Monday, May 18, 2015

Review of Enriching the Earth: Fritz Haber, Carl Bosch, and the Transformation of World Food Production by Vaclav Smil

Very typical of Vaclav Smil, we have Enriching the Earth, about the Haber-Bosch invention of synthetic nitrogen fertilizer, which was once the "holy grail of synthetic inorganic chemistry." He calls it the most important invention ever because the fixation of nonreactive, atmospheric, molecular nitrogen into usable form is alone what has allowed the world to swell to seven billion people.

Leibig's law of the minimum says that plant growth is limited by whatever substance is present in the soil in the least adequate amount. Many times, this is nitrogen, which is why most of the world's civilizations independently discovered intercropping of legumes in order to add nitrogen to soil, as early as 12,000 years ago.

Liebeg described agriculture's principle objective as "the production of digestible nitrogen," and as a 19th century chemist noted, "every vital phenomenon is due to some change in a nitrogen compound and indeed in the nitrogen atom of that compound".

But nitrogen was very scarce for humanity, because plants cannot use atmospheric nitrogen, and the only technology for increasing soil nitrogen was the symbiotic nitrogen fixing bacteria associated with legumes. The result was that the nitrogen cycle had to be kept very tight, with nitrogen wastes being returned to the soil, and even going so far as to harvest nitrogen-rich seabird guano from islands off the coasts of South America. There was federal legislation enacted in 1856, the Guano Islands Act:

"Whenever any citizen of the United States discovers a deposit of guano on any island, rock, or key, not within the lawful jurisdiction of any other Government, and not occupied by the citizens of any other Government, and takes peaceable possession thereof, and occupies the same, such island, rock, or key may, at the discretion of the President, be considered as appertaining to the United States."
In 1910, Fritz Haber developed a process for making ammonia (which can be used for fertilizer, or to make explosives) that would scale. The reaction N2 + 3 H2 → 2 NH3 uses an iron-based catalyst and extremely high temperature and pressure, which together overcome the strong triple bond holding the molecular nitrogen together.

The hydrogen for the reaction generally comes from natural gas, although if you have surplus electricity from wind or hydro or solar, you could make it by electrolysis of water. But apparently less than 5% of world natural gas production is used to make fertilizer, so there is no immediate need to worry about alternate supplies.

Depending on your theory of simultaneous invention, many people may owe their existence to Norman Borlaug and to Fritz Haber.

Another funny thing to think about is that given the ubiquity of nitrogen fertilizer in agriculture, and that the human body is 3% nitrogen by mass, everyone is carrying around a hefty slug of nitrogen atoms that came out of a natural gas well and streamed over a catalyst at an ammonia plant!


Some other Vaclav Smil books look interesting.
Prime Movers of Globalization: The History and Impact of Diesel Engines and Gas Turbines
Energy Transitions: History, Requirements, Prospects
Energy in Nature and Society: General Energetics of Complex Systems

Thinking About the Unthinkable Bond Bear Market

All of the federal, state, and municipal governments are planning to borrow to cover their operational and pension shortfalls. They think it will be no big deal thanks to low interest rates.

After all, who cares about promising to pay $X next year if what that really means is that you are going to amortize $X over the next thirty years.

The steady state federal budget deficit is probably a good $1T now (wait untill a bear market takes away capital gains), but social security should at least double that in the next few years [pdf].

Then, state and local governments have been averaging $300 billion a year in borrowing, but that could easily grow to be about a trillion every year, given that they will need to borrow for the pension benefits.

I could easily see $3T a year of sustained new government debt issuance. Plus, the Obama-era federal debt is almost all (~75%) notes, which is about $8.3T and about 1/8th being rolled every year makes ~$1T. There's also $1.4 trillion in bills which will of course need to be rolled every year [pdf].

This adds up to like six trillion a year and the thing is it would be more in bad years when government deficits are worse AND pension assets do not return what they were assumed to, so the plans have to borrow more. [And it does not even count roll over of existing state and local debt, which totals $3 trillion, until I figure out the maturity profile of that debt.]

The point is, the total federal debt held by the public was only $6T as recently as when Bush left office, and now the governments are going to need to borrow/roll that much every year.

I could never really figure out what would cause the bond bull market to end, but this is enough to do it in my mind.

The other scary thing for bonds is the effect that interest rate increases have on this system, because it contains so many feedback loops. The pension assets become worth a lot less, the interest expenditures rise (and they are borrowing to pay the interest since there is no debt service), so the credit quality (such as it is) deteriorates.

Also, corporate pensions have the same problem and an interesting feedback loop of their own. To the extent that their pension funds lose money, earnings will take a hit. As we know from Grantham, when earnings fall multiples fall too.

It is very, very nonlinear, because once bonds lose momentum, who will want to own them? Professional asset management and retail investor sentiment are both all about momentum. And every credit - government or corporate - looks much worse with rising interest expense. I think we will come to realize that a lot of stuff in the economy (junk bonds, private equity) was part of a virtuous interest rate cycle.

Maybe this is why the low on the 10 year yield is almost three years in the rear view mirror now.

For the counterargument that the Fed will just buy bonds to "keep rates low", you have to face the fact that QE invariably caused rates to rise, and you could (and we did) make money buying bonds every time the Fed stopped buying them. As I kept trying to explain, the QE bond purchases may have been respectably large in relation to the flow of debt issuance, but they were puny in relation to the stock of $60T of dollar denominated debt. It freaked creditors out about inflation more than it helped.

Sunday, May 17, 2015

Review of By the People: Rebuilding Liberty Without Permission by Charles Murray

Charles Murray, whose most well known books are probably The Bell Curve and Coming Apart, has a new book out this week: By the People: Rebuilding Liberty Without Permission.

Part One is about "coming to terms with where we stand": the Constitution has been completely discarded (after a century of attacks by progressives), the legal system functions "in ways indistingushable from lawlessness," and there is an "extralegal state within a state," regulatory bureaucracies and their administrative law, that threatens every business owner.

Most of us knew all of that already. What is new is that, first, Murray has given up hope of reforming these problems through the political system. (As even Romney noticed, a winning majority of voters is on the payroll of the government.) Second, Murray has a plan that does not require winning elections: attacking the regulatory state through the legal system.

He envisions nonprofits - along the lines of Goldwater Institute - that would take the side of victims of regulatory agencies (OSHA, EPA, EEOC, etc) and aggressively fight the agencies when they seek to disrupt business and citizens with punishments for violating nonsensical regulation. He gives examples in an essay in last weekend's Wall Street Journal.

What he describes is also a business model, which would not have to be done by nonprofits, and which he calls "treating government as an insurable hazard." A dentist buys insurance from DentalShield, and as long as he adheres to sound practices (as defined by dentists, e.g. the ADA), he is indemnified against fines and litigation costs imposed by the myriad agencies that could attack his practice.

You know who else has the business model of protecting against all hazards, and would gladly help a baker who was being fined for having the wrong kind of latch on his flour bins? The Godfather. Ultimately, I think Murray is right that people need and are going to want insurance against the hazard of government. The question is whether the business that delivers it is going to be nonprofit, for-profit, or traditional warlord/mafia.

Of course, if interest rates on U.S. government bonds ever rise - and I believe that that would happen automatically if a substitute currency or store of value superior to the U.S. dollar emerged - then the regulatory hazard will be obviated because there simply will not be the money to bother bakers about their flour bin latches. This extralegal state within a state is - just like the asset bubble, junk bonds, private equity - simply a creature of ultra-low interest rates.


Saturday, May 16, 2015

"On the Importance of Asset Class Bubbles for Value Investors and Why They Occur"

This was from a Jeremy Grantham speech at the Annual Benjamin Graham and David Dodd Breakfast (Columbia University, October 7, 2009). The entire thing is excellent, but his point about profit margins and P/E multiples is very important:

Every time the market crosses fair value, it’s efficient. For a few seconds every five or six or seven years, it’s efficient. The rest of the time, it is spiking up or spiking down, and is inefficient.

Now, the market should equal replacement cost, which means the correlation between profit margins and P/Es should be −1. Or, putting it in simpler terms, if you had a huge profit margin for the whole economy, capitalism being what it is, you would want to multiply it by a low P/E because you know high returns will suck in competition, more capital, and bid down the returns (conversely at the low end). But what actually happens? Instead of having a correlation of −1, our research shows it has a correlation of +.32. The market can’t even get the sign right! High profit margins receive high P/Es and vice versa, and the correlation is much greater than +.32 at the peaks and the troughs. Right at the peak in 1929, we had record profit margins and record P/Es. In 1965, there were new record profit margins and record P/Es (21 times). Now, think about 2000. We had a new high in stated profit margins and decided to multiply it by 35 times earnings, a level so much higher than anything that had preceded it. In complete contrast, in 1982 we had half-normal profits times half-normal P/Es (8 times). I mean, give me a break. We were getting nearly one-third of replacement cost at the low, and almost three times replacement cost at the high in 2000.

This double counting is, for me, the great driver of market volatility and, basically, it makes no sense.
In other words, coming to the same conclusion as Hussman but from a different angle.

"The Return of Nature: How Technology Liberates the Environment"

Cornucopian, but very interesting article,

"Measured by growing stock, the United States enjoyed its forest transition around 1950, and, measured by area, about 1990. The forest transition began around 1900, when states such as Connecticut had almost no forest, and now encompasses dozens of states. The thick green cover of New England, Pennsylvania, and New York today would be unrecognizable to Teddy Roosevelt, who knew them as wheat fields, pastures mown by sheep, and hillsides denuded by logging."
It certainly hasn't been a good four years for commodities. Young Money predicted,
"[T]he mining industry is heading for a perfect storm in which: 1) Chinese demand will fall as they stop building empty cities, 2) there will be a supply glut as the industry finishes bringing enormous amounts of new capacity online, and 3) financial demand will disappear and metals stocks that have been hoarded will flood the market as prices fall. There will be a huge sell-off that pushes prices below the marginal cost of production and keeps them there for years, and that will put the commodity supercycle theory to rest."
That's well underway. Sometime later this year, we will see bankruptcies begin of the formerly high flying commodity producers. In April 2011 (the commodity peak), Walter Energy traded at $144 and it had 53 million shares outstanding - a $7.6 billion market cap!

Going from that to unsecured debt trading in the pennies in under four years is incredible. But the resource extraction industry went through significant debt-fueled consolidation during the peak of the so-called commodity super cycle, which resulted in a funny kind of adverse selection where the most bullish managements with the worst historical sense and facility at market timing ended up controlling capital allocation for the whole industry.

Big leverage many years into a "boom" is a sign that the emperor has no clothes. Keith Calder is the guy who sold Western Coal to Walter Energy close to the top of the market in December 2010, and then resigned from the combined entity less than a year later.

Friday, May 15, 2015

Review of Bowling Alone: The Collapse and Revival of American Community by Robert

Most people will tell you that Bowling Alone is about how Americans are "increasingly disconnected from one another and how social structures—whether they be PTA, church, or political parties—have disintegrated," but fail to repeat the key reason: television.

As we know, broadcast television was an incredibly harmful invention and is used for evil purposes: state propaganda ("news"), sports watching (panem et circenses), pushing the police state (procedurals and "terrorism" shows); all programming and pacification of the dull masses.

Okay, I'm kidding. People certainly spend more time watching odious television and less time civically engaged, but this may be a symptom and not a cause.

Since Bowling Alone came out in 2000 (and it was based on a 1995 essay), Professor Putnam has done more research. In 2006, he said,

"[I]n the presence of diversity, we hunker down. We act like turtles. The effect of diversity is worse than had been imagined. And it's not just that we don't trust people who are not like us. In diverse communities, we don't trust people who do look like us."
This is an uncomfortable research finding, and indeed he waited six years to publish the data because it was so at odds with what he wanted to find.

That explanation is very compelling, yet there is another hypothesis that would help explain why so many of the civic disengagement examples that Putnam cites in the book are from very rural places. He does't address this one, either, because it would require engaging with Charles Murray and his book The Bell Curve.

The real thesis of The Bell Curve is that cognitive sorting based on IQ tests, and concentration of abstract reasoning jobs in major cities, has led to a brain drain in the rest of the U.S. This is documented in Hollowing Out The Middle: The Rural Brain Drain and What It Means for America, which is basically about how the smartest rural young people take the SAT, go away to college, and never come back. One essayist calls this "educating for civic suicide".

A correspondent commented last fall on the implications of rural brain drain:
"People with high intelligence trust strangers who come to them with win-win deals because they have the capacity to understand the mutual benefits. However if one is unable to understand the deal or the mutual benefits of interaction, then suspicion and mistrust of strangers is natural."
He says that dull rural Americans reflexively disregard proposals made by an outsider, even ones that are deliberately calculated to be win-win.

Read the Fragmented Future essay for more thoughts on what the U.S. economy in 2050 will be like. My money is on lower output per capita and more difficulty making money as a minority investor.


Review of The Godfather by Mario Puzo

Mario Puzo was the Jane Austen of wealth and power. As good as the Godfather movies are, the Godfather book is so much richer.

Wealth and power have decoupled in our civilization. How else could a 84 year old who can't bench press his weight have the ability to order hundreds of thousands of people around? It reminds me of a Paul Graham essay about wealth:

Making wealth is not the only way to get rich. For most of human history it has not even been the most common. Until a few centuries ago, the main sources of wealth were mines, slaves and serfs, land, and cattle, and the only ways to acquire these rapidly were by inheritance, marriage, conquest, or confiscation. Naturally wealth had a bad reputation.
The Godfather can have anything he wants in the world, but he doesn't have a phone number, a wallet, or a bank account. Think about that.

The coupling of wealth and power also reminds me of the oligarchs in Russia:
"[Berezovsky] liked to say that in Russia, the first treasure to be privatized would be profit, then property, and finally debt. He meant that the first thing he wanted to take in a company was its cash flow, and only later would be be interested in owning it, and perhaps never. [...] When he first won Yukos, Khodorkovsky sent three hundred of his best security men to Siberia to physically take over the company's wells and refineries."
In other words, the abstract claims like common stock shares there were a joke (like in China), and what mattered is power. Measuring the minority ownership discount in public companies is measuring civilization.

But the combination of a weak, bought-off legal system and organized crime is not the only combination that can devalue abstract, minority stakes. Remember what happened to the GM and Chrysler bondholders in 2009?:
Of the two proceedings, Chrysler's was clearly the more egregious. In the years leading up to the economic crisis, Chrysler had been unable to acquire routine financing and so had been forced to turn to so-called secured debt in order to fund its operations. Secured debt takes first priority in payment; it is also typically preserved during bankruptcy under what is referred to as the 'absolute priority' rule — since the lender of secured debt offers a loan to a troubled borrower only because he is guaranteed first repayment when the loan is up. In the Chrysler case, however, creditors who held the company's secured bonds were steamrolled into accepting 29 cents on the dollar for their loans. Meanwhile, the underfunded pension plans of the United Auto Workers — unsecured creditors, but possessed of better political connections — received more than 40 cents on the dollar.
What happened to the auto company bondholders in 2009 was a scary precedent, and it is one that has been completely forgotten.