Friday, March 31, 2023

Books Read - Q1 2023

Starting off the year with only two books read. 

[Previously: Q4 2022, Q3 2022, Q2 2022, Q1 2022, our 2021 Book Review Compendium, 2020 Book Review Compendium, 2019 book compendium, 2018 book compendium, and pre-2018 book compendium.]

  • Ducks: Two Years in the Oil Sands (1/5) You would think that it would be impossible to make a bad graphic novel about what it's like to work at a Canadian oil sands mine. For some reason, I was expecting this to be like an investor presentation with exciting tales about the mining process. The author Kate Beaton is a millennial Canadian girl who grew up in a small town on Cape Breton Island, part of the rural, economically depressed province of Nova Scotia. Her Catholic parents did not have a better idea for her and her four sisters except to get liberal arts degrees at small Canadian colleges. After graduating, she was single, in debt, and had no job prospects. Her best idea was to move to western Canada and make a bundle of money working in the oil sands mines in order to get out of debt. Life there was unpleasant: "people are bored and crazy". Imagine living in a place where the residents were selected for having poor prospects. It turns out that you can't walk into the mines and drive a ginormous, cool Caterpillar 797 hauling truck, either. (The trucks cost $5 million or so and can haul 400 tons. Their 4,000 HP engines have 20 cylinders displacing over 100 liters. The mining companies are working on making them autonomous.) The hours are long and her entry level jobs are tedious. Also, unfortunately, she is sexually harassed while working and while living in the man camps. I'm sorry that happened and I certainly would not recommend that a young woman work in mining. There has to be a better way of getting started in life. It looks like she got married at age 35 to a Canadian soyjack type of guy and they now have two kids. What was the point of waiting so long? What if she'd found a man in college and been a stay-at-home-mom after graduation?
  • An Everlasting Meal: Cooking with Economy and Grace (4/5) Quick summary: author Tamar Adler "explains what cooks in the world’s great kitchens know: that the best meals rely on the ends of the meals that came before them." (In other words, "a cookbook for leftovers".) As she puts it: "Meals' ingredients must be allowed to topple into one another like dominos. Broccoli stems, their florets perfectly boiled in salty water, must be simmered with olive oil and eaten with shaved Parmesan on toast; their leftover cooking liquid kept for the base for soup, studded with other vegetables, drizzled with good olive oil, with the rind of the Parmesan added for heartiness. This continuity is the heart and soul of cooking." Egg-maxing: "I usually have at least one nicely cold soft-boiled egg on hand to lure my thoughts away from eating lunch out." "The eggiest thing you can make is mayonnaise. The degrading of mayonnaise from a wonderful condiment for cooked vegetables or sandwiches to an indistinguishable layer of fat has been radical and violent." "Mayonnaise is egg yolk bound in oil, and oil bound in egg yolk." "Aioli is Proven├žal for garlic mayonnaise. If cheese is milk's leap toward immortality, aioli is garlic and egg's collective shot at the firmament." Based (on eating raw eggs in mayonnaise): "I trust the freshness of my eggs, and the cleanliness of the lives of the hens that lay them." Thoughts on chickens: "As soon as you boil a chicken that was raised outdoors, pecking at grubs, you'll notice that its stock is thick, golden, and flavorful. When it cools, it will thicken. Chicken that've led chicken-y lives develop strong, gelatinous bones..." French cuisine as buttermaxxing: "A little shallot, chopped finely and added to the butter along with parsley, makes the traditional French accompaniment to steak..." She really likes M.F.K. Fisher and suggests her book The Cooking of Provincial France. Geographical determinism: "Cuisines that cook in olive oil use herbs that grow well in the same climate as olive groves, like parsley, marjoram, thyme, rosemary, and sage. They are best for herby oils. Cuisines where food is cooked in butter have their own herbs, like chervil and tarragon. Where yogurt is treated as a sauce, mint, cilantro, and dill are prolific." Kids in the kitchen: "Children must help shell peas. In a world of things too big, getting peas from pods is a chance for pea-sized people to exercise authority." On beans: "Beans have always been associated if not with poverty, with the sweating classes." "In New Mexico, big pots of beans are cooked studded with pork and served for dinner."

Thursday, March 23, 2023

Thursday Night Links

  • Destructive pessimism involves either wanting or expecting things to fail. At first glance, the aspect of not expecting success may appear similar to how I operate, but there's a subtle distinction. I generally anticipate that things will be challenging but still achievable, and when it matters, I want them to succeed. An extreme example of destructive pessimism on the other hand is expecting climate change to end the world and assuming society will do nothing to prevent it. Whatever I personally do, I want it to be successful. I don't search for reasons why something won't work; instead, I focus on how to make it work while addressing or avoiding the issues I see along the way. That does not make me an optimist, that just makes me someone who wants to get stuff done and someone who strives for positive outcomes. On the other hand optimism to me is expecting to succeed against all odds, something I do not do. I fully expect that there will be failure along the way. (I also love venting about stuff I don't like even if it's not at all productive). Many individuals in today's economy worry about their retirement and harbor a general negative sentiment about nearly everything, from the unfairness of the labor market and increasing poverty to climate change and more. Believe it or not, I share much of this negative sentiment, but I've learned never to let such thoughts govern my life. Dwelling on negativity regarding your employer, job prospects, government, economy, or environment — especially when it's difficult to influence these aspects — leads to nothing but unhappiness and depression. [Armin Ronacher]
  • For the past year, this column has repeatedly warned that Quantitative Tightening (QT) would result in failure and force the Federal Reserve into another round of emergency liquidity injections, just like the repo crisis of September 2019. And just nine months after the official start of QT, here we are. After draining a trillion dollars of cash out of commercial banks, QT bagged its first victim. Silicon Valley Bank went bust, setting off a chain reaction of contagion and panic in the process. To quell the panic, the Fed backstopped uninsured depositors of the elite institution and invented a new emergency lending facility for other banks in distress. The latest Federal Reserve balance sheet data released on Thursday afternoon reveals the scale of new liquidity provided to the banking sector. In the past week, the Fed’s balance sheet expanded by $297 billion, reversing about half of the cumulative effect of QT to date. How is it possible that a liquidity crisis could occur so early into QT, and after the enormous monetary expansion of the prior two years? The Fed expected that QT would run in the background for years, reducing the overall size of its balance sheet by trillions. Instead, the Fed found itself frantically subduing a bank run. [The Last Bear Standing]
  • By calling into question the value of a significant portion of the country's bank deposits, the recent failure of one or more regional banks is equivalent to a sudden tightening of monetary policy, in which the supply of money is perceived to have contracted while the demand for the remaining portion has increased. Background: The "ideal" money can be defined as a highly liquid, universally-accepted medium of exchange that holds its value over time and can—but not necessarily—also pay a floating rate of interest, e.g., currency, checking and demand deposits, and retail money market funds. M2 incorporates all of these and is thus an excellent way to track the supply of money. Therefore, we might say that the current banking crisis is being caused by the perception that some portion of M2 (e.g., bank deposits in regional banks) may lose—or may have already lost—value in the event of a bank failure or expected bank failures. That perception automatically triggers an increased demand for the rest of M2. Together, this has the same effect as a sudden tightening of monetary policy; the supply of money has decreased at the same time the demand for money has increased. If the Fed does not offset this effective tightening by reducing interest rates, things could get ugly. [Scott Grannis
  • We analyze U.S. banks’ asset exposure to a recent rise in the interest rates with implications for financial stability. The U.S. banking system’s market value of assets is $2 trillion lower than suggested by their book value of assets accounting for loan portfolios held to maturity. Marked-to-market bank assets have declined by an average of 10% across all the banks, with the bottom 5th percentile experiencing a decline of 20%. We illustrate that uninsured leverage (i.e., Uninsured Debt/Assets) is the key to understanding whether these losses would lead to some banks in the U.S. becoming insolvent-- unlike insured depositors, uninsured depositors stand to lose a part of their deposits if the bank fails, potentially giving them incentives to run. A case study of the recently failed Silicon Valley Bank (SVB) is illustrative. 10 percent of banks have larger unrecognized losses than those at SVB. Nor was SVB the worst capitalized bank, with 10 percent of banks having lower capitalization than SVB. On the other hand, SVB had a disproportional share of uninsured funding: only 1 percent of banks had higher uninsured leverage. Combined, losses and uninsured leverage provide incentives for an SVB uninsured depositor run. We compute similar incentives for the sample of all U.S. banks. Even if only half of uninsured depositors decide to withdraw, almost 190 banks are at a potential risk of impairment to insured depositors, with potentially $300 billion of insured deposits at risk. If uninsured deposit withdrawals cause even small fire sales, substantially more banks are at risk. Overall, these calculations suggest that recent declines in bank asset values very significantly increased the fragility of the US banking system to uninsured depositor runs. [SSRN]
  • Inflation-reducing, wealth-creating supply-side options are given short shrift for a simple reason. While the Fed controls interest rates, Congress controls the taxes and regulations that can limit supply-side expansion. Of course, Congress also controls inflationary spending. Acknowledgment of that reality was on display at a congressional hearing earlier this month when Senator Elizabeth Warren told Federal Reserve chairman Jerome Powell that “your tool, raising interest rates, is designed to slow the economy and throw people out of work. So far you haven’t tipped the economy into recession, but you haven’t brought inflation under control either. Maybe the reason for that is other things are keeping prices high, things you can’t fix with high interest rates.” [Mark P Mills]
  • Both father and son were innovative in finding ways to attract customers: "to supplement their business, the Humphreys had become manufacturers ... of patent medicines for both hogs and humans. A sign featuring a wooden pig was hung over the drugstore to tell the public about this unusual service. Farmers got the message, and it was Humphrey's that became known as the farmer's drugstore." One biographer noted, "while Hubert Jr. minded the store and stirred the concoctions in the basement, Hubert Sr. went on the road selling 'Humphrey's BTV' (Body Tone Veterinary), a mineral supplement and dewormer for hogs, and 'Humphrey's Chest Oil' and 'Humphrey's Sniffles' for two-legged sufferers." Humphrey later wrote, "we made 'Humphrey's Sniffles', a substitute for Vick's Nose Drops. I felt ours were better. Vick's used mineral oil, which is not absorbent, and we used a vegetable-oil base, which was. I added benzocaine, a local anesthetic, so that even if the sniffles didn't get better, you felt it less." [wiki]
  • Parked out front was Paul Casey’s pimped-out black Porsche GT3 RS with gold wheels and a customized Arizona State license plate; the Scottsdale resident had driven from home, presumably at 180 mph. In the hotel lobby, Jason Kokrak made the scene in a plaid flannel like a roadie for Soundgarden, circa 1993. In his jeans, puffer vest and Oxford shirt, a graying Charles Howell III looked like a visiting lecturer at a community college. Numerous players milled around, showing off a variety of Air Jordans and flip-flops, backward baseball caps and receding hairlines. The lobby was also alive with khaki-clad agents, with their telltale leather-encased notebooks, and a phalanx of hot blondes, including Paulina Gretzky spilling out of a micro mini-dress. Cam Smith and Jediah Morgan were tossing around a rugby league ball. Harold Varner approached a random kid and tickled him without ever breaking stride. Pat Perez strolled by a couple of dour cops and said, “At ease, gentlemen. At ease.” [Alan Shipnuck]
  • I think one of the things that Jay Powell and the Fed are missing in the inflation fight is the supply side. The pandemic, government shutdowns, and stimulus payments (paid to people to not work) were and are critical components to the inflation. The labor markets and supply chains have gotten much better, but they are still normalizing. We need more people working, not fewer people. Let our remarkable economy do its thing. But Jay Powell apparently thinks increasing unemployment won't hurt the supply chain side of things. He is dead wrong. One example: the sharp spike in interest rates has already caused housing starts and construction to plunge. How does that help to increase housing/shelter supply? Increasing rates tomorrow in light of all this and the heightened anxiety and bank failures will go down as one of the dumbest moves in the history of central banking. The Fed should have cut rates by 50bp last Monday to stop cold the bank failure contagion in its tracks. [Scott Grannis]
  • Survey and experimental evidence documents discrimination against tattooed individuals in the labor market and in commercial transactions. Thus, individuals’ decision to get tattooed may reflect short-sighted time preferences. We show that, according to numerous measures, those with tattoos, especially visible ones, are more short-sighted and impulsive than the non-tattooed. Almost nothing mitigates these results, neither the motive for the tattoo, the time contemplated before getting tattooed nor the time elapsed since the last tattoo. Even the expressed intention to get a(nother) tattoo predicts increased short-sightedness and helps establish the direction of causality between tattoos and short-sightedness. [link]
  • In 2022, the adjustment to the monthly U.S. crude oil supply data published in our Petroleum Supply Monthly (PSM) averaged 786,000 barrels per day. This average annual adjustment was the biggest in our data history dating back to 1973. Based on our study of causes of the rising adjustment, we found two causes. First, our estimates of crude oil disposition have been overstated because we have been counting light hydrocarbons and unfinished oils that are blended into crude oil in our proxy for domestic petroleum consumption, which we refer to as product supplied in the petroleum balance. There is no product supplied of crude oil because there is no direct end use of crude oil. We believe this approach has overstated crude oil disposition above actual disposition because these light hydrocarbons and unfinished oils are blended into crude oil as exports or input to refineries. Second, we have been understating crude oil supply because of unreported field condensate blended into crude oil at natural gas plant processing facilities, producing region tank farms, or directly into pipelines that carry crude oil. [EIA]
  • Ford Motor said Thursday its electric vehicle business lost $2.1 billion last year on an operating basis, a loss that was more than offset by $10 billion in operating profit between its internal combustion and fleet businesses. The Detroit automaker expects 2023 to unfold along similar lines, forecasting an adjusted loss of $3 billion for its EV unit, adjusted earnings of about $7 billion for its internal combustion unit, and adjusted earnings of roughly $6 billion for its fleet business. [CNBC
  • CO2 rates have risen from use of fossil fuels, but use of fossil fuels is becoming increasingly expensive. The energy return on energy invested for fossil fuels is probably lower than at any moment since the industrial revolution began. It has declined by 23% in the last 16 years, according to the linked source. Some experts in EROEI believe we may already be below the point at which fossil fuels can sustain an industrial civilization. And I don’t mean to imply that Green Power will save the day — I mean to imply we might be doomed because it won’t. We can’t sustain our population without energy. But maybe we’ll electromagnetically poison ourselves before then. The radio frequency power density on Earth was 1,000 times higher than natural levels by the 1950s, 1,000,000,000 natural levels by the 1980s, and 100,000,000,000,000,000 times natural levels by the 2010s. I sure don’t know whether a hundred-quadrillion increase in RF power is safe for humanity in the long term. No one does — the power density and the rate of increase are entirely unprecedented. [Contemplations on the Tree of Woe]
  • Whig historiography is wrong because it falsely presupposes the inevitability of progress. If Whig historiography sees progress as a hockey stick, its arch-rival, cyclical historiography, sees progress as a sine wave. Cyclical historiography is nowadays in vogue among the dissident right, and there are a number of different cyclic theories of history. [Contemplations on the Tree of Woe]

Sunday, March 19, 2023

"The End of Abundant Energy: Shale Production and Hubbert's Peak"

[Previously from Goehring & Rozencwajg: "Why Won't Energy Companies Drill?", Q2 (2022) Natural Resource Market Commentary, "The Distortions of Cheap Energy" and Goehring & Rozencwajg and Horizon Kinetics on Commodities.]

Highlights from Goehring & Rozencwajg's fourth quarter 2022 Natural Resource Market Commentary, "The End of Abundant Energy: Shale Production and Hubbert's Peak".

  • Few of us properly appreciate the importance of the shales. Not only were they the only source of incremental growth over the past decade, but they were also tremendous in absolute terms. Between 2010 and 2020, US shale oil production grew by 7.6 mm b/d, while natural gas liquids (nearly all from shale) increased by 4.0 m b/d. Total liquid production from the US shales grew by 11.6 mm b/d – more than Saudi Arabia’s production of 10.5 m b/d.
  • Shale gas production grew an incredible 65 bcf/d over the same period. When converted to barrels of oil equivalent, shale gas added another 10.8 m boe/d – equivalent to a second Saudi Arabia.
  • In recent years, Goehring & Rozencwajg has become convinced that shale production growth will slow and eventually turn negative. So far, the data has confirmed our thesis. If current trends continue and the shales do indeed plateau and roll over, global oil markets will have lost their only source of growth. Many of the resource depletion theories of the 2000s will likely return as critical issues in the 2020s. Investors would be wise to study them now.
  • The development of shale oil spelled the end of public interest in Peak Oil. Like Professor Hall, many openly dismissed and even ridiculed Hubbert’s work., US production bottomed at 4 mm b/d in 2008 and, driven entirely by the shales, has grown since to become the largest oil producer in the world.
  • While Hubbert’s predictions look ridiculous when considering total US liquids production, focusing only on conventional crude production suggests Peak Oil is alive and well. Last year, the US produced 3 m b/d of conventional crude oil – 7 m b/d or 70% below the peak reached 52 years ago. In other words, the shales bailed out total US production but did nothing to change the forces underpinning Peak Oil and depletion. On a global basis, conventional oil production (total production ex shale and Canadian oil sands) has exhibited no growth in 17 years.
  • E&P companies successfully determined over time the “sweet spots” of the basins, where attributes such as thermal maturity, thickness, permeability, porosity, and organic content were ideal. In 2014, we estimate 45% of all drilling occurred within Tier 1 areas, whereas by 2018, it had surged to over 65%. If the industry were getting better at drilling wells, then previously low-productivity drilling locations would be converted into high-productivity locations, allowing production to continue to surge. Instead, we determined the industry was “high-grading” or drilling its best wells first. Our neural network told us that companies were drilling their best top-tier locations in all their basins. If our neural network was correct, we argued in 2019 that per well productivity would peak and begin to fall as tier 1 prospects dwindled, leaving the industry to either drill many less productive wells or, if not, see their production decline.
  • Given the shale’s prodigious production growth, almost everyone believed they were limitless. Analysts talked about chronic oversupply without once thinking about the underlying geological constraints. Although the shales are extremely large, we determined they behaved precisely like traditional (albeit enormous) fields. We concluded that shale basins exhibited Hubbert-style production profiles: they ramped up, plateaued, peaked, and declined. The two earliest shale basins, the Barnett and Fayetteville, peaked between 2011 and 2014 and have both since declined by 70%.
  • Interestingly, the Permian has been the only basin to grow drilling activity since the end of 2019. In the Bakken and Eagle Ford, activity remains 10% below pre-COVID levels, whereas, in the Permian, activity is 5% above late-2019 levels. The answer is the superior inventory of remaining Tier 1 locations. Unfortunately, this superior inventory is being drawn down. We estimate that closer to 45% of all Tier 1 Permian locations have been drilled. The Permian is quickly approaching the same level of development as the Bakken and Eagle Ford in 2019. Our models tell us the results will be similar: Permian production will peak, plateau, and decline much sooner than anyone expects.
  • All five companies in our super-major survey increased capital spending and production in 4Q2022. Spending grew 22% compared with 2Q2022 from $11.1 bn to $13.6 bn. Year-over-year, super-major capital spending is up 25%. Increased spending was driven by Chevron (up 37%), Exxon (up 28%), and Shell (up 22%). BP and Total grew their spending much less: 10% and 5%, respectively.
  • Crude demand has proved far more resilient than most analysts have expected for nearly two decades. For example, economic activity slowed following the 1980 oil price spike, and demand fell almost 10%. It took nearly ten years for demand to surpass the 1980 peak. On the other hand, economic activity plummeted following the 2008 price spike and the global financial crisis. Instead of falling by 10% (or even more), crude demand fell by only 1.5%, surpassing the 2007 peak in 2010. The difference was that in 1980, OECD countries made up 68% of global oil demand, whereas by 2010 it was only half. Emerging markets have a much different price elasticity and demand profile than developed countries: consumption is far more resilient. More recently, during COVID, energy analysts argued vociferously that global demand would never again regain 2019 levels. Less than three years later, the International Energy Agency (IEA) expects 2023 demand will be 1.4 m b/d greater than in 2019.

Friday, March 17, 2023

Friday Night Links

  • In Dickens's novels anything in the nature of work happens off-stage. The only one of his heroes who has a plausible profession is David Copperfield, who is first a shorthand writer and then a novelist, like Dickens himself. With most of the others, the way they earn their living is very much in the background. Pip, for instance, ‘goes into business’ in Egypt; we are not told what business, and Pip's working life occupies about half a page of the book. Clennam has been in some unspecified business in China, and later goes into another barely specified business with Doyce; Martin Chuzzlewit is an architect, but does not seem to get much time for practising. In no case do their adventures spring directly out of their work. Here the contrast between Dickens and, say, Trollope is startling. And one reason for this is undoubtedly that Dickens knows very little about the professions his characters are supposed to follow. What exactly went on in Gradgrind's factories? How did Podsnap make his money? How did Merdle work his swindles? One knows that Dickens could never follow up the details of Parliamentary elections and Stock Exchange rackets as Trollope could. As soon as he has to deal with trade, finance, industry or politics he takes refuge in vagueness, or in satire. This is the case even with legal processes, about which actually he must have known a good deal. Compare any lawsuit in Dickens with the lawsuit in Orley Farm, for instance. [George Orwell]
  • Mindbody founder Stollmeyer is the key protagonist in this drama. Stollmeyer is an impressive person. He started his business career as a child helping in his parents’ retail lighting fixture store. He attended the United States Naval Academy and served as a nuclear submarine officer for six years after graduation. He next landed a position as a program manager at Vandenberg Air Force Base, which took him to California’s Central Coast. In the mid-1990s, a friend showed Stollmeyer software he had written to support owners of yoga, Pilates, and spinning studios. This software inspired Stollmeyer to launch Mindbody with his friend. By fall 2000, Stollmeyer “leapt off a cliff,” in his words, by quitting his engineering job and taking out a second mortgage to start Mindbody in his garage in San Luis Obispo. From these humble beginnings, Stollmeyer grew Mindbody into a software-as-a-service (“SaaS”) platform that serves the fitness, wellness, and beauty industry. Stollmeyer took Mindbody public in 2015. By 2018, Stollmeyer had grown Mindbody to over $1 billion market capitalization, yet Stollmeyer had never experienced a big liquidity event. And he had made substantial financial commitments in the meantime. Stollmeyer had (i) invested nearly $1 million into his wife’s wellness company, (ii) invested at least $300,000 into “Stollmeyer Technologies, LLC,” (iii) loaned his brothers and his former business partner money for their own real estate purchases, and (iv) pledged $3 million to a local college, of which $2.4 million was unpaid. Stollmeyer described his unhappiness with his pre-Merger financial situation in a post-Merger interview for Alejandro Cremades’s “dealmakers” podcast. During the interview, Stollmeyer described how “98% of [his] net worth” was “locked inside” Mindbody’s “extremely volatile” stock, while Stollmeyer could only sell “tiny bits” of his stake in the public market under his 10b5-1 plan. Stollmeyer described those sales as “kind of like sucking through a very small straw”. [In re Mindbody, Inc. Stockholders Litigation]
  • Most Americans have happily moved on from the 2020 Black Lives Matter (BLM)-driven ransacking of some 200 American cities, which resulted in as much as $2 billion in property damage and at least 25 deaths. But that time must be remembered for more than rioting and destruction. The BLM pressure campaigns, harassment, and moral blackmail also amounted to possibly the most lucrative shakedown of corporate America in its history. Today the Claremont Institute's Center for the American Way of Life published the most comprehensive database to date tracking corporate contributions and pledges to the Black Lives Matter movement and related causes from 2020 to the present. Companies and corporations pledged or contributed an astonishing $82.9 billion to the BLM movement and related causes. This includes more than $123 million to the BLM parent organizations directly. These figures, while shocking, likely underrepresent the true magnitude of the shakedown as some companies failed to make known their contributions, and many BLM organizations remain unknown. [Claremont Institute Center for the American Way of Life]
  • Today, the U.S. Food and Drug Administration authorized U.S. Smokeless Tobacco Company’s Copenhagen Classic Snuff, a loose moist snuff smokeless tobacco product, to be marketed as a modified risk tobacco product (MRTP). Copenhagen’s moist snuff smokeless tobacco product is a pre-existing tobacco product that has been marketed in the U.S. for years without modified risk information. Today’s action now allows the product to be marketed as a modified risk product with the claim: “IF YOU SMOKE, CONSIDER THIS: Switching completely to this product from cigarettes reduces risk of lung cancer.” [FDA]
  • I have a theory: the [epi]genetics that provide the foundation for some of the greatest physiques may be suboptimal for cardiorenal function, so we see a lot of heart & kidney-related disease in this population. Ultra-high intensity exercise (at intensities much higher than what normal humans can muster) plus high dose chronic year-round PED abuse = recipe for disaster as some of those compounds are specifically toxic for heart, kidneys, and liver (and remember, these people may have suboptimal organ function to begin with). [Bill Lagakos]

Thursday, March 16, 2023

Fed Tightening (April 13, 2022 - March 8, 2023)

We wrote in our Energy - Q4 2022 Earnings Season post that we have been fighting two headwinds for the past year in our investments: tightening by the central bank, and releases of crude oil from the Strategic Petroleum Reserve.

The Federal Reserve began shrinking its balance sheet the week of April 13, 2022, after it had just hit an all time high of $8.96 trillion of assets. (The Federal Reserve prints money to buy the assets that it owns, which are mostly U.S. Treasury and mortgage-backed securities, so the size of the balance sheet essentially reflects the cumulative amount of money printed since the inception of this central bank.)

Prior to the bank failures last week, the size of the balance sheet had been reduced to $8.34 trillion, a reduction of about seven percent. The latest release shows that the assets have started to grow again:

The balance sheet now has $8.64 trillion of total assets. That is a weekly increase of $300 billion, or 3.6%, which means that it retraced half of the total reduction of $600 billion that took almost a year (from April 13, 2022 - March 8, 2023) to accomplish.

We have seen since 2008 that the Fed's attempts to shrink its balance sheet (i.e. "taper") are bearish for risk assets, and that they have been short lived, and also associated with rebounds that are much larger than the amount of reduction. That is why the balance sheet has grown over time and is an order of magnitude larger than it was twenty years ago.

As we wrote over the weekend, it seemed likely that the bank failures of Silicon Valley Bank and Signature Bank (and threatened failures of several other big, important banks) would bring this episode of tightening to an end:

Ultimately, though, it seems unlikely that this will stop until the Fed stops tightening. Continued interest rate increases have been widening the gap between what bank deposits pay and what customers could earn by buying Treasuries directly. At some point, the dam would just burst and deposits would get converted to direct Treasury investments, never to return. Also, higher interest rates have already basically wiped out the equity in commercial real estate (just look at a stock chart of an office REIT like BXP or VNO), and if the rates increase further, these properties will start getting handed back to the banks.

But once the Fed pauses, then no one will think that their bank deposits are at risk because of the interest-rate related decreases in value of assets which are still performing. Banks can then continue to earn their way out of their liquidation value hole, as they had been doing and as has normally happened at various points in past economic cycles.

However, the caveat here is that inflation will come back. They have to give up on trying to get it back down using monetary policy. Maybe they raise taxes, maybe they put a sumptuary goods tax on Ferarris and private jet flights. Maybe they stop printing money to send to Ukraine. There are all kinds of fiscal and regulatory things that could be attempted. Inflation would have been better over the past two years if we had more sawmills and oil refineries and fewer cryptocurrency startups.

We have only one data point to go on, but we seem to have reached the point where the path of least resistance is to go back to printing money. Our cynical view was that it was only a matter of time until they reached this point:

We like ConvexityMaven's theory that the Fed is going to do yield curve control. Instead of letting the bond market crash and taking everything else with it, print money and buy bonds - keep the yields capped. But as the Maven says, in this scenario, "the other side of the balloon gets squishy" - meaning inflation.

If you look around the world, you will notice tons of countries with fiat currencies are running high inflation rates. Meanwhile, deflationary collapses are rare. Can you imagine the central banks of Brazil, Argentina, or Ghana tightening enough to cause a deflationary collapse? It has never happened, because the path of least resistance is inflation.

Betting on inflation is the cynical bet. But we have to be cynical enough to realize that the central bank doesn't want us hoarding real assets and is going to try to trick us with jawboning talk. People will believe the talk and there will be violent selloffs. This is why we like "first class" inflation protected assets and not leveraged junk.

We actually mentioned back in October 2022 that banks would be a casualty from tightening that might force the Fed to stop:

Banks own tons of treasuries, and their balance sheets have been devastated by the increase in the ten year bond yield, something that is being chronicled over at Oddball Stocks. Higher interest rates also mean that the interest on the $31 trillion federal debt grows, which is a positive feedback loop since the debt is not being serviced. And high interest rates choke the economy, which is unpleasant and also lowers tax revenue - worsening the debt spiral - and causes banks' loans to default. So it has seemed clear to us that printing money to buy bonds (yield curve control, capping bond yields) is the path of least resistance, "kick the can" approach that the regime will choose.

This cynicism about the Fed taking the path of least resistance dates back to our "Rethinking Inflation" post from September 2021:

So it starts to seem that the people in this country who make the decisions are not even interested in playing the old deflationary squeeze game because, even if their precarious balance sheets could withstand it, their political Mandate of Heaven probably couldn't. Plus, baby boomer rich are very unlike the old school rich - they do not like seeing things marked down on their net worth spreadsheet. (Every baby boomer has a net worth spreadsheet.) If a big devaluation is going to happen, it would be best to own attractively priced assets that will grow earnings at least as fast as the currency is devaluing. Luckily for us, a major inflationary shock is brewing at the same time that people allocating capital are under the delusion that electric vehicles have "disrupted" oil.

Retracing half of the balance sheet reduction that took a year in only one week is consistent with the results of the previous attempts at tightening.

Note also that Berkshire was buying Occidental Petroleum every day this week while the market (and particularly energy stocks) were crashing.

Bank of Ghana Redenomination Song

Sunday, March 12, 2023

Sunday Night Links

  • I am seeing estimates that over 97% of the funds are not FDIC insured, and many of those accounts are held by start-ups.  An outright failure would be calamitous for the Silicon Valley start-up ecosystem.  Likely the best outcome is if a major bank steps up and buys the thing, rendering depositors whole.  Without such a buyout, regulators are in an awkward position.  Leaving depositors hanging might generate additional bank runs or financial market runs.  Making depositors whole, however, sets a crazy precedent (“in fact, we’re raising the guarantee to $10 million!). So what exactly does the FDIC/Fed/Treasury have to do to get a deal consummated ASAP?  What kind of behind the scenes horsetrading will be involved? Here is NYT coverage of the basic facts.  Note that every now and then the U.S. banking system is semi-insolvent, but matters work out because “on paper” losses do not have to be either realized or reported as such.  Remember the 1980s?  One danger is that if other banks start selling their bonds at a loss, the problems in the system will become increasingly transparent and compound themselves. [Marginal Revolution]
  • Financial regulators are discussing two different facilities to manage the fallout from the closure of Silicon Valley Bank if no buyer materializes, according to a source close to the situation. One way that the regulators would step in would be to create a backstop for uninsured deposits at Silicon Valley Bank, using an authority from the Federal Deposit Insurance Act, according to the source. The move would also touch the systemic risk exception that allows the Fed to take extraordinary action to stem contagion fears. [CNBC]
  • Since 2007, the FDIC has served as receiver for over 525 banks. Only 9 of these failed banks had assets over $10 billion. Thus, the overwhelming majority, over 98 percent, had assets under $10 billion. Approximately 95 percent of resolutions conducted by the FDIC since 2007 involved purchase and assumption transactions, generally involving a single acquirer assuming nearly all of the failing bank's liabilities. This resolution approach, particularly applicable to community banks, is generally the least disruptive both to depositors and the local community, and the easiest for the FDIC to execute. Only 25 banks since 2007 were resolved through insured deposit payouts, reflecting the general availability of acquirers for purchase and assumption transactions for smaller institutions. In only three resolutions since 2007 was a bridge bank utilized, and only one of those three cases involved an institution with assets above $10 billion. [FDIC]
  • Marlboro Friday refers to April 2, 1993, when Philip Morris announced a 20% price cut to their Marlboro cigarettes to fight back against generic competitors, which were increasingly eating into their market share. As a result, Philip Morris's stock fell 26%, and the share value of other branded consumer product companies, including Coca-Cola and RJR Nabisco, fell as well. The broad index fell 1.98% that day. Fortune magazine deemed Marlboro Friday "the day the Marlboro Man fell off his horse. [wiki]
  • If you synthesize the best parts of Falkenstein and Redleaf, you predict that the next crisis is going to come in the investment that is currently perceived as riskless enough for highly leveraged institutions like banks to buy. In the 2000s that was mortgages, at other times it has been other investments like railroads. Right now, government bonds are accorded zero risk in calculating bank capital ratios. The idea that government bonds are riskless when governments are planning to flood the market and when the expenditures are consumed (building no collateral) may prove to be the latest delusion. [CBS]
  • More Americans now favor legal cannabis than legal tobacco, surveys show, signaling a sharp societal shift from an era when cigarette-smoking was legal pretty much everywhere and pot-smoking was legal absolutely nowhere. [The Hill]
  • Empire of Pain: The Secret History of the Sackler Dynasty is timely given that a lot of our American brothers, sisters, and binary-resisters were just paid $600/week to stay home for two years and consume drugs and alcohol (this Senate document says there was a 30 percent increase in overdose deaths, but blames the “pandemic” rather than the “lockdown”). The antiracism experts at Mass General say that heavy drinking increased by 21 percent during lockdown. If nothing else, reading the book will make you cautious about taking that first bottle of painkillers that a doctor prescribes! [Phil G]
  • Ultimately, though, it seems unlikely that this will stop until the Fed stops tightening. Continued interest rate increases have been widening the gap between what bank deposits pay and what customers could earn by buying Treasuries directly. At some point, the dam would just burst and deposits would get converted to direct Treasury investments, never to return. Also, higher interest rates have already basically wiped out the equity in commercial real estate (just look at a stock chart of an office REIT like BXP or VNO), and if the rates increase further, these properties will start getting handed back to the banks. But once the Fed pauses, then no one will think that their bank deposits are at risk because of the interest-rate related decreases in value of assets which are still performing. Banks can then continue to earn their way out of their liquidation value hole, as they had been doing and as has normally happened at various points in past economic cycles. However, the caveat here is that inflation will come back. They have to give up on trying to get it back down using monetary policy. Maybe they raise taxes, maybe they put a sumptuary goods tax on Ferarris and private jet flights. Maybe they stop printing money to send to Ukraine. There are all kinds of fiscal and regulatory things that could be attempted. Inflation would have been better over the past two years if we had more sawmills and oil refineries and fewer cryptocurrency startups. [CBS]