Tuesday, August 21, 2012

What I'm Reading - First Toronto Edition

I thought it would be interesting for me to note here, after a very long and good hiatus, what I was reading now that I am in Toronto. I will write in this vein occasionally, tracking with curiosity how my reading changes. For I expect it will, given that:

1) I am now in business school, so I will likely read more extra-curricular business articles;

2) I am in Canada, so I will likely start reading more Canadian political pieces rather than U.S. ones.

Without further ado then:

1) SCOTUSblog's Alexander Bickel symposium on The Least Dangerous Branch

Specifically, I've read and been intrigued by the following contributors:
In particular, I enjoyed this quote from Epstein's piece. His examples on the majoritarian difficulty are worth thinking about too.

"Indeed, I think that it is fair to say that most of my beliefs were crystallized in direct and conscious opposition to the message that he pounded into us day after day."

In particular, here are two choice quotes:

"The present confidence and enthusiasm of investors about the ability of monetary policy to avoid all negative outcomes mirrors the confidence and enthusiasm that investors had in 2000 about the permanence of technology-driven productivity, and in 2007 about the durability of housing gains and leverage-driven prosperity. Market history is littered with unfounded faith in new economic eras, and hopes that 'this time is different.'" 

"What’s fascinating about the present confidence and enthusiasm about central bank intervention is that investors have stopped actually listening for fact, and are increasingly hearing only what they want to hear."

3) An old posting on shale oil from Foreign Policy, in particular the "Dispatch from the Oil Patch" section. Emphasis added where bolded.

By keeping up a steady drilling pace, the oil production from the field will rise rapidly at first because the production from the new wells will exceed the loss of production for the old wells.  This is what has been happening in the Bakken. However, if the rate of drilling stays constant for a long time, the growth rate of field production will decrease, then plateau, then begin to drop, slowly at first, then accelerate to a higher rate[.]

And if prices drop significantly during the time when you would normally expect to see a high drilling rate (or if drilling costs get too high), you could see a sudden decrease in the rate of drilling, and a field like the Bakken will go from high growth to high decline really quickly. A drop of oil prices to $70 per barrel (of West Texas Intermediate) could create an extreme drop in drilling and field production really quickly.

Resource plays don't work if oil or gas prices are low.  A huge part of the risk is evidenced by the Barnett Shale. It worked great at $6 to $15 per thousand cubic feet, but it loses money like crazy at $2.50 per thousand cubic feet.  The problem is that you really get clobbered when you drill the wells when gas or oil is high priced, and then the price drops and you have to sell your oil or gas at low prices.  Billions and billions of dollars have been lost in the Barnett because of this.  If oil drops to $70 (WTI), a lot of people will lose money in the Bakken.

4) John Hempton's piece on capital allocation in a bubble (iron ore and China, in his opinion), with a view at Fortescue's balance sheet and income statement

What I like from this piece is a view of how gross margins changed through the commodity cycle, and of course the question about what happens to the more marginal producers when the cycle ends. In all likelihood, this time really is not different, a point that I made during an orientation presentation; and a point I think both James Montier and he makes.

BHP's EBIT Margins
2001                  2011
11.9%               65.3%
Fortecue's EBIT Margins
2001                  2011
Irrelevant           41.5%

I consider 2001 EBIT margins irrelevant for Fortescue because it also had a medical business at the time (albeit, it was in the process of divesting it). Hence the comparison to BHP might not be that reasonable. The comparison Hempton points to is 2011 margins for both. With simple math, you can see that Fortescue is a more marginal producer than BHP. So, the question, as Hempton puts it, is indeed what is the normalized profit and prices for iron ore and other mining. Is it going back to 2001 levels? Is it today's levels? Is it somewhere in between? I must note I default into "this time is [not] different" but other than that have no opinion, yet.

Interestingly, pieces two through four have a commonality about "this time is [not] different". This is one of the most valuable lessons I've ever had. Given how short term minded we can be, it is also the most difficult of them. Hence, why I enjoy reading John Hussman, James Montier, Jeremy Grantham and John Hempton.

Anyway, a good morning to everyone!