Citizen Economists » infrastructure

China’s Future Deconstructed: Holmes vs. Chang

The Gold Report — Mon, 02 Jan 2012 13:50:21 +0000

China has become the $5.88 trillion question in the world financial equation for 2012. In an attempt to gauge the direction of this economic elephant, Cambridge House International is asking two China experts to debate the health of the second-largest economy at the Vancouver Resource Investment Conference January 22. We called the two speakers for a preview of the tactics they will take in this epic debate.

Frank Holmes, chief executive and chief investment officer at U.S. Global Investors, will focus on the upside of massive Chinese modernization and growth. He is the recipient of both Mining Fund Manager of the Year Award from Mining Journal and International Citizen of the Year Award from the World Affairs Council of America and has a long-term investor’s view of international geopolitics.

Author and Commentator Gordon Chang literally wrote the book on why investors should be wary of China’s growth. His book The Coming Collapse of China has attracted attention from the likes of the LA Times and Asia Times and many other publications in between. He has made appearances on Fox News and regularly contributes to Business Insider, Barron’s, National Review and Forbes magazines. When he lived and worked in China and Hong Kong for almost two decades, most recently in Shanghai as counsel to the American law firm Paul Weiss, he saw the ghost cities and environmental challenges up close.

“The debate is a direct response to attendees who need to know if China is on a course to grow, slow or blow,” said Nicole Evans, president of the Cambridge House International Conference Division. The Gold Report called these two experts to find out the numbers behind why they have such different predictions about how this enigmatic country will fare in the coming years.

Frank Holmes: This veteran investment advisor based his positive prognosis for China and its Eastern neighbors on a combination of tacit knowledge learned firsthand through travel and observation of geopolitical conditions along with explicit knowledge of history and the markets.

He studies S-curve patterns, modeled on economist Simon Kuznets’ 20-year long cycles. For example, the world’s population has grown from 1 billion in the 1800s to 7 billion today, which has drastically affected commodity consumption and infrastructure buildout. “Nowhere is this more evident than in the emerging markets, such as China,” Holmes said.

“When governments have invested in infrastructure, there has been a powerful impact on gross domestic product (GDP) numbers.” For example, he pointed to the 1950s, when Eisenhower signed the Federal Aid Highway Act, allowing commerce to expand across the nation, with restaurants including Dairy Queen and McDonald’s experiencing tremendous growth over the next several decades. “Paved roads from coast to coast helped sustain a more than tenfold increase in U.S. GDP,” Holmes said.

“Whereas the U.S. connected 160 million people with nearly 47,000 miles of freeways, by 2020 China will connect 700 million people across 250 cities, spanning more than 47,000 miles of interstate and 18,000 miles of rail,” Holmes explained.

Holmes estimated that over the next 25 years, about $41 trillion will be spent on global infrastructure—$6 trillion has been approved for the 2011 through 2013 timeframe with China projected to spend half of that $6 trillion. He believes these investments will result in rising GDP per capita and trigger a consumption economy.

“Once China connects its super cities, it will enable more Chinese to travel around the country, resulting in a completely different consumption pattern. You will see train stations with 50-story condominiums along with U.S. restaurants that have already been expanding in China, including McDonald’s, Dairy Queen and Starbucks. Major hotel chains, such as Wyndham, Starwood and Hilton, along with luxury goods businesses including Cartier, Hermes and Gucci will compete for market share. Infrastructure will change the face of the economy in China just the way it did in the U.S.,” said Holmes.

“We are big believers that government policies are precursors to change, so our investment team continuously tracks the fiscal and monetary policies of the world’s largest countries in terms of economic stature and population. The G-7 (industrialized) countries are 15% of the world’s population but 50% of the world’s GDP and growing only about 1%. Western countries seem to be focused on cutting back infrastructure spending and raising taxes to pay for entitlements. At the same time, E-7 (emerging) countries comprise 50% of the world’s population with 20% of the world’s GDP. However, these countries are growing at 7% to 8% and include a rising middle class of some 60 million people out of a total 2.2 billion people. But, 60 million people making $30,000 a year is very significant. Think about the movie “Slumdog Millionaire”—this is what is happening throughout Asia. That is why companies such as Gap and GM and KFC are focusing on expanding in China where its residents love American products and pack the stores in Beijing.”

Holmes also saw important policy changes in the works that could improve China’s economic outlook. “Over the past 10 years, we have seen a slow migration of more property rights being given to people in China. The largest transfer of real estate in the history of mankind took place in China seven years ago when more than $500 billion of real estate value was basically transferred to farmers. That was followed by condo building. Additionally, to attract public companies, Shanghai adopted the Hong Kong Stock Exchange listing and bankruptcy systems, which are based on common law. This is significant because if you look at all the countries that have had financial problems over time, no common law system has ever gone bankrupt. Civil law has. China is slowly adopting a rule of law system.”

Not all of the changes have been smooth. “One of the biggest things that China has been wrestling with is the fear of inflation,” Holmes said. “The government raised the minimum wage and that resulted in a big spike in food inflation. Then it had to deal with real estate inflation in Shanghai and the cities along the ocean. It required banks to keep more reserves, up to 20% in some cases, to avoid the problems now occurring in European banks. A tax on speculative real estate slowed the economy and it showed up in the psychology of the stock market.

“The spike is slowly reversing and rates are falling. Because there is so much less borrowing generally in China than in the rest of the world, prices rebound much faster,” Holmes said. “Only 25% of homes have mortgages so the impact of bankruptcies is much smaller. Also, I don’t think they’re going to print money the way they did in 2008. The Chinese government will move slowly to make sure the country doesn’t get hurt by Europe’s slowdown.”

Based on money supply, debt levels and the weakness of the dollar, Holmes predicted economic activity in the emerging countries should double over the next five years. “It is going to be between 8% and 9% this year and it has another 10 years of growth ahead of it,” Holmes said. “Investors need to understand volatility and not be fearful of it. If you are trading futures where your leverage is 10 to 1 and you have a big correction, you can get wiped out. But, if you are a cash business, you understand when these markets go through these corrections. Solid companies paying dividends can be an attractive investment over the long term.”

Gordon Chang: This China-watcher recently wrote an article for Forbes that said what others considered positive November trade numbers—exports up 13.8%, imports up 22.1% year-over-year—was actually an indication of flat consumer demand once the commodities were factored out. His conclusion was that the government was taking advantage of low prices to stockpile things like soybeans, copper and iron ore while domestic demand remained stagnant. “Since September, we have seen essentially flatlining growth,” he said.

“The growth over the last three decades has been absolutely stunning, but that was then, and this is now,” Chang cautioned. “After 35 years of virtually uninterrupted growth, the Chinese economy hit an inflection point, probably in September of this year. I think we are going to see a long-term cycle down. There are a number of reasons for it, some of them short term, some of them long term. The reasons that created this growth either no longer exist or are disappearing fast. Deng Xiaoping’s policy of reform paired with the end of the Cold War and expansion of globalization triggered growth in the 1980s. However, under current leader Hu Jintao, China has seen the reversal of reform, with the government partially renationalizing the economy. Today, we are in the second part of a global downturn, which will be much worse than what started in 2008. A trade-dependent economy like China’s is going to have real problems. Additionally, China was aided by the demographic dividend, an extraordinary bulge in the Chinese workforce, which by most estimates will level off between 2013 and 2016, leaving a demographic tax where one worker supports two parents and four grandparents.”

Chang pointed to stagnant electricity consumption, flat car sales, plunging industrial orders and collapsing property prices. “For example, in October, we saw property prices collapse 30% in places like Shanghai and Beijing, and actually across the country. That has to eventually trigger a negative wealth effect.

“Domestic growth is vital for a sustainable economy,” Chang said. “Last year, domestic consumption comprised less than 34% of Chinese GDP and it has been dropping in recent years. That means China is not restructuring its economy because the problems go to the core of the political model. The government would have to let the Renminbi float, allow banks to offer market rates of interest to depositors and state enterprises, allow workers to bargain collectively to get higher wages and provide a better social safety net, especially in the health care area. These are things that Beijing didn’t do a half-decade ago when it was growing at 9.9% and they’re certainly not going to do so now in a very difficult environment.”

On the manufacturing side, Chang referred to the December HSBC/Purchasing Managers’ Index (PMI). “It showed an absolute, outright falloff in industrial orders domestically. I think that is a really important indication of the problems,” Chang explained. Technically, the Chinese economy went from expansion in October to contraction in November when it crossed the critical 50 line. Any number above 50 shows expansion; any number below 50 shows contraction.

The fact that China is reporting negative numbers is telling in itself, according to Chang, who said often government-issued statistics conflict with reports from other sources. Beijing reported 13.8% export growth in November. However, during that same period factories went bankrupt, factory owners fled because they couldn’t pay their debts and some of them took their own lives. Even more damning are container and freight statistics, including reports from mega-container shipper Cathay Pacific that showed November cargo shipments down 13.8%. “Exports to Europe have fallen off the cliff and the EU was China’s largest trading partner so something doesn’t add up,” he said.

For the final blow, Chang pointed to the actions of the Chinese government. “If China really does have robust, 8–9% growth as everybody says, why is the central government starting to stimulate the economy again? That just doesn’t make any sense. If we look at things like imports and exports, I think the economy is really in trouble.”

Chang warned of political consequences if the country is not growing at least close to a double-digit rate. “I don’t know if China can stand 3% growth—or the other very real possibility, contraction. The American government bases its legitimacy on the nature of its political system. The legitimacy of the Communist Party is primarily based on the continual delivery of prosperity. Already, the number of protests in China has increased dramatically from maybe 70,000 mass incidents a year in 2005, to as many as 280,000 last year. In addition to strikes, riots, insurrections and bombings, the standoff between villagers and the authorities in Guangdong province are threatening the future of the Communist Party.”

One solution is for the Chinese government to continue to spend millions on infrastructure to create growth as it did when it spent $1.1 trillion after the 2008 downturn. “This tactic is of limited usefulness the second time around,” Chang warned. “It may be able to play out the game for 18 months, maybe two years at the outside, but it’s pretty much done. Plus, the artificial stimulus also created a stock market bubble, inflation, ghost cities, banking weakness and property bubbles. Massive spending didn’t avoid problems, it just postponed them and made them bigger and more difficult to solve.”

Chang said that people in China are starting to see the reality of the problem. “There is a sense of pessimism. Starting in October, we saw large, unexplained transfers of money out of the country.”

The bright spot, according to Chang, is that while China will not be able to fuel a global recovery with a consumer-driven middle class, a Chinese meltdown won’t be a major blow to the U.S. either. “We have the world’s largest internal market; 70% of our GDP relates to consumption. Exports don’t really play that much of a role in the U.S. as it does in other major economies. So China can fall off the cliff in a sense, and it would have some negative effect but not very much. In fact, we might benefit from it.”

Chang’s conclusion? “People say the Chinese economy is the global engine of growth, but that’s not true. The engine has been the American consumer because we are taking every other country’s exports, and the Chinese, through predatory and mercantilist policies, have been grabbing growth from other countries. For the last 200 years, China has been a potential source of customers for other countries. Still, domestic demand isn’t that significant. China’s imports lately have been commodities and that is going to fall off because China’s exports of manufactured goods, to Europe and the U.S., are going to be stagnant or lower than they have been in the past. So China really reacts to the rest of the world. If the changes over the next couple of months are as dramatic as they’ve been for the past two, then we’re going to be looking at a very different China. The Chinese economy could fall into a big black hole with 1–2% growth or even contraction. Can the government turn it around as it has in the past? That’s the money question.”

Frank Holmes is CEO and chief investment officer at U.S. Global Investors Inc., which manages a diversified family of mutual funds and hedge funds specializing in natural resources, emerging markets and infrastructure. In 2006 Mining Journal, a leading publication for the global resources industry, chose Holmes as mining fund manager of the year. Holmes co-authored The Goldwatcher: Demystifying Gold Investing (2008). A regular contributor to investor-education websites and speaker at investment conferences, he writes articles for investment-focused publications and appears on television as a business commentator.

Gordon G. Chang is the author of Nuclear Showdown: North Korea Takes On the World. His first book is The Coming Collapse of China. He is a columnist at Forbes.com and The Daily and blogs at World Affairs Journal. He lived and worked in China and Hong Kong for almost two decades, most recently in Shanghai, as counsel to the American law firm Paul Weiss and earlier in Hong Kong as partner in the international law firm Baker & McKenzie. His writings on China and North Korea have appeared in The New York Times, The Wall Street Journal, the Far Eastern Economic Review, the International Herald Tribune, Commentary, The Weekly Standard, National Review, and Barron’s. He has given briefings at the National Intelligence Council, the Central Intelligence Agency, the State Department and the Pentagon. Chang has appeared before the House Committee on Foreign Affairs and the U.S.-China Economic and Security Review Commission. He has appeared on CNN, Fox News Channel, Fox Business Network, CNBC, MSNBC, PBS, the BBC, and Bloomberg Television. He has appeared on The Daily Show with Jon Stewart.

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Geordie Mark: Iron Ore Still Strong

The Gold Report — Mon, 14 Nov 2011 12:50:43 +0000

In an environment of declining steel prices, Geordie Mark, mining analyst with Haywood Securities in Vancouver, nonetheless believes that iron ore juniors are poised for a rebound. Read his reasons for optimism in this exclusive Gold Report interview.

The Gold Report: About 37% of the world’s population is in China and India, countries in the early stages of their use of steel and, thus, iron ore. You’ve said their infrastructure requirements should trend up “for a number of years, if not decades.” Yet, benchmark prices for steel are down 15% since March. Is this price weakness a short-term problem or is there cause for concern?

Geordie Mark: I think we are looking at a shorter-term issue related to a tightening in money supply in China, particularly affecting the smaller mills. These smaller mills need to moderate output or get injections of commodities at lower prices. But we are still looking at underlying demand growth to meet the needs of increasing industrialization in the advancing economies, particularly in China and India.

TGR: Even though iron ore stockpiles are within 3% or 4% of record levels?

GM: We believe that stockpiles in ports and so forth are higher largely because steel demand is higher, and there is a coincident increase in iron ore imports. Compared to last year, China’s year-to-date crude steel production is up ~12%. If we measure inventory in terms of a proportion of steel output, we see that this higher inventory level has formed a plateau over 2011.

The recent pricing downturn for iron ore appears to correlate to a short-term issue in money supply where steel mills are sitting on more expensive inventories. This pricing scenario has witnessed a rebound over the last week where renewed demand and restocking has been taking place in China at cost and freight prices of $130/ton (t). The relative drop in China’s inflation rate announced on Tuesday also provides us some solace for an increased potential fiscal loosening in China.

TGR: Some producers have shut down furnaces because of an excess amount of steel in the market.

GM: We usually see some seasonality at this time of year where demand tends to plateau, particularly in Europe, from August through the end of the year. However, we have witnessed some demand softening outside Asia, but we expect that this will pick up again at the beginning of the year with renewed orders.

TGR: Iron ore swaps, based on anticipated first quarter prices at the Chinese port of Tianjin, are trading at about $129/t. Clarkson Securities says iron ore swaps are showing no price rebound until about 2013. In June, you were forecasting average freight-on-board Brazil prices of 62% iron at $124/t in 2012. Has your forecast changed?

GM: We are forecasting $130/t for 2012, based on our assumptions of continued demand from China together with potential increases in export taxes on iron ore in India, which are expected to place limitations of exports from that country. We think that underlying demand, as well as moderation in metallurgical coal prices, will help move the price higher in the shorter term and marry with our expectations.

TGR: Infrastructure growth in North America is stagnant. Is this a drag on the share growth of North American junior iron ore miners, despite the continued steady demand in iron ore use in the BRIC countries (Brazil, Russia, India, China)?

GM: For the time being, across the equities, we see a move away from risk largely independent of commodity. The juniors, in particular, suffer in the interim, independent of where commodity prices are going. Iron ore juniors have obviously dropped recently, but we do expect prices to rebound when commodity prices recover and risk appetite returns to the market.

TGR: In your coverage sector, you have 12-month target prices on more than one iron ore junior that could see its share prices quadruple from current levels. What’s the thesis for rebounding prices in this sector?

GM: Our thesis is continued demand growth. The world’s two most populous nations still require fundamental components for continued industrialization and urbanization. Other economies witnessed comparable infrastructure growth paths over their infantile stages of industrialization, such as the U.S., Germany, Japan and South Korea. In comparison, China has not reached the levels that those countries did in the past, and India still has an appreciable way to go if it is to reach the zenith of infrastructure investment intensities of the other economies.

In future support of our thesis toward growth in steel demand and maintenance of elevated iron ore prices, we see that India’s concern over the future needs of its domestic steel sector has resulted in the government looking to impose even greater tariffs on iron ore exports. Such a move, together with lower iron ore prices, is expected to temper Indian exports and provide a mechanism to moderate seaborne iron ore prices going forward.

In addition, while we see growth in demand from China, partially aided by the country’s domestic program of low-income housing development, the market sees risk in the housing sector beyond that supported by government investment.

TGR: Let’s get to your coverage sector, beginning with Alderon Iron Ore Corp. (ADV:TSX; ALDFF:OTCQX). You have a Sector Outperform on the company with a 12-month target of $5.80/share. Alderon is trading below $3/share now. Please map out how Alderon’s share price could be catalyzed between now and the spring.

GM: Our valuation anticipates that Alderon’s project will move into production by 2015. Over the next year, the company is expected to achieve a number of key milestones that could move it toward our price expectations. Those milestones include the company increasing its underlying resource base at Kami, lowering project risk at the deposit by completing a feasibility study and bringing an offtake partner onboard.

Alderon has increased the depth of management expertise in the iron ore sector recently. The company is making the right moves to lower risk and bring on partners.

TGR: Who are some potential offtake partners?

GM: I think the usual suspects, particularly steel utilities out of Asia, such as China and South Korea. Utilities are looking for security of supply and for access to supply at cost, which obviously moderates their ability to supply steel and lower steel price environments. These steel utilities also want to become less reliant on the big three iron ore producers: Vale SA (VALE:NYSE), Rio Tinto (RIO:NYSE; RIO:ASX) and BHP Billiton Ltd. (BHP:NYSE; BHPLF:OTCPK).

TGR: Would an offtake agreement inhibit a possible takeover?

GM: If structured in the right way, I don’t think so. Earlier this year, when Cliffs Natural Resources Inc. (CLF:NYSE) acquired Consolidated Thompson, the underlying offtake agreements that Consolidated Thompson had and its partnership with Wuhan Iron and Steel Corp. (WISCO) on a project and ownership basis didn’t limit the deal.

TGR: You are also bullish on Northland Resources Inc. (NAU:TSX), which plans to start mining iron ore in northern Sweden in late 2012. Most of the operations in Québec’s North Shore ship iron pellets, not concentrate. Do you have a preference as to what form the iron takes?

GM: I think the most important elements to consider here are what product captures the most value for a particular project and what is the proximity of the market that the company aims to sell into. An especially pertinent factor to consider for the iron ore sector is the generation of a project with the potential to feed into the market over the long term. On this basis, projects that can deliver higher iron content products—say 62% and above—are probably better positioned if they can moderate operating costs.

TGR: Your 12-month target on Northland is $6.80/share and it is currently trading at less than $1.50/share. That seems like a pretty bullish target. What are the catalysts?

GM: There is an overhang in the market related to the ongoing situation in Europe. Also, Northland must continue to finance project construction. The company is aiming to complete the raising of a syndicated $400 million in senior debt facility by the end of 2011.

We believe Northland’s Kaunisvaara project is on time and on budget for completion of construction by Q412. Completing the debt deal would be a significant catalyst because it removes significant uncertainty. Project completion in Q412, commencement of mining in Q412 and initial concentrate sales in Q113 are big catalysts for this company.

TGR: Northland recently worked out a deal to use Narvik as its port facility. Once the company starts shipping concentrate and seeing some cash flow, what will it do with that cash?

GM: We understand that Northland will re-inject its cash back into the company to facilitate organic output growth. It will look to increase output at Kaunisvaara, and then potentially develop the Hannukainen iron-copper-gold deposit just over the border in Finland.

TGR: Do you expect to see significant byproducts from the gold and the copper in that deposit?

GM: Northland’s predominant revenue generator is iron, but, certainly, copper from Hannukainen is likely to be a significant component. In the end, Northland is an iron ore company.

TGR: Once it achieves production, Northland will become the second-largest iron ore producer in Northern Europe. If an up-and-coming junior iron ore company can become the second-largest iron company overnight, that speaks volumes about how much room there is in this market.

GM: That is correct. In part, it has to do with Northland’s proximity to available infrastructure and the location of its deposits, which geologically reside within the same family of deposits that LKAB, Northern Europe’s largest iron ore producer, is exploiting today. It will be a big step for Northland to get into that 5 million ton (Mt) capacity.

TGR: Champion Minerals Inc. (CHM:TSX) has iron ore projects in the Labrador Trough. Your 12-month target there is $4.20/share, and it is trading at less than $1.40/share. Its Fire Lake North, Bellechasse and Harvey-Tuttle properties have a combined Measured and Indicated (M&I) resource of 400 Mt, grading about 30% total iron. There’s another 1.82 billion tons (Bt) at about 25.4% total iron. How does that resource compare with companies at similar stages of development, for example, Alderon?

GM: I think Champion compares directly with Alderon and Consolidated Thompson in terms of having ample resource size to consider a potential production path. Consolidated Thompson’s Bloom Lake resources had similar grade, but with more than 2 gigatons (Gt) of defined and compliant iron ore resources in its portfolio in the Fermont mining district, highlighted by more than 1 Gt on its flagship Fire Lake project, Champion is well positioned to use its resource portfolio to go into and expand on production.

TGR: What’s the likelihood that Champion will get its M&I resource above 1 Gt at around 30% iron within a calendar year?

GM: I think Champion has a good likelihood of graduating its resources into the M&I category. We expect to see a number of resource updates across the portfolio coming up. I would expect an updated preliminary economic assessment on Fire Lake North later in November.

TGR: Is 30.6% total iron a low grade for this sort of deposit? Is that a concern?

GM: It is similar to that exploited by Consolidated Thompson at the Bloom Lake mine. Many other features play a significant part if the underlying economics of a deposit (e.g., mass recovery and grind size). For instance, a measure of effective mass recovery is very important for iron ore resources as it can give you a gauge of the mass needed to be mined and processed to produce a certain amount of product of a particular quality. Mass recovery can vary significantly between deposits with similar iron content, so the figure plays an important role in evaluating the potential of an iron ore resource. You need to look at more than iron content to judge resource exploitation potential.

TGR: Do you cover any other iron ore stories our readers ought to know about?

GM: Talon Metals Corp. (TLO:TSX) is one that we have been keeping our eye on. It is included in our Junior X-Report. In late 2010, the company acquired a couple of iron ore exploration plays in Brazil, basically on the doorstep of Vale’s Carajás iron ore mine. Talon rapidly developed those projects and within a year moved it up to more than 1 Gt of defined iron ore resource.

We see a lot of catalysts going forward on Talon’s fairly rapid resource expansion and metallurgical definition programs. More resource expansion is likely to be announced via the publication of a number of resource updates over the next six months, and a preliminary economic assessment is expected to be completed in mid-2012. The company has now defined new resources of outcropping iron ore that look as though they have size potential in a region that is being actively mined for iron ore.

TGR: If investors want to add only one iron ore junior to their portfolio, how should they choose among the companies you’ve named?

GM: It all relates to their comfort with risk and geography, and whether they like to look at junior companies with resource expansion and development potential, or iron ore producers with output growth on the horizon. If investors are looking for resource expansion, Talon, Champion or Alderon deliver resource expansion and development potential. If they are looking for projects further along the development pipeline, New Millennium Iron Corp. (NML:TSX.V) and Northland are on the development path with their respective projects in Canada and Sweden. If they are looking for exposure to Canadian iron ore production, there is Labrador Iron Mines Holdings Ltd. (LIM:TSX) or Cliffs Natural Resources Inc. It just depends on where your risk comfort lies.

TGR: Geordie, thanks for your time and insights.

Dr. Geordie Mark, a research analyst with Haywood Securities, focuses principally on iron ore, coal and uranium companies involved in exploration, development and production. He joined Haywood Securities from the junior exploration sector, where he served in an executive role concentrating on exploration across Canada. Immediately prior to joining the exploration industry full-time, Dr. Mark lectured in economic geology in Australia and served as an industry consultant. He completed his doctorate in geology in 1998 at James Cook University’s Economic Geology Research Unit in Australia, specializing in aqueous geochemistry and igneous petrology applied to ore-forming systems.

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Daily Ranking – Underused Airports

Christopher Briem — Tue, 11 Oct 2011 13:25:46 +0000

The Infrastructurist has a list of the most underutilized airports in the world.

Yup.

Though I have to say the ‘reason’ they give is pretty misleading. No mention at all of a few bankruptcies for USAirways and a terminal built to spec for a hub operation they abandoned.

Quinn Kiley: MLPs Show Fundamental Strength in Uncertain Times

The Energy Report — Fri, 05 Aug 2011 17:10:53 +0000

As long as the investment environment remains “yield-starved and growth-challenged,” MLPs will remain attractive, says Quinn Kiley, Fiduciary Asset Management’s senior portfolio manager. In this exclusive Energy Report interview, Kiley shares his tips for finding the best apples in the NLG basket, where sector is just as important as size.

The Energy Report: Quinn, you forecast total master limited partnerships (MLPs) 2011 returns of 8–12%. Given the negative news throughout the second quarter, how could that forecast possibly hold up?

Quinn Kiley: When we made the forecast at the beginning of the year, we thought that, given the MLPs’ fast recovery from the 2008 sell-off, there was a chance MLPs might underperform the S&P 500, which has not recovered at the same clip. We were looking at the basic fundamentals of MLPs as a source of growth. MLPs are yielding a little over 6%. We thought distribution growth from MLPs would be about 6%. That 6%, plus no change in valuation metrics and an increase in that cash flow of 6%, should give you a 6% higher value, for a total return of about 12%.

In July, we’re at a little less than 4% return and distribution growth is coming along at a clip north of 6%. We think that’s a good portion of the return. The MLPs are going to pay their distributions at higher levels from today and definitely at higher levels than a year ago.

We also think the number and amount of organic capital expenditure opportunities—new builds, new infrastructure—by MLPs will be done at attractive multiples, which should further increase growth.

TER: Almost $30 billion (B) has poured into the MLP sector this year. With that much capital coming in, should investors rest more easily knowing that Wall Street power brokers aren’t about to let the government tax one of its “golden geese,” or is a less favorable tax structure for MLPs inevitable?

QK: You have to take into account that MLPs have a market cap north of $250B. Exxon’s market cap is north of $400B. So, while MLPs are an attractive investment, and certain banks and investors have done well in them, the size and scale of MLPs compared to the broader market is small. I think calling them the “golden geese of Wall Street” is an overstatement.

That being said, MLPs provide an essential service in delivering fuels and commodities around the country. From an energy security standpoint, you could make an argument for preferential treatment for MLPs to ensure that access to capital continues and that our infrastructure is reinvested in and grows to make the economy overall more efficient.

At the very least, if the Bush tax cuts expire at the end of 2012, there will be a marginal change. Given the current discourse in Washington, I think you are going to see ongoing discussion of the tax code, tax policy and tax reform. MLPs will pop up as they do every other year when those topics get raised.

It would appear to me that you are going to see some sort of tax reform in 2013. Given that the goal is higher revenue, something will probably affect MLPs or their investors. However, I don’t think it will negate the overall investment story, which is that energy infrastructure is necessary and growing, and investors are attracted to those characteristics.

TER: When we talked with you in September 2010, you said the total market cap on MLPs was around $190B. You just said that today it is $250B. That is about 32% growth.

QK: There are a couple of reasons for that. First, broadly speaking, MLPs are up over 20% since we last spoke. That’s a significant portion of that 32%. Since then we’ve also seen about $17B in new equity raised. It’s a combination of appreciation, which is the market realizing the benefits of the growth of the MLPs, and MLPs raising capital to fund that growth.

TER: Last September, retail investors made up about 70% of the space. What is that percentage now?

QK: Off the top of my head, I’d say the number is closer to 67% or 68% now. We have seen an uptick in institutional investors; in addition, more traditional investors like pension funds are starting to pay attention to the space.

Most state pension funds are significantly underfunded. As a result, they are looking for diversification and growth-oriented investments. Something growth-oriented with a significant yield, such as MLPs, is attractive and fits into a bucket for certain funds. We have seen several municipalities and states invest in MLPs as a class or conduct searches for the potential of adding them to their portfolio. That said, MLPs remain a predominantly retail-driven investor space.

TER: Do you think we will see the net market cap for the MLP sector eclipse a trillion dollars within the next decade?

QK: We look out five years and we see, on average, about $10B a year of new-build projects. A trillion is a long way between here and there, but if you look at the Real Estate Investment Trust (REIT) asset class as a corollary, U.S. REIT equities are about double MLPs. Getting to a trillion is possible, but probably not likely.

TER: The MLP sector relies heavily on an investment-friendly boomer generation seeking respectable yields in a low-yield investment world. How long can that thesis play out, and what other drivers do you expect to catalyze MLPs over the short to medium term?

QK: Clearly, there is a significant, rising population entering retirement. They will need income. MLPs can play a great role because they provide a significant yield, north of 6% right now. Compare that to Treasuries at 3%, money markets and cash are effectively at 0, and other yielding equities are in the 2% to 4% range. On a relative basis, MLPs provide a high yield, which is really a cash return. Real cash returns are attractive for any investor, especially those facing retirement or who are retired now.

But generally speaking, this is a yield-starved investing environment, regardless of your age or approach to the market. Our view is that if you are in an environment that is both yield-starved and growth-challenged, it’s hard to find attractive returns driven by growth.

Where will the growth come from? In an essential asset like energy infrastructure, there is a need for growth; it has to happen or the economy won’t function. So, you are delivering growth in a market that is probably not going to have significant growth-driven returns. Additionally, if you can get a large percentage of your returns through cash, it becomes very attractive.

As long as you have a low-yield environment, MLPs will look attractive. As long as you have a struggling economy, a growing yield will look attractive. MLPs have a positive, long-term outlook, but short-term it’s anybody’s guess as to what is going to happen. In the current market, it’s going to be a very choppy.

TER: How long do you think it will be before the bond market is competitive with MLPs again?

QK: In the last quarter, it was superior to MLPs. The Barclays Capital U.S. Aggregate Bond Index returned about 2.3% for the quarter, compared to a negative return for MLPs.

There are a couple of tricks to comparing fixed-income investments to MLPs. First is taxes. You have fully taxable income from a bond, but some portion of your MLP distribution is return of capital and not taxed until sale. There is a near-term tax advantage on a comparative basis. The other big difference is that MLP distributions grow over time; bonds do not. Bonds have maturity rollover risk; MLPs are perpetual. Depending on the environment you are in, bonds can be a very attractive investment if they have good, underlying fundamental cash flow supporting them. We like energy infrastructure bonds right now, but we think MLPs have a better long-term outlook.

TER: Is bigger better when it comes to investing in MLPs in volatile markets?

QK: I guess the classic answer is, “It depends.” It’s not just bigger; it’s which big MLPs you own. Over any short-term period, a bias toward large or small cap could be beneficial or detrimental to your portfolio. We tend to invest in names we think are well positioned for growth, well positioned to pay their distributions, and are of a high quality. Size isn’t a metric; we think of the quality of the name. But when investors flee the markets, the more liquid names are better able to deal with forced or indiscriminate selling. Thus, they perform technically better in a volatile market.

In a rebound, the opposite is true; you tend to see large caps lag and small caps gain strength in the market for the same reason. In today’s environment, large-cap MLPs outperform, but over the long term, it’s more important to buy high-quality companies with a growth component that is better than another MLP on a relative basis. If you make that decision regardless of size, you are going to come out on the right side.

Another thing that is important is not just what the prospects look like, but how well supported their distribution is with the cash flow available. Some MLPs may not do as good of a job of harboring cash and marshalling it to grow distributions over time.

TER: What are some big MLP names that continue to boost distributions and are likely to do so for the foreseeable future?

QK: The largest MLP, which is about $35B, is Enterprise Products Partners, L.P. (NYSE:EPD). The company has a great history and a great track record of putting investor capital to work in a way that creates cash flow. It has increased distribution quarter-over-quarter, year-over-year for a sustained period. Given the attractive footprint of both where their assets are geographically and based on what they do, we think the company is well positioned to take advantage of the domestic energy boom resulting from the recent ramp-up of nonconventional oil and gas production. Enterprise is definitely a blue-chip name that has a great outlook for distribution growth.

El Paso Pipeline Partners, L.P. (NYSE:EPB), is about a fifth the size of Enterprise. El Paso just announced a 20% distribution increase over the same period last year. It is a great long-term story at El Paso; the driver is the quality of the assets of the business it is in, not the size.

TER: What areas of the MLP space do you expect to outperform the sector at large this year and into 2012?

QK: If you take market volatility and political uncertainty out of the discussion, several areas of energy infrastructure are going to do really well, especially those tied into natural gas and natural gas liquids (NGLs): ethane, propane—things that occur in, or are associated with, natural gas or oil reserves. When these materials are produced, they have to be removed from the base commodities. For example, natural gas, like that used in our homes, is of similar chemical quality and heat component all the way around the country; it’s called pipeline quality gas. But to get that, you have to remove the chemical impurities. Those impurities have great value associated with them because they are priced off of crude oil.

If you have been following the energy world, you know crude oil is selling at very high levels, in the $90s/barrel (bbl.) range, and that natural gas has been anchored to the $4/Million British Thermal Unit (MMBtu) range for quite a long time. That means there is more value in NGLs than there is in natural gas itself. Anyone who has exposure to that, whether it be on the logistic side by storing, handling, or processing it, or the price side because they benefit from NGL prices, should do very well. I don’t see that apple cart being upset for the remainder of the year.

TER: What are some MLP names with large exposure to NGL plays?

QK: One of the MLPs, in what I’ll refer to as the gathering-and-processing sector, is DCP Midstream Partners, L.P. (NYSE:DPM) which has a significant NGL business. It has some exposure to both the logistics side and the price of NGL, and has a large geographic footprint and a good growth profile.

Other names have more exposure on the logistics side, like Targa Resources Partners, L.P. (NYSE:NGLS), which has exposure to the growing need for NGL infrastructure and transportation. It also has exposure to processing the fractionation, where you break the NGLs into individual components into what in effect becomes petrochemical feed stock.

Targa has been a great story because the proliferation of domestic resources for NGLs has led to a pricing advantage relative to European imports. The chemical industry here has really turned an eye inward and is trying to make sure it has the best access to feed stocks. As a result, you need new infrastructure to deliver that product to the market. Targa, DCP Midstream and ONEOK Partners, L.P. have strong exposure in this area.

TER: What about Energy Transfer Partners, L.P. (NYSE:ETP)? Do they have exposure to NGLs?

QK: Part of Energy Transfer Partners’ business is in NGLs; mostly it moves natural gas around the country through pipelines, including a significant pipeline system in Texas. It’s a quality MLP that pays a recurring yield. However, growth has been a little bit muted; over the last couple of years, distribution has remained flat.

The story there is much more about its general partner, Energy Transfer Equity, L.P. (NYSE:ETE) and its attempts to acquire Southern Union Co. There has been a back and forth battle between ETE and the Williams Company (NYSE:WMB), which is the parent of another MLP, to pick up these assets. In the end, the Southern Union shareholders have been the big winners. It has seen the price of its equities go up significantly.

Southern Union’s assets, combined with the existing assets of either one of those entities, will provide a lot of synergies and optimization that will allow for better profitability and significant cash flow growth regardless of which acquirer you are talking about. The question is, at what point do you pay too much for those assets? Currently, the market doesn’t believe it has paid too much for them, but the story isn’t over and we won’t know who wins until the deal closes.

But Energy Transfer Partners is definitely a growth-oriented MLP. It is always trying to get bigger and better by creating broader exposure to natural gas infrastructure around the country.

TER: Do you have some parting thoughts for us in terms of the MLP sector, any insights into the market?

QK: Our view hasn’t changed substantially over the year. It has been a rocky road, but we believe MLP valuations and returns will be higher going forward. There is a great long-term story of energy infrastructure build-out to deal with the ever-changing supply and demand dynamics of domestic energy. That fundamental strength, regardless of what is going on in the broader world economy, will play out over the next couple of years. Long term, more individuals and institutional investors are allocating some portion of their portfolio to MLPs. We think that will continue as the years go on.

TER: Quinn, thank you for your time and your insights.

Quinn T. Kiley is the senior portfolio manager of FAMCO’s Master Limited Partnerships product and is responsible for portfolio management of the firm’s various energy infrastructure assets. Mr. Kiley serves as portfolio manager for the Fiduciary/Claymore MLP Opportunity Fund, the MLP and Strategic Equity Fund Inc., the Nuveen Energy MLP Total Return Fund, the FAMCO MLP & Energy Income Fund and the FAMCO MLP & Energy Infrastructure Fund. Prior to joining FAMCO in 2005, Mr. Kiley served as VP of Corporate and Investment Banking at Banc of America Securities in New York. He was responsible for executing strategic advisory and financing transactions for clients in the energy and power sectors. Mr. Kiley holds a BS with Honors in geology from Washington and Lee University, an MS in geology from the University of Montana, a Juris Doctorate from Indiana University School of Law and an MBA from the Kelley School of Business at Indiana University. Mr. Kiley has been admitted to the New York State Bar.

Water Water Everywhere

Christopher Briem — Tue, 14 Dec 2010 20:10:14 +0000

Kind of a bad day for water in Pittsburgh yesterday. Beyond the seemingly unexpected resignation of the boss, there was also the bad news of rate increases along with some big water breaks as well. I’ve heard of a few other big ones out there beyond what made the news. Probably goes with the time of the year and temperature. Water line breaks will most likely be worse next week. All that on top of ongoing investigations and litigation. I feel bad for PWSA board chairman Dan Deasy since he is relatively new on the job and most of the things leading up to most of these things happened on the previous guy’s watch.

Lots of other strange things related to the water authority of late. Before Kenney resigned, there was the odd episode last week where he said he couldn’t answer whether Pittsburgh Brewing had paid its water bill. This was a big story and was a big $$ amount owed to the PWSA. You would think he would have some idea the status. Curious at best. It also relates to another story some may have caught that former Pittsburgh Brewing owner Michael Carlow, is getting back into business and this time it’s in the slag business. Yes, slag. There just has to be a joke in that. He ran up a big PWSA bill as well along the way I do believe. Water… beer… slag… bankruptcy.. perfect together?

Last month there was the recurrent bruhaha over the legacy payments made by the PWSA to equalize billing to the parts of Pittsburgh. Make note of the water breaks above. I hate to say this, and am a PWSA rate payer myself, but there is a simple answer to the whole American Water payment debate that keeps recurring. Raise PWSA rates to the private sector rates set for the southern and western neighborhoods benfiting from the subsidy. There is more than enough justification to spend any excess revenue into capital investments. Remember this is a story that fully acknowledges it can’t account for 40% of the water flowing through its system. I suspect that if anyone could put numbers on it, the city of Pittsburgh has the oldest working water infrastructure in the nation. I’ve heard of a few places in New England that still have working timber piping, but other than that we really must take the prize. For a place that claims water is a huge competitive advantage, there is this little problem of getting the water to where it is actually used and taking it away afterwards.

What I just noticed reading the rate increase story is that one of the reasons given by the PWSA is that it was necessitated by, among other things, increasing credit costs. Thing about that is most interest rates are historically low these days. Raises some interesting questions why their credit costs are up. Are they referring to their costs in the past resulting from the nearly disasterous variable rate debt they had entered into. Remember, that was the debt that became insanely expensive when our friend JP Morgan unilaterally walked away from the credit backing the variable rate debt required. Some huge irony in that some think JP Morgan is the city’s saviour with the parking bid while at the same time would have been responsible for the collapse of the water authority if they had not been able to find someone to take their place. It was far from a sure thing. It cost the PWSA dearly to get through. Why would they act so benevolently in one case, and the opposite in the other? There will be many issues of contention over the course of a 50 year lease and you want to have some trust in your counterparty.

Which leads us to more questions. Since the PWSA claims to have stabilized the variable rate debt problem with a new letter of credit…. then again why the increasing cost of credit? May not have anything to do with anything, but still worth noticing by someone is that the credit rating on that letter of credit was downgraded a couple months ago. Not just put on credit watch negative, actually downgraded. You just have to wonder what else is in play here.

and remember… think these are all city problems, and only city problems. PWSA problems are the region’s problems.

Comment on Pension Pulse Blog

D H Smith — Wed, 03 Feb 2010 13:05:07 +0000

Pension Pulse has a post, “Pensions filling the infrastructure gap?” It does not allow comments, but here’s mine.

I was formerly a manager & analyst of public securities in emerging markets for one of the big pension funds. We had people in the PE departments working on this. My experience with single-purpose public infrastructure securities (i.e. shares in one airport, one port, one road) had disappointing performance but securities of companies that developed, operated, and invested in portfolios of these things for growth performed well. I wanted Cheung Kong Infrastructure, but not Shekou Port, for example.

The Market Demand for Government Investment

David Barr — Fri, 01 May 2009 12:20:47 +0000

In my previous article on the bloated private sector, I failed to adequately explain my main point.

For the past 3 decades faith in the free market powers of the private sector have led to a massive misallocation of resources away from public sector investment. A careful reading of price signals reveal a severe under investment in public goods relative to private sector goods. I would further argue that the unstable bubbly nature of financial markets is the result of excessive capital being allocated to the narrow range of goods and services in which the market works well.

The following contrasting sets of investments opportunities demonstrate how the private sector has become bloated while the public sector has been starved of necessary resources.

Public Education vs. Information Technology

The development and rapid proliferation technologies such as the internet, cell phones and other communication tools has brought undeniable benefits. But is the market calling for more resources to be dedicated to these industries. Not really. Over the past couple of decades, the price of computing power and communication technologies has been in nearly continuous free fall. New innovations quickly become commodities while many of the best and most popular innovations from Youtube to Facebook have failed to find a revenue stream.

If some of the investment in IT has been misplaced, what would be a better use of the bright mathematically inclined minds. Over the long run, human capital is the limiting factor in innovation and growth. The wage differential between educated and uneducated workers is a clear price signal indicating demand for education. Yet we have ignored this rapidly rising price signal by failing to provide adequate support to schools at all levels. The rapidly rising tuitions at public universities is another indicator of declining public support for education at precisely the time when this sort of investment is most needed.

Public Health vs. Processed food

Public health spending is one of the ultimate public goods as it benefits the society as a whole. There is no doubt that American’s spend a lot on healthcare, more per capita than any other country. Yet our health outcomes are hardly impressive. Investing a little more in creating an environment that promotes health could save far more in future healthcare and lost productivity due to preventable disease. From teaching basic nutrition principles to providing safe places for people to be physically active to preventing outbreaks of food borne illnesses our public health efforts have been pathetic due to a lack of commitment.

While, we have barely attempted to create a healthy environment, the food industry has had no trouble bringing new food like substances to market. Given this failure it is not surprising that today’s young people may be the first generation in American history that fails to outlive their parents.

Urban Infrastructure vs. Suburban housing

The housing collapse of the last couple of years makes the misallocation of resources in the housing sector abundantly clear. Yet the market has been sending out the same signals for years. Developers always justified suburban car based residential development as providing what the market. Yet a simple look at price data tells a different story. Real estate prices in walkable urban areas have consistently been far higher than in suburban car oriented areas. In the current crises real estate markets in places like Manhattan, DC and San Francisco have held up far better than the rest of the country.

Yet it would be impossible for private developers to recreate high quality urban environments. These places require significant investment in transit, law enforcement, parks and other amenities that require government support. Without public investment private developers could only create a limited range of housing options. Hence the appreciation of urban real estate prices relative to suburban areas.

The market is incapable of providing the full range of investments needed to maintain a healthy growing society. If we come out of the current economic crises with a more balanced distribution between public and private investment we will be in a better position to maintain long term growth.