By Simon Grey, on December 6th, 2011
Street vending has been a path out of poverty for Americans. And like other such paths (say, driving a taxi), this one is increasingly difficult to navigate. Why? Because entrenched interests don’t like competition. So they lobby their powerful friends to erect high hurdles to upstarts. It’s an old story.
Now, growing local governments are crushing street vendors.
The city of Atlanta, for example, has turned all street vending over to a monopoly contractor. In feudalist fashion, all existing vendors were told they must work for the monopoly or not vend at all.
…
Institute lawyer Elizabeth Foley says the regulations make “it virtually impossible to be an effective street vendor. You can’t be within 300 feet of any place that sells the same or similar merchandise. That’s absolutely ridiculous for the government to use its power to enact a law like that. … These people are just trying to make an honest living, and the city is making it impossible to do so.”
…
Raul Martinez, the mayor when the law passed, defended the rule.
“You don’t want to have everybody in the middle of the streets competing for space on the sidewalk without some sort of regulations. In the city of Hialeah, we’re not overregulating anybody.”
He says one purpose of the law is simple fairness: Street vendors don’t pay property taxes. Brick-and-mortar stores must.
No one likes paying taxes, and so everyone tries to either avoid the misery or spread it around. One common justification for paying taxes, then, is fairness: Why should I pay taxes when my competitor doesn’t?
That is, perhaps, a legitimate question, but it is irrelevant nonetheless because fairness does not exist. For starters, no two people can even agree on what constitutes fairness. And even if they could, ensuring fairness requires more data than anyone possesses or could hope of possessing.
Taking the case at hand, it seems obvious that it is unfair for street vendors to not pay taxes. But should their tax bill be comparable to brick-and-mortar stores? The answer isn’t straightforward because one must consider how much less of a burden street vendors are to the local government relative to brick-and-mortar stores. One must also compare the relative advantages of each venue—a street vendor does not offer the same product as a restaurant, even if the menu offerings are identical. Trying to determine a fair tax rate in light of the considerations is simply impossible.
As such, it is simply best for the government to surrender the battle on fairness and simply say that the government needs X amount of dollars in revenue and that policy Y is the easiest way to attain this. The continual bickering over fairness simply increases systemic costs, damages the economy, kills people’s job prospects, increases political rancor, and does absolutely nothing to improve the system in the long run. Therefore, the government would be better off implementing one simple tax and living within its means, and stop concerning itself with fairness.
By Trace Mayer, on December 6th, 2011
The demand for gold is vastly underestimated. About 18 months ago I wrote about Euro Gold and the Euro Zone and Euro Evaporation Leading To Credit Default Swaps and IMF Gold. One key excerpt was:
The Euro is broken. This was its destiny. This is the destiny of all fiat currencies. These bureau-rats cannot stop this anymore than Cnut the Great could command the tide to halt.
And here we are.
THE GREAT CREDIT CONTRACTION
The Great Credit Contraction has been in relentless advance for years. This is a massively deflationary period as capital, both real and fictitious, burrows down the liquidity pyramid into safer and more liquid assets. The fictitious capital that does not move fast enough evaporates. Poof goes trillions of wealth!
In the Information Age bank runs happen with the click of a mouse and not lines outside the physical branches.
FRACTIONAL RESERVE BANKING
Fractional Reserve Banking is the banking practice in which banks keep only a fraction of their deposits in reserve (as cash and other highly liquid assets) and lend out the remainder while maintaining the simultaneous obligation to redeem all these deposits upon demand.
Fractional reserve banking occurs when banks lend out any fraction of the funds received from demand deposits. Despite being a form of embezzlement and fraud this practice is universal in modern banking.
This mismatch between time, borrowing short-term and lending long-term, is what creates the potential for a bank run. But an even larger looming problem lurks in ‘cash and cash equivalents’. Yes, those pesky Tier I, II and III distinctions.
 As a bank’s assets evaporate their ability to make new loans, even extremely short-term loans like overnight, becomes impaired. When an entire banking system knows that all the major players have assets on their balance sheets, assets which are not accurately priced or accounted for, then there is an extreme reluctance to lend.
This is what happened when Lehman Brothers evaporated. The credit markets seized up. People acting in their own self-interest according to principles of praxeology moved into safe and liquid assets and refused to lend.
Liquidity dried up overnight. Mortgage backed securities, auction rate securities and plenty of other assets which had for decades been treated as ‘cash equivalents’ were suddenly shunned. The bid evaporated from a loss of confidence, the prices plunged, investors were snookered and bank balance sheets were massively damaged.
The gears of industry are seizing up.
EUROPE’S WORTHLESS BANK DEPOSITS
The European banks have balance sheets with trillions of Euros in value recorded but assets which every rational non-ignorant person knows are severely impaired. The credit markets are freezing, trust is evaporating and as a result liquidity is drying up.
Sure, the central banks of the world have joined in a massive illegal effort to lubricate the system but it will fail. Years ago when QE1 was announced I wrote The Federal Reserve Will Fail With Quantitative Easing. They are still failing just on a grander scale.
 To recapitalize and lubricate the European banking and financial system would take at least €25 trillion and maybe upwards of €100 trillion. The failure is a mathematical certainty. The gears of industry are seizing up.
The Greek and Italian democracies were assassinated by banksters Lucas Papademos, Mario Monti and Mario Draghi who will attempt to prolong the failed banking and financial system by privatizing the gains and socializing the losses with inflationary tactics and bailouts in a vain attempt to prevent the credit liquidation. They will only succeed in prolonging and exacerbating the necessary correction.
What holders of capital should understand is that European bank balance sheets are caught in an unrecoverable credit contraction spin, the appropriate emergency maneuver is to Run To Gold and only a few will make it with their purchasing power intact.
The vast majority of assets will become charred wreckage as their purchasing power evaporates into worthlessness. Sure, there may be a few near miss recoveries between now and the ultimate failure but why take the risk?
LATENT GOLD DEMAND
There is massive latent gold demand as a ‘cash or cash equivalent’ asset. Why should a holder of capital store their wealth in bank deposits with counter-party risk when they can completely eliminate it by moving into unencumbered physical gold bullion?
Plus, by moving into physical gold bullion they eliminate the risk associated with fiat currency becoming worthless through the deflationary event called hyperinflation. Really, hyperinflation is just the next step in The Great Credit Contraction after capital has moved almost entirely down the liquidity pyramid.
The money managers allocating trillions of FRNs, Euros, Yen, etc. have not even begun moving into the monetary metals. In most cases it is only beginning to become acceptable to speak of them. Some fallaciously argue there is not enough gold to go around.
Sure, there is enough gold for it to be used as the world reserve currency but it is only a matter of price. A price that Jim Rickards argues the case for in Currency Wars of being between $8,000 and $54,000+ per ounce.
 CONCLUSION
The European banking and financial system is imploding before our eyes in a massive credit contraction which is just the latest wave in The Great Credit Contraction. The European banks are in an unrecoverable deflationary spin. There is only one acceptable emergency recovery procedure and that is to Run To Gold.
Because so few have, therefore, the real gold demand is completely hidden and obscured from view. It will come when people lose confidence in the current banking and financial system by turning to and using alternatives that do not possess the same kinds of risks. In the Information Age bank runs happen with the click of a mouse and not lines outside the physical branches.
DISCLOSURES: Long physical gold, silver and platinum with no interest in DOW, S&P 500, the problematic SLV ETF, gold ETF or the platinum ETFs.
By B.P.T., on December 6th, 2011
At 7:45 AM Eastern time, the weekly ICSC-Goldman Store Sales report will be released, giving an update on the health of the consumer through this analysis of retail sales.
At 8:55 AM Eastern time, the weekly Redbook report will be released, giving us more information about consumer spending.
By Simon Grey, on December 5th, 2011
From Bryan Caplan:
Many educators sooth their consciences by insisting that “I teach my students how to think, not what to think.” But this platitude goes against a hundred years of educational psychology. Education is very narrow; students learn the material you specifically teach them… if you’re lucky.
Other educators claim they’re teaching good work habits. But especially at the college level, this doesn’t pass the laugh test. How many jobs tolerate a 50% attendance rate – or let you skate by with twelve hours of work a week? School probably builds character relative to playing videogames. But it’s hard to see how school could build character relative to a full-time job in the Real World.
At this point, you may be thinking: If professors don’t teach a lot of job skills, don’t teach their students how to think, and don’t instill constructive work habits, why do employers so heavily reward educational success? The best answer comes straight out of the ivory tower itself. It’s called the signaling model of education – the subject of my book in progress, The Case Against Education.
According to the signaling model, employers reward educational success because of what it shows (”signals”) about the student. Good students tend to be smart, hard-working, and conformist – three crucial traits for almost any job. When a student excels in school, then, employers correctly infer that he’s likely to be a good worker. What precisely did he study? What did he learn how to do? Mere details. As long as you were a good student, employers surmise that you’ll quickly learn what you need to know on the job.
In the signaling story, what matters is how much education you have compared to competing workers. When education levels rise, employers respond with higher standards; when education levels fall, employers respond with lower standards. We’re on a treadmill. If voters took this idea seriously, my close friends and I could easily lose our jobs. As a professor, it is in my interest for the public to continue to believe in the magic of education: To imagine that the ivory tower transforms student lead into worker gold.
What makes the college bubble so problematic is that it is essentially inflationary. College degrees can be considered a form of currency in the labor market, wherein one purchases a salary with not only one’s labor but one’s college education as well. Obviously, this mechanism is not as direct as, say, buying milk at a grocery store, but the effect is similar.
The labor market, then, relies on college degrees to indicate a prospective employee’s fitness for the salary being offered. Certain types of degrees generally pay better than others, certain colleges’ degrees pay better than others, certain grade point averages are worth more than others, etc. Someone who receives an MBA from Harvard while maintaining a GPA of 4.0 will generally earn more than someone who receives an Associate’s degree from ITT Tech while maintaining a 2.0 GPA. This should make sense, as the quality of student varies by institution, degree, and grade, and there are ways to sort this. The college bubble, then, serves as a form of inflation because it distorts the signal that a college has in the labor market.
Basically, as is well known, the college bubble is the result of massive governmental interference in the post-secondary education market. The federal government offers direct subsidies of education costs (e.g. the Pell Grant), and also makes college loans a very enticing offer to lenders by guaranteeing the loans. With direct subsidies and easy credit, prospective students have a very strong incentive to go to college. Furthermore, with this much money on the line, colleges have a very strong incentive to accept more students.
The effects of this bubble, as noted before, are seen primarily in signal distortion. This occurs because employers now have a larger labor from which to select workers. This generally seems like a good thing, since employers can now offer lower wages, but this is not always the case because some potential workers are perhaps not as well-qualified for their position as others. The problem with using college degrees as a qualification is that, at this point, there isn’t enough data to sort the good from the bad. When there were a limited number of college-educated labor candidates, the quality was considerably better since colleges had an incentive to maintain quality control. This is no longer the case because the federal government is paying colleges, indirectly, to simply pass out degrees to young adults with no regards for their qualification.
Thus, the lower wages that have resulted from the increased pool of labor applicants can be thought of as a risk premium. Because there are more college-educated people in the labor supply coupled with increased variance of abilities without there being an increase in the sharpness of the signal generally associated with a college education, and because American labor is tightly regulated with regards to discrimination (particularly as it pertains to firing employees), there is consequently more risk associated with hiring someone because the chance that person a company hires turns out to be a bust, as it were, is considerably greater. Given the costs associated with firing incompetent workers, particularly if they are in a union or minority, employers have an increased incentive to mitigate that risk by offering lower wages.
As such, the most problematic aspect of the college bubble is the consequences that come with signal distortion. Because the supply of college educated labor has increased with a matching increase in demand for said labor, and because a college degree isn’t nuanced enough as a single, there will be an increase in the number of people who are overpaid and an increase in the number of people who are underpaid. This happens because the signal sent by a college degree is roughly the same for everyone who has one.*
Some people will be underpaid because their aptitude is such that they would ordinarily deserve more pay than they are currently receiving but, because it is now more difficult to tell who has what levels of aptitude, they must take a pay cut. The reverse is true for those who are overpaid. Basically, the inflation in the number of students undermines meritocracy, thereby distorting the pay scale. Thus, the current bubble has introduced not only distortion, but market failure on a large scale.
The irony of the current college bubble is that its existence is largely predicated on the belief that a college education makes one more intelligent. This claim is laughable on its face because it does not begin to account for the self-selection bias inherent in this sort of activity. Do students learn because they go to college or do they go to college because they like to learn? This is a crucial question because if the answer is the latter, then it seems likely that those who do go to college would become just as knowledgeable if they lived in a library for four years.
At any rate, the college bubble has had the nasty effect of giving diplomas to those who have no desire to learn, and have undermined the meritocracy that once was a college education, thereby depriving those who are truly above average from an income that would properly reflect this fact. This, then, is the lamentable effect of the college bubble: The attempt to make everyone equal in education has only led to a diminution of standards. We are all idiots now.
* Obviously, a Harvard diploma is still more valuable than an ITT Tech diploma. However, if Harvard’s business school doubles the number of graduates, year over year, the value of a Harvard degree will decline assuming that there is not a corresponding increase in demand for Harvard grads.
By Christopher Briem, on December 5th, 2011
So I wind up often getting into an agument that boils down to me disagreeing with a common belief that the recent recession for Pittsburgh is a slightly milder, but still very similar experience to the recession of the early 1980’s. Nationally it was actually two recessions officially (January to July 1980 followed by the longer period July 1981 to November 1982), though I think most would agree that the two recessions really were one big recession for the Pittsburgh region.
So as the national news parses the good unemployment numbers yesterday, the nabob version focuses on the drop in the labor force participation the numbers seem to show. It lead me to making the graph below. I took the labor force trends in Pittsburgh and made a comparable index from a period early in the two recessions. So from January 1982 and from January 2008 forward, the graph shows what happened to the national and Pittsburgh region labor forces over the subsequent 4 years. The graph shows the change from those baseline months. Lot’s to parse from it, but just take a look:
 The extreme differences for Pittsburgh in the two recession (1980s vs recently) go way beyond what that graph shows. That decline in labor force in Pittsburgh actually masks the decline in the male labor force a bit as women entered the workforce in record numbers to replace the men who were out of work. The drop in the labor force clearly correlate with the net migration that spiked from the region and the drop in population it caused. The folks who were leaving both the regional labor force and leaving the region period were predominantly younger workers who were the folks most capable of adapting and changing to new jobs in new industries. Those who stayed were far more likely to be older workers who had been displaced from the occupations they had had for decades and for many would never find new employment. Today we know that in recent years we have seen the first net migration into the Pittsburgh region in decades and changes in migration patterns almost entirely reflect changing migration patterns of young workers. It is folks in their 20’s who dominate migration flows with rates of migration dropping as folks get into their 30’s, 40’s and older.. until there is a bit of a spike in early retirement years. So if net migration for the Pittsburgh region flipped from net negative to net positive just a few years ago, it has to reflect changes in the flow of younger workers into the region.
So, just as the incredibly high unemployment rates of Pittsburgh in the early 1980’s persisted even though so many workers were leaving the region which would have taken a lot of potentially unemployed folks out of the regional labor force… masking how bad the employment situation really was; today the regional unemployment rates are being impacted by more workers, or those seeking work, flowing into the region and potentially making local labor force metrics look worse than they appear otherwise.
By Doug Gentry, on December 5th, 2011
The pharmaceutical giant, Pfizer, watched its main source of revenue and profits, Lipitor, lose its patent protection this week, and now faces competition from generic equivalents. In 2010 Lipitor was the second highest selling prescription drug with $5.2 billion in sales in the U.S. alone. (source: Drugs.com). Now, in the next year, prices of the generic drug, Atorvastatin, should drop dramatically. The Lipitor saga gives us an opportunity to see market forces in action, but it also points out the problems when insurance coverage is involved.
 Lipitor Brand  Generic Lipitor Like most first world countries, the United States uses the patent system to encourage research and development. If a pharmaceutical company can develop a new drug, they can maintain a government approved monopoly on the sale of that drug for up to 17 years. Monopolies drive higher prices, which helps the inventor, Pfizer in this case, recoup their research costs, and return a handsome income to their shareholders. Once the patent runs out, other manufacturers can apply to produce the drug. This increased competition then quickly drives down prices. So far, this is a classic example of market forces at work.
Pfizer has been planning for this day for a number of years, and with annual sales figures like those in 2010, this is vital to the company’s fortunes. The company has triggered a number of legal and regulatory efforts to delay the arrival of generic equivalents. For a compilation of news articles on Lipitor, see this page in The New York Times.
Two particular strategies twist prescription drug coverage in favor of the brand name. Many prescription drug plans have incentives to encourage patients and their physicians to use generic drugs. Often this is done with a lower co-payment on the part of the patient. The lower co-payment provides an incentive for the patient to accept a generic equivalent, and the insurance plan saves money by paying the lower, generic price. Pfizer (and other drug companies facing similar out-of-patent challenges) is trying to subvert this incentive. Here’s a hypothetical example.
These figures are illustrative – made up – but make the point.
Typical Brand vs. Generic Comparison for a Drug Plan
Brand: Patient Copay: $30 – Total Cost of Drug: $200 – Insurance Pays: $170
Generic: Patient Copay: $10 – Total Cost of Drug: $50 – Insurance Pays: $40
Now Pharmaceutical Company Offers a Copay Discount
(Pfizer discounts its price of the brand drug to cover reduced copay)
Discount Brand: Patient Copay: $8 – Total Cost of Drug: $178 – Insurance Pays $170
With this discount arrangement the patient is happy, the drug store doesn’t lose any money, but the insurance company still pays the larger cost. This puts upward pressure on insurance premiums.
Another strategy – Pfizer offers a significant discount on the price of brand name Lipitor to pharmacy chains as long as they agree to not provide generic equivalents. The chains save money, and can pass some of that on to patients, but the insurance plans that pay for the drugs don’t enjoy any savings.
Is this legal? The second, discounting strategy with pharmacies, smells a lot like restraint of trade/anti-trust concerns to me. The earlier example, offering a discount on copays, seems legal. Are either of these good social policies? Not a chance.
These creative approaches illustrate one of the problems that insurance introduces into a market. In healthcare, patients have enough discretion that they can alter their buying behavior, based on prices they face. Yet the patients don’t see or feel the full price of their purchase decision. In a regular market the patient balances the benefit of the purchase against the price, and makes a good decision on allocating resources. That good decision helps society. With insurance the patient sees only a small fraction of the total price, and may make a decision that is not socially optimal. This breakdown in market forces is one of the challenges our healthcare reform goals face. Ideally we would like patients to be full partners in the decisions made about their care. Insurance blunts that participation.
By B.P.T., on December 5th, 2011
At 10:00 AM Eastern time, the Factory Orders report for October will be released. The consensus is that there was a decrease of 0.3% in orders from the previous month.
Also at 10:00 AM Eastern time, the ISM non-manufacturing index for November will be released. The consensus estimate is that increased by 1 point to a value of 53.9, and will continue to signal economic growth as it remains above the mid-point of 50.
By Simon Grey, on December 2nd, 2011
Let’s assume a 2% productivity increase per year over 30 years. Let’s also assume a 2% inflation rate over 30 years. This is what it looks like, starting with a baseline of “10,000.”
Your cost of living has gone up by 78% in notional dollar terms but it should have gone down by 44%!
The spread between those two lines was literally stolen by the banks and government acting intentionally as a group. They defrauded you, stealing your economic output and improvement in productivity, using it to hide the impossibility of continual deficit spending. Summed, the line is flat—but it should not be; that improvement in standard of living belongs to you, not them.
Basically, as production becomes more efficient the cost of products should decline. For example, computers that once cost millions of dollars in 1970 should cost roughly $50 today.* Instead, it costs six times that. What’s amazing is that efficiency of production has increased so dramatically for computers that the nominal price has decreased in spite of the dollar’s purchase power declining by roughly 83%.
At any rate, inflation works as a form of theft because it robs people of the benefits of their increased productivity in the form of higher prices. This happens because of the very simple rules of supply and demand.
Nominal price is determined by demand of a product relative to supply of a product relative to the money supply. Products with high demand low supply will generally have high prices; those with low demand and high supply will have high prices. As long as the money supply remains stable, nominal prices will be mostly contingent on the supply and demand of the product in question.
If, however, the supply of money fluctuates, nominal prices will fluctuate accordingly. Decreases in the money supply will lead to decreases in the nominal price, assuming that supply and demand remain unchanged. Conversely, increases in the monetary supply will lead to nominal price increases, again assuming that supply and demand remain unchanged. The reason for this is simple: the monetary base does not, in and of itself, make more things available for purchase. If you have ten cars, it does not matter if the monetary base is ten units or ten thousand units; fluctuations in the monetary base don’t change the underlying reality that there are a finite number of goods available for purchase.
Now, what makes inflation so pernicious as a form of theft is that it requires that the increased money supply make its way into the economy. This is not accomplished smoothly or evenly (i.e. the government doesn’t dump in all the money at once, and doesn’t distribute the extra money to everyone in the economy). As such, the government must give the money to someone.
In recent cases, the recipients of inflation have been major banks. Because they get the extra money first, they benefit from the effects of the increased money. While markets are efficient, they do not act instantaneously to new information, which is a fancy way of saying that it takes some time for the new money to make its way into the economy. The early recipients take advantage of the lower prices by buying more, which drives up the price of goods. The later recipients of the money see the prices rise before they get the extra money. Basically, then, inflation works as a tax on the politically disconnected (usually the poor and middle class) since the rich tend to get the money first and buy at low prices which drives up the prices for everyone else. Thus, inflation is basically a form of income redistribution.
Since the government has control of the money supply and gets to pick the initial recipients of inflation, it is therefore fair to say that the government is stealing from the poor and middle class and giving to the rich because it is basically robbing the poor and middle class of their increased productivity (which should be seen in the form of lower prices) and giving to the rich (who get to purchase at lower prices before driving them up). Thus, it should be clear that inflation is nothing more than outright theft, and should be viewed as such. The government, then, deserves the outrage of all of its productive citizens.
*It’s impossible to match machine specs across eras, so I simply took the cheapest computer available today, which is this HP desktop and adjusted the price for inflation using Tom’s inflation calculator. The dollar amount was 300, the starting year was 2010, and target year was 1970. Data for the cost of the best computer of 1970 was found here. Note that that Wal-Mart’s crap computer is still superior to the best the 1970 had to offer.
By The Energy Report, on December 2nd, 2011
 Attention Shoppers: There are some amazing values currently available at bargain prices in the energy department. That’s pretty much what Chen Lin told us in this exclusive interview with The Energy Report. The current level of risk aversion by most investors has left the doors wide open for those who are willing to see real values and major potential in oil and gas producers.
The Energy Report: You last spoke with us in early June. What has transpired in the oil and gas markets since, and has it altered your investment thesis?
Chen Lin: The oil price has been going up and down because a lot of traders are mispositioned and are scrambling around. That makes the market very volatile. However, WTI is around $100 again, which is quite surprising because we are still in the middle of a recession. World oil demand is still there, and whenever there’s a drop in the oil price there’s a lot of buying. I’m quite surprised that oil is still around the $100 mark. Personally, I would like to see it in the $80 to $90 range. That’s actually good for the oil consumers. If gasoline is below $3.00 that really helps the U.S. consumer.
TER: Domestic natural gas prices, on the other hand, have been in a continuous downtrend since June. It seems shale gas has created a glut. What’s your assessment of that situation?
CL: There’s so much natural gas being produced in the U.S. that we can’t consume it and, then there are no facilities to export it. The oil/natural gas price ratio may go up further. It really depends on how much gas is produced. If you want the market to really work you need to create more natural gas demand with export facilities or a policy to make cars run on natural gas. Then drivers can enjoy $1/gallon equivalent in gas. That would be a huge demand boost and would make natural gas prices go higher. Without those on the horizon, the natural gas price may come down further.
TER: So, what do you think would happen to the oil market if the Eurozone situation deteriorates further?
CL: It would be negative for the oil market; that’s for sure. Globally, investors must take into account the demand disruption in Europe versus the demand increase in developing countries, which is still an ongoing trend. If there is a depression in Europe, of course oil will go down, probably as far as it did in 2008. If Europe can avoid a depression, we may see an even higher oil price.
TER: How has your energy stock portfolio performed since we spoke in June?
CL: Last June, I was in the process of reducing energy stocks because of the European crisis threat. In the past few weeks, I started to increase oil exposure substantially because there are a lot of very cheap energy stocks. You can buy your oil stocks for pennies on the dollar. Also, energy stocks, even though they are very capital intensive, are not as capital dependent as mining stocks. Energy companies can drill a well and then pump the oil and sell it. Then they can use the capital to finance the next well, whereas mining companies need to keep raising money to maintain production. That is why I like oil producers. With $70 -$80 oil, they can make good money, and $100 oil is really great money. They will have a lot of capital to deploy and enjoy a lot of cash flow.
TER: You get a pretty immediate payout and don’t have to sit around for years waiting for approvals and licenses and building. So, there’s definitely that advantage.
CL: Exactly.
TER: In June you mentioned that your biggest holding, at that point was Mart Resources Inc. (MMT:TSX.V). Is that still the case? What’s been going on with the company since then?
CL: That’s still the case. I’m holding a lot of Mart Resources. During the summer when the market turned south, I was still holding the stock because I really believe in this project. I heard the company was making presentations at conferences where it was talking about the potential for very large dividend payouts, starting next year. Right now it’s trading about one times after-tax cash flow, according to the management. So, it can basically pay out any dividend it wants. It will probably start low—maybe $0.05 or $0.10. A $0.10 dividend is almost a 20% yield at the current share price. Then it will start going higher because it is going to accumulate so much cash from its oil drilling program. Every well in this year’s drilling program is a successful well—every well! I think two are around 10,000 bpd. One is 6,000–7,000 bpd. In North America, if you have 600 or 700 barrels, it’s a very good well. These are much bigger. So, Mart is just waiting to reach a deal with the pipeline company so it can start pumping more oil out. It’s supposed to be very soon. Once it reaches that stage, it will be cash-flowing at one times market cap. That will be a huge catalyst. Plus, the dividend payout will be another big catalyst. I’m looking for a much higher stock price.
TER: This is Umusadege Field in Nigeria you’re talking about, is that right?
CL: Right. Mart just found an amazing amount of oil. Its well production in the past 2–2 ½ years has shown no decline. In North America, after a month or two it could drop in half, like in the Bakken. The steady production means the company is sitting on a much larger pool than people can imagine. The next catalyst will be its reserve calculation. With all the production it’s had and all the successful drilling, this year’s reserve will be much higher than last year’s. With last year’s reserve, if I remember correctly, the 3P net asset value (NAV) of 2010 is way over $1.00 per share. This year it could easily double that, maybe even more. Meanwhile the stock is still at $0.64. That tells you how much upside it has just from the NAV. Then you can look at it from cash-flow side and the dividend side and you can see that the stock is very, very undervalued.
TER: So, what’s the market cap for the company at this point?
CL: I think it’s about $200 million (M) and they will probably cash-flow more than $200M.
TER: Boy, that is a real bargain, isn’t it?
CL: I’ve been holding this as my largest position because I feel so compelled. It’s been undervalued for a long time. Partly it’s because the market was very bad this year. Nobody really paid attention. In the meantime, the company has had one drilling success after another. Not just successful but very successful. The market has shown no response to that. But the company can immediately sell the oil and get into cash-flow. So, if the market doesn’t respond now, it will respond later. That’s why I was holding it as my largest position throughout the turmoil this year.
TER: Do you think is the project’s location in Nigeria might make some investors wary?
CL: That could be the case. The Nigeria situation is a little bit volatile. But, again, this is an OPEC nation and Mart exports through its standard pipeline. It has some interruptions from time to time, but management has already factored that into its cash-flow calculations.
TER: What do you think the chances are that the company will get bought out by a major with this kind of production?
CL: It could be. There was another Nigerian company that was bought out by a Chinese company for $7 billion (B) last year. Mart will likely be producing at that level in a year or so. Right now it only has a $200M market cap. So, you can see the upside is huge. Furthermore, the company does not need to come to the market to raise money. That’s why it’s in an ideal situation and why I like it.
TER: Another one that you were quite positive on last time was Harvest Natural Resources (HNR:NYSE). You said that you thought that it might be up for sale. What has transpired with that one?
CL: Its Venezuelan project is still for sale. That project is actually generating very nice cash flow. The company has about $3–$4.00 cash on its balance sheet. So, it’s pretty well cashed up. It is producing oil from its oil field in Venezuela and it is paying dividends. It uses the money to drill wells elsewhere. The stock had a little bit of a setback when the company hit a well in Indonesia and the first part of the well was not as good as people expected. But it hit a very good well off of Gabon in Africa and then it will drill another well in Oman. Plus, it is continuing to drill in Indonesia. So, it has a lot of excitement coming. The company is still trying to find a buyer for its Venezuelan asset and probably a Chinese or Russian company that is closer to the government that might buy it.
TER: So, the upside still looks pretty good for that one as far as you’re concerned.
CL: Yes, the upside is big. It’s just that the market has not put all the pieces together yet and calculated how much the company’s assets are potentially worth.
TER: Maybe that’s because Harvest is spread out geographically and people have a hard time understanding it versus if it were all in one country or one location.
CL: Exactly. That’s also a big issue.
TER: Another one you talked about last time was Porto Energy Corp. (PEC:TSX.V). It had a new gas discovery in Portugal. At that point, the value of that was much greater than the price of its stock. What’s going on with that one and where do you think it is going?
CL: Right now the market is so afraid of risk that investors seem to be getting rid of any company that’s associated with risk. Porto is a perfect example. It already has a natural gas discovery and is trying to expand and bring that into production. The natural gas pipeline runs through its property. The company was IPO-ed earlier this year at $1/share. Right now it’s about $0.25. It’s getting close to the cash it has on hand and it can generate immediate cash-flow. The Portuguese government is extremely supportive of what the company is doing because the nation wants the tax revenue and the jobs. Portugal’s government is trying to help Porto anyway it can so production can come online.
TER: So that one is definitely undervalued, compared to where it was in June, with a lot more upside potential.
CL: Exactly. There are a lot of companies, both in energy and in mining, that have been hit hard. If you are willing invest with a little bit of risk appetite, you can find a lot of very undervalued stocks that can go up very significantly once the market stabilizes. I’m still trying to stay with companies that have strong cash flow, and good balance sheets so that they don’t need to come to the market to raise money. That can help you weather the storm.
TER: Are there any other companies that you might want to mention at this point?
CL: I’ve been taking a position in quite a few energy companies, some quite aggressively. One is Pan Orient Energy Corp. (POE:TSX.V). I had the stock before. It’s at $2 recently from $6 earlier this year. The company raised money at more than $6 earlier this year, so it has a very strong balance sheet with about $1/share on its balance sheet. It drilled two wells in Indonesia. One was a failure. The second one was non-conclusive. The company couldn’t finish it. So, it stopped and tried to find another driller. It will start drilling, I believe, this month. In the meantime, the market hit the stock hard. Pan Orient has a producing oil field in Thailand, which is producing a lot of cashflow (It is trading at about 2 times cashflow). It also has an oil sand property in Canada. In addition, it will be drilling this big potential well in Indonesia. Can the stock go lower? It’s possible. But, I feel it’s so undervalued that I started buying it quite aggressively.
Another stock I bought quite aggressively recently is PBN, PetroBakken Energy Ltd. (PBN:TSX). It is paying a 10% dividend right now and the stock is less than $10.00. You get a monthly $0.08 per share dividend. The stock was hit very, very hard because it missed its earning guidance in the past few quarters. In addition, it has a sizeable debt. So investors are worried about that, which has caused rounds of selloffs. It sold down to where it was paying a 15% dividend. So, I picked it up not long ago at a slightly lower price. It had very good production in the recent quarter and seems to have hit its targets. Management has indicated it has no problem paying all the dividends as long as the oil price doesn’t crash. So, basically you’re getting paid a 10% dividend while you wait for the stock to appreciate, which it is.
TER: How do you think energy investors should plan for the coming year, given the turmoil in Europe, the world and domestic economic situations and the 2012 elections?
CL: I’m just looking at global production, supply and demand. Investors should know that India has no strategic oil reserves and it is a very important oil user right now. China is still expanding and building its strategic oil reserves. Last time I checked, China’s oil reserves can last only one-third as long as U.S. reserves. China will likely fill up more of its tanks on any dip in the oil price. There should be good demand for oil in the current market unless we have a complete breakdown of the euro.
On the investment side, I like to invest in land-based oil producers because sea-based oil production has high capital requirements. I also prefer oil producers versus natural gas producers in North America because these kinds of companies tend to perform better in this market.
TER: Do you expect the year-end tax loss selling season to present some good buying opportunities?
CL: Oh, yes, absolutely. For example, on Pan Orient, one of my plans was to wait until tax-loss selling in December to buy, but in November it already dropped to below $2.00. I said, “Okay, let’s buy it right now, right here.” There could be more tax-loss selling coming, but these are very good opportunities to buy—especially companies with very strong balance sheets and good cash flow, which don’t need to raise money. The dip will, most likely, be temporary and there will be very good buying opportunities for a lot of these stocks.
TER: So, we’ve got another few weeks to pick up some bargains before the end of the year.
CL: Yes. I do want to mention that, generally, the oil market bottoms in the winter and then goes up in spring all the way to summer. So, we’re coming to a very strong part of the seasonal oil price cycle.
TER: That’s a great suggestion. Thanks for taking the time to talk to us today.
CL: Thank you for the opportunity.
Chen Lin writes the popular stock newsletter What Is Chen Buying? What Is Chen Selling?, published and distributed by Taylor Hard Money Advisors, Inc. While a doctoral candidate in aeronautical engineering at Princeton, Chen found his investment strategies were so profitable that he put his Ph.D. on the back burner. He employs a value-oriented approach and often demonstrates excellent market timing due to his exceptional technical analysis.
By Ajay Shah, on December 2nd, 2011
q: How big is the market for the rupee?
The rupee is now a big market. Summing across both spot and derivatives, perhaps $30 billion a day of onshore trading and $40 billion of offshore trading takes place. Both these markets are tightly linked by arbitrage. In other words, for all practical purposes, it’s like NSE and BSE which are a single market unified by arbitrage. If you place a small order to buy 100 shares on either NSE or BSE, you get essentially the same price, and arbitrageurs are constantly at work equalising the price across both markets. It is a similar state of affairs between the onshore and the offshore rupee. Both markets are tightly integrated by arbitrage.
The offshore market for the rupee, and a large part of the onshore market, is OTC trading. Hence, the efficiencies of algorithmic trading and algorithmic arbitrage cannot be brought to bear on onshore/offshore arbitrage. So the arbitrage is done by manual labour. Still, it gets done. Both markets are tightly linked and show the same price. We should think of them as one market. It’s one big market, it is one of the big currencies of the world, it’s roughly $70 billion.
q: How might RBI do manipulation of this market?
If RBI wants to hit the market with orders big enough to make a difference, they have to be ready to do fairly big orders and to be able to do it on a sustained basis. As a rough thumb-rule, I might say that in order to make a material difference to a market with daily volume of $70 billion, they have to be in the market with atleast $2 to $3 billion a day.
q: What would go wrong if they tried this?
Three things would go wrong.
First, foreign exchange reserves are $275 billion. If RBI sells off $2.75 billion a day, the reserves would be quickly gone.
Second, when RBI sells dollars and buys rupees, this sucks liquidity out of the market. The side effect of selling dollars would be a sharp rise in domestic interest rates. In other words, monetary policy would get hijacked by currency policy. This would not be wise. Monetary policy should be focused on delivering low and stable inflation: it should have no ulterior motives.
Third, suppose you and I saw a fake market price of Rs.45 per dollar, which is created by RBI and not a market reality. We would know that in time, the truth will out, that the price will go back to Rs.52 a dollar. The rational trading strategy for each of us would be: To sell any domestic assets, and to shift money out of the country. This would trigger off an asset price collapse in India. We would take the money out, and wait for RBI to give up on these adventures. At that point (perhaps Rs.52 a dollar, perhaps worse) we would bring the money back to India and buy back our assets. We might make two returns here: first, on the move of the INR/USD from 45 to 52 (or worse) and on the drop in asset prices.
q: Isn’t it hard to take money out of India in this fashion?
It’s easier than we think. Remember September 2008? The mythology in our heads was: India is crouching safely behind a wall of capital controls. In truth, the wall wasn’t there.
q: But until recently, Mother RBI used to give us a pegged INR/USD exchange rate! What changed?
In late 2003, RBI ran out of bonds for sterilisation. Associated with that, there was a first structural break in the rupee exchange rate regime, with a doubling of volatility. A short while later, in March 2007, there was another doubling of volatility. From April 2009 onwards, RBI’s trading in the market has gone to roughly zero. Mother RBI stopped managing the exchange rate a while ago.
The exchange rate is the most important price of the economy. The decontrol of this exchange rate is the biggest achievement of the UPA in economic reforms. The credit for this goes to Y. V. Reddy and Rakesh Mohan (who took the first two steps of doubling exchange rate flexibility) and to Dr. Subbarao (who got out of trading on the currency market, which did remarkably little to INR/USD volatility).
q: Why did nobody tell me that something changed in the exchange rate regime?
RBI should be talking more transparently about what is going on. But they are not transparent about what they do. Even though hundreds of millions of people are affected by their trading on the currency market (or the lack thereof), the manual which governs their currency trading at any point in time (i.e., the documentation of the prevailing exchange rate regime) is not transparently disclosed to the people of India. We have to decipher what is going on by statistically analysing exchange rate data.
q: So what might happen to the rupee next? Is there a `law of gravity’ which will pull it back to erstwhile values of Rs.45 or Rs.50?
When you don’t manipulate a financial market, the price time-series comes out to something close to a random walk. In the ideal random walk, all changes are permanent. The random walk never forgets; there is no law of gravity which takes it back to recent values. Your best estimator of what it will be tomorrow is: what you see today.
In order to get a sense of what will come next, go through the following steps. First, go to INR/USD options trading at NSE, and pluck out the implied volatility for the four at-the-money options. I just did that, and the values are: 10.43, 10.32, 10.33 and 10.08. Calculate the average of these. With the above four values, the average is: 10.3. (This is a quick and dirty method; here is one which is much better).
This tells a very important thing: The options market believes that in the future, the volatility of the INR/USD rate will be 10.3 per cent per year.
In order to re-express this as uncertainty per month, we divide by sqrt(12). This gives the volatility for a month as : 3% per month.
Roughly speaking, the 95% confidence interval for what might happen over a month, then, runs from -6% to +6% (this is twice the standard deviation, which we just worked out was 3% per month).
The INR/USD is now Rs.51.62. By the above calculation, we can be 95% certain that one month from today, it will lie somewhere between 48.5 and 54.7.
These trivial calculations have been done by equity market participants for the longest time. It is a standard and trivial idea: To read the implied volatility off the Nifty options market, and to do such calculations to get a sense of what might come next with Nifty. But on the currency market, this is relatively novel. Only recently have we got a nice currency options market, and only recently have we got to a genuine market. Now these skills can be brought to bear on the currency market.
q: What changed in imports and exports which gave us the big recent move of the rupee?
The current account (goods, services, and then some) adds up to a mere buying and selling of $4 billion a day. The bulk of currency trading is about the capital account. The currency is a financial object; the exchange rate is defined by financial considerations and not by current account considerations.
q: What happens to the Indian economy when the rupee depreciates?
This has been the source of a great deal of confusion and it’s important to think straight about this. There are exactly three important effects in play:
- Some people had borrowed in dollars, and left is unhedged since they were speculating that the INR would appreciate. They have got burned. That’s okay – in a market economy, many people place bets about future fluctuations of financial prices, and half the time the speculator loses money. (If the rupee had not depreciated sharply, these speculators would have been truly joyous).
- When the rupee depreciates, imports become costlier and India’s exports become more competitive. So exports (X) gradually start going up and imports (M) gradually start going down. The net gain in X-M is increased demand in the local economy. In this fashion, INR depreciation is good for aggregate demand (and conversely INR appreciation pulls back demand). However, we have to bear in mind that these effects are small and take place with long lags.
- Many things in India are tradeable. It is important to focus on the things that are tradeable and not imported. As an example, there are many transactions between a domestic producer of steel and a domestic buyer of steel. Both buyer and seller are in India. But the price at which they transact is the world price of steel (which is quoted in dollars) multiplied by the INR/USD exchange rate. Through this, the domestic prices of tradeables go up when the rupee depreciates.
q: What is the impact of costlier tradeables for RBI?
RBI’s job is to fight inflation. RBI must work to deliver year-on-year CPI inflation (a.k.a. `headline inflation) of four to five per cent. When tradeables become costlier, domestic CPI inflation goes up. So the rupee depreciation has made RBI’s job harder. RBI will have to respond by hiking interest rates. (Note that one impact of higher interest rates will be that more capital will come into India, which will tend to yield a rupee appreciation).
q: What is the impact of costlier tradeables for business cycle conditions in India?
As the example above about steel suggests, the price realisation of all tradeables companies goes up when the rupee depreciates. Costs change by less, and profitability goes up.
Firm profitability has dropped sharply in 2011. My prediction would be that firms producing tradeables will show better profitability in Oct-Nov-Dec 2011 when compared with the previous quarter, thanks to the rupee depreciation.
This is great news for business cycle conditions. Profitability goes up, which yields more cash for investment by financially constrained firms. And, when profitability is higher, more investment projects look viable.
q: In the bottom line, what is the link between the rupee and India’s business cycle stabilisation?
If RBI tried to peg the exchange rate, the lever of monetary policy would get used up to deliver the target exchange rate. By not trading on the currency market, the lever of monetary policy is now available. A pretty good use for this lever is to deliver low and stable CPI inflation.
But floating the exchange rate also yields stabilisation purely in and of itself. In bad times, capital leaves India, the rupee depreciates. This gives higher profitability in tradeables firms. Conversely, when times are good, more capital comes into India, the INR appreciates, which crimps profitability of tradeables firms. This is the most remarkable feature of the floating exchange rate: it exerts a stabilising influence upon the economy. Purely by doing nothing on the currency market, RBI has unleashed this new force of stabilisation which will help India.
q: What should RBI do next?
RBI should do as they have done, i.e. avoided trading on the currency market.
RBI should keep driving up the short-term interest rate until point-on-point seasonally adjusted CPI inflation shows a decline and goes into the target zone of 4-5 per cent. Once it hangs in there for a year, `headline inflation’ (y-o-y growth of CPI) will be in the target zone.
 
|
|
Most Popular Posts