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The anatomy of a summer oil glut!

Matein Khalid
Filed on February 20, 2012
The anatomy of a summer oil glut!

It is ironic that Brent crude has risen to as high as $120 even though the supply-demand fundamentals in the wet barrel (physical crude) trading markets continue to erode.

This disconnect in the world’s most valuable, liquid commodity market is a testament to Iran geopolitical risk that has created a supply shock premium on the markets, particularly after 100 VLCCs (supertankers) have now refused to load Iranian crude at Kharg Island in deference to draconian US/EU sanctions.

This supply risk also explains the inexorable rise of the Brent-WTI premium to almost $19. EU sanctions preclude ship insurance, the reason Frontline and Nova Tankers, owners of two of the world’s most prominent tanker fleets, have now refused to load/transport Iranian crude. A sharp fall in Iran’s exports in inevitable, an eerie replay of the Seven Sister boycott of Mossadegh crude that culminated in a CIA coup that restored the Shah to his Peacock Throne in 1953.

The supply-demand metrics for Brent flash a bearish SOS. Opec production is now at 30.9 MBD, the highest since the failure of Lehman. Saudi Arabia alone is now pumping almost 11 MBD, the highest since the onset of the Iran-Iraq war. This means Opec quotas, let alone, quota discipline in nonexistent. Meanwhile, the IEA has again cut global oil demand for the sixth consecutive month. Oil demand has actually contracted by 300,000 barrels/day in Q4 2011, the first contraction since the 2009 global recession.

Libyan, Iraqi liquid fuel, Russian and Mexican crude is also hitting the market, so the risk of an inventory buildup is all too real at a time when a surge in US shale oil production (unemployment rate in North Dakota is three per cent, a black gold rush?) limits American imports.

The reason Brent trades at stratospheric levels is the epic easy money policies of the Federal Reserve, the ECB and the Bank of Japan, despite the Molotov cocktails in Athens, Saudi Arabia’s refusal to play the role of Opec’s swing producer, the collapse in Indian industrial production and the decline in Chinese exports. The tidal waves of central bank liquidity are amplified by the Iran supply shock. It is entirely rational for Sama and GCC central banks to prefer to sell crude at current Brent levels, than invest in risk free Uncle Sam T-bills at 20 basis points. This is all the more true since post-Arab spring government spending and budget break evens have soared.

Real dollar interest rates are negative and the threat of war in the Straits of Hormuz, not supply-demand curves, explain the surge in Brent. This is the reason I have tried my best to flag opportunities in high beta energy (Oxy, Schlumberger, Apache, Noble, etc) for our readers in Global Investing. Notice Noble is now 20-60, a vindication of my bullish thesis outlined only two weeks ago.

The fate of Brent depends on Ben Bernanke and Ayatollah Khomeini until the oil market again refocuses on supply and demand. But Europe is now in recession, Club Med in another credit crunch. Brent can well rise to $130 but that makes the subsequent hit to oil demand all the more traumatic. A major fall in Brent is inevitable as the glut builds in OECD inventories. If the Iran crisis does not escalate into war, a $20-$25 fall in Brent is my base scenario in the next six months. This has to be the macro trade of 2012, if the stars are aligned right, dear Brutus.

Risk rallies and easy money

The tories are in power, the Queen will be at Ascot in June but all is definitely not well in the world’s financial empires. The Greek austerity deal has triggered a social explosion on the streets of Athens. Earnings shocks devastated the share prices of Credit Suisse, UBS, ING, Barclays and Macquarie Bank. The money centre bank shares have skyrocketed since December since they were the clearest beneficiaries of stronger economic growth data, were grossly underowned by investors and were the major beneficiaries of the ECB’s epic LTRO, that has caused tail risk of a European banking system collapse to plummet and interbank market sovereign fund risk spreads to decline. Yet liquidity driven rallies have boosted the share prices of the good, the bad and the ugly in global finance.

Risk rallies are all too vulnerable to spikes in volatility as financial markets get sandbagged by negative news which deleveraging, debt crises and regulation/political attacks make almost inevitable. After all, the ECB repo under LTRO saw 523 eurozone banks bid for €489 billion. This is not exactly a bullish premonition for the sector. The US banks have no comparable systemic risk but the colossi of Wall Street are exposed to Europe, Federal Reserve bank stress tests, Basle Three and the political fallout from Dodd Frank, the Volcker Rule and homeowner debt relief programmes. Instrument banking remains mired in a revenue death spiral. FICC revenues fell by 25-35 per cent in UBS, Barclays Capital and UBS, Europe’s leading bulge bracket investment banks. So while LTRO acted as a game changer in international finance, akin to Hank Paulson’s Tarp, it does not negate the fact that European banks are still vulnerable to a high risk of Club Med debt contagion, recession, rising NPL and even political risks.

HSBC under Stuart Gulliver has hardly been a winner for shareholders. Yet expectations for the biggest strategic makeover in UK banking are all too pessimistic even as management has executed on the new “think global, slash local” strategy. HSBC share performance is highly correlated with global liquidity metrics, which have improved after recent easing moves by the Fed, ECB, Bank of England, the PBOC and the Bank of Japan.

With headcount shrinkage of 14,000 and the sale of no less than 20 global businesses, HSBC has definitely performed in Gulliver’s five filters strategy, loan/deposit ratio is a conservative 76 per cent and the exit from US credit cards/mortgages all suggest higher valuation metrics. HSBC also has valuable stakes in China’s Bank of Communications, Ping An and Industrial Bank and should benefit from the exit of European banks from Asia. HSBC New York ADR could be a value buy at 38 for a 45-48 target.

On economists, markets, mandarins and maestros

What books best help us understand the impact of greed and human folly in high finance?

Charles McKay’s Extraordinary Popular Delusions and the Madness of Crowds. It illustrates how prone to delusions human being are and how they take hold. It’s deeply rooted in the DNA. As Sigmund Freud remarked: “Illusions commend themselves to us because they save us pain and allow us to enjoy pleasure instead. We must therefore accept it without complaint when they sometimes collide with a bit of reality against which they are dashed to pieces.” I think we are going through one of those “collisions with reality” currently.

What book helps us best understand China’s political/economic culture?

Everybody sees in China what they want to see. It’s amusing to see Europe (where average incomes are $40,000) begging China (average income $4,000) for money. People have superimposed certain expectations on China driven by their own needs rather than the reality. China can’t possibly live up to those expectations. I think you need to start with the Chinese political structure and then work to the economy from that. In that sense, Richard MacGregor’s The Party: The Secret World of China’s Communist Rulers is a useful starting point. For people with little experience of China and who believe that China is something like a Western economy, it is quite enlightening. There is a joke about Pakistan — it’s an army with a country. In the case of China, it is a communist party with an economy. Former Chinese Premier Zhao Ziyang’s Prisoner of the State, the secret journal of former Chinese Premier Zhao Ziyang and Ma Jian’s novel Beijing Coma also provide nuanced perspectives of how China works or doesn’t. Importantly, the books are written by Chinese or people who have lived there long enough to understand how it works (Macgregor was the head of the Beijing bureau of the Financial Times). The worst dross about China is from businessmen who assume Beijing’s inner ring and Shanghai’s Pudong is the real China and economists who have talked to other economists.

Why are you so fascinated with the Jazz Age?

The Jazz Age presaged the Great Depression. So it’s less a fascination with the Jazz Age but rather an attempt to understand what is happening now. Also it provided us with the enigmatic Jay Gatsby and F. Scott Fitzgerald’s puzzling but evocative The Great Gatsby. Gatsby literally sums up different phases of the current financial crisis. The lead up: “Gatsby believed in the green light, the orgiastic future that year by year recedes before us. It eluded usw then, but that’s no matter — tomorrow we will run faster, stretch out our arms farther”. The bailouts: “It was all very careless and confused… they smashed up things and creatures and then retreated back into their money or their vast carelessness, or whatever it was that kept them together, and let other people clean up the mess.” The attempts to deal with the problem: “Can’t repeat the past? Why of course you can!” But Gatsby wasn’t really a tragic hero. He was a sentimental, self deluding fool. That is probably the most pertinent connection between the Jazz Age and our time.

Who are the Jay Gatsby’s and Daisy Buchanans of our times?

There is no one really that interesting today. We have celebrity not significance. But the central bankers and policy makers are all Gatsby-esque in their self delusion. And the fading prospects of a return to economic prosperity and strong growth resemble the insouciant and indifferent Daisy, who Gatsby so desired.

Which is the best single book on finance you ever read?

It still hasn’t been written! Finance books are generally terrible — financial pornography. It isn’t literature. It’s more like reading a road map or car manual — you turn this screw here and then remove, etc. Frankly, I avoid reading finance books generally and only do so when I have to — for work or writing book reviews.

What lessons do you feel Galbraith and Von Hayek have to teach us?

They both teach us we are willing victims of our history and background. They were both products of their classes and upbringing — Galbraith’s patrician roots; Hayek’s Central European sensibility shaped by the collapse of the Austro-Hungarian empire. Galbraith’s great strength is he understood the paucity of economic thought and saw it as instrument of social policy. Hayek thought economics was more powerful than it is but also saw it as an instrument of social policy. Galbraith writes elegantly and well, with great wit. Hayek is generally unreadable and incomprehensible. Most people who espouse him haven’t read him. So people read Galbraith for pleasure. People read Hayek or better still read something second hand about him to quote in support of some argument. Probably it shows, paraphrasing Woody Allen that its best not attain immortality through your works but rather by not dying.

Buy/sell zones for three trophy fund managers

Blackstone is the world’s largest, most successful private equity fund, the Mount Olympus where Steven Schwartzman is unquestionably Zeus. The beauty of Blackstone’s business model is that it is a specialist asset manager with global franchises in leveraged buyouts, distressed credit/secondary loans, mezzanine hedge funds, real estate and even merger advisory businesses. Wall Street values management fees far more highly (16 to 20 times earnings) than performance or even corporate finance advisory fees (eight to 12 times). Blackstone is also growth stock since AUM has increased at a compounded rate of 24 per cent, a testament to its brand and distribution in global finance. I am reluctant to buy Blackstone above 14 for a 20-22 target as its real estate, hedge fund, mezzanine and even a new $1 billion shale oil fund have attracted loyal LP inflows.

The spectacular rally in emerging markets has naturally lifted the shares of Franklin Templeton, given that its star manager Mark Mobius runs the world’s biggest EM equities funds. Since 60 per cent of Franklin funds beat their peer performance , the global asset manager is a prime beneficiary of the new warmth for financials, though it has redemptions in its Global Bond thesis. Franklin Templeton manages $670 billion in leveraged to the global market and has one of asset management’s iconic brands, so I do not question the logic of its trophy, premium valuation. Yet the share are now expensive at eight times enterprise value/Ebitda and I cannot see credible upside above $125. The risk-reward calculus suggests an accumulation zone for BEN somewhere in the 98-102 zone, a lot lower than current levels. Will it be possible to buy Franklin at lower levels? Yes. Volatility in the capital markets has not done a Rip Van Winkle.

BlackRock, the world’s largest money managers and an institutional legend on Wall Street, has surged from $141 in September to $190 now. While this unique firm is a most own in any blue chip investor portfolio, I believe the risk/reward is just not there for risk averse buyers, even the shares can well rise to $220. BlackRock’s Q4 was stellar, with $24.6 billion inflows (more than almost all Middle East asset manager AUM!) in its active and index products (the old BGI global quant franchise is on a roll as the ETF revolution deepens.

This legendary firm, founded by Larry Fink, consigliere to the world’s finance ministers and central bankers, manages no less than $3.5 trillion. By any criteria of value or growth, BlackRock is one of history’s greatest financial franchises. EPS could be $13, in 2012, earnings with its 15 per cent and shares are not expensive at 12 times forward earnings. Yet markets fluctuate, an existential reality that has not escaped the attention of any of us who play the Great Game of Global Money. So I would hope to reenter BLX at 165-170.

Researched and compiled by MATEIN KHALID. Mr Khalid is a fund manager, a Wharton MBA and Director of a securities firm. He can be contacted at: ktglobalinvesting@gmail.com


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