nearing crunch time for the oil price

recap

By allowing/encouraging the oil price to stay over $100 a barrel, OPEC unwittingly created a pricing umbrella that spawned a significant new, relatively high cost, shale oil industry in the US that, at its peak last year, was pumping an extra 5 million barrels of crude a day onto the world market.  At that point, world supply rose above demand, with the natural consequence that prices began to fall.

The OPEC response ot lower prices has been to increase its production, with the intention of spurring new demand and of forcing shale oil producers out of business.  Since for most OPEC countries, oil is the principal source of GDP and of hard currency, more barrels out the door also eased revenue shortfalls somewhat.  Nevertheless, OPEC is generally experiencing a significant cash squeeze.

The plan has worked, to some degree.  American consumers have lost their taste for compact cars and are buying gas-guzzling trucks in huge numbers.  Shale oil production is gradually fading.  Overall world demand continues to rise at 1.5+ million barrels per day.

where we stand now

The excess of supply over demand is still about two million barrels per day, according to the International Energy Agency, (whose latest monthly report can be found in financial newspapaers).

The end to economic sanctions on Iran is likely to free 500,000 barrels of Persian oil for sale sometime next year, however–and that figure might be as high as a million.  And China has been using the fall in prices to increase its strategic petroleum reserve.  Some reports say that this process is close to an end.

storage is a key 

The most important near-term factor to watch, in my view, is overall world inventories–which are at extremely high levels.

Petroleum storage is of two types:

–storage of crude, normally in tank farms, but also in rented oil tankers

–refined products storage, both in tank farms owned by refiners and (the thing we know least about) in customers’ hands–from industry to the gas tanks in individuals’ automobiles.

We do know that crude tank farms in Asia and Europe are full, and that refiners’ output storage tanks are bursting at the seams.  In addition, the cost of renting a crude oil tanker to store barrels for future delivery is now higher than the profit an arbitrageur would make by buying oil now and entering a futures contract for later delivery.

On top of all that, warm weather has meant that the usual seasonal buying surge for heating oil has not yet happened.

to summarize

At the current rate of adjustment, oil supply and demand may not come into balance until late 2016–and maybe early 2017.

The world is running out of places to stash the extra crude.  The globe already appears to have run out of places to do so at a profit.

Therefore, it’s possible that, at the very least, the oil price will decline again–even in a period of seasonal strength like the present–to a level where the arbitrage of buying now and storing for future delivery makes money.  But when stuff like this happens, the world is rarely rational.  The Goldman scenario in which the crude price falls to $20 no longer seems like a footnote.  It’s something that has–I don’t know–say, a one in three chance of occurring.

If that happens, I think it would be a great chance to sift through the rubble for medium-sized US shale oil firms that will survive until better days arrive in maybe 18 months.

 

 

extreme agency issues

The agents that we as shareholders hire to act for us can hurt us in a number of ways:

securities fraud

The 21st-century poster child here is Enron, which created the appearance of earnings growth by fabricating lots of energy trading profits.  A generation ago, the leading name would have been Equity Funding, an insurance company that had a division that made up people it “sold” insurance to.

Many times, such cases are hard to detect, since management has either corrupted or bamboozled its auditors, on whose yearly inspections of  a company’s financial accounts we, as investors, crucially depend.  There’s not much we can do to defend ourselves from fraud, other than to try to have an ear for market rumors and a nose for implausibility.

managers who do really stupid things

The name C. Michael Armstrong comes to mind.  As CEO of ATT, he attempted to diversify the company away from the Plain Old Telephone business.  By my count, however, he masterminded $100 billion worth of dud acquisitions that ultimately drained the company of its ability  to morph into something else (this “performance” earned him a seat on the board of Citigroup, however).

Then there are pets.com, whose signature achievement was its sock puppet mascot, and the gaggle of companies that all leveraged themselves to the sky to create gigantic fiber optic networks–all operating during the Internet Bubble.

 

I don’t think the Valeant Pharmaceuticals story has yet unfolded completely.  The company, a hedge fund favorite, has come under fire for acquiring mature drugs and raising their prices by huge amounts.  The attack on this practice by, among others, Charles Munger, a long-time associate of Warren Buffet, as “deeply immoral” has caused the stock price to plunge.

 

Mylan, a new twist

Drug maker Mylan completed a tax inversion early this year that transformed its country of incorporation from the US to the Netherlands.

In April it made use of a provision of Netherlands law to create a trust, called a stichting, supposedly staffed by completely neutral parties but arguably controlled by company management.  It issued the trust an option to buy new shares equal to all those previously outstanding, at a price of one euro cent each.  It then used this device to fend off a takeover bid, unwanted by management, from Teva Pharmaceuticals.

Subsequently, Mylan defended its actions by saying it had moved to the Netherlands because the US is “too shareholder-centric.”

In addition to the ability to create a stichting, moving to the Netherlands appears also to have insulated the board of Mylan from the possibility of removal by shareholder vote.

It appears to me that Mylan reincorporated in the Netherlands with the intention of disenfranchising shareholders.  In a highly technical sense what Mylan has done may be legal, although media reports suggest the SEC is investigating whether the company adequately disclosed to shareholders what it was doing.  Nevertheless, Mylan’s actions seem to me to be a massive breach of the bond of trust that should exist among business partners.  I’m not sure what the consequences will be.  I can’t imagine, though that they’ll be good for Mylan’s stock, or that any other US-listed company will be able to reincorporate into the Netherlands.

the agency problem

principal – agent

The principal – agent relationship arises when one person, the principal, hires someone else, the agent, to act on his behalf in some matter.

agency problem

The agency problem is that the agent may have a different set of economic interests from the principal and may act on them rather than do the best thing for the client.

examples

Studies seem to show that real estate agents behave differently when they sell their own houses than when they sell for a client.  Working for themselves, they take more time and achieve higher prices.  This is also the issue in the current discussion about whether brokerage financial advisors should be fiduciaries, that is, whether they should have a legal obligation to recommend the best investments for their clients.  At present, they aren’t   …and don’t.

for us as investors

If we hold shares of the common stock of individual companies, we are in some sense owners of the company.  (Note:  we can also hold shares of stock  in individual companies indirectly by buying shares of ETFs or mutual funds.  We can hold the shares in, say, a 401k account sponsored by our employer, too.  These create further layers of principal – agent relations.  In this post, I’m going to ignore them.)

The chief power we have as shareholder-owners of a company is that we vote to elect a board of directors to act as our agents.  The board, in turn, selects a management team (another set of agents) to run the operations of the company in our behalf.

an aside:  stakeholders

Management hires employees, makes ties with suppliers and customers and may borrow money from a bank.  The group comprised of this wider net of interested parties plus us as principals and the two sets of our agents is usually referred to as stakeholders.

potential stockholder – agent conflicts of interest

the board

Where do board members come from?  The slate we vote for is typically put together by the management of the company.  The list will consist of some members of top management, plus “outside” directors.  This latter group may include retired managers from other companies in the industry, or executives from suppliers or customers.  But it may also contain prominent political, military or academic figures, who have little knowledge of business generally–and still less of the particulars of the company on whose board they sit.

As agents, the board has its own set of interests and priorities.  More important, though, it can easily have a much closer attachment to the management that nominated them than the anonymous group of shareholders who voted for them and are technically their bosses.   And, of course, management may seek rubber stamps instead of gadflies.

If individual shareholders had a problem with the composition of the board, how would they take effective action?

management

Let’s say a CEO has spent 25 years rising to the top spot in a corporation, where he has, say, five years to collect high salaries and bonuses and cash in on stock option awards.

Suppose our CEO sees a severe structural problem with the business, which can be papered over for a while but which will begin to erode market share and profit margins within, say, six years.  The problem can be fixed, but only by a restructuring that will crush profits (and maybe the stock price) for at least the next two years but which will pay huge dividends toward the end of the decade.

What does he do?    …restructure and risk turning his $60 million five-year day in the sun into $25 million, or simply paper over and collect the higher sum?

 

Tomorrow:  the latest twist.

 

 

 

is the e-commerce market in China saturated?

I’ve recently begun receiving emails again from the Fung Business Intelligence Center, an arm of the Hong Kong-based, garment-oriented logistics company Li and Fung.  One of the latest poses the question that’s the title of this post.

The answer:  yes  …and no.

Yes, the market in the developed areas of China is close to saturation today.  However, rural areas of the Asian giant remain relatively unexploited, both by internet and traditional bricks-and-mortar retail.  FBIC thinks that the rural sector, which now makes up about 10% of Chinese e-commerce revenue will be at least as large as the urban sector in as little as 10 years.  My back of the envelope calculation is that rural e-commerce growth will add at least five percentage points annually to what overall e-commerce expansion would otherwise be.  Presumably, some Chinese e-commerce players will be more adept at wooing this business than others, meaning their rural business could add 10% or so to annual sales growth.

The FBIC report, which is relatively short, is well worth taking a look at.