Friday, June 18, 2010

Oil Drilling Leases, Liability & US Government Thuggery

I wrote this post earlier this week discussing Congress' and the administration's implicit roles in the BP undersea gusher disaster.

I wrote, in part,

"How is it that the same administration and Congress that looks elsewhere for the cause of the recent financial crisis, while overlooking their own complicated regulatory schemes and agencies, can repeat the act in the energy arena?

Whatever regulatory processes exist would seem to have been deemed appropriate by Congress. If the MMS was 'captured' by industry participants, then Congress' legislation pertaining to the agency must have allowed for that.

If we are to believe the president, nobody has ever tried to find alternative, renewable energy sources, despite the immense payoff which would accrue to the first person or company to patent such discoveries.

How is the US supposed to remain competitive if the only way to bring new energy sources to market is to subsidize them with government money? By definition, they'll be uncompetitive on a cost basis. Otherwise, those discoveries would already be providing said energy.

It's disappointing to see an administration and Congress so totally ignorant of economics that they believe that nobody has tried to find profitable renewable energy sources, and, thus, are only awaiting government handouts to make such ideas a profitable reality."

Throughout the past few days, as I've listened to dozens of pundits exclaim on various aspects of the Gulf oil disaster, I've formulated some questions and thoughts of my own.

Suppose the US were starting from scratch in the area of extracting minerals, metals and valuable liquids and gases, e.g., oil and natural gas, from our land and the sea and seabed which we control. What questions would we, as a nation, confront as we sought to enjoy economic benefits from the extraction of said natural resources?

Certainly we would seek to sell leases and licenses to explore for valuable resources and extract them. We'd probably want to hold said lessees liable for any damage they caused through their operations, and to return the land, water or seabeds to acceptable, near-original condition.

To assure ourselves that any lessee could fulfill his obligations not to cause unwarranted external costs to others, including our nation, by failing to finish restoring sites and removing unwanted structures, etc., we'd probably require some sort of bond or insurance in an amount considered adequate by knowledgeable professionals.

So far, this seems reasonable, doesn't it?

But what about that liability clause? If a lessee encounters some situation, whether accidental or by poor management, that creates a disaster on the scale of BP's Gulf rig gusher, do we seriously expect to hold that company totally responsible for every penny of expense related to the problem?

The US does not exist in a vacuum. There are deposits of virtually all of our natural resources located in other countries, on other continents. Many other countries offer far less onerous regulatory environments than those which currently exist in the US.

As tempting as it would be for the US to insist on carte blanche, unlimited liability assumption by its natural resource lessees, competitive realities could easily cause such a policy to result in no lessees whatsoever.

Even an honest, scrupulous adherence to a rule of law that mandated unlimited liability could leave the US with no firms interested in the assumption of such unlimited liability, against very limited revenues and profits from such leases.

But in reality, it's much worse than that.

Our country's president has just mugged BP, shaking it down, as Representative Joe Barton correctly observed, for $20B. Completely abrogating the rule of law in the process.

What global energy or mining company will now wish to risk its solvency by bidding for and operating under a US lease to explore and exploit natural resources?

Against the unlimited, company-killing risks now apparent for operating in the US, any company would be considering much higher tangible exploration and production costs anywhere else in the world.

It's all well and good to want a pristine environment. It sounds reasonable to expect a natural resources exploration and production firm to pay for every dime of damage they cause to the environment.

But in a competitive global economy, it's foolish and naive to actually demand that.

The result is far more likely to be an exodus of global mining and energy firms, and the jobs and capital that accompany them.

The administration's recent extortion of BP to the current- not necessarily final- tune of $20B, and Congress' vilification of BP and its CEO, before final conclusions regarding the rig failure are known, seem to be at odds with a desire to foster economic expansion, job creation and risk taking in America.

And it doesn't stop at extractive industries. If one administration is capable of illegally shaking down a private company for cash, outside or due process channels, who's to say that administration, or another one, won't trample due process rights on any matter of business operation? Perhaps, next, it will be a food processor. Or a trucking firm. Maybe, again, finance?

Nobody really knows. Once extortion becomes an established, accepted practice by government, no business is safe.

Those of us who are citizens may not wish to move overseas to ply our trades. But others who live overseas may think seriously about continuing to do business here, or commencing operations on US shores.

The effects of the recent treatment of BP on long term US economic health could be truly enormous, unanticipated and unintended consequences.

Before I finish this post, consider one other dimension- global political-financial issues. For example, this hypothetical.

Suppose next Monday morning, you read that financially crippled, value-depressed BP has sold itself to a consortium of Chinese banks, a Chinese sovereign fund, and Chinese mining interests. Later in the week, you read that the Chinese foreign ministry, at the behest of BP's new owners, have announced that they will renege on the $20B fund, and, further, demand US cessation of all criminal and civil penalties against the BP operations, on penalty of China selling its US debt obligations?

What would be the US response to such actions?

The recent trend toward sovereign control of minerals and metals production is a fact. The Chinese have been engaged in a battle over control of iron ore production for the past year. This hypothetical would simply be an extension of that trend. But the implications would be staggering.

Dealing with private firms in the area of unexpected environmental disasters is one thing. The prospect of facing a major sovereign creditor which owns a major oil firm with substantial interests in the US, with global economic and military ambitions which are at odds with ours would be catastrophic.

Thursday, June 17, 2010

Congressional "Fact Finding": Today's BP Hearing

I've watched a fair amount of today's Congressional hearing featuring BP CEO Tony Hayward, and I must admit that both Hayward and most of the members of Congress have behaved dreadfully.

It started yesterday, when retiring Michigan Democrat Bart Stupak apparently said Hayward would be "sliced" up by the Congress' members during the hearing. The absence of fairness and decorum in the House is truly stunning. It's living down to our Founding Fathers' view of the chamber as filled with mannerless rabble.

One Texas Republican Representative, in his opening statement, correctly characterized the $20B fund which BP was coerced by the administration into offering as a "shakedown." Every single other member whom I've heard speak has basically used the hearing to grandstand, bully and embarrass Hayward, while admitting absolutely no culpability on the part of federal regulators or the Congress' own legislation which has required deep water drilling in the first place.

Hayward, for his part, is about the worst guy BP could possibly have as its public face. When a demonstrator was forcibly removed from the proceedings, Hayward sported a grin from ear to ear that looked remarkably inappropriate.

Michigan Democrat "Tailpipe Johnny" Dingell repeated the performance he crafted for the Goldman Sachs CDO hearing, requiring "yes" or "no" replies to questions he knew that Hayward could not answer, because they were operationally-oriented and applied to lower-level BP or contractor employees engaged in managing the actually drilling on the rig which exploded.

Hayward looked totally out of touch with the operations of his company during that exchange. It's sort of hard to believe that he wouldn't have brought either documentation concerning the rig's operation, or a lieutenant with more direct knowledge of the decisions about which questions were asked. Additionally, he gave needlessly vague, circuitous replies to many questions, which did give the distinct impression that he desired to be evasive. His expression was often disdainful, which doesn't come across as either sympathetic or empathetic. In the situation at hand, that's a mistake.

Never the less, Dingell made a telling point. He homed in on whether BP had made decisions based on saving money and time. The overall impression left by Hayward is that BP saved, at best, less than $20MM and maybe a few weeks' of time by apparently skipping on steps which would have resulted in safer drilling and perhaps the avoidance of the deep water blowout.

I've noticed in Hayward a disturbing trait. Maybe it's because he's British, or maybe because he is of the particular class he is, but his answers impart a decidedly distant, uncaring tone. He seems profoundly detached from the incident, offering only an annoyingly repetitive "very sorry" at every turn.

Combined with his chairman's gaffe yesterday referring to the "small people" along the affected Gulf Coast, Hayward didn't help BP's cause or image today.

Truth be told, in its zeal to roast BP's CEO, the members of Congress apparently failed to understand that, by the necessity of operation of a large company, Hayward couldn't answer, under oath, most of the detailed rig operation questions put to him. Anyone watching for more than ten minutes would have, I think, like me, quickly deduced that the Congressmen were simply piling on an easy target with ludicrous questions, given that Hayward wasn't the supervising manager of the failed rig.

In short, a lot of wasted time.

But, additionally, as I'll discuss tomorrow, like the Goldman hearings on CDOs, and earlier bank CEO grillings, yet another example of why global businesses should think twice now before choosing to enter the US market.

Federal Government Lies & Fantasies Concerning Regulations & The Oil Industry

One of the aspects of the recent BP undersea oil gusher is a sudden flurry of lies from Congress and the administration regarding regulation in the sector.

To hear the president and selected members of Congress tell it, the oil industry has been unregulated for, oh, just about a decade. Sound convenient in terms of presidential terms?

Yet, I vividly recall then-CEO of ExxonMobil, Lee Raymond, caustically observing all the sudden experts in oil refining, when gasoline prices hit new highs several years ago amidst shortages. Raymond, among others, replied to the accusation by government that no new refineries had been built in the US since about 1968, by pointing to the complex, expensive and time-consuming permitting process.

Sounds like regulation to me.

Raymond explained that it was far easier, faster and cheaper to expand an existing refinery than to build a new one from scratch. Nobody, at least until they can't buy a gallon of gasoline, seems to want a refinery in their backyard.

How is it that the same administration and Congress that looks elsewhere for the cause of the recent financial crisis, while overlooking their own complicated regulatory schemes and agencies, can repeat the act in the energy arena?

Whatever regulatory processes exist would seem to have been deemed appropriate by Congress. If the MMS was 'captured' by industry participants, then Congress' legislation pertaining to the agency must have allowed for that.

Who's fault is that? Not BP's.

Perhaps regulations were inadequate. But it's a joke to suggest there are none, or they are totally unenforced. And then blame industry firms for that.

Last time I looked, only Congress could pass legislation in this country, not publicly-held companies.

Taking this travesty a step further, it's simply ludicrous to ignore Congress' legislative culpability in the oil gusher mess, then use the disaster as a reason to swear off of oil and nuclear.

If we are to believe the president, nobody has ever tried to find alternative, renewable energy sources, despite the immense payoff which would accrue to the first person or company to patent such discoveries.

As no less than, I believe, Jack Welch intoned on CNBC yesterday morning, if technology and ideas existed to build functioning, profitable alternative energy markets and businesses, someone would have done so already.

Having a president use a crisis of oil exploration to declare an end to our use of oil is just plain stupid. It's even more stupid to then propose to throw more unaffordable federal dollars into subsidies for non-existent replacement energy sources.

How is the US supposed to remain competitive if the only way to bring new energy sources to market is to subsidize them with government money? By definition, they'll be uncompetitive on a cost basis. Otherwise, those discoveries would already be providing said energy.

It's disappointing to see an administration and Congress so totally ignorant of economics that they believe that nobody has tried to find profitable renewable energy sources, and, thus, are only awaiting government handouts to make such ideas a profitable reality.

Now, that's a fantasy.

Wednesday, June 16, 2010

Gary Kaminsky On ATT

I saw part of the noon time CNBC program featuring David Faber yesterday. The guest was ATT's CEO, Randy Stevenson.
Somewhere near the end of the discussion with Stevenson, Gary Kaminsky, the program's co-host, began to rabidly insist that ATT was a growth company which wasn't appreciated as such.
While Stevenson politely attempted to deflect Kaminsky, the latter badgered the CEO about why ATT dividends out so much income, when they should be growing even more rapidly, in necessary, through acquisition.
After Stevenson's departure, Faber tried to talk some sense into Kaminsky by reminding him that ATT wasn't just a wireless firm. That it, for better or worse, still has a long distance unit and substantially more corporate business than merely running a consumer wireless unit which features the iPhone.
I took a look at ATT's recent income statement. Let me assure you, it's no growth firm. I checked my proprietary analyses of the S&P500 for consistently superior revenue growth. ATT isn't among those firms. Not for at least the last several years. The firm simply does not exhibit the sort of revenue growth that characterizes a growth firm.
The nearby five year price chart for ATT and the S&P500Index illustrates that the firm certainly isn't valued, over time, as a growth firm. It barely outperforms the index over the past five years. And I'm being generous giving it that, since the difference is microscopic, and doesn't adjust for the risk of holding ATT versus a basket of 500 equities.
I wonder what Gary Kaminsky was drinking or smoking before that program? Because he ought to quit whatever it was.

Merrill Lynch's CDO Sales

I recently had the chance to read last week's Wall Street Journal article discussing Merrill Lynch's selling of CDOs to customers who were clearly not suitable for the instruments.

The piece focused on how unsophisticated some of Merrill's technically-qualifying "sophisticated" customers actually were. In particular, the article cast doubt on the notion that mere asset levels should have anything to do with sophistication in a legal or regulatory sense, as some of the Merrill customers either inherited their wealth, or made it in fields completely unrelated to financial services.

However, what drew my attention was the several cited examples in which Merrill personnel, including at least one VP, assured clients that the CDOs has "zero risk."

It seems to me that Merrill's documented actions are far more egregious than Goldman Sachs' in the matter of CDOs. Goldman had a mortgage-related synthetic CDO constructed in order that institutional market participants might buy and sell the associated risks. You may disagree on the amount of disclosure Goldman should have made, but they clearly kept the instruments among institutional investors.

Merrill, on the other hand, judging by the Journal's revealing article, pretty clearly stuffed risky CDOs into customers' accounts while deliberately and materially misleading those customers concerning the risks and nature of the CDOs.

I can't help but wonder if the BofA's purchase of Merrill will, ultimately, turn out to be a good deal, as behavior like these CDO sales comes to light.

Tuesday, June 15, 2010

The Oil Industry Strikes Back- At BP!

I caught the opening statements of several oil company CEOs this morning. Most notable were those by ExxonMobil CEO Rex Tillerson and ChevronTexaco's John Watson.

Each of them took pains to criticize BP's inadequately-engineered drilling operation. It was quite clear that, in advance of a presidential address this evening focusing on the BP oil gusher, the industry and energy legislation, these two CEOs wanted to go on record, forcefully, stating that the BP mess is no accident.

From Tillerson's and Watson's comments, it was unmistakable that they view BP's operations as substandard and unsafe. They want to distance themselves from BP's approach, draw attention to their own, better safety records, and hopefully assist in heading off any damaging restrictions on deep-water drilling.

Commentators on CNBC referred to these CEOs 'throwing BP under a bus.' But that's not really quite true.

All that Tillerson and Watson did was provide their very informed opinions on the nature of the BP mess, i.e., it was the result of bad management and operations.

Even as I write this, various uninformed talking heads on CNBC are accusing the other oil CEOs as unwisely breaking ranks. One even cited Jack Welch, referring to some comment the former GE CEO was alleged to have made earlier today, or yesterday, that the execs must stick together because this is an industry problem.

No, it's not. That was Tillerson's and Watson's shared point. It's not an 'industry issue,' because nobody else in the deep-water drilling sector has managed to effect this sort of disaster.

If the Welch attribution is true, it just shows how far out of touch with reality Jack has become in recent years.

As I listened to the two prominent oil firm CEOs adamantly state their cases, it was obvious they were taking the opportunity, only hours before the scheduled presidential address, to give Congress and the viewing public their own, different view of events and reality.

Sebastian Mallaby On CNBC

Apparently Sebastian Mallaby's recent editorial, on which I commented yesterday, in the Wall Street Journal, was part of a well-orchestrated publicity campaign for his new book.

I didn't catch the book's name, but Mallaby was stumping for it on CNBC yesterday morning. When pushed, he made the same lame arguments about average hedge fund leverage on air that he did in his Journal editorial.

Mallaby wasn't any more convincing in person than in print. I didn't hear him address the over-leveraged hedge fund disasters, such as LTCM. Nor how the highly-leveraged hedge funds' dumping of positions in 2008 contributed to the market's downward shear.

From what I saw and read, Mallaby appears to simply ignoring the evidence that doesn't fit his particular hypothesis.

More Findings On The Dis-Utility of Homeownership in America

Richard Florida, listed in the Wall Street Journal as "a director of the Martin Prosperity Institute at the University of Toronto,"wrote a provocative editorial a week ago in the paper entitled Homeownership Is Overrated.

Florida's central contention is that today's world of greater job mobility has made homeownership a much less valuable activity than it was in the past in America.

A few years ago, the Journal published a piece by a researcher in Washington, D.C., providing evidence for this among low-income workers. Her findings were that the lower-income group of Americans had to move to follow work, as they are semi- or unskilled. Thus, houses tie them to places that may lose work, and cause them to default on the mortgage.

Florida, however, did something a little different. He examined relationships between homeownership, local economies and incomes. What he found is, at least to me, astounding.

Here's what he wrote,

"But cities with high levels of homeownership- in the range of 75%, like Detroit, St. Louis and Pittsburgh- had on average considerably lower levels of economic activity and much lower wages and incomes. Far too many people in economically distressed communities are trapped in homes they can't sell, unable to move on to new centers of opportunity.

The cities and regions with the lowest levels of homeownership- in the range of 55% to 60% like L.A., N.Y., San Francisco and Boulder- had healthier economies and higher incomes. They also had more highly skilled and professional work forces, more high-tech industry, and according to Gallup surveys, higher levels of happiness and well-being."

Thus, Florida found not only the same downsides to homeownership among lower-income workers as the earlier researcher, but he also found associations between higher incomes and less homeownership in cities with healthier economies, as well.

Isn't it ironic that our federal government began to push homeownership so heavily, from both parties, just when our economy began to value mobility more than ever? Especially as pensions have become more portable?

Perhaps, as Florida suggests, we really should reconsider the sacred mortgage deduction and let homeownership drift down to the 55-60% range. Based upon his research, it would seem that propping up homeownership beyond that interferes with the natural mobility of labor and economic activity in America.

Yet another in the growing list of federal government-originated market-distortions in our modern economy.

Monday, June 14, 2010

In Praise of Hedge Funds?

The weekend edition of the Wall Street Journal featured a long article in defense of hedge funds as a stabilizer in our financial system.

Distilled to its essence, the article cites several features of hedge funds which contribute to healthy market dynamics and don't drain taxpayers.

Specifically, it notes that hedge funds, due to the owners/managers receiving a sizable share of the funds' profits, tend to: identify genuine profit opportunities which make positive, risk-adjusted returns; manage risk better than insured public financial entities; through their ability to short equities, contribute to pricing efficiencies; don't require nor expect public funds to rescue them from failure.

All these points are true. The one caveat comes at the end of the piece. Sebastian Mallaby, the author of the long editorial, contends that the average hedge fund is much less leveraged than the average bank. That may be true, but it's not the averages that should worry us.

Rather, as noted in my comments on Scott Patterson's recent book, The Quants, here and here, and a related post here, leverage and risk management are the Achilles Heels of these outfits.

In this later post, I describe Larry Kelly's risk management theorem, derived from Shannon's information theory. Ed Thorp, the godfather of the modern quants, mentioned so lavishly in Patterson's book, revered Kelly and his Criterion. Kelly's Criterion is absolutely crucial in its focus on risk management via bet size.

None of this made it from Thorp to his progeny, nor, really, into Patterson's book. Patterson mentions Kelly in an aside so vague it originally escaped my attention. Luckily, a retired Bell Labs colleague lent me Poundstone's tome on Kelly.

It's leverage that makes otherwise-reasonable strategies toxic. Especially when, as Patterson did emphasize, several large hedge funds are pursuing the same instruments and investing with similar strategies.

As I've written in earlier posts, blame the lenders, usually commercial banks, for not adequately supervising hedge fund positions and risks. Blame the hedge fund managers for being ignorant of Kelly's work.

Mallaby's lengthy ode to hedge funds is sensible until that last, fatal passage about leverage.

If too much capital is employed, and leveraged up, by several investors, into the same positions, that, in itself, makes for an inefficient, risky market. With today's lightning-fast trading systems, it's virtually impossible for all that capital to exit without losses. Those losses then magnify the downward price spirals in the markets for the affected instruments.

I'm not at all sure that most of the offending hedge fund managers who came so close to death prior to the TARP's rescue learned anything. In Mallaby's ideal world, they would have been wiped out, and more prudent hedge funds would have, in a Darwinian consequence, survived to expand and fill the vacant market niches.

But that's not what happened. So it's debatable whether, in even today's environment, nearly two years later, large, highly-leveraged quantitative hedge funds are a benefit to our financial system.

Mallaby didn't explicitly endorse the quants, but most of his modern examples were quantitative funds. And it is precisely this variety which is vulnerable to such large, immediate losses from over-use of leverage.