Permanent Pricing Pain?

Of course, nothing lasts forever, least of all reserves of crude oil. However, at present, US shale (or “tight”) oil production, particularly in the Permian Basin (where there is something of an acreage acquisition frenzy continuing) is seen, whether accurately or not, as the global swing producer, usurping the long-standing role played by Saudi Arabia.

The Saudis and OPEC tried to destroy the opposition by driving down prices to what were considered unsustainable levels for the US shale oil industry, only to see that backfire by decimating their own budgets. There was a winnowing of marginal players in the US, as the level of bankruptcies and restructurings over the past 2 years or so amply demonstrated. However, the attempt at destroying the US competition signally failed, as producers retrenched, adapted their business models, significantly improved their technology and operations and reduced their breakeven levels.

Consequently, OPEC tried to re-group and enforce discipline by setting production quotas in an attempt at least to put a floor under prices. Perhaps surprisingly, the quota restrictions were largely observed. However, as OPEC (led by Saudi Arabia) and Russia try to extend the programme they face dissension, as well as the fact of more production from Libya and Nigeria; while, naturally, the “undisciplined” Americans revert to ramping up production, as rising rig-counts amply demonstrate.

Couple this with uncertainty about the level of demand in the near term (let alone the longer term impact of factors such as the rise of electronic vehicles, and renewable energy sources) and one has the makings of further volatility in crude oil prices, but this time to the downside rather than the upside, as those who forecast such things reduce their pricing expectations below the USD 50 per barrel level, with nadirs into the USD 30/bbl range.

All of this points to continuing budgetary pain for the majority of oil producing “petro-states”, for whom oil revenues generate the majority of their tax revenues. Even the mighty Saudi Arabia is considered to have a “breakeven level” closer to USD 70/bbl before it can balance its budget.

And budgetary pain has social and political consequences, particularly in the “brittle” systems that govern many of the world’s petro-states, because few if any of them have equipped their societies to deal with the potential end of the dominance of hydrocarbons as the key energy source, even though Saudi Arabia’s new Crown Prince is at least trying.

If one were truly Machiavellian, one might even wonder if the attempt to squeeze and disrupt the economy of Qatar was a ploy to create sufficient uncertainty about its own 600,00 barrel per day output to bolster oil prices.

It is also somewhat ironic that the ending of the decades-old prohibition on the export of US crude oil towards the end of the Obama administration probably contributed to the current pricing environment, because it introduced a new source of crude oil exports onto the world market.

So, at Awbury, we would be circumspect in anticipating any major upswing in crude oil prices in the near to medium term. Yet we recognize that, because of all its variables, choke-points, animosities and sheer complexity, being “certain” about that outcome is a mug’s game. Therefore, as always, we factor multiple scenarios into our assessment of any hydrocarbon-related business, because the historical record amply demonstrates that being wedded to any one view will almost certainly not end well.

The Awbury Team

The Italian Job…

The Italian Job…

Quite clearly the Italians have a somewhat different interpretation of how to deal with a failing bank than the rest of the EU, as has been demonstrated quite clearly in the case of Banca Popolare di Vicenza and Veneto Banca, both of which faced a deadline of the end of June for a decision on how their increasing non-viability would be addressed.

Unlike the Spanish authorities in the case of Banco Popular, who appear to have followed the letter of the European Bank Resolution and Recovery Directive (BRRD), the Italians decided to do things differently. As a result they have arguably put into question the credibility of the BRRD as a mechanism that will be applied even-handedly, with the distinct impression given that the ECB and the European Commission acquiesced in actions which will ultimately cost more than if the BRRD had been applied.

For example, the ECB determined that the banks were “failing or likely to fail”, as a result of which the Single Resolution Board (SRB) needed to decide whether they should be “resolved”. If that had been the SRB’s decision, the outcome would likely have been losses being imposed beyond the level of shareholders and subordinated debt holders and into the “senior” section of the banks’ capital stack. This did not happen. Instead, the SRB decided that the banks were not sufficiently important for this to be required. As Martin Sandbu of the Financial Times quite rightly pointed out, this was a paradox, because, hitherto, the Italian government had persuaded the EU to permit it to support the banks because of their importance to financial stability, even though their combined assets totaled no more than 2% of the domestic banking system.

So, the SRB permitted the Italian Government to apply instead Italian insolvency laws, which allowed (with EU acquiescence) the state to shield the banks’ senior bond holders from losses. Not only that, but in order to clean up the mess it had created, the state then sold the “good” assets with attendant liabilities to Intesa, enticing it to do so with a grant of EUR 4.8BN and public guarantees of EUR 1.2BN, so that it would not suffer any detriment. Contrast this with Spain, where Santander had to raise EUR 7BN to support its acquisition of Banco Popular. To add insult to injury, the Italian taxpayer is on the hook for up to EUR 12BN of state guarantees to enable the orderly winding-down of the now-failed banks.

The Italian government acted in this way because a significant portion of senior debt had been sold to retail investors, and the authorities appear terrified of a political reaction if yet more voters find themselves, yet again, to have been duped. While one can understand that action in political terms, nevertheless the Italian authorities have created a much larger and less certain liability on the part of Italian taxpayers, instead of directly addressing allegations of mis-selling and any claims that might arise as a result.

In doing so, they have created a precedent, while making it obvious that the EU’s institutions can be “persuaded” to do favours if one of the largest member states is persistent enough. Of course, what Italy has done further adds to the financial obligations of an already over-indebted central government. If it is lucky, the sums at risk will at least be sufficient and bring to an end fears about the overall health of the Italian banking system. Somehow, we doubt this is the final act in the long saga of procrastination and special-pleading.

However, at Awbury, we continue to work to provide our banking clients with more effective and rational solutions with which to address their problematic assets and capital needs- and in ways that do not put the long-suffering taxpayer at risk.

The Awbury Team

It’s all Greek to me…

It seems that Thucydides (the ancient Athenian author, considered the first true western historian- with Herodotus being more of a storyteller) is having “a moment”.

The term “the Thucydides Trap” has suddenly become “le mot just” to describe the fear that the current global hegemon, the United States, will need to confront a rising power, the PRC, which is challenging it for supremacy, and thus inevitably become engaged in a war that will not end well.

Of course, it is never as simple as that.

For a start, the Athenians and Spartans, and their assorted allies, did not have the capacity to destroy Humanity, only each other; which is not the case with the 2 nuclear powers. When does a “conventional” war between Great Powers go “nuclear”?

Secondly, war does not have to be inevitable. Thucydides was somewhat biased, because he admired the Athenian statesman, Pericles, who as an individual leader had a major role in provoking what ensued. Political leaders make decisions based upon a range of calculations and influences, which can precipitate confrontation and war, or avoid it.

Thirdly, and paradoxically, trying to accommodate a rival, in the hope of avoiding war can be counter-productive, because the rival gains more confidence that emboldens it to undertake ever more provocative steps. Consider World War II. The focus is often on “Munich” and 1938; but if the Third Reich’s re-militarization of the Rhineland in 1936 had been resisted, it is certainly arguable that the resulting humiliation of the Nazi government would have stopped, or at least significantly postponed what happened subsequently in 1939. This makes the strategic calculations in the western Pacific and South China Sea all the more important, as the PRC incrementally tries to “see what it can get away with”.

Fourthly, historians have a habit of personalizing international relations. While there is no doubt that individuals can and do have a major influence, the trap that many fall into is that they believe that they “understand” their opponent and so make judgements that are visceral and emotional, rather than properly informed, ignoring all the influences that weigh upon even a pre-eminent leader. Of course, when each party possesses nuclear codes, one had better hope that there are at least some institutional constraints!

The point we are trying to make is that, elegant and compelling as such terms as “the Thucydides Trap” are, applying them in a facile and uninformed way can lead to unfortunate outcomes, especially when those in thrall to them are those who control the military chain of command. Sometimes the simplest interpretation is the most appropriate, but in our own complex world often it is not.

The ensuing war with Sparta destroyed the Athenian empire; and, as always, led to the subsequent rise of other powers. A confrontation leading to outright war between the US and the PRC would have far more devastating consequences, and not just for the belligerents, because its “fallout” could literally harm the entire planet.

So, while, as students of history, we at Awbury are somewhat amused to see how much attention is being paid to a millennia-old concept, we become somewhat concerned that it may be used by those who do not understand all its nuances, nor the context in which it arose, potentially to justify actions that could further de-stabilize international relations.

As always, a little knowledge is a dangerous thing, while ignorance can have terrible consequences.

The Awbury Team

It’s complicated…

To say that the timing, swiftness and apparent ferocity with which several of its neighbours recently ganged up on Qatar was something of a surprise would be an understatement, while the consequences are potentially de-stabilizing for the wealthy states that adjoin the western side of the Persian Gulf.

It is one thing for violence and mayhem to roil Syria or Yemen, in which complex proxy wars have caused untold misery and suffering; quite another for one supposed US ally (Qatar, which hosts a major US air base at Al Udeid) to be vilified and ostracized by several supposed other allies, including Egypt, Saudi Arabia and the UAE.

So, the questions that arise include: “Why; why now; and what will happen?”

Ostensibly, Qatar is accused of supporting terrorists and terrorism, and of being a little too friendly with the Saudi bete noire, Iran. However, there is more to it than that. The Al Jazeera network has long provoked the regimes of Qatar’s “neighbours”, while Qatar’s support of the Muslim Brotherhood (an example of political Islam) frightens those, such as the Egyptian autocracy which supplanted it. One of a new list of demands includes the closure of a Turkish naval base, leading the Turkish government (which is already helping the Qataris to evade the boycott) to state that it is contemplating “enhancing” its presence (with Turkish tanks recently parading through Qatar). Qatar is also being told to surrender all “designated terrorists” on its territory, which seems more like an attempt by various regimes, which have little respect for due process, to get their hands on annoying opponents.

One trigger may have been the alleged payment of a huge ransom to the kidnappers of a Qatari hunting party in Iraq, with the funds said to have been paid to terrorist groups; but one senses that this, even if true, is cover for the desire to bring to heel a regime that has proved rather too independent for its adversaries’ taste, and an attempt to curb the influence it has wielded as a result of the wealth generated by production from its enormous natural gas reserves.

Of course, whatever the true cause(s), (and one cannot say that Qatar is exactly an “innocent” in all this), what really matters is what the potential consequences are.

It seems unlikely that the Qatari regime will simply give in to the demands being made upon it, as the “blockade” is not yet that effective given Qatar’s ability to use alternative supply lines and the fact that the Turkish government is openly supporting it. Similarly, as its main source of wealth comes from giant gas fields operated jointly with Iran, it will not wish to jeopardize that relationship. The Trump Administration has, so far, given no real indication of its intentions (even if there is speculation that it tacitly encouraged the Saudis to take action) and certainly appears to have no interest in “banging heads” in order to resolve the stand-off. As a result, the chances are increasing that one of the numerous parties involved, directly or indirectly, will act in a way that triggers an escalation in the conflict, even if that is not the intention. A bilateral argument is one thing; a complex, multi-lateral one entirely another.

So, the situation bears watching closely because of its potential for causing armed confrontation between US allies, which will, no doubt, delight the Iranian regime and give it more latitude in its continuing proxy wars elsewhere.

At Awbury, we always monitor such events, because we are looking for second order effects, and are well-versed in how seemingly modest acts can create a cascade of outcomes that can change seemingly stable environments into chaotic ones.

The Awbury Team

Orthodox or Heterodox?

In the realm of business, there is a tendency to believe that every decision must be the result of a rational and explicable process, that is based upon a proper review of all the essential factors.

Would that it were so.

Many large bureaucracies and corporations appear to be managed on the basis of avoidance of regret or blame. As long as one does not stand out, one cannot be blamed or held responsible for an outcome- hence the tendency for “herding” in much of the financial industry. Similarly, what are actually emotion-driven decisions (the “gut” gone rogue) are rationalized ex post facto, because that is a classic human behaviour. Impulses become “decisions”.

And yet, ironically, if an entity miraculously, and after huge effort, becomes completely rational and efficient, it runs the risk of becoming too predictable in its behaviour and thus vulnerable to being out-competed and ultimately superseded by others. “Keep them guessing” is actually quite an effective tactic. So, there is a paradox (which may also have ramifications in the realm of Artificial Intelligence) in that human beings, no matter how rational they may appear or claim to be are somewhat random in their behaviour and decision-making; and if they become too rational and predictable they become more vulnerable.

This is not to excuse “corporate decision-making” that has no explicable basis; but rather to point out that, given that almost all corporations are still formed of individuals, with their own prejudices and biases, one should not expect, nor even desire “perfection”.

What then is any self-respecting CEO to do to reconcile the several contradictions? Should one be orthodox or heterodox?

If one looks at the nature of really successful organizations, they tend to have a structure, business model or culture which differs from that of their perceived peers or competitors, and which is focused on the longer- rather than the shorter-term, while also being adaptive. In many publicly-quoted businesses, the so-called shareholder value movement is actually detrimental to the business’s sustainable performance, because it tries to place constraints on the management of a business, and can lead to what amounts to sociopathic, or even psychopathic behaviour on its part. Ultimately, value is destroyed, not created.

So, the thoughtful CEO has to create a structure in which the rational, process-driven, more formal approach to decision making is combined with a less structured more creative one, while managing the inevitable tensions that will arise, as different interests compete for dominance. While structure matters, flexibility and adaptability are essential. Of course, the less confident CEO may feel the need to call in the consultants to “validate” his or her approach, which ironically almost invariably leads to the outcome that should be avoided; namely, conforming to the consultants’ belief that “their” approach works, because it is “best practice”- thus creating an unfortunate “orthodoxy”.

At Awbury, we believe that the only real test of a particular approach is whether it demonstrably creates sustainable value; and differentiation from the crowd. We have built a business on being heterodox, not orthodox; because the latter approach has a tendency to produce “orthodox”, or mediocre outcomes.

The Awbury Team

Spanish Popular-ity…

Overnight on Tuesday 6th June, medium-sized Spanish bank, Banco Popular, having suffered a “run” on its deposits and notified its regulators that it would struggle to open for business, was swiftly declared to be in danger of failure; put into resolution; and sold for a nominal Euro to Banco Santander.

Apart from the fact that this was the first true exercise of the new EU bank resolution regime (even if some argue it was not the “full-on” version), a number of aspects of what occurred are interesting.

Firstly, the event occurred some 10 years after the onset of the Great Financial Crisis, demonstrating that, even in economies such a Spain, which have begun to recover from its impact, banks can still fail because of the burden of their legacy portfolios. So, not surprisingly, questions are being ask about whether and how the resolution mechanism should be applied to ailing banks in Italy.

Secondly, unlike the politicized and botched shambles that constituted the “rescue” of the Cypriot banking system (and let us not even talk about the Greeks!), in the case of Banco Popular, the process worked remarkably swiftly and smoothly, within a space of 24 hours (and not even over a weekend.)

Thirdly, regulators wiped out the equity holders of the failing bank and all Euro 2BN of its subordinated bond holders, yet the contingent capital or “coco” market barely flinched.

Fourthly, there are concerns now about the health of a much smaller Spanish bank, Liberbank- perhaps because some “scent blood in the water”, and are looking for the next target. Thus, it will be interesting to see how the Spanish Central bank and the ECB address the risk of contagion.

Banco Popular, is by European standards a relatively small bank, so one cannot say that the “too big to fail” concept was tested. Nevertheless, unlike Italy, where there remains a continuing reluctance to allow even small banks to fail (largely for political reasons), the Spanish authorities have demonstrated that they can and will take action.

Of course, the real test will come when the resolution of a bank requires not just losses being imposed on equity and subordinated debt holders, but further up the liability structure on senior debt holders, or even depositors. Nevertheless, the swiftness of the exercise (given the number of parties involved) and the avoidance of having to use public funds are commendable, even if one can properly ask questions about why regulators had not imposed capital-raising requirements earlier on Banco Popular.

Returning to Italy, time may be running out for 2 banks in particular, Banca Popolare di Vicenza and Veneto Banca; as, if agreement is not reached by the end of June between the Italian authorities, the ECB and the EU, they too may suffer the same fate as Banco Popular.

And before those in the UK become too smug, bear in mind that UK banks are still subject to the EU Bank Resolution and Recovery Directive (BRRD) and its stipulation of haircuts on bank’s liabilities of up to 8% of their total before public funds may be used; and that Co-operative bank is struggling to raise capital and impose losses on its bondholders, making it too vulnerable to being “resolved”.

At Awbury, we have long worked closely with banks in helping them manage their capital and address problematic portfolios, which is why we always pay close attention to such events, as well as the potential impact of political and regulatory actions.

The Awbury Team