timid’ steps taken so far (these came from TMM who offer more detail and better writing):

1. The EFSF has 250 billion euros at its fingertips. If it can find a lender (not Chinese, perhaps ECB?) this could potentially be leveraged to 750 billion.
2. The ECB is purchasing 5 billion euros of sovereign debt a week, which comes to around 250 billion a year.
3. European Stability Mechanism has capacity of around 500 billion, from July 2012.
4. IMF has 300 billion – the recent summit offered lending of 200 more.

Obviously using the IMF is far from ideal: under default the fund gets paid first, making remaining debt worth less and less, causing a feedback loop where IMF assistance actually worsens yields, making debt levels more unsustainable, locking countries further out of markets and so on but all that aside, using the existing arsenal we are finally getting to the point where 2012’s funding looks manageable, especially with a little arm-twisting of real money pension funds, insurance companies and the like who have to turn up and buy at auctions anyway.

Now add in the fact Mario Draghi will allow the banks to buy sovereign debt at yielding 6-7% and park it at the ECB with only a mild yield haircut, and all of a sudden things are a whole lot less scary.

Across the globe a eurozone blowup is held up as the major risk to global growth, leading companies and investment managers to hold extremely high levels of cash. If the feared blow-up doesn’t actually occur, that cash can’t stay on the sidelines forever. Buy the fucking dip.

Advertisements

Chill out on the zone – Part 1

There is nothing more irritating than someone being deliberately ‘out of consensus’ and priding themselves on their own bravery. Right now, heroes from the commentariat are jumping over themselves to declare the death of the eurozone, the end of the euro and the descent of the continent into fascism, madness and apocalypse. This is only a mild exaggeration.

For the eurozone to break up, a politician would have to wilfully make that decision. Since pulling your country out of the eurozone is, in fact, the worst case scenario, it is hard to envisage this making sense to anyone.

Leaving the Zone would mean swapping an entire nation’s cash into a new currency overnight, in a simple step wiping out far more wealth than any increase in taxes or mass sacking of civil servants could manage. If Greece left, responsible money managers would have to assume the same outcome was on the table for Italy, Spain and Portugal, sparking a rapid race to pull cash from those countries and dump it in German deposits. Such a sudden withdrawal of funds would send those countries entire banking systems insolvent overnight.

In the leaving nation there would be chaos, perhaps nihilism and anarchy. All contracts denominated in euros would be under question, and all hiring, investment and swathes of commerce would halt until the dust settled.

But the effects would be more dire than that. Borders would close as transporting cash out of the now-pariah nation would likely be made illegal, shattering one of the Zone’s more inspired achievements. Reactionaries across the spectrum would surge in influence, as anarchists to neo-fascists would offer simplified, fundamentally incorrect yet convincing narratives for the calamitous times.

There was quite a scary moment in September when governments in Rome and Athens fell in the same week – it looked like economic affairs had finally bubbled into the political instability so many feared. And what did we get? Reasoned technocrats in power and the fall of one of the more ridiculous leaders of our times.

The fearless commentators chiding politicians for their timidity and adherence to clumsily constructed Zone law, are simultaneously predicting the same will cause all of the above by pulling the trigger on the entire continent. Chill out.

Oil Bear

The price of oil is going down.

The resilience of oil prices in the face of an onslaught of grim economic and political developments around the world implies supply is currently quite tight. But don’t be fooled by oil over $100: The energy market is about to be turned on its head, and it’s all about shale.

A rather lax regulatory regime (courtesy messrs Bush and Cheney) has led to rapid exploration, immense investment in technology and huge increases in estimates of US shale energy reserves. It is quite likely that in a matter of years the US will shift from being an oil importer to an exporter – with interesting consequences for the global economy and political ecosystem. The percentage of US oil that’s imported has dropped from 60% during Bush’s second term to under 45% now.

As a sign of how fast reserves are being discovered, in 2011 the US Energy Information Administration more than doubled its estimate of technically recoverable shale gas reserves to 827 trillion cubic feet (for a sense of scale, in 2010 the US consumed about 24 trillion cubic feet). This is not the sort of thing that would lead to an increase in global energy prices.

The consequences within the industry are no less dramatic. Currently most oil in the US is travels South from the oil sands in Canada – with a production cost of around $80 per barrel. The cost of producing a barrel of shale oil is around $60, with some fields potentially as low as $40 – Royal Dutch Shell announced it could produce in Colorado at $30 a barrel. The numbers themselves tell the story. Once these fields pumping at full capacity, higher cost producers are up the creek, so to speak. Since they’ll have already made huge fixed investments they will have to keep pumping, as even producing at a loss would be better than idling the wells and losing more. The result will be disaster for the weaker capitalised and vast profits for the shale producers.

The impact will be far more broadly felt than that. Cheap energy, the lifeblood of industry, is exactly what the world needs right now. Cash saved on petrol is cash left sitting in all of our wallets. Every industry relies on the price of energy, so lower prices would be a boon to all. Traditionally periods of low energy prices have corresponded with booms (think 1970s vs late 90s), while the mid-2008 oil spike is arguably the most under-estimated causes of the sharp recession that followed. Perhaps this could be the boost to growth that the global economy is lacking right now. Hope so.

A good way to play it would be on the futures curve. Selling 12-18 months forward would have better risk-reward – the price will respond less sharply to any positive oil shocks while a clever move would be to cover the position by selling long-term puts around $50-60, or higher, giving you a much wider range of profitable scenarios. I’ll post later on specific long-short equity plays that also make sense.

Now there are obviously darker consequences to cheaper energy, most obviously the effect higher consumption has on global warming. There are also concerns over the health, safety and environmental impact of harvesting shale. The process involves pumping oceans of water underground, which ominously appears to increase local seismic activity, while there are (perhaps a little hysterical) concerns gas could enter the water supply, with a video of tap water igniting recently going viral. These concerns, magnified by higher population densities, have left Europe years behind in developing the legal and technical structures to make use of their own vast reserves. Whether these fears play out and the US slams the break on shale development is impossible to discern, though a health disaster in the headlines would probably have more impact than simmering environmental concerns, valid though they may be. But with whole continents stagnating and no end yet in sight to the crisis, almost into its fifth year, it would be a foolish politician who wasted this potential windfall.

Spread that.

The WTI-Brent spread has gripped the attention of the financial world. Historically trading in a tight band the spread dramatically blew to as high as $28 intraday before plunging just as dramatically to around $9 where it is now – particularly odd considering the greater refining yields and lower sulfur content of WTI.

A bottleneck at the Cushing terminal in Oklahoma, where the Nymex WTI contract is settled, caused incremental Canadian oil to build with only expensive barges to transport the crude to refineries.

Exacerbating the problem was ConocoPhillip’s decision to keep the Seaway pipeline flowing towards Cushing. In doing so the company protected the profits of its Midwest refineries by keeping WTI crude artificially cheap, all at the expense of Canadian oil sand producers who were pushed to breakeven levels.

The sudden tightening of the spread occurred after the sale of Conoco’s 50% stake in the Seaway pipeline to Enbridge for $1.15 billion, which allowed the reversal to take place. Curiously, the spread began tightening as early as October when WTI entered backwardation, a clue that supply/demand story was tighter than thought.

An initial capacity of 150k barrels / day by 2Q12 is expected to expand to 400k barrels / day by early 2013. This will probably displace the use of the congested and expensive barge market from 2Q12-4Q12.

Whenever prices get this out of whack the gods of economics demand a physical respones. In this case rail capacity was immediately planned with the aim of circumventing Cushing, which may induce further tightening as Cushing prices rise to encourage more oil flow through the terminal.

How I’d recommend playing it: inventories at Cushing will likely build up in anticipation of the opening of the Seaway pipeline. The best risk reward is probably in longer dated Brent spreads, while perversely inventories at Cushing may actually build as oil is pumped there in anticipation of the opening of the pipeline. This would push down prices at the front end of the curve, while leaving the back end free to compress below $6.50 – which is the cost of transporting WTI to Brent.

On this theme, selling the March 2012 WTI-Brent spread and buying the March 2013 spread would benefit from a rotation of the curve – simultaneously profiting from any short term widening while betting that by March 2013 the excess inventories have cleared out. Quite a likely scenario.