Tuesday, December 15, 2009

Exxon Deal Looking Greener Today

After a day of reflection, the post-game analysis of the ExxonMobil-XTO Energy deal is turning more to our positive viewpoint, so much so that the New York Times' green energy blog is laudatory about the increasing mix of natural gas in the portfolio. It does make sense.

ExxonMobil is a company that uses return on average capital employed (ROCE) as a key metric for the effectiveness of their business model. Their five year average ROCE is an impressive 30.7%, while the return in their most recently reported fiscal year was 34.2%. Looking through their extensive and useful disclosures, what they call "upstream activities" comprise their basic oil and gas operations. For all the complaints about difficulties of dealing with foreign governments and state-owned oil companies, ExxonMobil's ROCE in non-US petroleum operations is significantly above the corporate average. It's interesting to note that with the acquisition of additional natural gas resources through XTO, and a recovery in natural gas prices as inventories are worked off and economies recover, the ROCE in the worldwide gas operations looks to have substantial upside, which should really benefit shareholders and add value.

A December presentation at the Morgan Stanley Energy Conference also reiterates some of the rationale for the large acquisition. Talking about ExxonMobil's natural gas operations, a slide notes (1) gas is one of the fastest growing energy sources from the present until 2030; (2) unconventional gas resources will be key to supplying the markets in the future, and (3) technologies for efficient exploitation of the unconventional resources will be key.

Again, for some of the rightful criticism of the company in the past, its historical returns on capital have been very strong, and this deal has the potential to enhance them significantly in the medium and longer-terms, which is where governance theories say managements should be focused.

Monday, December 14, 2009

Paul Samuelson

Today's papers marked the death of Professor Paul Samuelson, a real, trail-blazing economist. His Foundations of Economic Analysis, which I read for my introductory graduate school course in microeconomic theory, really turned my head around, as it was a masterful application of rigorous mathematics to economic markets and behavior. The book, which is much more influential and better done than his textbook, won a Wells Prize for Harvard dissertations in 1941. In one of my introductory operations research courses, I later ran across his writing again in Dorfman, Samuelson and Solow, "Linear Programming and Economic Analysis, affectionately known as DOSSO, that took some dry theoretical concepts and applied them to real-life problems. Again, Professor Samuelson fired my imagination. I mourn the passing of a real intellectual giant who advanced knowledge that benefited many disciplines.

Exxon Strikes A Good Deal

The Wall Street Journal, as it must, put out a quick piece about ExxonMobil overpaying for XTO Energy. Their analysis was confused and off-the-mark. It sounds like a good, opportunistic strategic deal that should be in the interest of ExxonMobil shareholders and perhaps also for those concerned about the global environment.

The paper contends that ExxonMobil's deal values XTO's natural gas resources at $17.50 per barrel-of-oil equivalent (BOE) versus the implied value of $14.90 shown in XTO's disclosures. This dubious premium is 17.4%, less than the 25% premium implied in the total deal value. However, it's the wrong number to look at in the first place. The report talks about "proven reserves," which are those that have been demonstrated to exist and to be recoverable with conventional technology at current prices. This is the most conservative measure of XTO's asset base, but it should only be a fraction of the resource base.

The press release itself talks about the energy assets of XTO Energy including"...shale gas, tight gas, coal bed methane and shale oil." These resources are unconventional resources, as opposed to reserves. ExxonMobil's alternative to the acquisition would be to create a worldwide unit to explore for and acquire these resources, and then to develop the extraction technology. That would take time and lots of expense. Why build this capability when natural gas prices are at cyclical lows, and XTO has proven technical and organizational capabilities, which is the other real asset that ExxonMobil is buying?

ExxonMobil, as well as the other global majors, have really not over invested in their fundamental businesses in recent years, as they have focused on using free cash flows to buy back shares and increase dividends. In one transaction, the company has tipped the balance towards investing in a cleaner-burning, hydrocarbon fuel that will, along with oil, still account for the lion's share of global production and consumption into the medium-term future. What better transaction than this from a fundamental viewpoint?

The December ExxonMobil Energy Outlook for 2030 indicates the average annual growth rate in worldwide demand for natural gas to be 1.8% per year, which is much faster than the demand for petroleum. So, in this transaction, the company has significantly enhanced its reserve and resource positions in the fuel that the world economy will demand. It all makes perfect strategic and economic sense. Given the culture in the global oil patch, it's unlikely that this transaction materialized out of the air, and I would venture to guess that it's good for both organizations. Looks like a good deal to me.

Tuesday, December 8, 2009

News From Newport Beach

My investor antennae went up after reading that PIMCO's Bill Gross, my investment writer/analyst of choice and global bond guru, had started up an equities research effort, built around a "deep value" approach. To that end, the firm made several key hires, including Neel Kashkari formerly of Goldman, Sachs and a key figure in creating and implementing Fed and Treasury programs for AIG, Bear and Lehman.

Bill was a long-time, perceptive critic of GE's empire-building using the cheap currency available to GE Capital. This took place during go-go markets, when GE was the darling of every conglomerate and industrial analyst on the Street. So now, PIMCO wants to look at public equities with a value approach. That makes me sit up and take notice; it should be a development worth watching.

PIMCO's early strategy for the New Normal was to "shake hands with the government," i.e. own lots of GSE and Government-guaranteed mortgage paper, plus buying high quality corporates and staying high up the capital structure. This approach has proved a winner in spades, and it may continue to outperform, with some adjustments.

The ten year records for alternative investments have been lackluster, and many college endowments are stuck in illiquid investments with portfolio imbalances. According to Kaplan and Schoar (Journal of Finance, Volume LX (4)), the average private equity fund's return net of fees were roughly equal to the return of the S&P 500 for the period 1980-1997. The Venture Capital Index returns for the one and three year periods ending June 30,2009 were -17.1% and 1.3%, respectively. Considering the risks, lackluster is a kind word.

As the world economy recovers, the reward profile for equities should improve, with larger being better (risk adjusted) than smaller, and OUS being better than US. Stay tuned for news from Newport Beach.

Monday, December 7, 2009

New Century Financial In The News

The SEC is finally bringing a case against the founder, CFO and Controller of New Century Financial, once one of the nation's largest originators of sub-prime mortgages. The case against the three officers involves fraud for, among other things, reporting to investors in 2006 that the loan portfolio was healthy and outperforming its peers, even when there was substantial internal data to the contrary. New Century filed for bankruptcy protection in 2007, and it once had a market value of more than $1 billion.

It is amazing that it has taken the SEC this long to bring an action in this high profile case. To be fair, part of the problem is that SEC core functions suffered under the dreadfully inept watch of the former Chair under a Republican administration. To do its job, the SEC needs leadership, a mandate, and resources, of which it had very little under the prior administration.

A special master for the bankruptcy court, Michael J. Missal, wrote a scathing 581 page report, which I have to admit that I read, excoriating the external auditor's complete breakdown in internal supervision and QC. It also faulted the auditor's failure to heed the signals of a coming meltdown that were evident from their own working papers. The firm vehemently denied the accusations, and their huffing and puffing rang hollow.

It is certainly good that some company officers will be held accountable for this fraud, but the light should also be shone on the board and its ineffectiveness, along with the passivity and inattention of the auditors. It's a real life, educational case for audit committees of financial services companies.

Countrywide Financial is another egregious case that had a direct impact on the current mortgage crisis, but it was acquired by Bank of America, and it may be old news given the euphoria about BofA paying back TARP funds.

Sunday, December 6, 2009

Reform Runs Out of Gas

Last week I attended a presentation by Bob Pozen, author of "Too Big to Save." Bob is Chair of MFS Investment Management, former Chair of Fidelity Management & Research, and lecturer at the Harvard Business School. Bob is an attorney by profession and Robert Shiller, the Yale economist, is his co-author of the book. I came with a lot of optimism, but left with a sense, at least from the slides, that reform of the financial markets has now been, as the Brits say, "crocked." That is to say, the plate has been thrown down on the floor and broken into shards of crockery. Reform now means a lot of incremental procedural changes that altogether don't add up to much.

Pozen says that there is too much focus on bank lending to business as being the key to economic expansion. He notes that bank lending was about 26% of total credit creation in 2006. Much more important, he says, is the task of reinvigorating the securitization market. He says that current volume, if I heard it correctly, is about $20 billion annually versus $1.2 trillion in 2006.
One reason that the market imploded, among many, was the fact that issuers were not required to hold a retained interest in the securitizations, and I would presume that establishing this as a norm would be one of the enhancements discussed in the book.

I felt that he glossed over the role of S&P, Moody's and Fitch in the whole debacle. The capabilities, business models, and governance of these institutions have not changed. Pozen's answer is to have these and other credit rating agencies, submit bids to an SEC master who would pick the best one for each issue. This seems like a procedural step that leaves all the significant issues behind the failure of the agencies untouched. It's another "check the box" procedure, a la Sarbanes-Oxley.

He rightly points out the popularly misunderstood nature of the extent of financial institutional bailouts. Out of about 650 financial companies that have been recapitalized, there are 290 small banks. Many of the companies don't hold deposits, but received TARP money anyway. The program was rolled out without any limits or rationale. That was, and is, reflective of management incompetence on the part of the Government. Remarkably, he notes that the Government got 15% warrant coverage on its deals whereas Warren Buffett demanded and received 100% warrant coverage for his Goldman deal! Don't want to ruffle any CEO feathers, especially with the taxpayers' money.

Repealing Glass-Steagall was clearly a humongous mistake. Pozen says reinstating a separation of commercial and investment banking is not desirable. It may not be, but his argument escaped me. He says that underwriting securities is not the problem. That may be true, but principal trading of all manner of convoluted instruments surely is the problem, and it takes place on the same trading desks. There was an obligatory comment about financial innovation, but who needs the kind of "innovation" that got us here? Finally, he rightly points out that if other nations don't follow, then US banks would be at a disadvantage. But, wouldn't the UK and the other G's want to coordinate this kind of policy?

On the subject of executive compensation, he noted the failure of the whole system for regulating the banks that took TARP money. We've always pointed out that this was a blunt instrument, and that focusing on the back-end compensation without getting at the philosophical issues about economic rents and short-termism in corporate objectives would be a futile exercise. He noted that Wells Fargo responded to the guidelines by stripping down the options-related compensation of its terrific CEO, whom I have always admired for his focus and consistency. Unfortunately, his base salary went from $900,000 to $5.6 million, and his restricted stock grants more than made up for any "loss" of option-related potential gains. Pozen said that this is not the kind of "reform" that was intended, but that it was a rational and predictable response to the foolish rules-based structure.

Pozen mentions that there is no data to support the notion that procedural-based SOX led to better stock price performance or less malfeasance or bad governance. Again, our systems are based on rules and bright lines, and Europeans tend to favor principle-based systems. Ultimately, it's the people in charge of Governments and the corporations, along with an informed citizenry that make a system fair and reasonably efficient.

I'm sure that there's lots of good ideas in the book and some good analysis of the historical origins of the crisis from Robert Shiller. After all this time, though, I would have expected more penetrating ideas for reform.

Saturday, November 28, 2009

Ethanol On Life Support

With overall gasoline consumption declining and with inventories still high, the ethanol industry will be lining up at the Federal trough to accelerate the mandated move to E-85. This mandate will be negative for food prices and for environmental (soil, water, and air) quality. It is somewhat disappointing to see Cargill dabbling in trying to resurrect ethanol plants, when it was Cargill that was among the first to rightly point out the folly of putting food into the fuel tank of an SUV. This might have been a distressed asset play, but it looks like their experiment may be coming to an end.

E-85 would require substantial improvements and upgrades to the pipes, seals and fittings of gas stations, a sector that is not very attractive for investment right now. The auto manufacturers are wondering how much the E-85 mixture would affect the life of our expensive catalytic converters and other engine components. Only the Renewable Fuels Association would argue that ethanol would put us on the path to energy independence.

Poet, one of the consolidators in the ethanol industry, has reportedly lowered their pilot production plant costs per gallon of cellulosic ethanol to about $2.35, which is progress. However, the costs of having reliable cellulosic feedstocks in proximity to a nationwide plant system would intuitively seem uneconomical. Cellulosic is preferable to corn-based ethanol, but it is a second-best choice. If we were serious about giving life to this biofuel, we should probably eliminate the tariff on Brazilian, sugarcane-based ethanol. This would take the pressure off corn prices and stop a mad rush to increase acreage for this crop that has such intensive input demands for water and fertilizers.

Like NINJA mortgages, corn-based ethanol was an idea without environmental or economic benefit that was hyped completely out of proportion. Let's not be afraid to take the patient off life support.

Thursday, November 19, 2009

How to Hurt Our Capital Markets

The Financial Accounting Standards Board (FASB) is governed by the SEC, and it is the independent and definitive body that sets standards for financial reporting and investor protection. Largely populated by auditors and lawyers, some of their pronouncements were overly arcane and difficult to implement for the small company CFO. However the pronouncments were always conservative in nature and aimed at investor protection. We have a good system that is widely respected by domestic and foreign investors.

Now, there is a proposal to vitiate the FASB and transfer its duties to the yet unnamed and yet to be constituted, "systemic risk regulator." The sad thing is that the hare-brained proposal has the support of the American Bankers Association, mother hen of the folks who got us into the current mess. Of course, the ABA doesn't want to face up to the realities of marking its members' assets to market with the resultant hit to earnings and implications for capital ratios. Former SEC Commissioners, like Harvey Pitt, who has always been visonary, practical and sensible, are against it. Were this proposal to be accepted, it would be a blow to the integrity of our capital markets, just when they need to be reinforced and not called further into question.

Monday, November 16, 2009

Old Economics: Still Good Economics

Despite the bad rap given to traditional economic models in the aftermath of the global financial crisis, economic theory and economic history together still best point the way to understanding the rhetoric surrounding U.S. deficits, the role of the dollar in trade, and the Chinese trade surplus. Today's New York Times Op Ed page contains two related articles by Ferguson and Schularick ("The Great Wallop") and by Paul Krugman that discuss some of the issues.

First, there is no doubt that the biggest contribution that the U.S. can make to global welfare is to get our fiscal house in order over some reasonable time horizon and secondly, to reform financial system regulation to choke off future systemic crises before they become lethal.

However, it is equally fair to say that the behavior of the Chinese in managing the RMB exchange rate vis-a-vis the dollar is deleterious to the world economy, especially Third World countries with large volume of potential exportables and to the U.S. adjustment to its twin deficits. We all know from economic history that this "beggar thy neighbor" policy of artificial devaluation results in a diminished volume of world trade and large welfare losses to the world economy. The Chinese government is doing this to protect their global export engine, which is rational only in the very short-term.

There is some occasional rhetoric about "replacing" the dollar as the primary instrument of world trade. However, the dollar enjoys this primacy not because of a popularity poll but because there is a large, low risk, highly liquid market in short-term Treasury bills. What about purchasing power risk associated with higher U.S. inflation? Right now, the Federal Reserve governors have almost been unanimous in saying that significant inflation is not a risk given all the slack in capacity utilization and in the labor market. Even if it were a prospect, interest rates would adjust to compensate the holders for this risk. So far, so good.

What about the using the euro or the yen as alternative reserve currencies? Despite the growth of the Euro capital markets, they remain fragmented and nowhere as deep and liquid as dollar markets. Since reserve holders cannot hold the euro directly but rather hold euro-denominated securities, one has to look at a potential issuer of euro-denominated, government debt with large outstandings. As Richard N. Cooper of the Peterson Institute points out, the largest issuer of euro-denominated government securities is the government of Italy, with $1.8 trillion in outstandings. It's highly unlikely that the world will place its confidence in the reliability and transparency of Italian monetary and fiscal policies in order to switch to the euro through this issuer. The government of Germany is a possibility, but only $266 billion of their outstandings are in short-term maturities, which is inadequate to finance world trade and reserve movements. The yen has significant outstandings ($7.9 trillion in government debt) and $2.3 trillion in short-term maturities, but the near-zero rates and the long-term fiscal issues cast a pall over using this issuer as the bulwark for global trade and finance. As Cooper notes, "none of the other leading currencies in the world today is ready to replace the U.S. dollar in its international role." The reasons are based on fundamental market economics, which are still the optic through which currency traders view the world, however fancy their trading instruments.

I won't go into the idea of using SDR's for trade and private settlements. It makes for nice conversation in the halls of the European Parliament, IMF, BIS, and World Bank, but it's not an idea whose time will likely come in the near future.

Global trading partners are really inter-dependent. We don't call the shots because of our fiscal and economic issues, and neither do the Chinese because of their unsustainable policy to grow exports at the expense of domestic consumption in a fifteen year orgy of subsidized export growth. Everyone has to adjust, and the biggest traders will have to adjust more.

President Obama's trip to Asia puts him at the top of Presidential travellers measured in mileage. It's hard to imagine the Chinese taking anything he says seriously. By all means, let us get our domestic fiscal and foreign policy houses in order and focus the agenda on jobs and economic growth. The markets would really take notice.

Sunday, November 15, 2009

Why Did They Do It?

I attended an interesting workshop at the University of St. Thomas Law School, sponsored by the Holloran Center for Ethical Leadership entitled, "Crime, Punishment & Redemption: Three Unique Reunions." Three panels discussed three cases of white collar crime. Each panel was composed of the perpetrators, the judge who sentenced them, and the U.S. Attorney who brought the case. Additional comments were made by very senior Federal judges. I am not a lawyer, but the human side of it all was very hard to listen to without some emotion.

The first panel concerned Stephen Rondestvedt, who came from a middle class background with a record of high achievement in his undergraduate studies and then in law school. Steve started a solo practice in the area of workman's compensation and disability claims. He said that his clients were not well-to-do generally. He got caught up in the pressure to upgrade his home, and his wife wanted to badly close on the new home before the old one was sold. So he had to come up with a $28,000 down payment, which he did not have because the business was sucking up his liquid resources. Under the emotional pressure to satisfy their aspirations, and with an inability to say "No, we can't do this now," he tapped the trust fund of claims money held for his clients. He firmly believed that he would pay it back so rapidly that it wouldn't matter, though as an attorney he fully realized the ethical and fiduciary violations the withdrawal represented. From there, the sense of entitlement got worse and eventually morphed into a fraud of $789,000. He served 20 out of a 46 month sentence in the Federal Penitentiary in Yankton, South Dakota. He was clear and candid about his weaknesses and his bad judgment. He has rehabilitated himself and is now Executive Director of Axis Medical Center in Minneapolis, which provides services to the primarily Somali community in Minneapolis. Why? Financial pressures to upgrade the lifestyle and an inability to postpone satisfaction led to a bad judgment in a moment of weakness. There was a perception that the act would not linger around long enough to constitute theft and betrayal of trust; it did much more and morphed into fraud. It ultimately cost him his marriage. Tough stuff.

The second case was David Logan, who while a City Administrator in Pipestone, took bribes from companies looking for city business over a long period of time. What started out as a legitimate desire to cut red tape and generate development, turned into a career of working with his hand out. Again, there was a sense of entitlement--after all, he was working harder than his peers and he was actually bringing development revenues to the city of Pipestone. From there, in a desire to flee the history, he became CEO of an industrial hog farm, where he got involved in generating fraudulent loans that were tied to hog prices as part of the terms. Ironically, while perpetrating these fraudulent loans, the history at Pipestone was being uncovered and he received the notice of Federal Court proceedings relating to his city career while he was in his new CEO job. In the end, the U.S. Attorney recommended a sentence in the lower range of 34-71 months, as part of the plea agreement. Here's where it got interesting.

Michael Davis is the Chief Judge of the U.S. District Court in Minnesota. While on the dais with Logan and the U.S. Attorney, Judge Davis who had not seen Logan since the sentencing, proceeded to tease out a much less sympathetic portrait of Logan, whom he sentenced to 71 months in Federal prison, the maximum term according to sentencing guidelines. Logan made the statement that the bank loans were eventually repaid, with the implication that no one was harmed. Judge Davis noted that this happened only because Logan "had made the right bets," that is hog prices rose dramatically during the loan period assuring repayment. It seemed to me that Logan, of the three cases, had not really acknowledged to himself the real extent of his crime.

Judge Davis then gently, but forcefully excoriated the system for focusing almost entirely on punishment of offenders as opposed to rehabilitation and for treating white collar crime, dealing with large amounts, as somehow more benign than a black kid sticking up a store for $100. He raised a lot of interesting questions, most of which I first ran into when I read the "Autobiography of Malcom X," in high school. We cannot incarcerate large segments of our population for longer and longer terms with no plans for what these individuals might do when they are released. No easy answers, obviously, but Judge Davis' quiet indictment of the process was worth listening to. The program was recorded by Twin Cities Public Television, and the Holloran Center will publish a transcript.

The third case was a couple where the husband was a senior HR executive for a large company, who told his wife to start a personnel consulting company in her maiden name. Nick Ryberg then hired his wife's company to provide "research support" for HR recruitment programs, for which no work was done. The false invoicing scheme billed more than $1 million! What was the motive here? Nick said it was "corporate ego," the feeling that he was smart enough to manipulate the system, that he was entitled because he was a corporate hitter and that he could deflect any questions and explain everything away. Corporate ego. Hubris. A sense of entitlement....

The person's background was not predictive of whether or not they would be lured into fraud and white collar crime. In the case of Steve, for example, his background, early family life, and parental values were all exemplary. Moments of weakness where the person loses their bearings seems to be the common descriptor. They all also seem not to have had confidantes who might have pushed back on their decisions. As the frauds grew, so did the sense of isolation and even desolation. Alcohol was the "drug of choice" to make the pain go away. The frauds were clearly toxic to relationships both with spouses and with children, who are often the forgotten victims.

Board Engagement with Shareholders

Recent academic research, such as the paper by Simon C.Y. Wong of the Northwestern School of Law (Brunswick Review, No. 2, pp. 53-56, Winter 2009) suggests that boards of directors engage directly with shareholders on a regular basis in order to establish relationships of trust. We believe that this is an inherently risky strategy, without commensurate benefits.

It is certainly true that institutional owners want to feel comfortable that they understand the character and motivation of the managements of their portfolio companies. It is less clear what they expect, and have a right to expect, from the board of directors. The primary charter of the board of directors is to appoint, incent and monitor the performance, character and integrity of a professional management team. Very, very few members of public boards are conversant and current with the character and personality of institutional investors, particularly with the momentum investors, hedge fund investors, and activist investors.

Sad to say, but widely reported, is the fact that boards of many financial service companies are not fluent with the business models of their companies or where the risk resides on the balance sheet. Were it otherwise, we wouldn't have had the recent debacle and the subsequent conversation about enterprise risk management in director forums.

This conversation with investors should be the meat and potatoes of the CEO and CFO duties. There should be at least one director whose brief it is to follow these issues carefully and to provide additional color to the board, as required in quarterly meetings. It is an area where professional advice from skilled and knowledgeable outside professionals pays large dividends and mitigates risk.

If a conversation were to take place between, let's say a hedge fund investor and an untutored director, the conversation would quickly be steered to eliciting material, non-public disclosures from the director. These investors are Zen masters at filling out the information mosaic with repeated, seemingly unrelated questions. The management would never know what had been divulged or not. An additional question would be "Which investors merit a private meeting with a director?" Is it a question of size? If so, then the information playing field is not level, which is something about which past SEC commissioners have felt strongly. So much so that they passed Reg FD.

If the relationship with a company's larger institutional owners is poor, this is a critical problem that needs to be addressed, but the academic solution proposed is one that should be avoided.

Wednesday, November 4, 2009

GM and Opel Re-Revisited

From the early days of government intervention in the auto industry, some White House policy wonks decided that the sale of Opel be a mandatory part of the GM restructuring. We thought this was a foolish move back in July when we wrote about it. Opel is a valuable brand in Europe, where there is a long history of building smaller, more efficient and fun to drive cars. The new GM board has apparently scuttled the plan to sell Opel to a group led by the Canadian parts supplier Magna International. It remains to be seen in the German government will stand up to their unions and go along with the board's directive. Retaining Opel, if labor relations can be managed, should be a smart move for GM in the medium term, as the consumer markets rebound and world demand switches to more smaller, multi-fuel vehicles.

Monday, November 2, 2009

Oh, Cisco!

Robert Cyran writes an interesting "Breakingviews.com" column in the New York Times, about Cisco Systems. This stock points out a number of evergreen issues that affect investors. First, there is the slowly receding aura of the charismatic, larger-than-life CEO. John Chambers famously claimed that Cisco could grow sales by 50% per year for the long term, whereas the actual growth rate has been 7% per year, with acquisitions, according to Cyran.

Next is the continuing froth surrounding acquisitions, including the mysterious "Cisco model," and its vaunted ability to "integrate acquisitions." If this were true, it would have shown up in increasing returns on capital employed, which usually merits sustained stock market out performance. Five years to date, Cisco is up about 15% which closely tracks the performance of the NASDAQ Computer Index. At the height of the 2007 bubble, Cisco diverged from the index and strongly outperformed before falling back into the pack. Over the same period, the prosaic IBM was up more than 30%.

Over ten years to date, the performance is worse. Cisco looks as if it lost about 40%, while IBM was up 30% over the same period. Clearly, the market did not see promises materialize, and apart from commodity-like trading cycles, Cisco's fundamental performance was not significantly different from its index.

Peter Lynch in his classic book, "One Up on Wall Street," coined the term "diworsefication." He was right then, and he's still right now. Conglomerates like Allied-Signal and Tyco failed with their models of acquiring companies in diverse industries. Cisco in theory is acquiring companies in its space. But what is that space today? Earlier marketing campaigns from Cisco touted the fact that the company provided the plumbing for the Internet. Today, it's unclear what Cisco's mission is, apart from getting bigger.

Shareholders can do a better job of diversifying their portfolios with less risk than can the management of a public company driven by short-term pressures like stock prices and option values. Cisco has always received plaudits for share repurchases, but what these have done, at best, is partially offset the hugely dilutive effect of option grants, which were supposedly integral to the ability of technology companies to retain and recruit talent.

Cisco clearly has overpaid for its $22 billion in acquisitions since 2002, and when it was enjoying high multiples itself, management could feel good about overpaying. The New York Times says that Cisco employs 59 internal boards and standing councils to "involve more people in decision making." Shareholders benefit when they know where the decision making buck stops, and the better they understand the minds of the decision makers. With these invisible councils, it's a crap shoot for them.

Cisco, like Microsoft, is a mature company. Paying a dividend, and hewing to the discipline of writing a quarterly check, is a good thing for shareholders because they can diversify as they choose. However, management has a hard time choosing this option because as a CEO might say, "It says that we're out of ideas, and that we can't grow any more." Certainly this is an overwrought sentiment, but not uncommon.

Talking about conglomerates, what about Berkshire Hathaway, isn't that a collection of diverse businesses? There are at least two distinct features of this company that are notable for me. First, when a business is acquired, it is for the management as well as the cash flows, and the management is incented and stays in place. Their performance almost always improves over time, as evidenced by the Annual Report commentary. Second, the real magic, in my opinion, is the redeployment of cash flows from the operating companies by Warren Buffett, Charlie Munger and the rest of the executive team. So a company like Sees Candies throws off consistent free cash flows which are then redeployed into buying other attractive businesses completely removed from confectionery. The net effect is that the portfolio diversifies and gets stronger.

Investing in mature technology companies looks like it's most efficiently done by buying the appropriate technology index, judging by the performance of bellwether Cisco Systems.

Friday, October 23, 2009

Look,It's Someone Doing Their Job!

The New York Times today reported a story about Dr. Suzanne Stratton, a Ph.D. molecular biologist and researcher in clinical oncology, who was brought in to oversee the quality of clinical trials at Carle Cancer Center in Urbana, IL. Upon taking up her position, Dr. Stratton finds, among other issues, failures to properly consent patients in cancer trials. In the world of clinical studies, this is a major "No No." In addition to opening up the institution to considerable liability if, let's say, the patient died due to an experimental treatment that was not properly explained, that patient should also properly be taken out of the enrollment pool for the study because of the failure to properly document informed consent.

It sounds like Dr. Stratton had done her job and found this fundamental violation of good clinical practice, and had pointed it out to her superiors, along with other issues. For this, she was discharged and led out of the office the same day. In the mean time, it turns out that one Principal Investigator at Carle, Dr. Ken Rowland, "has simultaneously overseen more than 130 clinical trials in more than 20 cancer types, ..., and he personally enrolled about one-quarter of the 500 patients Carle signed up for experimental treatment in a typical year." This is analogous to a lawyer billing 5,000 hours a year--implausible to say the least.

This kind of high volume throughput does lead, just like in the financial world, to moral hazard and perverse incentives. In fact, the NYT article suggests that "doctors too often promoted trial treatments as superior to standard approaches, even when there was no supporting evidence."
Get 'em in and get 'em enrolled, and let's bill the Government based on enrollment. The primary body for regulatory oversight in this setting is the Institutional Review Board (IRB), and Dr. Stratton had the temerity to suggest that it was too deferential to researchers and did not maintain its own, independent documentation.

Kudos to Dr. Stratton for doing what she was supposed to do and for following the chain of command and for calling it like she saw it.

Monday, October 19, 2009


An interesting item came across my desktop from Richard Herring, Professor of Finance at the Wharton School. He notes that "the 16 largest financial institutions control 2.5 times as many subsidiaries as the 16 largest non-financial firms. One of the most complex financial firms controls 2,435 subsidiaries, half of them chartered in other countries. Many such subsidiaries are formed to "minimize regulatory burdens" or reduce tax bills," he says. "Such complexity makes it difficult for anyone -- including regulators and the companies' own managers and directors -- to fully understand all the risks the firms are taking, or how those risks might interact with ones other companies are taking."

Here are some thoughts. Let's simplify a tax system that encourages and allows such non-productive activity like creating a network of 2,435 subsidiaries whose purpose is to transfer income from the Treasury to management and shareholders. Second, having just spent some time with a few directors of large financial services company, I hate to say, and I include myself, that they would be hard pressed to find pockets of radioactive risk inside of a corporate rabbit warren like the one Professor Herring cites. Unfortunately, in the case of TBTF financial institution, the directors failure soon becomes a taxpayer burden, and this chain also needs to be broken by sensible, basic regulation.

Conscience and Character

What do these have to do with the crisis of the American financial system? Nothing. And, that's exactly the problem. Wall Street fosters an environment where a person's governor or self-regulator, called a conscience is switched to "Off" during office hours. The name of the game is always to go to the edge, and over the edge. If someone calls you on it, pull back, with no consequence and go about your business. Each minute, hour, day, and quarter is serially independent of any other. "Size of the book" is all that matters, and the positive or negative sign means little. Size means you're a player, and a negative sign means that you are "aggressive."

Unfortunately, a variation of this theme applied to bank regulation during the build up to the crisis. That truth is slowly coming out. Here's a self-assessment of the Federal Deposit Insurance Corporation's loan review process reported on the Calculated Risk blog:

"The FDIC’s Office of Inspector General analyzed 23 lenders taken over by regulators from August 2008 to March and found that for 20, the agency’s examiners didn’t identify the issue early enough or should have taken stronger supervisory action after recognizing the banks had dangerously high levels of the loans before they failed. ...“It’s often we’ll see in our reports that the FDIC detected problems in the bank in a timely fashion, but in some cases forceful corrective action wasn’t required by the FDIC to be taken quickly enough,” Jon Rymer, the FDIC’s inspector general, said in a telephone interview." (Source: Calculated Risk)

So, it's not a matter of inadequate process or regulation. Examiners were in place, and they went out and followed their processes, which pointed out the issues. What is unclear is why the levels of bad loans were allowed to get so high, and why "forceful corrective action" wasn't taken. It's the same issue: a failure of character and faithfulness to one's mission. Of course, having worked for a few agencies of the Federal government, it's easy to construct a scenario where an examiner calling for shutting down lending in a go-go market in a "free market" administration might not think this was a good career move. And that's a shame.

I've never responded negatively to one of my staff giving me bad news or taking a stand on something. Overzealousness shows passion and commitment; it can always be remodulated, if it has to be. Failing to call attention to a problem or being inhibited about bad news is a more complex problem; it's being tepid, which is a bad thing in sports, life and in the world of character and conscience.

Reverend Dr. Martin Luther King, Jr. longed for the day when a man would be judged "not by the color of his skin, but by the content of his character." Perhaps the latter is something that should start going onto performance review forms.

Monday, October 12, 2009

Silence in Islamabad

The recent brazen Taliban attacks on Pakistani military headquarters, the killing of international civilian food program officials, and the taking of hostages has been greeted by a very muted public response from the government of Pakistan. Normally, the head of state would be issuing press releases to the worldwide community, flanked by the top generals, expressing outrage and a program for reestablishing security and punishing the organizers. The most publicly quoted international official has been Secretary of State Hillary Rodham Clinton!

If I were sitting in New Delhi, I would be very worried as well, because there is no real benefit to India from a collapse of the Pakistani state, but it seems as if there are messages being sent by the Pakistani Taliban, paraphrasing Alexander Haig's famous quote, "(We're) in charge now." No targets are off limits, and that includes employees of international agencies, who had traditionally been given safe passage to do their humanitarian work. The international community has also been challenged, and there is no response. I'm not sure what it could be, but unfortunately President Obama's choices in Afghanistan will ultimately trigger events inside the frontier territories of Paksistan, which are becoming nerve centers for the wider conflict in Central Asia.

Wednesday, October 7, 2009

Give Me Your Tired (Old Ideas)

The New York Times had a great article about the Simmons bankruptcy. It took me back to 1986, when I was working as a sell-side research analyst, and I read about the $600 million LBO of Ohio Mattress. Ohio Mattress was itself a roll-up of lots of small mattress makers, and the company eventually became Sealy. As I heard our analyst recount the numbers, it seemed unbelievable to me that so much debt could be piled on a business that put padding on coiled springs and covered them with fabric.

Fast forward to 2009, and we read about the bankruptcy of Simmons. T.H. Lee & Partners makes a cool $90 million on their investment, but, for the record, is "disappointed." Banks have made fees and padded their earnings. Bondholders are out $575 million; "apoplectic" should appear in their press releases. Finally, the employees who dutifully went through all the changes that generated the higher cash flows required to pay off THL were rewarded with cake at their holiday parties and now have nothing. Warren Buffett, who has no aversion to making money, has railed at the private equity paradigm in his shareholder letters for years. This kind of "looting" (a term used in an academic article from 1994) is now called "financial innovation."

Ares Capital Management, the new owners, will benefit from wiping out creditors and bondholders and the cycle starts again. The bondholders, though, have only themselves to blame, as they were apparently told that the use of proceeds for the various debt issues were to pay special dividends to the owners and not to bolster the long-term earnings power and sustainability of the enterprise. Which of our compassionate political parties speaks for the employees?

Thursday, September 24, 2009

The FSA Gets It Right

Lord Adair Turner, Chair of the Financial Services Authority (FSA) of Great Britain, is a former non-executive Director of Standard Chartered Bank, former vice-Chair of Merrill Lynch Europe, and a former senior executive at McKinsey & Company. Near to my heart, he studied History and Economics at Gonville & Caius College, Cambridge University. As my musician son would say, "He's got the chops."

As our Financial Crisis Inquiry Commission held its first meeting on September 17th and grinds along, I believe that the March 2009 "Turner Review" from the FSA is an excellent, informative, clearly written one-stop resource on the origins of the crisis and on the market and policy changes needed for the future. It has some very striking charts that bring home the points in sharp relief.

The opening chapter, "What Went Wrong?" should be read and actively discussed in classes and in the board rooms of financial services companies. Lord Turner has become a bit of a controversial figure, which to my mind means that he is getting to the right issues on wholesale financial services.

Summarizing the benefits of securitization, the Review correctly notes that it should: (1) reduce banking system risks; (2) cut the total costs of financial intermediation; (3) pass credit risks on to end investors, thereby freeing banks from holding unnecessary and expensive regulatory capital.

Markets in securitization-related products ballooned during a period of extraordinarily low real interest rates as everyone hunted for yields. So, for example, the credit default swap market stood at $5 trillion in 2H 2004 and soared to almost $60 trillion by 1H 2008. As the markets expanded, relatively little of the securitization production went to end investors, and much of it went to the proprietary trading desks of other banks (see Lehman Brothers et al). The retained tranches were themselves hedged via CDS. Some of the product was repackaged into CDOs and CDO-squareds. Finally, some of the product was used as collateral for short-term bank liquidity. So, the basic premise that created the securitization industry was completely turned upside down.

Repeal of Glass-Steagall again seems like a horrendously bad political and regulatory decision. What it allowed was for trading books at banks to have capital requirements much lower than the capital requirements for the banking books of the parent company. As commercial banks became extensively involved in proprietary trading, when asset prices started collapsing that directly affected parent bank profitability, creating a crisis in confidence and in short-term bank liquidity. Historically, that crisis in confidence could have only occurred from a run on deposits. Now it occurred due to trading activities that were remote from the fundamental commercial bank mission of "maturity transformation."

Think Wall Street knows how to manage risk? Here are two pithy quotes, "At the individual bank level, the classification of these (Structured Investment Vehicles) as off-balance sheet proved inaccurate as a reflection of true economic risk, with liquidity provision commitments and reputational concerns requiring many banks to take the assets on balance sheet as the crisis grew..." There is a breathtaking chart showing the historical leverage ratios of the larger banks, and the charts for UBS and Morgan Stanley are poster children for irresponsible risk management.

Financial innovations (lower tranches of CDOs and CDO-squareds) had "very high and imperfectly understood leverage..." The complete failure of the VAR models have been well-documented by Roubini and others.

According to the Review, "...the development of securitized credit has ended up producing the worst financial crisis for a century." The introductory chapter talks about poor regulation and inadequate capital standards, a message that was recently reiterated by Secretary Geithner in a speech that was not attended by a single money center bank CEO. Again, it must mean he was on to the right issues.

Some basic economic points are well made. Market efficiency does not mean market rationality. Even market efficiency is not something we should take for granted on Wall Street. For example, a chart on bank CDS spreads shows that the market did not anticipate the credit problems ahead. At best, the spreads ranked the relative risks of certain banks (such as Northern Rock in Britain) accurately, but the spreads were a useless leading or even coincident indicator. Neither were the share prices of the banks themselves, and yet stock prices are a big component of US leading economic indicators.

Individual rationality does not sum up to collective rationality. Economic behavior of individuals is not dominated by the "rational maximizer" model that we study in economics and finance.

Finally, Lord Turner starts to stake out some meaningful and controversial ground when the report says that the increases in market efficiency from the creation of complex financial products is essentially trivial. This is a powerful quote that forms the basis for the recent speech Lord Turner gave at Mansion House: "Wholesale financial services, and in particular that element devoted to securitized credit intermediation and the trading of securitized credit instruments, grew to a size unjustified by the value of its services to the real economy." How did this happen? The margins in financial services, and in particular on proprietary trading of these products are opaque. There is substantial knowledge and information asymmetry in the markets. Finally, there are the principal/agent relationships between investors and banks, and between banks and the employees running the trading desks.
This leads to a fundamental economic process called "rent extraction." Trying to regulate compensation does not get at rent extraction fundamentally.

Just a word to the Financial Crisis Inquiry Commission, there's no need to reinvent the wheel. The origins and mechanisms of the crisis have been very well laid out. Let's get right to better regulating markets and the products for the future.

Wednesday, September 23, 2009

What Sunk the Ship?

Andy Kessler in today's Wall Street Journal makes the same basic point that we made in our last post about the futility of focusing on executive pay at banks. There is one philosophical difference that probably originates in the fact that Kessler is a former hedge fund manager. He says it wasn't excessive compensation schemes or excessive risk-taking that almost sunk the global financial system. Rather, he says it was the excessive use of leverage. He claims that Wall Street is good at managing their day-to-day risks. I have a hard time following this one.

Leverage is a decision variable that magnifies risk and returns, and so it is part and parcel of risk taking. So when Bear, Stearns or Lehman Brothers leveraged their portfolios at 35x, these were the accumulation of conscious decisions taken on their trading desks. It is the produce and distribute model for products that are as economically useful as carnival elixirs that needs to be changed and regulated. Unfortunately, there is no appetite to do this any more, as everyone is worn out by the minute-by-minute crisis watch over the past three quarters.

Just like SOX was a victory for accountants, consultants and lawyers with little impact on long-term shareholder value, so too will be the pursuit of executive compensation in banking. It's become so ridiculous that a local paper featured a story about a school board that rescinded performance pay bonuses for senior district administrators. Their performance measures, which included increasing enrollment in special programs, increases in minority performance and the like, were set a year ago; they seem clear, reasonable and measurable. The bonus amounts were a reasonable percentage of the base compensation. Now the administrators were told to give back their bonuses as contributions into special programs, "for the kids." It's not the fault of school administrators that Wall Street got the entire country into the crisis of the century!

Misguided populism is raising its head because the Administration and its Congressional lackeys don't have the guts or understanding to attack the problem at its roots because they are all running for their next campaigns. What a shame.

Monday, September 21, 2009

Executive Pay in Banking Is A Symptom

The Fed and other politicians are now grabbing headlines by vetoing pay packages for banking executives. Look, there is no doubt at all that pay packages for public company CEO's in US public companies was, and is, out of hand. However, it wasn't the level of the payouts that got us into the financial meltdown.

The financial system, and especially the shadow financial system, originated and distributed products such as MBS, CDO's, and CLO's that shifted risks off the balance sheets of the originators and offered investors high returns with what they thought were AAA credits. The creation of credit default swaps, where a buyer or seller need not have any actual interest in the underlying interest caused this market to explode. Proprietary trading in these same toxic instruments was and will always be a very profitable business, because it is dominated by a few large traders and it is not transparent.

Regulation needs to address (1) bringing the shadow system into the regulatory light; (2) forcing originators to retain a substantial portion of the securitization on balance sheet; (3) reforming the rating agencies that gave the AAA tranches their unjustified ratings; (4) perhaps requiring that traders in credit default swaps have some demonstrable interest in the underlying instrument; (5) meaningful SEC regulatory review of financial product creation process-- a firm can't just decide to package pay day loans into a new class of securities without going through some meaningful examination.

Corporate boards of large financial services company were ill equipped to deal with these issues. Jay Lorsch et al. quote a director of a giant financial services company, "[Two banks]--I think they crashed and burned. Neither one of them had anybody that I could detect on the board that's had any serious financial skills. And doesn't look to me like these boards demanded to know what was going on off balance sheet." Another director at the same company questioned management's financial acumen as well. "The bank boards and the bank CEOs and leadership, obviously, with the exception of maybe one or two, did not understand the risks they were managing." Again, it's not a problem of risk management process, it is a lack of care and competence.

Executive pay in these sectors was a symptom of the overreaching, overly coddled CEOs controlling passive boards, which the board members themselves admit, as above. Focusing on pay without focusing on regulating the creation, distribution, marketing, trading and accounting for toxic ("innovative") financial products is a futile exercise.

Saturday, September 19, 2009

Catching Up With Afghanistan

With the turmoil surrounding the Afghani elections, I've had a chance to catch up with friends from Central Asia, and it strikes me that we have now lost our way in Afghanistan. There was such hope last Fall. The reasons are fairly straightforward. The Taliban control the global poppy trade from the fields to consumers in Europe. Many communities rely on Talib leaders for security and for funds to build minimal infrastructure. President Karzai wisely prefers life to death and has allowed rampant corruption to go unchecked among his own supporters. He can then appear on CNN in his multicolor robes and say, "It's not my fault."

The second reason is the deafening silence from Pakistan. What is going on there? Where is our engagement? Without some sort of understanding about our common interests with Pakistan, their instability only contributes to the instability in Afghanistan. Academics had suggested a "divide and conquer" approach to Afghan power groups. That might have worked last year, but not now. Our troops need relief and they need a mission.

Meanwhile, here's a link to a publication from the Central Asia Institute, where you can see how some real progress is occurring on the ground in a small way, namely educating young women.

Market Dances

For the 52 weeks ended Friday, the S&P 500 was down 12%, with every sector down, excepting a slightly different from zero performance from IT. Yet, looking at bellwether Oracle's earnings report, there was very little to cheer about. Positive equity earnings report continue to be built on cost cutting, which is reactionary and backward-looking.

For the same 52 week period, the FINRA-Bloomberg Investment Grade Corporate Bond Index was up 19%. Investors piled into corporate bond funds, to the point where PIMCO's Total Return Fund became the largest bond investor, period. So, up to this point being senior in the capital structure, tilting towards size and quality issuers has proved far, far superior to being in equities.

Now it has always been a classic technical indicator that when retail investors start piling in, it's usually a market top. Perhaps it is so for investment grade corporates, but it's still hard to understand what fundamentals that are going to drive consistent outperformance in equities.

Firms need to be reporting top line revenue growth for things to be fundamentally better. There will be no help from pricing, so the gains will have to be volume driven. So, for example, the Street has been recommending consumer stalwarts like P&G and Colgate--we all to brush our teeth and shampoo our hair after all. Whatever domestic volume gains that we see will be largely at lower margins and will represent temporary shifts in market share. All of these fundamentals seem fairly priced into the market, which is why the market seems so directionless.

China's economy is booming, and most of it seems to be inwardly directed. Again, this doesn't appear to hold a lot of promise for US and European industrial multinationals. There is still a lot of liquidity sloshing around the global markets. Since this appears to be a trader's market, I would guess that there will be more activity in commodities and in distressed financial assets.

Monday, September 7, 2009

A Colossal Failure of Common Sense

I couldn't get Lawrence McDonald's book about the demise of Lehman Brothers out of my mind, so I went back and re-read some parts. McDonald cites the starting point of "America's living in a false economy" as the Greenspan Fed's "free money" that was issued in "defiance of the natural laws of the universe." This is not from a metaphysicist, but from a hugely successful Wall Street trader. As he notes in June 2003, Greenspan pushed rates down to 1%, and this was the beginning of the bubble's rapid inflation.

McDonald writes vividly about the Stockton, California market, east of San Francisco. This area was a market that originated the NINJA ("No Income, No Job") mortgage. "Body builders," working with the home builders generated annual incomes of $300-$600,000 selling mortgages to financially unsophisticated and sometimes illiterate customers. Some of the mortgages were for 110% of the inflated, appraised value, and so the buyer was actually "paid" to take on the mortgage. These instruments went to more traditional, middle class buyers and their workout stories are now turning up in California newspapers. As buyers flocked to Stockton, its population increased by 5,000 per year from 2000-2005, all driven by real estate speculation.

New Century Financial was the largest sub-prime mortgage lender in the United States by 2007. Between 2003-2004, it was one of the fastest growing companies in the United States and listed on the New York Stock Exchange. By 2006, it was clear that the residential mortgage market was turning sour. Congress called for hearings. At one of the hearings, the hapless, inept head of the SEC, Christopher Cox (Harvard MBA and Harvard Law), assured Congress that all was well with corporate governance, financial reporting, and corporate disclosures. How could the head of the most powerful securities regulation body in the world be so clueless? How did he neuter all the internal analytical capabilities and any dissent in his own organization?

Meanwhile, Lehman's distressed debt trading desk, and with the foundation provided by analysts like Christine Daley, aggressively shorted paper issued by players like New Century and made tens of millions. They did it by just looking at public documents, and by asking the penetrating questions! Ironically, in the post-mortem on the New Century bankruptcy, the Delaware Court special examiner wrote, "(New Century's auditor) contributed to these accounting and financial reporting deficiencies by enabling them to persist and, in some instances, precipitated the company's departure from applicable accounting standards."

The culture and internal safeguards of a Big 4 auditing firm had failed once again, just as it had when Arthur Andersen was blessing the voodoo accounting at Enron. In fact, the failures during this crisis have been across the board. Start at the top with the Federal Reserve and its abandonment of rational monetary policy and its failure to supervise bank lending and capitalization. Move down to the boards, analysts, auditors, attorneys, rating agencies, appraisers, real estate agents and no one said "No, I am not going to approve this document or this way of doing business." As Charles Prince said, "As long as the music's playing, I've got to dance." The problem started when the music stopped, and we are all living with the aftermath, for which no one is accountable.

The problem now is that there is no natural constituency for meaningful, fundamental reform. If there were, the first step would have been to hold people accountable. CPA's who blessed the bogus statements of players like Countrywide and New Century are still practicing their craft. The armies that put together and sold the securitizations that went radioactive are probably looking into securitizing payday loans. The body builder salesmen are probably back in the gym, which they probably own. We are now off tackling the window dressing issues, like "say on pay."

Unfortunately, our markets are built to have these kinds of cataclysmic events and now that the surviving global financial investment banking industry is more concentrated and needs to generate bigger profits to feed the machine, we have to see which market will produce the next bubble.

Tuesday, September 1, 2009

August Vehicle Sales

The market gets excited for a while about August vehicle sales of 14.1 million at a SAAR, the highest level since May 2008. It doesn't take much sleuthing to find that the "Cash for Clunkers" program accounted for this strength, and the corollary is that the sales were probably borrowed from the normal September/October uptick. I talked to my neighbor who cashed in a Subaru that was a clunker only in Government terms, and wound up netting a Chevy Cobalt for about 1/3 off the lowest possible price imaginable under the convoluted pricing system. He's an engineer and worked the pencil furiously, as did thousands of others.

Nissan dealers were notified that some "hot" 2010 models are not being delivered in September/October, but in January. What does Nissan know? They know that there's no benefit in pushing deliveries of a decent value sports sedan and having it languish in lots and then have to throw money at their dealers. It's better to wait, take the temperature of the market, and produce JIT the right number of cars for the market when better data is available. Watch what the smart companies are doing, and Nissan is smarter than the average metal-bending automotive company.

Incidentally, looking over my neighbor's Cobalt, which I badly wanted to like and which seemed like a good value, I couldn't help but notice the poor fit and finish. It is irritating and inexcusable to see this after decades of Japanese leadership in quality. The trunk appears to be offset to one side, and the left hinge is causing one side to be slightly higher than the other. The buyer will get it taken care of because GM is being very solicitous, but there's no excuse for this kind of poor performance.

Sunday, August 30, 2009

Where Are We Now?

I've just finished "A Colossal Failure of Common Sense: The Inside Story of the Collapse of Lehman Brothers," and I want to take some time to digest it and put it into context. I find that we're in a curious position right now, where there are still forthcoming books "explaining" the roots of the financial crisis. So, we're still looking back. Reading McDonald's book, along with many other presentations, it seems to me that the causality and chain of events is quite clear, as we've written about many times. McDonald tells the story from the trader's viewpoint, which is at the center of the storm, and it's quite a tale.

Meanwhile, while we are still looking back, it seems as if notions of regulatory reform, elimination of moral hazard, shrinking the size of the financial sector, and the need to regulate the creation and trading of lethal financial instruments in a casino environment have conveniently been forgotten. Remember "TBF" (too big to fail)? Psychologically, it's not hard to figure out why. I think it's "crisis fatigue." 24x7 coverage of the issues by talking heads and blathering Congress persons has numbed interest and critical thinking. Realistically, most of us are worried about employment and personal finance issues.

Taking advantage of this, the Federal Reserve has now shifted its own commentary from financial market and central banking issues to the shape of a recovery. Now, we're arguing about "V" versus "W" shaped recoveries. This is easy and fun, because everyone can have an opinion and nobody is responsible for where the Dow goes. "How 'bout those Yankees?"

In McDonald's book, it's ironic to hear a hugely successful trader of distressed debt talking about the lunacy of unwinding Glass-Steagall, even though it has allowed his desk and Lehman Brothers to makes tens of millions of dollars in profit in a day. Yet, this foundational issue is now lost in the reading of stock market tea leaves. Barney Frank, who fiddled in his role as head of Congressional oversight, has now quietly also slipped out of the spotlight.

Finally, we read that the new head of AIG is seeking wise counsel from the former CEO, who constructed the house of cards that threatened to incinerate the world financial system. It's too much irony for me.

Friday, August 7, 2009

That Was The Week That Was

Americans have no equivalent to the wacky, satirical, and cerebral BBC show written by Cleese, Chapman, Peter Cook, and Kenneth Tynan. I think we need something like this is the current manic depressive environment of Wall Street News. Equity markets are running the bulls in Pamplona because of the coming Q3 and Q4 inventory rebuilding, softening energy prices, and a positive unemployment report. Goldman Sachs now forecasts 3% or better GDP growth in the second half of 2009.

Fundamentally, it doesn't seem as if the snapback has legs to sustain it in 2010. Failure to act early and aggressively to head off foreclosures is now yielding its bitter fruit, as one-third of home sales are coming from foreclosures. Just as the Columbia Business School researchers stated last year, the servicers are now standing in the way of meaningful loan restructuring, claiming that they don't have the power to carry these out; the truth is that they are sitting back enjoying billing and collecting a plethora of new fees. Let's sweep this under the rug. Cars, appliances and other consumer durables are continuing to languish, with the exception of expensive and inefficient programs like Cars for Clunkers. Nothing meaningful has been accomplished in the financial re-regulation arena. Investment grade corporate spreads have narrowed significantly and that's appropriate normalization. It's also the past. What about the future?

Dr. Fathi Birol of the International Energy Agency published its study of more than 800 major petroleum fields around the world and found that production declines have been faster than previously thought. He notes that the world must discover the equivalent of "four Saudi Arabias" by 2030 if current levels of daily oil production are to be sustained. This seems like a remote possibility. Our July post reporting the comments by the CEO of Hess Oil captured all these issues. They have not gone away. Dr. Birol laments the "chronic underinvestment by oil producing countries" in exploration and development to maintain or grow production. The international majors, kept out by resource nationalism, have found it easier to buy back their shares than to take risks of investing in projects for which the terms may be abrogated in the future. Demand is down now, but if the economy recovers, demand comes back and supply won't keep pace.

Consumer spending still has to be impacted with the massive loss in wealth and the continuing uncertainty about employment stability and growth. Early into the conversations about a New Deal type of recovery plan, there was talk about a nationwide infrastructure rebuilding program. Now that seems like something that is necessary, and it could be far-reaching and create employment in lots of trades and professions. Our grid is outmoded, our water supply systems are antiquated and at risk, and a combination of technology improvements and good, old fashioned reconstruction could yield real benefits. It beats Cars for Clunkers!

Dieter (Mike Meyers), the host of "Sprockets" on SNL said it best, "Zis conversaton has become tiresome!"

Wednesday, August 5, 2009

The Management Myth

Today's Wall Street Journal carries an interesting article by Philip Broughton, who writes about Matthew Stewart's book "The Management Myth." It discusses some first principles in thinking about corporations and the values that sustain the American model. We've written about these issues before, using the work of Professor Rakesh Khurana of the Harvard Business School.

Stewart approaches the issue by looking at the consulting business and how it operates within the largest American corporations. He notes that work of these consultants--you know the names-- are "built on a science of management that is both narrow minded and intellectually bogus." The skeleton of modern consulting practice evolved from the early work of "efficiency experts," and like a comet's tail, picked up material as it moved through time from economics, organizational theory, computer systems, pop psychology, and marketing. We've even picked up an odd label or two from genetics, when we speak about "growth being built into the corporate DNA." Now, that is real blather, but you hear it on almost every other corporate earnings call.

Stewart also talks about the corporation as being "obsessed with its own perverse value system and view of human nature.." Corporations are torn between presenting themselves as "environments" where people can realize their aspirations and contribute to some high-faluting corporate goal, or as "black boxes" devoted to growing earnings at 15% a year come hell or high water. Both kinds of entities wind up having cultures or value systems, but in the case of public companies rarely does anyone know where these came from. Apple for example started in a garage with the legend of Wozniak and Jobs, and somehow whatever drove that original culture is supposed to be continued into the papacy of Jobs. It really makes no sense. The American corporate view of human nature is still overwhelmingly Theory X, which everyone publicly repudiates but lives with every day.

Larger private corporations, where representatives of the founders are still active, seem to do a better job of articulating a value system with continuity that evolves into a culture that mirrors the value system. The changeover of corporate management in public companies makes it hard to accomplish the same continuity.

I've counseled some of my very talented financial staff not to shortchange themselves by going into MBA programs in finance. They were more than capable of absorbing all the rote technical material on their own. They owed it to themselves to learn much more about foreign languages, culture, philosophy, anthropology and economics. One of them solved the dilemma by going to business school in India from Minnesota! I'm anxious to see how it turns out. We should be educating our future business leaders much more through what's called the Core Curriculum at Columbia, or the classics at Chicago. More Plato, Seneca, and Montaigne and less Porter, Black-Scholes, and Merton.

Tuesday, August 4, 2009

Make That a Pepsi Without the Fizz

The Pepsi bottlers being acquired today might be more likely to say, "Make that a Dom Perignon, please!" Back in April, we should assume that Pepsi's $6 billion bid for the companies represented the best estimates of fundamental asset values, cost savings, volume growth, and some padding to make the deal palatable. Today, that number becomes $7.8 billion.

The fundamental problem for both Coke and Pepsi is the secular low case volume growth for carbonated colas, and for carbonated beverages in general. Looking out into the future, there are clouds on the horizon when pundits like Dr. David Kessler talk about making sugar the "new tobacco." That can't be good for for Coke or Pepsi, even if it might be good for American waistlines.

The distributors clearly have a better view of the endgame, and they enjoy a grand payday. Interestingly, the cost savings from the acquisition were stated as $200 million in April, whereas today they are $300 million by 2012. Perhaps the April numbers were disinformation. Either we found $100 million by definition, or it was conjured out of the air. The latter is more likely.

Thursday, July 30, 2009

NetFlix and Outmoded Corporate Organization

Some years back I networked into a group of people who were planning an IPO for a company with a software product that predicted consumer movie preferences, called MovieLens (now GroupLens) developed at the University of Minnesota. At that point, Amazon was getting off the ground primarily selling books with some music, and the group's idea was going to take the world by storm. Everybody was skeptical about Amazon's business model, but we know how that story developed.

I was struck by how the MovieLens techie people used business lingo but had no clue about a business model. Everybody was an Internet acolyte. It seemed ridiculous to build a big corporate scaffold around an interesting analytical functionality that had no value proposition for the consumer. I passed and there was no IPO, needless to say.

Now, I read the articles about the NetFlix Prize with interest. They have the same functionality in the back of the house. What are some of the ways a traditional corporation would address the issue of improving the predictive accuracy of consumer movie preferences by ten percent? First, hire a deluxe executive recruiter to lure an ultraluxe executive away from Sony Entertainment (they know movies, don't they?) and let them spend three to five years staffing up and spending lots of money before coming up with nothing and parachuting out. Second, hire McKinsey to spend a year and a couple of million to define the problem. Third, hire Andersen Consulting to take up residence and overrun the company with consultants like locusts, turning over every department before morphing the issue into a systems implementation. Sound familiar?

Instead, NexFlix's specification has produced collaboration and real team behavior, where international partnerships between established groups and unaffiliated specialists arose to put a winning group over the top. A traditional, isolated corporate model would not have struck these kinds of alliances. In fact, for so many years, even the simple notion of joint ventures between established corporations have not worked. The current form of the American corporation grew up after the Korean War, as they imitated the structures, language and hierarchy of the military organizations that had successfully prosecuted large scale, global military efforts. The world has changed dramatically, and whether it is hot and flat or not, we can learn something from the progress and perhaps the eventual demise of NetFlix. I think I'm going to start a subscription because I just like those folks!

Tuesday, July 28, 2009

Reflecting on The Recession

After reading today's Verizon's announcement that it was reducing its employee base by 8,000 workers, it made me start thinking about how Employment has fared in this recession compared to other downturns. Using monthly payroll data from the Labor Department, a Wall Street Journal chart showed that 19 months after the start of the 2007-2009 recession, there were 6.7 million fewer Americans working than in December 2007, a 4.7% decline versus 3.1% for the short, sharp recession of '81-'82.
According to Stanford economist Bob Hall, quoted in the WSJ, "In terms of employment, we've now passed 1982 and we're just about to cross the worst postwar recession, which was 1948."

So, the stock market moved up 23% or so in the second quarter. The positive earnings reports and "upside surprises" in the second quarter were driven by cost-cutting, one-time events, and absurdly low expectations. There was nothing to report in general on the top line. Valuations expanded from bargain basement levels to fair market levels, or "boring" levels to use Jeremy Grantham's phrase. How can it move up from here without quality earnings?

The movement in junk bond indices is hard to fathom, but these moves are usually precursors or coterminous with a movement in equity prices. High quality corporate bonds had a twelve month return of about 8%. Grantham's advice is "Go long quality and short junk." It seems reasonable given the lack of support from fundamentals going forward a quarter.

Meanwhile, the Federal largesse being handed out to Goldman, J.P. Morgan and other Most Favored Banks has yielded windfalls to their execs and shareholders, but it has done little to help the traditional banking sector. Robert Willmers, the CEO of M&T Bank puts it well in the Washington Post, "we must restore the balance of regulatory oversight between commercial banks and other parts of the financial services industry. We should do so not only to be fair to banks but because the nation's ailments won't be cured unless solutions are directed at the entire financial system, not just one-third of it. "

Monday, July 27, 2009

Spending Twice As Much On Healthcare

An oft-repeated refrain goes like this, "We Americans spend twice as much on healthcare as the Europeans, but we don't live any longer." Attending a lecture by Dr. Mehmet Oz, Professor of Cardiac Surgery at Columbia College of Physicians and Surgeons, gave me an "Aha!" moment on this issue. He opened up his lecture with the statement, "We spend twice as much on healthcare as the Europeans because we're twice as sick!"

Dr. Oz gets involved when cardiovascular disease has progressed to a critical stage. Starting at the beginning, Dr. David Kessler has documented the effects of the three demons--sugar, fat and salt--on our diets. Our kids are overweight and sedentary. Moving into adulthood, they may become obese. With obesity comes the beginning of cardiovascular disease, hypertension, high cholesterol and inflammation, diabetes, peripheral vascular disease, and stroke. Certain population groups have very high incidence of end stage renal disease which is expensive to treat, and difficult for the patient's quality of life.

Cultural norms and the significantly lower degree of commoditization of food in Europe helps them avoid some of this progression, at least to our degree. Remember the wisdom of "The Mediterranean Diet?" We also tend to spend a lot of lifetime healthcare dollars at the end stages, and Europeans are more sanguine about end of life issues than we are. A distinguished German cardiologist said to me once, "Over here, it's okay for people to die. We don't pull out every high tech intervention for every patient." Cold, but a good point.

We have wonderful research, medical diagnostic and treatment tools, and the best doctors and institutions. We overuse many of these tools, and sometimes use them beyond their clinically indicated uses to little incremental patient value. We haven't asked some of the hard questions implicit in the German cardiolgists remarks; at least we haven't done it in public debate.

The transaltion of the spending comment to the increased lifespan comment is ripe for some quantitative treatment, and you can find a lucid treatment on the Becker-Posner blog.

Friday, July 17, 2009

Reflecting on India

Nandan Nilekani is the CEO of Infosys, and a highly visible leader in the global IT CEO pantheon. He recently wrote a 500+ page book called, "Imagining India: The Idea of a Renewed Nation." He was recently interviewed at the Wharton School Forum. He saw one of his functions as being a global ambassador for India, as he visited customers around the world and they asked him questions about the country. Eventually, he decided that he couldn't answer many of their pressing questions, such as "How can India have such shiny corporate campuses co-existing with miserable slums right on their doorstep?" So, he interviewed more than 125 leaders in different fields, thought long and hard, and came up with this book. I applaud what drove him to this effort. I hope to able to tackle reading the book, but some things he said in the interview struck me right away.

The critical problem for India, he says, is to expand access to resources and opportunities for a very young population. That young demographic gives India tremendous potential in the sense that a productive workforce of that size can support a large, older population and provide social stability. He duly notes that in the South (especially Kerala) and the West of India, the demographics show an aging population and stable or declining birth rates. In the North and Central parts of the country, the population is young and growth rates are high. Unfortunately, this is exactly where the rural-urban migration is taking place, and these are the people who are creating and populating the slums that his questioners are asking about. That rural-urban migration has to stabilize and eventually stop. Unfortunately, India has been wrestling unsuccessfully with this problem since Independence.

Nilekani rightly notes success in what he calls "infrastructure" by citing the example of the wireless communications infrastructure story in India. He cites more than 8 million cell phone users among the middle class population, of which he says more than ninety percent are prepaid phones. Good for the companies, and hopefully good for the users too. Speaking about the Indian elections, he notes that India is the only country in the world that relies on electronic voting machines, were 1.1 million electronic machines collect and tabulate the vote for an electorate of more than 700 million. These are certainly successes to be admired.

However, the most basic infrastructure like water, power and transportation remains a disgrace. "Seventeenth century" would be an appropriate epithet for these sectors. If you've ever driven behind a diesel public bus in any large Indian city, I don't have to say more.

If ordinary communities don't have water, power and sanitation, then agriculture can't flourish, people can't feed themselves and remain on the land, and they will migrate to the big cities. If urban households don't have the same amenities, then kids will face challenges in doing their homework and staying motivated because they're hungry and they don't have a comfortable environment to study. It affects everyone, and I see the same thing here in Minneapolis, tutoring inner city minority children in mathematics.

The issue isn't a lack of ability or a lack of desire. For many kids here, it's the fact that no one is home to make them breakfast before school or there is no food on the table for anyone. For others, it is a lack of a quiet space in an overcrowded, uncomfortable apartment that makes it impossible to concentrate. It's magnified in a country like India. For a small percentage of the population that can overcome the odds and get into an elite college, there's a pathway out, but the percentages don't work.

Nilekani is right; it is about access and opportunity. But, this presupposes the existence of basic infrastructure for stable families and communities. It presupposes a balance between industry and agriculture, where some people can remain tied to the land and live decent lives. India, unfortunately, is getting stumped on these issues, and its corporate elites have to find a way to take these issues on because it's the right thing to do, and it's in their own self-interest. Otherwise, over time, extremism and dissatisfaction will roil the political system and overturn the gains we've earned so far.

Citigroup's Second Quarter Earnings

Citigroup's second quarter earnings were interesting. In no systematic order, we noted a few key items. Citicorp's North American banking operations, the old John Reed core business, saw deposits grow by 12% year-over-year. Expenses are down 21% year-over-year. Tier I capital ratio improved to 12.7% at the end of the quarter. The interest margin was healthy but can go higher once the separation of the companies and asset sales are done.

Their credit card business and their mortgage business, both now sequestered into Holdings, look like delinquencies are still increasing and charge-offs are ahead. Consistent with this view, provisions of $9.9 billion for Holdings were consistent with a similar level in 4Q 2008. These trends are visible in the slide presentation to accompany the call and shouldn't be a surprise going forward. Sub-par performance from the credit card master trusts impacted Citigroup in the quarter. It's hard to see how this plays out and over what time horizon.

The other piece of good news is that Richard Parsons seems to be quietly improving relationships with all the multiple regulatory bodies overseeing Citi, and it no longer seems as if anyone is looking to take Citi as a scalp for being a reluctant ward of the state.

The one thing that is now a serious issue, in our mind, is the culture inside the organization, which has never been anything but awful even in the growth years. There is so much turnover and changes in reporting relationships, it's hard to see why anyone would be enthusiastic about helping the organization through the current crisis given the disconnect between risk and reward for all but the super-elite management. The troops need a mission, a message, and a strongbox full of lucre if the company succeeds that will be shared throughout the organization.

Thursday, July 16, 2009

All Atwitter About Goldman

So Goldman Sachs earnings declined 10% but beat Wall Street's lowered expectations, so the market is euphoric. It doesn't make sense. What drove their earnings is something akin to a confluence of one-time events, namely the timing of government-mandated equity issues and the fact that given the absence of competing underwriters like Bear and Lehman, among others, Goldman took a bigger share of a lucrative fee business. Investors now want to equate the health of "the banks" with the health of the Goldman and Morgan duopoly. The banking sector proper still has massive issues that are being swept under the rug using the whisk broom of press releases.

Stephen Roach was for many years the readable, insightful economist for Morgan Stanley. He sums the issue up for me.

"The financial crisis is not over,” Stephen Roach, chairman at Morgan Stanley Asia said on CNBC. “The (International Monetary Fund) is telling us that by the end of this crisis $4 trillion worth of bad assets will be written down. Thus far financial institutions have written off, at most, half of that. So there's plenty more to come.”

Ted O'Glove's phrase, the "quality of earnings" is germane to the Goldman report. Big numbers, but low quality because of the "one time" issues. As for missing Wall Street expectations, that's easy to explain. What's left of the Street's banking analysts are so shell shocked and afraid of being whipsawed that it's safer for them to take estimates down through the basement and then be "surprised" but cautious going forward. The owners of the stock are happy with the "upside surprise" too.

Wednesday, July 15, 2009

The Supremes

I find it really disheartening to see the level of attention we lavish on these rituals for elevating someone to the Supreme Court. Judge Sotomayor seems like a nice person, but is she the best candidate we can come up with nationwide? Now, we all understand that she is going to be confirmed. Yet we have to go through this mind-numbing ritual. And, in grand political style, the candidate has to skate delicately away from some of her nonsensical and injudicious remarks. The Congressional staffers helping her out have all the stock phrases: "I was quoted out of context;" "That was then, this is now;" "I'm a different person now;" "I would be a Supreme for all the people." Pick one and rework--we're done.

I've written before about my meeting with Chancellor William Chandler III of the Delaware Chancery Court some time back. Sitting at a table of lawyers, the questions came rapid fire for the Chancellor. He had several qualities I admired. The first is that his pace did not rise to match the rapid breathing, high heart rate of his questioners. He sat back, Zen-like and listened intently. He also thought about his response before he spoke. On television, the producer would have been crying about "dead air."

When he responded, at first, it didn't seem as if he were answering the question. However, if you listened carefully, it was exactly what he was doing, and the response was not, "I think, I think..." He gave a short, very precise response to what the salient point was, or should have been. It was very impressive.

The good news is that since most public companies are still Delaware corporations, that bench will still have lots of influence on corporate law and governance. The Harvard Law School governance blog carried a nice piece about the work that the Chancery court is doing.

If only the Supremes would aspire to be these qualities.

Tuesday, July 14, 2009

Walking on the Economic Moonscape

GM is emerging out of bankruptcy, but it's hard to believe that such a short visit to "the box" will have changed much about the organization. A real learning organization is able to look at its past mistakes and figure out how things went off track. Creating the Saturn division was a bold move, but starving it for investment at a key juncture in its life was a critical mistake. Then, with the division starved for product and the dealers crying "Foul!" it rebadged a number of its new models with the Opel platform. For me, the interesting thing is how good these cars like the Vue and the Aura look. They are also good value in the US market, probably on a par with Hyundai.
But, giving a brand a last-ditch makeover with no sustained marketing or dealer support is not a real solution. It's like putting lipstick on a critical patient and saying, "There, get better!"
As the sale of Adam Opel GmbH nears closing, GM plans to retain a 35% stake, which is a good thing, as Opel was the source of the rebadged Saturns and clearly can make, design and produce good cars. Meanwhile, talking about brands, I walked by a Chevy and a GMC truck parked side-by-side in a parking lot and couldn't tell the difference. What does GMC stand for? Time to keep walking the moonscape.

The market is searching for direction, as Goldman Sachs reports gonzo earnings when the the financial sector, witness CIT, is still taking hits. So, the whole bailout candy store operation has achieved what? MFN's like Goldman, now under the bank holding company umbrella, are purring like a Cheshire cat that swallowed the canary. Bank of America will now owe fees for an agreement it apparently didn't sign, and for which it shouldn't be held responsible. Bank earnings up because margins will be up, fee income stays steady or rises, but troubled assets are still in the root cellar and lending remains sluggish.

I've been trained to look for inflationary shoots in the levels of unprecedented monetary expansion and fiscal stimulus that we've seen. However, if labor is the biggest expense for most corporations, it seems as if the unprecedented levels of job loss may mean an on-going slack in the labor market, even if the recovery gains traction in 2010 or later. Maybe the inflation concern is something to be rethought. It seems more and more likely that few corporations will regain the kind of pricing power that they enjoyed during the last two expansions. Something to think about on Bastille Day.

Thursday, July 2, 2009

What's Up With Oil? July Hiatus

When the equity market tries to convince itself that the second quarter gain of 15% in the S&P 500 is real, it occasionally frets about oil prices. We recently heard a presentation by John Hess, the CEO of Hess Corporation, at Harvard's Belfer Center. Here are some things we took away.

Oil represents 35% of the global energy supply today. Separately, Ian Bremmer of McKinsey notes that the world's 13 largest oil companies, measured by reserves, are controlled by governments. They are : Aramco (Saudi Arabia), Gazprom (Russia), CNPC (China), NIOC (Iran), PDVSA (Venezuela), Petrobras (Brazil), and Petrona (Malaysia). Hess, as the CEO of a multinational producer himself, makes the point that the future energy policy of the world's major producers will become their foreign policy. To put this into perspective, multinational corporations today produce only 10% of the world's oil and gas and hold only 3% of the world's reserves. U.S. policy makers need to keep this in mind in the future. No amount of political wind about wind will take away the global dependence on hydrocarbons, particularly oil and gas, for the intermediate term future.

From 1986-1996, oil was $15-20 per barrel. Demand growth led prices upward from there. 86 million barrels per day (mbd) is the current worldwide demand. The recession has shaved about 2 mbd off that total, but in the near future, demand will outstrip supply, and prices should start moving up once more. Hess said that we are nearing a crisis in productive capacity, and not a crisis in reserves, or oil in the ground.

He cites a total reserve number of 2-3 trillion barrels of oil worldwide. The problem is that existing fields are being depleted by about 6% per year, and continuing production from these mature fields will require increasing pressures for extraction, which is more expensive. Hess says that we need to add 5 mbd to replace the depletion from producing fields and to provide for demand growth. However, industry exploration hasn't replaced reserves at this level since 1984.
The top 6 multinationals, including companies like Exxon and Conoco, produce about 11 mbd, or about 13% of world demand, and their depletion is about 6% per year. OPEC's swing capacity is about 3 mbd, a little bit more than the current recession-driven decline in demand. Aramco is producing at about 8 mbd today, but OPEC is reinvesting only about 10% of its proceeds in exploration and development to maintain production and provide for future growth. The rest is being fed into their domestic economies for current consumption and diversification through sovereign investment funds.

The industry cycle is five years from prospecting to the drilling of exploration wells. Hess says the average is another five years to the drilling of production wells. So we need a ten year lead time to offset depletion and provide for growth. He characterizes the industry's $400 billion per year exploration budget as inadequate.

Iraq's production is 2 mbd versus 5mbd before the onset of the Iraqi conflicts. However, Iraq's reserve potential is said to be #2 behind that of Saudi Arabia. The problem is going to be an economic and political one. There will clearly be a resource-based nationalism that seeks to control the development of the oil resources by a state-owned company, and yet they cannot achieve that goal without the technology and resources of the multinationals. How can these companies, some of which are public, assess not only the political risks of force majeure but the relatively new security risks to the lives of their international personnel on the ground? They can do this by placing exceptionally low bids for their licenses. However, this will not be acceptable to the national oil company. Again, the outlook for prices is not good.

Investment in equipment has lagged. Rig rates have gone from $100,000/day to $500,000/day because of the shortage.

It was interesting to hear Hess, speaking at Harvard, say that the worldwide shortage of geologists, geophysicists, drilling and reservoir engineers is one of the biggest constraints that the industry, and his company, faces today. Fewer finance MBA's and more P.E.'s!

Worldwide, he said, the transportation sector accounts for about 50% of oil demand, primarily through automotive, commercial, and jet fuels. He cites the 20% total efficiency of the current gasoline auto engine as something that should be addressed post-haste. He favors putting out a challenge CAFE level of 35 mpg by 2020. We know one major auto company, currently in bankruptcy, that would be gonzo under that regime.

China's oil demand is about 7 mbd, or a little less than 10% of world demand, and non-OPEC demand is growing at 1 mbd currently, and could accelerate if worldwide growth resumes.

It was a sobering, but realistic scenario, and one that computes. No amount of talk about ethanol, wind, residential solar, or fuel from algae will address the near-term and intermediate term futures without demand reduction/efficiency strategies and strategies to increase the development of reserves.

Before going on a July hiatus, we wanted to give our loyal readers some food for thought. Talk to me and let me know your thoughts, even off line. Happy Fourth of July!