Sunday, May 27, 2012

Additional Views on US Energy Independence

Should the US pursue a policy of  energy independence?

Today I am continuing a discussion began in last week’s blog about the economics of  international energy policies.  I offered opinions about these topics prompting a response from my long-time friend and adviser, Dr. Philip M. Neches,  the founder of Teradata, who has spent a great deal of time studying the Energy sector.  Phil Neches received his BS, MS, and PhD from the California Institute of Technology;  he is a successful entrepreneur, writes a thoughtful blog and sits with me as a trustee of  Caltech. 

Last week a portion of my blog explored an Adam Smith-inspired hypothesis that would have the US buy up and deplete as much of the world’s oil as possible, using its own production and reserves for long-term international competitive advantage.  Berkshire-Hathaway’s Charlie Munger, among others, have also discussed this approach.

Oil pricing as a factor

Phil Neches began his response by indicating that he thinks my analysis of oil did not take price sufficiently into account.  He writes, “Yes, the US depends less on imported oil than major economic competitors, but that matters only in the extreme.  In the more ordinary course of business, it will take several more decades of consumption for oil to actually become scarce,  and, as you point out, that can be stretched out by more efficient use.”

He continues, “The short term issue with pricing is not as much about the ultimate depletion of world oil reserves but by the imbalance between demand, which can shift quickly with economic circumstances, and supply, which can only change slowly through expensive development of fields, refining capacity, and transport. Bad actors can make quick changes in supply, and this causes the risk perceived, correctly I think, by the general public and politicians of all stripes.”

US Strategic Petroleum Reserve

Last week I buffered my position with the fact that the US Strategic Petroleum Reserve provided some solace for future emergencies.  Phil offered an offsetting  point I had not mentioned, that today’s military depends upon the civilian economy much more than in the past.  As Phil states, “If the civilian economy is crippled, the military may still be able to operate, but will be far less effective.”

Natural gas

I am mostly in agreement with Phil when he writes that “The most obvious strategy for the US is to encourage substitution of natural gas for oil and coal.”   He continues,  “the biggest win is in electricity generation, for a number of reasons: 

First, it would permit early retirement of the dirtiest coal burning plants.   From a Pareto analysis standpoint, this is the best thing we could do to reduce not only carbon emissions, but other pollutants.

Second, gas-fired plants can be sited closer to loads, stretching out the investment in the distribution network.  This is important because there is more capital tied up in distribution networks than in generating capacity.

Third, to the extent that people adopt electric vehicles (either plug-in hybrids or all-electrics), then demand from the transport sector can shift away from oil.”

My thanks to Phil Neches for his additions to this conversation

Investment implications

Careful long-term focused investments should be considered to take advantage of the transportation of oil, gas and coal. The use of energy will go up, adjusting for the cyclically of the global economy. As long as the sources of energy are distant to its users, energy in some form will have to be transported. In the intermediate time period that would include ocean-borne oil, gas and coal. In addition, land-based pipelines and railroads will still have good payloads. I suspect that these thoughts are behind the disproportionate current and future capital expenditures in these areas by Berkshire Hathaway* and other large capital investors. Currently many of these stocks are down from recent peaks because the level of shipments and prices are down. I cannot accurately predict when they will go up, but I believe they will as the world recovers and we move toward rational energy independence.
Disclosure: I personally own a position in Berkshire Hathaway, as does the private financial services fund that I manage.

Historical context

In the United States we celebrate Memorial Day on Monday, May 28th.  Officially the holiday was started to recognize the death of so many Union (Northern) forces in the Civil War, which some still call the War Between the States. Over time the holiday was combined with a similar day of remembrance for the fallen Confederate soldiers.  For the US, the Civil War was responsible for more total deaths than any war before or since.  In addition to the many domestic causes of the American Civil War, economic forces, particularly international trade, played an incendiary role. As European harmony deteriorates, this holiday weekend I am reminded of the curse of one citizen/nation fighting another on the basis of economic interests and tariffs.


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Sunday, May 20, 2012

1776 Can Make Us Independent Again

Historical Introduction

Most Americans believe the single most significant act of 1776 was the signing of the Declaration of Independence. I suggest that when facing today’s economic problems we consider a still more important event that occurred  in 1776, the publication of Adam Smith’s The Wealth of Nations.  (Not to be confused with the very insightful contemporary author and television personality who uses Adam Smith as a pseudonym.)

The two events are very much related. Our Declaration of Independence was driven by the colonists’ abhorrence to the Navigation Acts and other laws of Great Britain that raised the costs of imports into America and restricted the transportation of our exports. Remember the famous Boston Tea Party was caused by the tax on imported tea.

These laws were an outgrowth of the mercantilist philosophy of European governments to promote their own exports and restrict imports into their lands. This governing philosophy reigned between about 1500 and 1800, and was based on the need to get trading partners to ship gold to those countries where they had an unfavorable balance of trade. The importance of gold was not primarily economic, but rather to pay for their constant wars. In the minds of the European leaders, particularly the British and French, this was a matter of survival.

What Adam Smith advocated was that nations should specialize in their production of items to be exported and import those items where they did not have a cost advantage. Over the succeeding generations his ideas were finally accepted.

Today and for some time American Presidents have announced policies that would make the US independent of foreign oil. In response to questions and comments from a number of regular blog readers, I will attempt, in a small way, to play an Adam Smith role.

My biases

I have never seen a totally unbiased report. Most of the authors are not fully conscious of their own biases, particularly those that were inculcated into them at their universities. As we are all captives of our experience, biases cannot be completely avoided. The best we should do is to identify either the biases or the sources of our biases. Mine starts with a college course in Middle-Eastern history, geology and geo-politics. I learned that in Saudi Arabia, the direct lifting cost of a barrel of oil was approximately four dollars and did not change much over the years. From time to time I have invested directly into domestic gas producers to make money or energy-focused mutual funds as an inflation defensive move. When I was lucky enough to become a trustee of Caltech I was exposed to numerous professors who were focusing advanced scientific approaches to find energy and use it more efficiently. These inputs allow me to think about a problem from different viewpoints, and therefore biases. 

Parsing the search for energy solutions

The three main fuel sources of energy are oil, gas, and coal. (For the purposes of this search I am ignoring nuclear, solar, wind, hydro, and geothermal with the belief they will play an expanding role, but won’t provide sufficient power in the short to intermediate future.) I believe that each of the age-old big three should be addressed individually.


This is where I put my hat on as a modern Adam Smith. The popular view of Americans from the White House to Main Street is that it is dangerous for us to rely on the importation of oil from those nations that  “don’t like us.”  The fear is that in time of military conflict those that supply us with oil will cut off flow, or at least hold it up for ransom. There are many counter arguments to this fear. First, our military has developed lots of means to defeat an enemy without the need for the quantities of petroleum products required in World War II and subsequent engagements. Second, we have built a strategic oil reserve which is intended for military emergencies. (Not to be used as a politically-inspired price mechanism.) Third, if needed, government agencies believe that there is more oil underlying US government-owned land than has been discovered in the rest of the world.

There is another set of economic arguments which update Smith, the canny Scotsman. If oil is a scarce resource and cannot be easily replaced, we should deplete other countries’ reserves and political power by buying all that they will sell to us. Further, a rise in the international price of oil, while somewhat painful to the US in the short-term, dramatically changes our competitive position in the world. The US is less dependent on foreign oil than Western Europe, Japan and China. If petroleum manufacturing costs for the rest of the globe goes up and we have competitive products at a lower price, the US share of market will go up which can aid our job growth. Based on what we have already seen, the threat of higher priced oil will trigger greater conservation efforts and the development of more efficient uses of energy.


There are reasons to believe that the US and certainly Canada can be net exporters of natural gas. Other countries are also developing their gas properties. From a strategic viewpoint, I might be reluctant to become too reliant on imported gas except from Canada. Over time I would expect the bulk of our heating requirements will be filled by natural gas. We are likely to see both the military and large trucking fleets switching to hybrid or fully dependent upon “nat. gas.” The environmentalists will need to prove that fracking is dangerous to the neighborhoods of gas extraction and then our technologists will probably find solutions.


Some politicians have proclaimed that there is no such thing as clean coal. Considering the US has a reported 250 year supply of coal, I hope they are wrong.

If the price of energy goes up, I believe that there will be enough room in the final price of coal for both steel-making and heating to cover the costs of technological fixes that are underway.


Just as 1776 brought forth thoughts and actions that changed the world, I think we are at the point of achieving meaningful economic energy independence in the near-term future as we modernize our thinking.

As is my wont turning to investments, I would suggest investments in stocks of companies that are devoting some of their efforts to new ways to make our search and use of energy more efficient. These areas could be mining and extracting efforts, transportation efficiencies, and battery producers among many other beneficiaries of the application of new and improved technologies. These could include some, but not all, of the major oil, gas and coal companies.

Are you ready to be independent in the new world?  Let me know.
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Sunday, May 13, 2012

Unknown Impacts from JP Morgan

Since Thursday night, no single financial topic has gotten more print and airtime than the announcement of the unexpected net loss of an estimated $800 million, out of a $2 billion gross loss sustained in the Chief Investment Office (CIO) at JP Morgan Chase (JPM) London. With market participants and the media searching for more information and in some cases insight, one can perhaps benefit from former US Defense Secretary Donald Rumsfeld’s method of dealing with the press. He divided the questions he was asked between known knowns, known unknowns, and unknown unknowns. According to Rumsfeld:

  • There are known knowns; these are things we know we know.
  • We also know there are known unknowns; i.e., we know there are some things we do not know.
  • There are also unknown unknowns; these are things we do not know we do not know.

I will array my thinking using this pattern.

One should understand the biases of the sources one is using. Regular readers of this blog already know that I have investments in many financial services companies. These investments were largely obtained through stock-based mergers in my personal account as well as a selection, I think of the better ones, in a private financial services fund that I manage. While I have been a long-term investor in the JPM stock in my personal account, I do not own the company in my managed fund. This is the same distinction that Warren Buffett revealed at the recent annual meeting of Berkshire Hathaway (BRK-A), (BRK-B); he personally owns JPM, but invested heavily in Wells Fargo (WFC) and US Bank (USB) for Berkshire Hathaway. Up to this point my reluctance to add JPM to the fund is based on what I perceive to be a requirement to a higher standard of selection for the fund than my personal account. To the best of my knowledge, JPM has by far the largest single gross investment in derivatives of any publicly disclosed financial institution. My focus on the gross commitment, adding the long and short positions rather than netting them, is based on closely examining trading desks that have experienced simultaneous problems in both their long and short books. Further, I will admit I am not comfortable with my lack of full understanding of these instruments. Thus despite the fact my family has dealt with the JP Morgan organization for three generations and has great respect for some of its present leadership, my lack of sufficient understanding of the use of derivatives has prevented me from owning the stock of JPM in my managed fund.

Known knowns

On Friday after the Thursday evening announcement, the price of JPM shares crashed -9.28%, with a record 217 million shares traded. Shares of Citigroup (C) declined -4.24%, Goldman Sachs (GS) -4.19%, Morgan Stanley -4.17% and Bank of America (BAC) -1.95%. (Both Goldman Sachs and Morgan Stanley are in the fund and the others are owned personally.) At least as of this weekend, the combined wisdom of the marketplace is that JPM has a very specific problem on its hands. The two investment banks that have become bank holding companies may have somewhat similar problems. There is a view that Citi is similarly hobbled and Bank of America’s price already recognized lots of its problems.

Before this announcement, I was trying to better understand JP Morgan. Thus, I was reading its massive reports to the SEC. In a section entitled Treasury and CIO Selected Income Statements and Balance Sheet Data, a couple of items struck me as significant. The first was securities gains in the first quarter, which were up 344% from the prior year, to a total of $453 million. This item was footnoted to reflect repositioning of the corporate investment securities portfolio. Clearly this was a highly volatile component to JPM’s earnings and something of significance was going on. The post-quarter disclosure of an estimated $800 million loss in what may have been fifteen days (as reported by some) compared with the first quarter’s securities gains, is a further indication of the type of volatility that one could expect. The second figure that caught my eye in this table was that at quarter-end, the aggregate investment securities portfolio totaled $375 billion ($362 billion averaged for the quarter). While the size is staggering, the return for the quarter was only 1.3%, hardly a worthwhile return considering what we now know to be the early second quarter risk.

Known use of derivatives

Based on what we have already learned or suspected, the London CIO office was not primarily focused on making money, but on hedging the bank’s credit exposure. As of March 31, 2012, JPM had a total credit exposure of $798 billion, up from $776 billion at the end of the year (again relying on the report to the SEC). At the end of the quarter the bank had credit derivative hedges just shy of $30 billion to hedge their perceived credit risks. Perhaps one clue to the mid-April to early-May large losses is that JPM had net credit derivative hedges of almost $11 billion against $22 billion of credit exposure to central governments. During this period, the news flow and foreign exchange rates were negative to many central governments.

Known unknowns

The media has reported that very senior officers of the bank, including its much respected CEO, were involved with twice daily conferences about this unfolding situation. Some were dispatched to London to personally get a hand on the situation. Various government agencies were alerted to the growing problem. One of the issues to be determined is why JPM’s vaunted risk control measures did not alert or stop the mounting losses. One report has as a contributing factor the switch to a different index as a benchmark. This change proved to be faulty, and there was a switch back to the previous indicator. The Financial Times reports the index used is the Markit CDX.NA.IG.9 which is comprised of 125 North American credits that were investment grade at the time of their inclusion in the index. The net notional value for the index has surged from about $90 billion to $150 billion at the end of April, according to the FT.

Conjecture analysis

Note that the notional value of the reputed index at the end of April was about $150 billion. The size of JPM’s credit exposure (excluding its exposure to central banks) is approximately $776 billion. If, as is believed, JPM was trying through the CIO to reduce its overall credit exposure, the near-term market was too small to accommodate a safe withdrawal. If a swarm of hedge funds saw one big insistent player on one side of the market (as was reported in the news media) they could profit by being on the other side, and make the exiting more expensive. I believe this is the reason why JPM will take its time exiting its position and possibly exposing itself to greater losses.

Unknown unknowns

Various politicians and media pundits are calling for increased capital rules and size restrictions. If they are successful, they may cause more rapid and for some, disastrous change. I believe that we are in an early stage of radically changing the financial structure of our world. I believe we have insufficient equity capital to create sound long term jobs, and this has been true globally for many years. Whatever progress that has been made is largely due to individual, corporate and governmental borrowing. The money has been borrowed from different elements of retirement capital at each level. The net result in the current periods of interest rate suppression is that current retirement capital is insufficient to pay for our longer-lived lives. Anything that raises the costs of banks will raise the cost of borrowing at all levels, impeding meaningful long-term job growth. Higher interest rates will drive inflation higher, particularly hurting the non-working retired population. Over the last several years we have paid this group low interest rates, and now when rates recover to something like a normal level, the inflation-induced, devalued currency will hurt their real spending power. We are creating two new economic class sub-sets: first, those that no longer are earning their keep and second, their grandchildren with large education loans. Thus, the issues surrounding the losses at JPM have wider impacts.

Investment Implications

  1. As many of our readers are aware, I have a certain allergy to what I call crowded trades, where too many are trying to do the same thing at the same time. JPM is very much involved with a series of crowded trades. To some degree this fear, excluding the IPO dances, makes me more interested in smaller companies.

  2. Our political leaders are trying to repeal history. Throughout recent times, certain banks have failed. Their failure hurts their equity owners, some of their debt holders and possibly some uninsured depositors. These are momentary disruptions in people’s lives and practices. But in almost every case that I am familiar with, new or expanded banks replace the failed bank. Society, perhaps wounded, progresses.

I will be completing my 200th blog post in early June. Are there are any particular topics you would like me to readdress in my weekend musings? If so, please email me early in the week with your thoughts.

Did you miss Mike Lipper’s blog last week? Click here to read.

I invite you to be part of this Blog community by commenting on my Blog posts or by adding your perspective to the topic. All comments or inquiries will be handled confidentially.

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Sunday, May 6, 2012

Lessons from Omaha and Louisville


On Saturday there were two iconic events occurring in the heartland of America. In Louisville there was the 138th running of the Kentucky Derby, America's most famous horse race for three year olds. As regular readers of these blogs may remember, despite graduating from Columbia University, I count my two most important learning experiences the analysis of thoroughbred horses and my experience in the U.S. Marine Corps. One of the things that I learned from handicapping races was to select races that I could assess the critical elements of picking winning bets with some confidence. In terms of this year's Derby, the appropriate statement is, “I did not have a horse in that race.” There were 19 horses running. That the first two horses to finish had the smallest odds of 5 to 1 and 2 to 1, indicates that the betting crowds lacked confidence in their choices. (Often winning favorites have odds of 1 to 1 or lower.) The inability to pick winners and the lack of confidence shown by the crowd (or if you prefer, the market) are similar to the lessons learned at Berkshire Hathaway's (BRK-A),(BRK-B)annual meeting celebration.

The warm up

My wife Ruth and I were privileged to attend the Friday night dinner hosted by Charlie Munger for his large family and his friends, (mostly from his days of living in Omaha) and other well wishers. For those who don't know Munger, he has been Warren Buffett's business partner for at least 47 years. His training as a leading attorney combined with a wonderful laconic delivery of encapsulated logic has been something of a control rod to Warren Buffett's natural enthusiasm. Keeping with his tradition of few words, his remarks were brief and to the point and can be summarized as follows:

  1. The decision as to the successor to Buffett is probably the most important decision of Warren’s life and probably will be one of his best.

  2. For Berkshire-Hathaway, making the second $200 billion will be easier than making the first $200 billion.

  3. The managers of BRK’s subsidiaries are an unusual circle of trusted associates unlikely to be found at any other company.

The main event

What one takes out of the six hours of questions and answers is very much dependent on what one expected. The media used the estimate that 35,000 attended the meeting, which is possible including the exhibition space with its closed circuit television. However, I am told that the main arena has only 18,300 seats. Early in the day almost every seat was filled. As the day wore on, particularly after the lunch break, there were many empty seats. Either the lack of significant news or the distraction of buying, at a discount, merchandise from Berkshire’s subsidiaries, partially emptied the main arena. Nevertheless, my son Steve and I found some of the afternoon answers to the questions of interest. In summarizing the lessons of the day, it may be useful to respond to particular types of attendees. For example:

  • Those primarily interested in valuing the stock

  • Analysts trying to model near-term results

  • People who are interested in business principles

  • Those who have political considerations

Valuing Berkshire Hathaway's stock price

There is a belief that the stock should sell at a price equal to an unidentified intrinsic value. A poor substitute for this would be book value. Currently the company has announced a policy of buying back the stock at 110% of book value, (it believes the stock is undervalued by book value). For instance, BRK’s auto insurance company, GEICO, is being valued at $1 billion over its historic cost. The intrinsic value for that company is the firm's current book value plus the size of its float. Management stated that it would not accept a bid with a $15 billion premium over GEICO’s carrying value .

Analysts trying to model near-term results

With the exception of the housing-related operations, operating earnings are up at Berkshire-Hathaway. The current level of float is approximately $70 billion. Buffett and Munger are warning that the float is unlikely to rise further. Over the next ten years, it is possible that Berkshire’s utility operations and probably the railroad (Burlington Northern) will need additional capital of $100 billion combined. Creation and management of float has been one of the keys to the firm's success. These concerns led to a decision not to go forward with a possible $22 billion acquisition. If they did do this particular deal, the transaction would have forced Berkshire to sell some securities, either owned or to be issued, which management did not want to do. There is a desire to maintain a reserve of at least $20 billion for all possible opportunities and contingencies.

Todd Combs and Ted Weschler, the two internal investment managers had $2.75 billion each to manage as of the end of March. Each has a base salary of $1 million and an incentive on the excess return in which he would get 10%; 80% based on his own performance and 20% based on the other manager's results. This is similar to the arrangement BRK had with the former CIO of GEICO. (The company does not use compensation consultants or have a standard compensation plan for their operating executives.)

Business principles

There is a recognized risk of getting too big to manage effectively. Buffett and Munger believe they are pioneering with an uncoordinated holding company approach. Even with their various insurance companies, they do not attempt to coordinate their risks. The use of mathematical measures of market price risks is not believed to be prudent or realistic. Barriers to entry are critical for them in their acquisition and business planning. They do not believe in erecting barriers, but buying them. In their mind, a brand is a promise.

National (political) policies

Judging by the sound of applause, a large number of the audience were opposed to the popular understanding of the so-called "Buffet Rule." Some believed that his pronouncements have hurt the stock and are causing the stock's price to be below where it would normally trade.

Because of the current US interest rate repression that is likely to lead to inflation and higher interest rates, it was suggested that investing in medium and long-term bonds should be avoided. Instead of investing in developing more US-based oil and gas, the United States should import as much as possible, just the opposite of energy independence.

More reactions are available to members of this blog community by emailing me specific questions.
Did you miss Mike Lipper’s Blog last week? Click here to read.

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