MFA Financial and Invesco Mortgage Capital: COME ON DOWN! You’re the next mREITs to succumb to the turmoil in repo markets and beg your counterparties to enter forbearance agreements!
Jokes aside, these are big ones. Invesco and MFA have $17.5B and $9.5B in current financing arrangements, respectively. Both missed posting collateral to cover their margin calls as of close of business yesterday. I don’t see a need to get into details about why this is happening, as you already know the story.
This is a big deal, though. You now have four different companies that need to (i) either convince all of their counterparties to enter into the forbearance agreements or (ii) dump their assets into the open market to raise cash and basically implode the mortgage bond market – simultaneously. I can’t imagine a scenario in which they can all convince their counterparties to lay off, as I’m sure there is overlap between who is providing these companies with financing. Some of these firms will have to go away, and it will be the smallest to liquidate first.
In any event, there is a fire sale looming in the mortgage bond market and it may get pretty ugly.
You always have to think bigger picture. Just yesterday I touched on the mortgage market unraveling and, in my hubris, declared I thought that Cherry Hill Mortgage would likely be the next victim. Obviously, having a direct competitor of MITT and NYMT be the next shoe to drop seemed likely – albeit it predictably boring. Then, out of nowhere, Bloomberg drops this bomb about ED&F Man just to shake things up a bit.
To be clear, ED&F is not in the same business as MITT or NYMT. They’re a traditional broker-dealer, making markets and structuring products in a variety of different assets classes (they’re traditionally an agricultural and commodity-focused merchant). The firm is over 200 years old and much more well capitalized than the mREITS so, were things to get even more dicey, they would likely be able to source liquidity in some way, shape or form to avoid disaster.
Anyway, back to the fun stuff. ED&F transacts in a space known as the TBA (to be announced) market. TBAs are pass-through securities issued by Fannie, Freddie and Ginnie. It’s essentially a contract to purchase a mortgage bond in the future. To be clear, you’re agreeing to buy pools of mortgages in the future but you’re unaware of which pools at the time of the trade. This seems risky at face value, but the securities are issued by government agencies and are normally of the same general quality, so the market runs efficiently and the risk is generally well understood.
It seems that ED&F was long TBAs, essentially taking a long view on the price and performance of U.S. mortgages. The thing you fear when long mortgage bonds (besides non-payment) are falling mortgage rates. When mortgage rates decline, people generally tend to refinance their mortgages. This (i) eats into the interest payments an investor had planned on receiving when they bought the bond and (ii) forces them to invest the recently returned principal into lower-interest mortgages, leading to losses. As prudent risk managers, ED&F hedged against this by shorting 10-year treasurys because normally mortgage rates are inextricably tied to this benchmark. If mortgage rates were dropping, so would the yield on the 10-year, thus mitigating much of the downside risk for ED&F.
Wrong! Times are not normal, adjust your hedging strategy accordingly. The long mortgage / short treasury trade has exploded in the last few weeks, as investors have dumped mortgage bonds over non-payment fears related to COVID-19 and piled their cash into U.S. treasurys as a flight to safety. As a result, ED&f posted $100M in additional collateral just on Friday.If the precipitous fall in mortgage bonds continues, the firm will likely be hit with additional margin calls, further straining their liquidity profile.
Again, I actually do not believe that ED&F Man is in any real trouble. They’re relatively large, liquid and have great counterparty relationships. If they need to tap equity or debt markets to raise additional capital, I don’t doubt they’ll be able to do it. That said, they’re not the only firm with this trade on at the moment, so if they’re feeling the heat, I’d imagine some other firms are, too.
In my last post titled “I’m Back. Markets Are Not.”, I spoke about how repo market liquidity was drying up and why it would impact counterparties that rely on the market for financing. In the post, I used mREITs as an example of how dire the situation had become, as investors began dumping their shares hand over fist in an effort to get ahead of any possible solvency issues:
“The equity market is essentially looking at these companies and saying, “Yeah, we’re gonna wake up one morning and one of these guys won’t be able to open for business” (read: bankruptcy). If the repo market completely dries up, there will be another Bear / Lehman event. The banking business is entirely built upon borrowing short to lend long, so any material interruption in that business model will prove absolutely fatal for some of the more highly-leveraged financial institutions.”
As of 6:30am ET this morning, we received our first look into how bad it had really become. AG Mortgage Investment Trust (NYSE: MITT), a publicly traded hybrid mREIT managed by Angelo Gordon, filed an 8-K stating that they had missed posting collateral Friday evening for their margins calls, and that they do not expect to be able to meet expected margin calls later this week. As a result, they’ve entered into discussions with their financing counterparties on forbearance agreements in order to avoid triggering a technical default under their current financing agreements. MITT’s stock cratered, both common (-38%) and all classes of preferreds (-66%). The only reason the common wasn’t down in tandem is because it had gotten absolutely massacred as of late, but pref investors up until now thought they may be spared from the carnage of dividends cuts / suspensions.
It’s hard to say what exactly is happening at MITT, but I think I have a pretty good idea so I’ll take a stab at it. MITT has an investment portfolio of $4.3B, but only $3.4B is comprised of relatively liquid mortgage securities. The rest of their portfolio is made up of illiquid whole loans, commercial loans and investments in affiliate entities (and very, very little cash). Alongside those investment assets, MITT has $3.5B in current financing arrangements. In and of itself, this isn’t a problem – MITT’s business model is to utilize leverage in order to juice returns for their investors. The problem is that the market for mortgage securities is, to put it nicely, in a state of uncertainty. Investors are worried that in light of the COVID-19 pandemic, mortgages will not be getting paid – which would impair the mortgage bonds that MITT owns and effectively eliminate the bid for the bonds in the open market. As a result, investors are dumping the bonds and as the value of the bonds decline, MITT’s financing counterparties are demanding they post more collateral to support their positions.
Enter the negative feedback loop. What I believe is likely happening to MITT is simple: (i) the value of the bonds they own decline; (ii) they’re required to post additional collateral; (iii) they become a forced seller of the bonds to raise cash at whatever respectable bid they can find; (iv) forced selling at buyer-friendly prices leads to larger bond price declines; and (v) MITT is now required to post more collateral. Trying to sell securities into a down market that’s experiencing liquidity issues in an effort to cover margin calls will usually result in one thing: insolvency. If they can’t convince a large majority of their counterparties to enter forbearance agreements, it will likely be impossible for MITT to liquidate assets in an orderly manner to fulfill immediate repayment obligations. Barring some sort of miracle, MITT is essentially toast.
I don’t want to pick on MITT though, because they’re not the only one going through this (and they won’t be the last). This evening, New York Mortgage Trust (NYSE: NYMT) issued a press release stating that they too were unable to meet margin calls issued for today. As a result, they’ve preemptively suspended all dividends on common and preferred shares, likely diverting that cash to help shore up their collateral position. I suspect we’ll see more actions like these from competitors and, as a betting man, I’d put my money on Cherry Hill Mortgage Investment Corporation (NYSE: CHMI) to be the next shoe to drop.
The regrettable part about this mess is that to a large extent, these firms didn’t really do anything wrong. They acted within the manner they told investors they would, using leverage to finance the U.S. mortgage market. The bonds they hold aren’t dogshit like they were during the GFC, they’re just being adversely impacted by some black swan virus that threatens to decimate the global economy. That won’t matter, though, people will still peg them as reckless when shit hits the fan:
In any event, I think this whole thing is just getting started. The credit markets remain strained despite all of the help pledged by the Fed. The government is amazingly repeating the mistakes they made during the GFC by bitching and moaning about fiscal stimulus. Markets will likely continue to decline and the real economy will continue to bare the brunt of everything. As I see this all unfolding, I’m reminded of a great quote from everyone’s favorite Marxist, Lenin:
“There are decades where nothing happens, and there are weeks where decades happen.”
There is a chance we’re living through a few weeks that will define the next decade and beyond. The bankruptcies of some obscure mortgage funds won’t cause the next great financial upheaval, but they’re sure as hell trying to let you know that one is lurking around the corner.
The bull market is dead, LONG LIVE THE BULL MARKET!
This fucking virus, man.
I’m not an epidemiologist or virologist, so I’m just going to focus on the market impact here. Cities around the world are effectively shutting down in an effort to contain COVID-19. Aside from the loss of life, these measures are also presenting real challenges to the short-to-medium term viability of the global economy. Credit is freezing up, equity investors are getting hosed and the real economy is suffering from reduced spending. So, what’s going on here?
The credit markets are shutting down, a la ’08-’09.Anyone that lived and/or worked through the GFC knows this all too well.
The first major problem is the commercial paper market. At a high level, this is where corporations come to finance their payroll, accounts payable and other short term costs. Essentially, a company will issue a short term note (usually for a few days but no longer than 9 months), issued at a discount to the par value of the note, in exchange for cash now. The notes are issued at a discount to par which then becomes the investors’ return upon repayment. Since we’re talking unsecured notes, the credit quality of the companies issuing commercial paper is relatively high quality. This is a very mature market that normally functions incredibly well.
Enter COVID-19. As citizens around the world hunker down to “flatten the curve” of new virus cases, the obvious concern for investors has become the implications of what it means to shut down the global economy and how that impacts the liquidity profile of companies. We should even be discussing whether certain companies will be able to operate as a going concern in the future. Worries about liquidity have forced the hand of commercial paper investors: if they’re not sure whether you’ll be generating enough free cash flow through ordinary operations to pay back the notes, then they’re also not sure they’ll lend you the money.
Were the entire market to seize up like it did in the GFC, the effects on both the real and financial economy would be devastating. You’ll see companies struggle to make payroll and pay their bills, which will lead to lay offs and plummeting share prices as equity investors try to assess what it all means for profitability.
The second major problem we have on the funding side is the repo market. This is where banks and financial institutions come for short term financing (similarly to the commercial paper market for companies). A borrower will sell high grade paper (usually government bonds or agency-backed paper) to investors, with a contractual agreement to repurchase the collateral from the investors at a slightly higher price in the future. The repo market is massive, trading anywhere between $2 trillion – $4 trillion EVERY. DAY.
There is an immense amount of friction within the repo markets at the moment. Banks see that a recession (possibly depression) is now inevitable, and there will absolutely be some corporate casualties. They’re becoming more and more skeptical of lending to each other and any market analyst worth their salt knows this is always the kiss of death. The Fed has implemented a handful of programs in excess of $2 trillion to keep the repo market open, but the impact of even those efforts has so far been, muted. If you need just one example of how exacerbated the issue has become, look no further than the mREIT space.
While most people are familiar with the equity REIT space (buying properties and profiting from rents and/or capital appreciation), mortgage REITs (or mREIT) are a bit more opaque. Their business model is to borrow in the repo market at 4-5x leverage in order to finance the acquisition of mortgage-backed securities or originate whole loans themselves. Here’s a one month look at what happens to a highly-leveraged repo participant’s share price when the market starts to freeze up:
That’s not great! The equity market is essentially looking at these companies and saying, “Yeah, we’re gonna wake up one morning and one of these guys won’t be able to open for business” (read: bankruptcy). If the repo market completely dries up, there will be another Bear / Lehman event. The banking business is entirely built upon borrowing short to lend long, so any material interruption in that business model will prove absolutely fatal for some of the more highly-leveraged financial institutions.
But here’s my number, so call me maybe…
Equity markets are plummeting. Gold was rallying but then fell off a cliff. Bonds rally and sink every other day. Oil isn’t remotely putting up a fight. Even fucking bitcoin looks like shit. Everything is selling off. How can that be? Where are the safe havens? Oh, that’s right:
SELL IT ALL! The ultimate feedback loop. Markets spiral > PMs sell to cover margin calls > forced selling tanks markets further > PMs sell more to cover more calls.
The stock market has been on an 11 year tear. The economy has been on fire, juiced (perhaps irresponsibly) by the Trump tax cuts. Credit has been pretty loose in a post-GFC era. It’s not difficult to imagine why portfolio managers around the world borrowed money to buy stocks and, to be fair, I don’t think you can ask a PM to hedge for pandemic-related exposures, either. After all, they don’t make a derivative for that (paging all structured products desks).
That said, none of that matters in this moment. The leverage in the system has exacerbated the equity sell off we’re seeing now, and it’s impact is going to be felt not just by fund managers, but by anyone with a 401-k, IRA or brokerage account. Those are real losses that are going to trickle up into the economy via reduction in consumer discretionary spending.
C.R.E.A.M.
The dollar is absolutely ripping, no surprise. There are a few reasons for this outside of the traditional safe haven trade.
The first is that since the U.S. capital markets are so dominant in the global economy, international investors have a lot of U.S. exposure. Typically, they’ll hedge their FX risk by selling USD and buying their local currency in their portfolios. The problem is that when U.S. markets start collapsing or fund managers begin selling, they’re left with hedges that are notionally too large for their overall U.S. equity exposure. This leads the international fund managers to scramble for the dollars needed to pare down their USD shorts in their portfolios.
The other reason, which hasn’t been in the headlines yet, will end up being the Eurodollar market. A Eurodollar is essentially a USD-denominated bank deposit that lives outside the U.S. financial system. The purpose of this market is avoiding U.S. capital requirements. In a Eurodollar transaction, an international bank will issue a short term deposit instrument to investors that will be denominated in USD. The deposits immediately become a USD-denominated liability on the bank’s balance sheet. This is all well and good in prosperous times. However, the rapid ascent in the value of onshore dollars during a crisis has a devastatingly deflationary effect on the international bank’s USD-denominated liabilities. Every time the USD increases in value, it costs more money for the international bank to repay the deposit instrument (their liability). This will likely force the international banks to go to market and purchase dollars as quickly as possible to avoid any more losses, akin to a short squeeze:
Combine the traditional safe haven trade, a general unwind of FX hedges and a Eurodollar squeeze, and you’ve got the recipe for a global dollar funding shortage – better known as a good ol’ fashioned liquidity crisis.
Where do we go from here?
The pain is likely to just be getting started. As quarantines become more prevalent, so will their impact in the economy. Institutions will continue to have difficulty funding their operations and share prices will continue to fall. Aside from markets imploding, however, there will be real human costs to this crisis.
There are thousands of restaurants and bars across the country (and millions across the world) that will never open again. Those people will lose everything and so will their employees. The supply chain is going to become increasingly strained as borders shut, likely inducing shortages of some goods. People are going to lose their savings, and that will take an indescribable toll on some.
Who knows what the next 12-18 months holds in store for everyone. All I know is that it’s getting weird out there and I’m not sure I have enough wine stockpiled. All we can do is sit back, go cash and enjoy the show.
Waiting for the coming recession is going to be like ordering an UberX: you know it’s going to be a terrible ride, but you won’t really know just how bad until that black Camry with seat protectors pulls up.
Bill Ackman had the idea to raise a permanent capital vehicle a few years ago via a closed end fund (CEF). Without getting too much into it, many times a CEF’s stock will trade at a discount to its net asset value (NAV). This can happen for several reasons: (i) the fund has a high concentration of illiquid assets, (ii) it may have an outsized amount of leverage within the vehicle, (iii) it may just be a function of the yield / distributions, etc. Many times when the discount persists, funds will use cash flow to buy back stock, close the discount gap and keep investors happy. Bill Ackman is not doing this. He has instead decided to raise $400M in new debt and ante up, which has rightfully pissed off investors. Their argument is essentially:
“Look – we understand using leverage to increase returns for equity investors, but there are two ways to do that. Instead of raising new debt to purchase additional assets, why wouldn’t you just buy back a bunch of stock to reduce the discount to NAV? You could’ve easily done that and gotten your leverage ratio to the same levels as you did by borrowing the new money and forcing additional free cash flow to interest and principal payments.”
I’m not gonna lie, either – they’re right. It really doesn’t make any sense, when you have two options for levering up, to choose the option that is less advantageous for your shareholders – unless you understand Bill Ackman. AVI alludes in the following quote that Billy Boy is motivated by one thing only – greed:
“We note Bill Ackman’s comments in PSH’s annual report on buybacks and leverage: “Buybacks have other drawbacks as they reduce our shareholders’ equity and increase our leverage. We would not be surprised to find that a higher leveraged PSH trades at a greater discount to NAV when compared to a less leveraged PSH”. Given gearing was at 20% when this report was written and the new debt issue will see this increase to 25%, it seems Bill’s aversion to an increasing leverage ratio could more accurately be described as an aversion to shrinking the assets on which management fees are earned.”
While true that Ackman would lose fee revenue by shrinking the equity float, this isn’t why he’s chosen to forgo that strategy. Anyone who has been following Ackman throughout his career knows he isn’t motivated by greed – he’s motivated by his insatiable need to prove how great an investor he is. The real reason he’s decided it’s better to lever up with new debt vs. shrinking the float is that he believes he has a real, long term winner lined up and needs some capital to play with. In his mind, he is going to out gain any short term stock improvement from buybacks with good old fashioned alpha generation.
You have to remember, though, that Bill Ackman is the best, but he’s also the worst. He’s the guy that correctly called the subprime crisis and made a killing on his MBIA play. He’s the guy that parlayed a $60M investment in General Growth into a $1.6B stake post-turnaround. He’s also the guy that blew up his first fund, Gotham Partners, by piling capital into a portfolio of illiquid investments and golf courses. He’s the guy who lost, quite publicly, billions of dollars on a poorly executed bet on Valeant. Lastly, he’s the guy who picked a fight with both Herbalife and Carl Icahn, only to lose more money and his own dignity, on national TV, in the process.
That’s why I have zero sympathy for this rinky dink fund that is upset with this atrocious allocation of capital. Ackman is undoubtedly smart. Ackman is undoubtedly smug, as well. You pay him to manage your money, not the other way around. So don’t sit there and be a backseat driver while he’s out here picking winners (or massive losers). That’s always been Billy’s style and your diligence team should’ve picked up on that. Regardless, you’re about to make a lot of money or lose it all. The only thing you can do is sit back, enjoy the ride and just:
“The gift that keeps on giving: the 2008 financial crisis.”
Well six months later that statement still rings true, of course, as we see one of the juicier stories of the crisis resurrecting itself: Goldman’s family of Abacus CDOs. While this isn’t the same exact Abacus deal that placed Goldman and Paulson & Co. into the crosshairs of regulators, I can’t pass up an opportunity to discuss some crisis-era structured credit.
Goldman sold investors a synthetic CDO called “Abacus 2006-10” in the early spring of ’06. A synthetic CDO is a bit arcane of a concept but not that difficult to understand if it’s explained properly. Basically, Goldman had exposure to a bunch of mortgage bonds, known as reference obligations, and they were looking to hedge the risk of the bonds from default. They found a group of savvy investors to fund a special purpose vehicle (“SPV”) that would write Goldman a credit default swap on their reference obligations and Goldman would pay the investors quarterly premiums for that protection (just like insurance). But, if any of the reference obligations defaulted, then the investors would have to pay Goldman on that loss. At the end of the trade, the investors get back anything that’s left in the SPV (hopefully 100% of their principal) plus the premiums they had been receiving all along.
When the investors buy into the CDO, they don’t keep a bunch of cash in the SPV, though. That cash is managed by Goldman to build out a portfolio of high quality bonds, known as the collateral pool. Then, if any reference obligations default, the collateral is sold down to pay out Goldman. However, if nothing defaults then Goldman gets to keep any of the carry generated by the collateral pool – the CDO investors see none of it (which may sound unfair at first). But! While Goldman gets to keep any carry generated, they also need to reimburse any losses the pool suffers from poorly performing collateral so, ipso facto the CDO investors shouldn’t care about the collateral pool performance, just the reference obligations (which is exactly what they signed up for). The performance of the collateral pool has no bearing on the CDO investors’ return profile – only reference obligation performance does. It sounds quirky but this is just how the synthetic CDO market is structured and it’s players can at least agree on that much.
Here’s where it gets hairy. This distressed credit fund, Astra Asset Management, is claiming that Goldman breached the CDO’s collateral pool requirements in 2013 by purchasing riskier bonds that didn’t meet quality requirements laid out in the indenture. They’re now suing to terminate the CDO contract as of 2013 and insisting that Goldman return $124M in default payments that they received from the CDO over that period. On top of that, wouldn’t you know it, the CDO is overcollateralized by ~$70M and Astra wants that too. Although, it seems pretty clear cut the excess collateral belongs to Goldman – not sure what the legal basis would be for that.
Goldman’s counter to all of this is that the indenture is pretty clear that they’re responsible for any collateral shortfalls like I mentioned above, so even if they technically did breach the agreement they never put any CDO investors at risk as they’d make the pool whole. That makes sense, but it also makes sense that if there’s a technical breach of contract the infringed upon party has some sort of recourse. In the end, I doubt this moves works for Astra but kudos to them for trying. Either way, I’m just happy to be talking about Abacus deals again.
I love these types of stories. Pull out a big Wall Street pot and mix in equal parts of leverage, some win at all cost trading and an esoteric financial instrument. Kick in a dash of regulatory incompetence and you’ve got yourself one delightful tale about how someone inevitably blew up their book and caused some turmoil in the broader market.
We see these messes pop up every so often and they usually play out the same way: (i) someone has a “brilliant” trade that almost always includes derivatives or a structured product; (ii) they get caught flat-footed as the market turns against them; (iii) they try and trade their way out; (iv) other market participants catch wind of their troubles; and (v) the book blows up and regulators step in. The only thing that really changes is the asset class. Well gather round, folks: today we’re talking about power markets.
I’m not sure if the general population understands how wholesale power markets even work, so I suppose a quick intro couldn’t hurt. As a result of deregulation in the 90s and early 00s, two distinct market structures developed: (i) traditional, regulated markets in which a single utility company is responsible for generating and transmitting power to both wholesale and retail end users and (ii) RTO/ISO markets where private companies own the generation plants and transmission lines of a particular region. The generation companies participate in auctions, run by the RTO/ISO, for the ability to sell wholesale power into the market based on the energy efficiency of their plants. Once they win the auction, they’ll pay transmission companies a toll to use the grid to deliver the power. In layman’s terms, power generation companies say:
“Hey – we can provide xx megawatts of power at this price because we have a brand new, natural gas powered plant. The other guy who burns coal can’t come close to our price so we should win the bid.”
And that’s exactly what happens. The company with the new, more efficient plant is awarded the contract and is now obligated to provide a fixed amount of power into the system, in the future, at a certain price – done and done. In a vacuum the system works perfectly – but the world doesn’t operate in a vacuum. Sometimes power demand is higher than normal (like during a heatwave) so the system becomes congested, leading to higher tolls for the power plants and eroding their profits in the process. Well here in America we like profits, so the RTO/ISO markets decided to develop a financial product to hedge against fluctuations in the tolls, which is where our friends at GreenHat Energy come in.
I don’t want to get into all the nuance of what happened with these guys but here’s the skinny. The two traders, Andrew Kittell and John Bartholomew, took a look at historical congestion trends in the PJM market (the largest RTO/ISO in the country) and decided not only would that historical pattern continue to play out, it would be exacerbated into the future. They then went out and amassed a huge portfolio of hedges that would payout were their thesis to come to fruition (mind you these guys weren’t hedging exposure, they amassed a naked, speculative portfolio of power derivatives). The problem for these two rocket scientists was that they didn’t factor grid equipment upgrades / repairs into their congestion models. The aforementioned upgrades reduced congestion rates materially over the last few years, slowly eroding the value of their portfolio until 2018 when the floodgates opened.
According to RTO Insider, the derivative portfolio represented a hedge on 890 million MWh of generation – an absolutely massive financial liability for a fund of their size. The value of the portfolio continued to deteriorate and is now facing estimated losses of $145M… and counting. It doesn’t even matter for GreenHat, either – they’re already in default and thus the losses will be absorbed by PJM and it’s participants (including retail customers). So how were these two guys able to use so much leverage to put together, and subsequently blow up, a portfolio and pass the losses on to everyone else? Put quite simply the problem was poor market structure and lax regulatory oversight.
There were two key weaknesses in the way PJM ran the market that brought GreenHat where it is today. The first is that market participants don’t pay for the contracts in full until settlement which is normally a few years out. GreenHat was able to operate on 100% margin and, as long as their trade was profitable at settlement, never had to worry about paying out on losses (kids, hubris is a terrible risk management strategy). Now is the point where you should be asking yourself about collateral requirements:
“Well, sure – they didn’t need to pay out on the contracts yet, but of course they had to post collateral as the portfolio fluctuated in value. Right?”
Wrong, actually! The collateral requirements are determined on a portfolio-level basis, not a position-level one. This past April, PJM changed it’s credit policy for market participants which would have resulted in a $60M collateral call for the GreenHat portfolio. However, market participants were given thirteen months to comply with the changes and rework their trading strategies. GreenHat used this window to amass enough new, profitable positions on 100% margin to negate the $60M collateral call coming down the pipe for their losing positions. Lipstick, meet pig. The window dressing worked for a bit until those positions moved against them as well, sewing the seeds of GreenHat’s demise and sending PJM and FERC scrambling to stop the bleeding. Regulators and market participants are currently kicking around different ideas on how to best equitably absorb at least $145M in losses.
I’m not exactly sure these guys are two of the most prudent fiduciaries out there. However, while I wouldn’t sign up to be a LP in their next venture, I have to point out that they operated within the framework that PJM and FERC had laid out for them. This will obviously force PJM and the rest of the RTO/ISO markets to restructure their credit policies going forward, hopefully they can figure one out that works this time.
First things first: the blog has been eerily quiet for the last two and a half months. Yeah well, I was a little busy with work and enjoying my summer – sue me. I don’t think I missed any big stories other than Elon Musk trying his best to destroy TSLA’s stock price or every bitcoin speculator piling their money into weed stocks – but in any event the blogging engines are fired up and as a first order of business I’d like to touch on something very dear to me: energy markets.
I wrote a blog in late June discussing the lack of midstream assets / capacity in the Permian and what impact that would have on regional WTI and nat gas spreads. You’ll recall that Scott Sheffield, CEO of Pioneer, predicted that WTI Midland would trade at a discount of $25/bbl within the next quarter. Well here we are three months later and the discount is ~$15/bbl – not quite $25 but still a sizable Midland / Cushing spread. On top of that, Permian natural gas is trading at an all time low of $0.66/mmBtu compared to Henry Hub product which currently sits at $2.98/mmBtu. This is bad news for Permian producers. The worse news, though? It’s about to get worse as refineries enter maintenance season this fall / winter. As refineries shut in for scheduled maintenance, the demand for crude will drop in lockstep. With even less demand for crude in the markets, Permian producers will be forced to reduce prices even further, eroding already delicate cash flow profiles.
It’s likely that some producers will have to shut in production and move rigs away to save cash for the spring and summer months. You may even see some consolidation among smaller independents and private equity drillcos – although many of these players may be too indebted to make a transaction like that pass muster with their boards / investment committees in this environment. Whatever does happen, it will be interesting to see how it plays out. One thing’s for certain: the E&P space is no stranger to booms and busts, good times and bad. The industry always makes it through, it’s just a matter of what players are left to fight in the next round.
I’ve been hearing a lot of chirping around these parts about a trade war with China.
Talking heads across the political and economic sphere have voiced grave concerns about the Trump administration’s foray into hardline trade negotiations with China. Conventional wisdom is that China has entrenched its neo-mercantilist economic model so deeply into the globalized economy that any challenge to their long-standing goal of economic supremacy will prove to be damaging and, possibly fatal. With that, to the detractors I say, “Take a long walk off a short pier.”
Now, before I explain why that’s not the case, I have to point out how terribly embarrassing it is to have so-called experts espousing such a fatalistic view toward America’s economic future and our ability to determine it ourselves.
“Welp, there’s nothing we can do to stop them so we may as well play nice and hope for the best.”
Anyway – In order to understand why a trade confrontation with China is long overdue, it’s important to have at least a high level understanding of how American companies have to operate within Chinese borders. It’s no secret that the Chinese market, through its expanding middle class, is a key growth engine for American companies. That said, operating and/or selling in China often comes with high entry fees such as handing over trade secrets and intellectual property to the government, forcing American companies into JVs with other state-owned enterprises and already high tariffs. As the communist government has tight controls over the mainland economy, the trade secrets and IP are almost always handed over to local Chinese companies in order to leverage their depressingly low labor costs to replicate (steal) American products and compete with American firms in the global market. In other words, American companies are collecting large upfront payments via initial sales, but giving away future profit and market share to their Chinese competitors (and government).
So, what is America to do here? Furthermore, how is China supposed to respond? Most importantly, who comes out on top? Well, let’s take a look at the tools each side has at their disposal in an increasingly ugly trade spat and see why America will inevitably come out on top.
Tariffs v1: The Trump administration campaigned on imposing tariffs on Chinese-made goods and they sure did deliver. As word spread Trump was serious about the taxes, the Chinese government compiled a list of their own which was released almost immediately after Trump’s were announced. It appears as if that round was a wash, but in reality we can chalk this up as a victory for America. While past administrations have spoken about getting tougher on China, rarely has anything ever been done on this scale. This shot across the bow brought China to the negotiating table and, while the first round of talks fell apart, the U.S. got what it wanted in opening up a dialogue regarding the restructuring of U.S. – China trade relations.
Tariffs v2: The original tariffs that Trump imposed largely targeted raw materials, which China then mirrored in its response. This was an attempt to protect consumers from the direct impact of tariffs and lay the burden on companies. While there would obviously be marginally higher prices for consumers in order to compensate for higher production costs, they likely wouldn’t move the needle enough to have a material impact on wallets. Round two of tariffs have moved from raw materials to finished goods: a battle China can’t win and doesn’t want to fight. This means that the U.S. consumer has finally been dragged into this kerfuffle and will now be paying noticeably more for many finished goods imported from China. The problem for China is they need us to import more than we need them to export. I mentioned in the second paragraph that China is practicing neo-mercantilism. They’ve built their entire economic model off utilizing tight capital and currency controls, low labor costs and raw materials to encourage exports and discourage imports, with the hope of becoming the world’s indispensible manufacturing hub. We’ve always been China’s best customer in this model (we still are and likely will be going forward). We don’t have to be, though. Labor conditions in the U.S. have never been tighter and the Trump administration has been looking for ways to rebuild our manufacturing base while providing high-paying jobs. If the severity of tariffs or length of time in force were to increase, it’s likely that companies manufacturing abroad and importing to America would slowly begin to onshore production here. Not only would that avoid tariffs, but it would likely improve supply chain economics by consolidating operations locally and reducing transportation costs in a post-globalization world (which is where we seem to be headed). In fact, you’ve already seen this with Foxconn’s $10B capital investment in Wisconsin to build a LCD screen manufacturing plant. My point here is we aren’t really as reliant on China for manufacturing purposes as people think, and as the tariffs will be targeted on specific goods and not broadly implemented, I’m confident America has the work force, technology and guts to onshore any lost Chinese capacity and produce those specific goods here.
Currency Controls: A key component of any mercantilist economy is the aggregation of foreign currency reserves in order to help the local government more tightly control the value of its own currency. The idea is that U.S. dollars flow into China in exchange for goods and those foreign reserves are then actively bought and sold by China in order to keep its currency at a value it believes is optimal for driving exports. There has been chatter that instead of retaliating to Trump’s second round of tariffs with tariffs of their own, China may simply begin selling RMB and buying USD in order to make it cheaper for Americans to import Chinese-made goods, thus circumventing the impact of Trump’s tariffs and keeping trade humming along. This is actually a relatively effective strategy for China both from an economic and geopolitical standpoint. Economically it suffers very little and geopolitically China comes out looking like the adult in the room by not escalating the tariff fiasco, even though they’re doing it stealthily. The problem is that this mechanism’s effectiveness is likely capped as China is a member of the WTO. The Trump administration, since day one, has railed against China, calling them a “currency manipulator” and accusing the government of keeping the RMB artificially low in order to drive exports to America – even though at the time of Trump’s inauguration the RMB was relatively strong historically speaking. It didn’t make sense at the time, but one has to wonder if they were setting the stage for a trade war they knew they’d eventually launch and were using bluster to pre-emptively target and draw attention to one of China’s most effective weapons. Any prolonged, material weakness in the RMB through government intervention would likely result in cases brought in front of the WTO, which the U.S. has quite the track record of winning.
Raw Materials: This is an area where China has our number as it stands now. Chinese companies have, quite presciently, amassed large positions in raw materials all around the globe – especially in the rare earths space, which is absolutely critical to technology production. If push came to shove, China could inflict quite a bit of damage on the U.S. by restricting or outright banning the sale of some raw materials into the U.S. or to U.S. companies. Again, we don’t have to be so reliant on China for supply of raw materials. According to the USGS, the U.S. alone boasts a $6.2T supply of minerals and rare earths – so our problem is largely self-inflicted: regulatory burden. The permitting process to excavate a new mine in the U.S. is a grueling, years-long undertaking that many mining firms aren’t willing to endure (with good reason – if there isn’t a need to mine and pollute our ecosystem we should refrain from doing it). Things are changing, however, as Trump signed an executive order last December to increase critical minerals production domestically in order to end America’s “vulnerability” to China. Despite this, I will give this round to China as they would be able to turn off the spigot relatively quickly, leaving the U.S. scrambling to source enough materials to meet production needs. In the long run, though, America has the flexibility domestically and relationships abroad to diversify our mineral supply chain – and we should.
Capitalism / Open Economy: This one isn’t even close. Despite China’s ascendance on the global stage, the U.S. has built the deepest, most dynamic economy the world has ever known. The ability for individuals to raise capital, innovate and cash out has given the U.S. one major, distinct advantage over China: human capital. People flock to America to learn at our universities, work for our companies, invest and, frankly, to have a better life. The same can’t be said for mainland China, or many other places in the world, either. This is our ace in the hole. This is what glues all of my other arguments together. The Chinese have built a powerful economy through brute force and coercion, not opportunity and profit. Were a trade war to actually break out in a prolonged fashion, the U.S. economy would handily outlast the Chinese as our system would likely adapt to new opportunities, whereas the Chinese government would need to devise and implement a new strategy through bureaucracy and decree. Toss this one to the U.S.
That’s that. The United States has been far too complacent for far too long when it comes to trade. We’ve always been proponents of free trade and open markets and we always will be – but we can no longer turn a blind eye to the hollowing out of our finances by third parties at the expense of our citizens. This isn’t about reckless nationalism. It’s not about blowing up the global economy. It’s about math – that’s all.
This is a story that has been making the rounds over the last few days, but for the energy-initiated, there is no surprise here. I actually touched on this topic back toward the end of March in a post titled “Here’s the Thing About Energy Markets…”, in which I spoke on the negative impact that the MLP model would eventually have on Permian asset prices. The idea was that MLPs were forced to shed debt and assets after the oil rout, using most of their FCF to do so, which prevented any meaningful infrastructure development going forward. This all happened in concert with private equity capital piling into prime, Permian acreage at fire sale prices. I posited that while acreage value and production were reaching all time highs, there would inevitably be logistical constraints around moving product to refineries, which would force producers to begin discounting their product to ensure it was sold downstream.
So where do we stand, just three months later? Here’s Bloomberg:
“We will reach capacity in the next 3 to 4 months,” Scott Sheffield, the chairman of Pioneer Natural Resources Co. said in an interview at an OPEC conference in Vienna. “Some companies will have to shut in production, some companies will move rigs away, and some companies will be able to continue growing because they have firm transportation.”
While nothing Sheffield said is overly concerning regarding how producers will manage capacity constraints, it is a notable admission from the CEO of a company who announced a plan to divest all non-Permian assets and invest heavily in West Texas, that not all is well in America’s super basin. They say necessity is the mother of all invention, and wouldn’t you know it upstream production is no different:
“The problem has grown so bad that oil companies have been forced to load crude on to trucks and drive it hundreds of miles to pipelines in other parts of the state.”
Truthfully, shipping crude via rail and truck isn’t that unorthodox. In fact, this was a primary method of transport when the Bakken exploded in popularity, as North Dakota was never really known for its logistical prowess. What is unorthodox is that the most prolific play in American history has resorted to such an elementary solution because nobody was a prudent enough thinker to understand the correlation between production increases and infrastructure.
The issue now becomes what the impacts of capacity constraints are on price and how that will impact the broader oil markets. Scott Sheffield thinks that “…West Texas Intermediate crude at Midland in the Permian is likely to trade at a $25-a-barrel discount to price at the industry’s hub in Cushing, Oklahoma.” – great news for arb guys. While I haven’t done the work on a specific discount price, Mr. Sheffield is likely correct directionally. However, that’s a relatively micro-economic answer from my perspective, as I think there is potential for more disruption than tighter cash flows.
Depending on how long the constraints persist, less and less Permian product making its way downstream will be bullish for the overall oil and distillate markets (crack spread traders, rejoice), but bearish for Permian acreage. While I wouldn’t be concerned by the market’s ability to weather logistical problems and the pricing issues that come with them, I would be concerned about how any cash flow disruptions would impact heavily indebted private equity acreage assets. Should lower Permian prices be around for the long haul, the problem for PE firms (and their investment committees) becomes twofold: the first being that their cash flow profile is deteriorating, impacting their ability to service debt. The second is that the lower prices and inability to sell product into the market is killing their acreage value. The first indication that funds are looking for the exits could result in a mea culpa moment for everyone that plowed into Permian acreage in 2016, forcing a fire sale across the basin as nobody wants to be left holding the bag.
I don’t think this is a terribly likely scenario, but coming from a guy that worked in energy private equity from 2014-2017, I wouldn’t write it off, either. We’ll see what happens going forward, at the very least it’ll be interesting.
