Month: October 2014

Thoughts on the Shale Boom

The shale boom in the US is a highly controversial topic. There are the enthusiasts forecasting US energy independence and even net exports to Europe and the rest of the world. Sceptics argue that the boom is fake, by which they mean that while production in the US has indeed risen substantially, it is not sustainable due to the high depletion rates of shale sources. I have the feeling that many people in Europe are sceptical about the US shale boom and by that I do not mean usual suspects such as environmentalists. Acquaintances of mine whom I deem to have a better understanding of the relevant variables (geologists, engineers…) forecast – in no uncertain terms – a bitter end to the shale boom. Since I found it difficult to weigh the contradictory information properly, I had a neutral opinion on the topic – until now.

Shale Requires Constant High Levels of Capex

I am by no means an energy expert and not at all in a position to make definitive statements on this issue, but I took away one thing by reading about the topic over the years: both camps agree on the fact that in order to keep shale output constant, continuous capex for drilling is required. For instance, Daniel Yergin – an shale enthusiast as far as I can tell – in his recent FT-piece makes this point again:

How low will prices go? The US holds the key. Unlike conventional oilfields, the tight oil being produced there requires continuing investment in new wells to maintain production. Lower prices make such investment less attractive – but the effect may be smaller, and slower, than many people think. Some new fields become uneconomic if the oil price falls much below $90 – higher than it is today. But most of them are economic at $75 or well below that. Of course, if oil prices fall further, the impact will be greater.

Now, every business has to spend money on capex or R&D to stay afloat in the long-term – this is true for major oil companies as well. It just seems to be the case that due to shales high depletion rates (again an uncontroversial fact) capex needs are even more pressing, relatively speaking. I generally do not like business models that need to dedicate a substantial amount of their resources just to stay in the game. Too much depends on management skills and luck, if you have to redeploy a large part of your resources over and over again. And if constant drilling is the name of the game then surely the amount of reserves in the ground matter a lot.

And it was this chart on zerohedge which changed my position from neutral to sceptic,

Shale Reserves
Optimistic Management

The chart shows the reserves of the main shale players in the US. Note that there is a huge difference between estimated reserves presented to the SEC and those that are shown to investors – they differ by a factor of 6 on average! A Bloomberg article explains,

The SEC requires drillers to provide an annual accounting of how much oil and gas their properties will produce, a measurement called proved reserves, and company executives must certify that the reports are accurate.

No such rules apply to appraisals that drillers pitch to the public, sometimes called resource potential. In public presentations, unregulated estimates included wells that would lose money, prospects that have never been drilled, acreage that won’t be tapped for decades and projects whose likelihood of success is less than 10 percent ……..

Many of the companies use their own variation of resource potential, often with little explanation of what the number includes, how long it will take to drill or how much it will cost. The average estimate of resource potential was 6.6 times higher than the proved reserves reported to the SEC, the data compiled by Bloomberg News show.

So the executives are liable for the SEC figures, whereas there is no such constraint with respect to what they can tell investors in the presentations? Hmm…

This reminds me of the GAAP vs. “adjusted” earnings debate, where the first is figure is produced following general accounting rules and the latter is calculated by management as it deems fit. I am not aware of any case where, in the long-term, the GAAP figure has not been a better indicator of a company’s economic position than management earnings – none. How could it be different? It is simply the incentives at work: management has a tendency to be overly optimistic about their business. Some say they have to be that way, yes, but I am not so sure about that. IMHO it helps to be a cool, sober calculator if you have redeploy large resources year in and year out.

Oh, and before I forget it: a lot of managers out there are crooks…


Now, to be fair it is possible that management is just overly cautious as it fears the sometimes very harsh legal punishment in the US. Maybe the definition of what constitute probable reserves for  SEC purposes is suited for conventional oil fields and not for shale reserves? This is absolutely possible – as I am no expert, I do not know. But before I become convinced I would like somebody to explain this discrepancy to me. Until then, count me sceptical…



This does not mean I am bullish on the oil price. I believe the reduced demand from China far outweighs any supply side counter effects.


Standard Chartered On China

FT-Alphaville drew my attention to Standard Chartered’s recent earnings report (as the post is short, I will quote in full):

In the first quarter:

By the third quarter

Which helps explain why impairments almost doubled at Standard Chartered in Q3 compared to a year ago. Also of note in terms of EM corporate stress… StanChart’s loan book is actually shrinking. It fell under $300bn in the quarter.

StanChart’s profitability is 3/4 derived from Asia. Are the sinking loan book and the tighter underwriting criteria (timing!) a sign that the party is over in Asia?

I think so. Watch that space!


Back From China

I have been on the road for the past two weeks, visiting Beijing for business. Since WordPress does not work well in China (neither do Google, Facebook or Youtube) posting was difficult. As you can imagine, given my bearish view on China, I was extremely excited about this trip to see how a credit bubble feels like. Of course, I am aware of the fact that the capital doesn’t necessarily convey a realistic picture of a country – but better than nothing. In this post I want to share my observations.


I arrived in Peking in the morning. As expected, the airport was huge and empty, although I liked its design. You can imagine my joy: “… my first white elephant: a huge, empty airport – that’s what a credit bubble looks like…,” I said to myself.

Alas, no such luck: we had merely been the first plane that had been allowed to land due to the heavy smog. Oh, and the rest of the week I had blue sky and sunshine – an absolute rarity in Beijing.

Beijing is a modern city, the infrastructure well-developed with huge roads and bridges, airports and train stations. I was told all Tier 1 cities in China look like that. I occasionally stumbled across an empty skyscraper. I had the feeling additional infrastructure is the last thing China needs. House prices nevertheless are ludicrously high. An apartment in the business district (a huge area, probably comparable to large parts of Manhattan in size) sets you back about USD 18.000 / sq m. Rents are way higher than in Vienna. Despite the huge roads there are large traffic jams and German cars are ubiquitous. The city government was planning to restrict the number of cars and they did: they restricted the number of – Taxis!

And China is not cheap. Eating out is fairly cheap, yes, but the quality of ingredients is, ahem, highly volatile. European products cost 2- 3 times more than in Vienna, Starbucks and Mc Donalds about the same.

The corruption purges

Being used to European politicians’ empty promises, I had thought that the vows by the new prime minister, Li Keqiang, to tackle corruption were nothing but empty words and a no-show to please concerned Western observers. I was proven naive. This guy means business. I heard many stories about how a company got into trouble because the CEO was arrested out of the blue and questioned for weeks, presumably to provide information on corrupt local politicians. Often this left the company paralyzed as it was without its main decision maker for weeks. In short, a lot is going on under the surface causing quite a stir – some even compared the current period to Deng’s market reforms 40 years ago.

Fortune Asia had a good article  (“Beijing pulls back the welcome mat“) about how the new government behaves more aggressively towards foreign companies many of which have been accused of “monopolistic” behaviour and who see their fat profit margins under threat. This is underreported in western media, but a big concern to many foreign executives.

Of course, tackling corruption, while sounding nice, doesn’t mean the country is becoming more “western,” transparent, or anything like that. I had the impression that “reform” just means replacing one entrenched elite with another one. Economic policy goals may change, but not the main rules of the game.

The power of the state

What was really surprising to me, though, is the degree to which the state exerts power in China. Russia felt like child’s play in comparison (except for the oil and gas sector, probably). Private companies are at the mercy of the state to a degree I haven’t seen anywhere else.

For instance, the next APEC (Asia-Pacific Economic Cooperation) will be held in Beijing in the beginning of November. In order to present a smog free skyline, the government will force surrounding coal and steel companies to substantially reduce their output prior to the event – no matter the cost.

Interestingly, some of my Chinese sources mentioned that laying-off people is not that easy in China as riots are not unheard off and “social stability” ranks high on the list, which doesn’t sound like a highly competitive labour market to me. Since the obvious cost advantages have disappeared (China is NOT cheap) and the economy slows down the rigid Chinese labour market will be put to the test. Extrapolation of the stability of the past 20 years would be a serious mistake. I expect serious riots as the overcapacity in various industries starts to bite…

Liquidity crunch and the banking industry

One of my major goals was to verify to what extent reports about the liquidity crunch and the fraudulent activities at the port of Qingdao were accurate. And I have to say that the information on the ground (expats and Chinese working in banking) pretty much confirmed what I had read in the media. I also asked about the famous city of Ordos and it apparently really exists, people, not just finance guys, know about it. Especially the liquidity crunch was a topic of great concern in some regions and has hurt many a company forcing the government to step in and provide liquidity, which in China means the goverment tells the banks -private and state owned alike – what to do. Listening to the stories I learned a great deal about Chinese banking industry specifics.

Any discussion about China’s banking system has to start with the fantastic book “Red Capitalism“. The authors, two American Investment bankers with more than 25 years of experience in China’s financial industry, brilliantly describe the sinister workings of China’s financial system – a must read. It has been a while that I have read the book, but I do not remember that the authors mention the topic of cross guarantees. They should have, as guarantees are pervasive throughout the system and played a crucial role in the recent liquidity crisis. Nothing comparable exists anywhere else so I will briefly describe it as it is necessary to understand what happened.

It is a custom in China, I was told, that Chinese banks require a guarantee from another party before granting a loan. Just for the case.

“Why would any company provide a guarantee to a third-party?” I hear you ask.

Answer: Well, simply because the guarantor himself has a loan and needs a guarantee himself. In other words, if you want a loan you have to play the game. Note, that this has NOTHING to do with shadow banking. The system is official and guarantees have to be reported to the central bank. As a consequence of this habit, the rationale behind which nobody could explain to me and which most likely is a remnant of some rule which probably made sense in a distant past, most indebted Chinese corporates have issued substantial off-balance guarantees to third parties – often  a significant percentage of their equity, with the consequence that on balance sheet information is not very informative for most Chinese corporates. Sometimes it is even tricky for the banks to appropriately rate the company in question. With that information, it is easy to see how a liquidity crunch at one company can spread like wildfire: all you need is a minor default and the cross guarantees start kicking in which is exactly what happened at the beginning of 2014.

Given the fact that M2 has grown by more than 1000 (one thousand) percent in China over the past 14 years, it is no surprise that defaults have been rare and the negative effects of the cross guarantee system not yet exposed. I expect to hear more about cross defaults as the money supply growth slows down further, as the following chart (via FT Alphaville) shows,




The new Chinese government is a big force of change that is underestimated in western media. It is also behaving aggressively towards private and foreign companies and, given its power, it is safe to assume that profit margins have peaked for western companies in China. While I can understand China bulls’ enthusiasm for the country – those huge infrastructure buildings and skyscrapers are impressive – I absolutely cannot see how the demand for raw materials and energy can continue at the pace of the past two decades. Who will buy all that steel and concrete? Beijing needs clean air, the rest is already there and in size.

The liquidity crunch caused great havoc at the beginning of the year and serious damage could only be prevented by granting liquidity lines. Like every government in the world, the Chinese government probably believes/hopes this is merely a liquidity issue. Overcapacity in most sectors, however, suggests that we should think in solvency terms. Due to the cross guarantees across the system, a small default can have large impact. Consequently, the system is fragile both ways: a lot of companies are insolvent and the financial system is opaque – a toxic combination.


If History rhymes, China-bulls should be worried

Fascinating:  FT-Alphaville puts an interesting historic perspective on the recently completed purchase of the famous Waldorf Astoria by a Chinese buyer.

As it is a short post, I will quote in full:

Compare (2014):

Hilton Worldwide Holdings Inc. (“Hilton Worldwide”) today announced it has entered into an agreement with Anbang Insurance Group Co. Ltd. (“Anbang”), under which Anbang has agreed to purchase the Waldorf Astoria New York for $1.95 billion. As part of this long-term strategic partnership, Anbang will grant Hilton Worldwide a management agreement to continue to operate the property for the next 100 years, and the hotel will undergo a major renovation to restore the property to its historic grandeur…

Contrast (1989 — 25 years ago this month):

The Rockefeller Group, the owner of Rockefeller Center, Radio City Music Hall and other mid-Manhattan office buildings, said yesterday that it had sold control of the company to the Mitsubishi Estate Company of Tokyo, one of the world’s biggest real estate developers.

Richard A. Voell, Rockefeller’s president and chief executive, said Mitsubishi would pay $846 million in cash for a 51 percent interest…

China’s Anbang — which according to its website has $114bn in assets — is paying $1.3m per room, or $356 per day for 10 years, on FT Alphaville’s calculations.

A basic room at the Waldorf Astoria costs $329 a night, plus tax.

It looks as if the buyer is paying approximately 10x  annual sales per room (I say approximately because I assume that executive rooms and suites will fetch a higher price). This buyer must really have a very, very long-term horizon, or he is misallocating capital at a large-scale. And look, what a coincidence:even the transaction amounts are similar. Like China now, Japan looked like the country of the future in 1989. Does this simple comparison have predictive value? I think the answer is yes…

Pireus Bank Follow up: still do not understand what they are thinking

I started this blog with two posts (here and here) about Pireus bank – the largest banking group in Greece.

The stock aroused my interest as I learned that prominent value investors, such as David Einhorn, Seth Klarman and John Paulson had taken long positions in Pireus Bank (via stock or warrants). I basically tried to “reverse engineer” their decision-making process, i.e. try to understand where the value is by looking intensively at Pireus financial statements. To make a long story short: I could not find any reason to buy the stock: the balance sheet looked horrible, with steadily increasing NPL ratios and one-third of the book value of the bank due to a rare bird – a “negative goodwill” item booked as a profit from takeovers of failed Greek and Cypriot  banks. Just to explain: if this value (“negative goodwill”) is correct, it implies that shareholders of the taken over banks have been massively screwed due to the forced takeover, i.e. they were paid less than their assets were worth. This is theoretically possible due to the good political connections of Pireus Bank management (the current governor of the Greek central bank worked at Pireus in the past).

Anyway, the market disagreed with my analysis and even priced the Stock at a slight premium to book value (1.2x). The stock has derated somewhat since then (I wrote about it in April), but still trades at 0,92 x book!


What has happened to the fundamentals since then?

brief answer:

the NPL ratio has risen in Q2 2014 to 38,5% from 37,9% in Q1, i.e. asset quality has deteriorated further. Net profit ytd. is around EUR -80 million (unaudited Q2: + 164, Q1: -247), not as bad as it was but still no reason to assume this stock could justify a valuation of EUR 8.5 billion. By the way, as long as the NPL ratio shows no sign of falling I do not trust profit figures of any bank: a rising NPL book basically means that bank management cannot unload NPLs at book value as selling them would lead to additional losses. I am sure they would, if they could. But, it gets worse…

Dubious accounting practices at Pireus bank

I have had debates about Pireus bank with Klaus Kastner, a retired Austrian banker whose wife is Greek and,  I understand, spends a considerable time in Greece. He generously shares his thoughts about the Greek economy on his blog “Observing Greece” which I read regularly, also because I am still trying to understand what the gentlemen from Manhattan find valuable in this stock.

He recently had a piece about a deal between Pireus and Marfin Investment Group (MIG), a well-connected Greek conglomerate. The piece is worth reading in full and can be found here. For those of you lazy to read the post, here is a quick summary:

MIG is basically insolvent (negative tangible equity), bleeding cash and, oh, almost half its debt is in contractual default (I am taking Klaus’s analysis of the financial statements at face value here).  Nevertheless, Pireus bank managed to book a gain – presumably a release of previously booked loan loss reserves – of EUR 144 million by refinancing its loan by a convertible whose sole buyer was, drumroll, the bank itself. At least, now I know how they managed to book a profit of EUR 164 million in Q2!

Only I few days ago I wrote about my recent trip to Asia that I felt the business practices leave something to be desired there. I also wrote how he types of deals seen there would not be possible in Europe and the US. Well, I stand corrected (in record time): carrying the debt of a defaulted company, with no signs of a turnaround, at par is ridiculous and requires a blind eye by regulators and auditors.

(A word of caution: given that neither Klaus nor myself have full disclosure about the nature of the transaction we, of course, might miss important details about this deal).


For me there is no doubt that Pireus’s earnings are of very low quality. The same goes for its book value of which 1/3 is due to a “negative goodwill” item. I fail to see how the market can price this stock anywhere close to book.  The transactions mentioned above should raise all kinds of red flags with Einhorn or Paulson and I would have a few tough questions for management. I have never understood – and now understand even less – how they can touch this stock. Is it due to the institutional imperative of showing activity to your investors?