Fragile Five or Shaky Six?

Readers may be beginning to think that we are a little obsessive about oil. However, while money may make the World go round, without oil the global economy would also come, literally, to a grinding halt. It pays to keep a close eye on what is happening in the oil markets, because surprises and “shocks” have a tendency to reoccur with some frequency, often as the result of a geo-political event or trend.

There is much debate about whether supply and demand for crude oil will be in balance in the near to medium term and perhaps maintain some sort of floor under the current pricing of both the Brent and WTI benchmark crude oil blends. One thing we know is that any forecast of oil prices is usually wrong because of all the factors which can influence that all important supply/demand balance.

One can enumerate a catalogue, including:

– US shale or “tight” oil production levels continuing to grow, and whether the US will become structurally a net exporter of crude oil
– The transition away from internal combustion powered vehicles
– Alternative energy sources, such as solar and wind
– The price levels petro-states need to balance their budgets
– OPEC’s (and its allies such as Russia’s) willingness and ability to enforce production level quotas
– Economic slowdown in the PRC and elsewhere
– Political crises in the Middle East and Persian Gulf

Geopolitics is always in the mix, which is where the Fragile Five and Shaky Six come in. The former comprises Angola, Iran, Libya, Nigeria and Venezuela. The latter adds Algeria, a surprise late-comer in the wake of the political disturbances set off by the supposed determination of the ailing Bouteflika to run for a fifth term as President (on behalf of Le Pouvoir, or Deep State) and then his abrupt withdrawal. Bear in mind that in 2017, these 6 countries exported some 8MM barrels per day, or just over 8% of global production according to ENI’s 2018 World Oil Outlook. While, the 6 may not all see significant reductions at once, Iran’s exports are being constrained by US sanctions; Nigeria is increasingly unstable; Libya is anarchic; and Venezuela’s PDVSA is in freefall. Stable they are not.

Yet, the US, in the guise of the EIA, apparently blithely still expects a global surplus through until the end of 2020- and the forward curve for WTI is essentially flat out to the end of 2020, if not in slight backwardation- presumably relying on growth forecasts for US shale oil production and increasing exports.

Such lack of expected volatility and “received wisdom” always makes us skeptical. Of course, life would be easier if the forecasts were accurate. Historically, the US could generally lean on key allies such as Saudi Arabia, to “do the right thing” and turn on the taps. However, that relationship is now dysfunctional (being polite) and the Saudis have a new (entirely self-interested and untrustworthy) “friend” in Russia, which is more than happy to be given the opportunity to administer another “poke in the eye” to the US’s perceived interests. This is compounded by the fact that the Saudis see themselves as in a potentially existential battle with the US shale oil industry over who is the “swing producer” and at what price levels. In fact, the shift in the US’ overall position from a net importer to a potential net exporter is already beginning to have “second order” effect in terms of its policy decisions affecting the Middle East, including the State of Israel. And, in the meantime, the opaque policy- and decision-making process in the PRC always has the potential for the unexpected.

At Awbury, we take the view that one should never assume stability and predictability in crude oil prices (or those of any other commodity, for that matter), and that it is essential to closely examine and stress any risk that involves a direct or indirect exposure, to ensure that one is not “negatively surprised” when volatility returns. To do otherwise would be remarkably naïve.

The Awbury Team

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The wrong way to approach risk identification and assessment

The World Economic Forum’s (WEF) annual Davos global elite “love-in” is now behind us, and life goes on. As usual, just prior to its convening, the WEF published its “Global Risks Report”- a document we have written about before. This is intended to act as a mechanism to identify and publish a Top 10 list of risks in the categories of “Likelihood” and “Impact” by canvassing the views of those who form part of the self-same, self-selected elite at the WEF.

While the document is full of colour (and confusing diagrammes), and is supposedly the product of much effort, its value in any real sense is becoming debatable. The FT’s Alphaville column used the telling phrase that the product was the result of “conference room homeopathy”- so diffuse as to have no demonstrable efficacy. And we doubt the “placebo effect” works on risks!

The Report’s content does demonstrate what its creators are most concerned about. However, as one reads through the lists, one notices that the wordings used are so vague and broad as to be practically meaningless, or laughably obvious- “Extreme Weather Events (#1 in Likelihood), or Weapons of Mass Destruction (#1 in Impact.)The “insights” are stunning in their banality.

We are quite sure that, individually, there are many deep-thinking and original minds within the group surveyed. Unfortunately, assessing risk by survey of a self-referential “elite” has completely obscured their existence, to such an extent that there is nothing controversial or thought-provoking in sight.

If one adds to that the “interconnections” maps, showing the supposed key links between various risk categories, one is then left with a presentation of information that has essentially lost any value. It conveys nothing other than visual noise- cognitive dissonance, not cognitive diversity.

Of course, it is easy to mock such earnest and well-meaning efforts, but one has to ask whether any policy-maker is going to have an epiphany as a result of reading the document, thus leading to a significant shift in behaviour or actions.

Turning to the real world (something whose existence seems to escape many Davos attendees), to have any value, risk assessments have to be specific, concrete and probabilistic in terms of timing and scale. The contrast between the approach of the WEF and that of, for example, Philip Tetlock’s Good Judgment Project is quite telling. While the latter also uses the “wisdom of crowds” it asks very specific questions and seeks probabilistic answers which can then be analyzed ex post facto to identify so-called “superforecasters” who have a demonstrable capability in assessing risk, even if only in relative terms.

As “ground up’ underwriters of very specific risks, the Awbury Team recognizes that it is much more effective to focus carefully on what actually matters in a particular set of circumstances rather than worry about nebulous concepts that provide no additional value to the process of trying to obtain a deep understanding of the risk being underwritten. Contexts, connections and correlations truly matter, but only to the extent that they are relevant to the matter at hand.

Reading the WEF Report itself is merely an exercise in witnessing “groupthink”, because an unexacting consensus is the goal- not a reasoned dissent, a difference of perspective, or true originality.

The Awbury Team

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Information is alpha- as long as you know what to do with it…

In a world that often seems to be drowning in data masquerading as information, how is “alpha” or an “edge” to be found?

There seem to be two main alternative routes: one either has to have better information than one’s competitors; or, with the same information, a superior ability to identify and exploit patterns in it to identify both risks and opportunities.

It is obvious that there is an escalating “arms race” in acquiring “better” information, with the term “alternative data” now widely used in business and financial circles. For example, the use of data from commercial satellites is becoming increasingly common for hedge funds and others as a means to acquire “non-public” data. Yet, paradoxically, this simply leads towards a scenario in which all those who can afford it, have it. The edge is increasingly blunted. This then leads to the search for the next “alternative” source, but begs the question of whether “the next big thing” has any real value.

So, what about superior pattern recognition? Human beings are, after all, programmed by evolution to look for patterns in what their senses perceive as a means to avoid the lion lurking in the underbrush. What began as a mechanism necessary for survival has become a dominant trait, with the ability to recognize patterns, for example, visually/spatially considered an essential component of intelligence.

In the world of credit and risk analysis, the ability to understand and forecast what may happen in respect of a particular obligor or scenario is essential. To a large extent, this involves the ability to discern patterns that one knows from experience and acquired knowledge are likely to lead to a particular outcome, good or bad- for example, over-leverage, or insufficient liquidity. However, it also involves being able to distinguish between patterns that are meaningful (a signal) and those which are merely distracting noise, as well as to recognize that there may be a new pattern or paradigm, because one can be lulled into a false sense of comfort by failing to question what one perceives or “knows”.

Naturally, the growth of AI has led to something of a frenzy in terms of interrogating data for patterns that no-one else has yet discovered. Within certain parameters, specialized AI (for that is all that exists at present), backed by ever-rising processing and computing power has the potential ability to see things quicker, or differently from human beings, no matter how experienced or skilled. One only has to look at the fact that AI systems can now overwhelm even the best human players of chess or Go (to mention only two examples) to understand that.

However, the world is a complex, non-linear place, which means that, for now at least, even if the existential risk from AI to the role of (re)insurance underwriters in high-volume, commoditized product lines looms ever nearer, in the more complex areas in which being able to understand causation, correlation, constraints and the nuances of game theory and human behaviour are critical, the pattern-recognition abilities of human operators should prosper for much longer.

While we are eternally paranoid at Awbury about mistaking noise for a signal, or to our thesis being simply wrong, we believe that there is hope for us yet, given our relentless focus on complex, non-standard risks!

The Awbury Team

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The chaos beneath the surface…

“Civilization is hideously fragile… there’s not much between us and the horrors underneath, just about a coat of varnish”- CP Snow

Reading Seth Klarman’s (of Baupost fame and fortune) year-end letter set us thinking about how fragile seemingly stable environments can be.

Those of us who are fortunate to live in what are considered well-ordered and reasonably well-governed societies, tend rather smugly to believe that “‘twill ever be thus”. This is a good example of recency bias and the availability heuristic in action: because it is so, and has been for a long time (in our terms); because our experience has always been the same, we find it hard to bring ourselves to believe that our world will not simply continue as before. In market terms, for example, there has been an almost 36-year bull market in US bonds. Careers have passed without the experience of a real bear market. Knowledge has been lost. What happens when a true reversal starts?

As the CP Snow quotation warns, there is often a fine line between order and chaos- systems or trends are stable, until they are not. Disruptive forces can evolve remarkably quickly, such that seemingly invincible and secure companies, long-standing markets or even governments find themselves at risk of degradation, dissolution or irrelevance. Who would have thought that December 2018 would bring the worst final month for major equity indices since 1931- the depths of the Great Depression?

In this context, the quality, agility and effectiveness of analysis and decision-making become paramount.

Unfortunately, as Klarman pointed out in his letter, there are signs that US markets in particular are leveraged not just in monetary terms, but also in structure, algorithmic bias and investor psychology, such that the historic tendency to “herd” becomes potentially even more exaggerated in scope. For example, if trading algorithms are designed by human beings (as they still are) and those human beings share the same experiences and biases, the speed of algorithms once put into use can overwhelm markets given the fact that the majority of US stock trading (and probably increasingly that in many other markets) is actually initiated and conducted by algorithms.

Turning to government (and no matter what one’s political affiliations may be), there are also worrying signs of a deterioration in the quality and rationality of policy- and decision-making in many jurisdictions. Of course, politicians acting irrationally and for partisan purposes is not exactly a new phenomenon, and by the standards of history, political discourse is actually quite restrained in most true democracies. However, in a complex world, where new media enable the dissemination of thoughts almost instantaneously, the risk of a statement or assertion causing disruption rises inexorably. By the time anyone actually stops to think it is too late. The Latin tag “festina lente” (literally “hurry slowly”- more haste less speed) is worth bearing in mind in this context.

And what of the world of (re)insurance? In a still consolidating industry, as market power becomes ever more concentrated within the traditional business models (and perhaps more volatile in the realm of alternative capital), there is a risk (always present in the industry) of doing what everyone else is doing, because “the market” cannot be wrong, when clearly it can. As we have written before, unbridled enthusiasm for certain types of risk (e.g., cyber) can lead to a deterioration in the quality of thought being applied to understanding, defining and managing the risks entailed.

We are in no sense saying that the “end is nigh”. However, we do think that, for example, (re)insurers should constantly re-assess and test the robustness and continuing fitness for purpose of their decision-making systems and processes to minimize the probability of tipping over into the abyss of fundamental error or misguided belief.

The Awbury Team

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Certainty is a delusion…

To be absolutely certain about something, one must know everything or nothing about it”- Henry Kissinger

As the wry old joke goes: “The only certainties in life are death and taxes”, yet human beings like to extend the aura of certainty to areas in which it has no credible place, with sometimes unfortunate consequences.

Even in “hard” science what are sometimes stated or perceived to be “certain” facts (axioms), turn out to be simply untrue, incomplete, or more nuanced and complex- whether the nature of the cosmos and Earth’s place within it, atomic theory, or Newtonian mechanics. Karl Popper stated that for something to be scientific it must be able to be proven false. If things are falsifiable (able to possibly be proven false) then they can be used in scientific studies and inquiry. In other, words, even “certainties” need constantly to be tested.

This fact was brought to mind recently in reading David Quammen’s excellent book “The Tangled Tree: A Radical New History of Life”, which tells the story, amongst other things, of how as recently as 1977 it was axiomatic that the “tree of life” (popularized by Darwin’s work) had only two main branches from its trunk- for bacteria and for eukaryotes (essentially everything else) and that species only changed vertically through mutation and natural selection over time. That was until a molecular biologist called Carl Woese (who was not even looking for the result), realized that, in fact, there are three branches- the two mentioned previously, and what are now called archaea. Not only that, but genes can be swapped between species- via horizontal gene transfer. So much for the certainties of what you were taught in high school biology. In fact, the “tree” is now considered to look more like a tangled web, so perhaps it should be the Thicket of Life?

When it comes to the world of credit risk analysis and management, it would be wonderful if one could be certain of anything and everything! One could then predict the true risk of loss and one’s pricing would be perfect. Dwight Eisenhower (during World War II) pointed out: “Plans are useless, planning is essential.” Of course we build models and make forecasts. These are an essential component of any financial business. However, any experienced analyst knows that actual outcomes can easily be very different from what was assumed because of some unforeseen or unexpected factor (which is one reason why we are also habitually paranoid). The real world places constraints on possible outcomes, but the number and weighting of the variables that go into assessing, say, the risk of default is inherently probabilistic. The real skill lies in understanding the range and scope of potential outcomes over time, and how to manage and mitigate actual outcomes if they deviate significantly from the range of reasonable expectations- planning, not plans, constantly updated.

History also teaches that seemingly minor variations in decision-making or apparently unconnected events can interact and cascade in ways such that what seemed “certain” and inevitable, turns out very differently. At Dunkirk, in 1940, it seemed certain that the trapped British and French forces would be overrun by the Nazi German Wehrmacht. Yet that did not happen, with the outcome that everyone knows.

So, when someone states that they are certain about something (a 100% probability!), the immediate response should be to ask how and why. At Awbury, we believe (and can demonstrate through outcomes) that our approach to risk analysis, management and mitigation is effective in relative and absolute terms; but we would never be so foolish or arrogant as to state that we are absolutely certain of the outcome on any of our transactions. That would be doing ourselves and our partners a singular dis-service. After all, our business model is founded upon assuming real risks.

The Awbury Team

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It is the Devil’s excrement…

Readers may recall that this sentiment was uttered in the mid-1970s by Juan Alfonso, formerly Minister of Mines and Hydrocarbons of Venezuela, and often called “the Father of OPEC”. In full, it reads: “I call petroleum the devil’s excrement. It brings trouble… Look at this locura [madness]- waste corruption, consumption, our public services falling apart. And debt, we shall have debt for years.”

This was an allusion to the natural resources “curse”, most particularly that caused by the discovery of large oil and gas reserves. A politer term is “Dutch Disease”- namely, the negative impact on an economy of anything that gives rise to a sharp inflow of foreign currency. The currency inflows lead to currency appreciation, making the country’s other products less price competitive on the export market, as well as potentially to the economic and social distortions, endemic mismanagement and corruption to which Alfonso referred. An expectation of future export revenues from oil leads to the avoidance of putting in place sustainable government revenues based upon taxation.

It is a rare country that manages to overcome the “curse”. Canada, Norway and the Netherlands are examples of those that have, albeit with different approaches; while the sheer scale of the US’s economy has muted any material impact over time.

However, the catalogue of the “cursed” is a long one- including Russia, Saudi Arabia, most of the other Gulf states, Iran, Iraq and, of course, Alfonso’s own Venezuela, which is perhaps the most egregious and painful modern example.

In the case of the last, one can argue that it is the archetypal petro-state gone wrong, with oil revenues in the “good times” being used to influence and co-opt potential opposition, as well as to “bribe” the population through a latter-day version of “bread and circuses”. Unfortunately, when the subsequent “bad times” coincided with the demise of a charismatic leader (Chavez) and his replacement by a thuggish plodder (Maduro) desperate to cling to power (and supported by those who had benefitted from the corrupt largesse during the good times- the military, in particular), the result has been one of the most rapid collapses of a still-functioning state into “failed” status in recent history. And entirely self-inflicted.

The sheer scale of the regime’s stupidity beggars belief. No rational government would gut, coerce and starve of investment its primary source of revenues. Yet that is exactly what first Chavez and then Maduro have done to PDVSA, the national oil company (NOC). It used to be axiomatic that, even if the Venezuelan government could barely be trusted to do anything right or rational, it would not jeopardize PDVSA’s ability to produce and deliver oil from Venezuela’s abundant reserves. Nevertheless, that is exactly what has happened, with an end-game of regime change perhaps now in sight.

For underwriters of complex credit risks, such as the Awbury Team, events in Venezuela provide a salutary reminder that one has to judge the outcome of risks that depend on the decisions of others by reference to their track record, incentives and constraints. Assuming that people (and governments, like any other entity, consist of people) will actually act rationally and in their long term interests can prove quite misguided. One should always be willing to factor in the probability that actors and agents will not be rational (by the standards of the person making the assessment).

The Awbury Team

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Only the lawyers (and accountants) get rich…

The New York Federal Reserve’s excellent Liberty Street blog recently published a series of 5 posts aimed at assessing the scale of value destruction, both direct and indirect, following the bankruptcy filing of Lehman Brothers on September 15, 2008, which now seems so long ago as to belong to another era.

What many may not realize is that the Chapter 11 proceedings for Lehman Brothers Holdings Inc. (LBHI) and a number of its US subsidiaries are still continuing, a period of time which is apparently some 8 times that of the average Chapter 11 proceeding of 14 months. What may also not be appreciated is that Lehman’s US broker-dealer subsidiary, Lehman Brothers Inc. (LBI), was resolved and liquidated under a separate process under the Securities Investor Protection Act (SIPA), which took some 4 ½ years to be essentially completed in March 2013.

These separate processes have had very different outcomes in terms of creditor recovery. In the case of LBI, customers received 100% of their claims- almost USD 190BN. In the case of LBHI and its other US subsidiaries outside the SIPA process, the outcome was much more complex, protracted and unsatisfactory.

When LBHI filed, its senior bonds implied a recovery of 30%, falling to 9% a month later. In early 2011, LBHI estate estimated recovery for its creditors at 16%. In a plan filed in June 2011, allowed claims by third-party creditors totaled USD 362BN, against which recovery, net of expenses, of USD 75BN was expected, or c.21%. The total for 16 distributions made to date is c. USD 94BN against estimated allowed claims of just over USD 300BN, implying a recovery rate of c. 31%. Of course, that is in nominal dollars. Discounted at UST yields, the recovery is c.26%. That brings home just how large the financial impact of the Lehman’s bankruptcy has been, without even taking into account the human and economic costs for its then 25,000 employees, many of whom were pitched into unemployment at a time when the financial system appeared to be in meltdown.

As the blog points out (even though there had been signs of “cracks” within the financial system in 2007), Lehman’s stock reached its all-time high in January 2008, then beginning a decline which accelerated mid-year and turned into a rout after its now-infamous “pre-announcement” on September 10 of disastrous Q3/08 results. Even as late as September 10, LBHI’s senior bonds were at USD 77 (“distressed” levels, but not “bankruptcy imminent”). Interestingly, with hindsight, the proverbial “canary in the coal mine” may well have been “free credit balances” (analogous to bank deposits) in LBI, Even though such balances were supposed to be segregated from those of LBI itself, they declined 60% between May and September 19 (the day on which LBI filed for bankruptcy). Of course, most of this would have been anecdotal and not that easily visible in the timeframe involved.

So, why should anyone care about any of this? Simply because it demonstrates that not only close and predictive monitoring of all counterparties is essential; but that one should also clearly understand the nature of one’s claim, in terms of both legal and structural ranking and subordination. Just accepting what the “market” believes is far from sufficient.

At Awbury, we aim to be rigorous in all aspects of our risk analysis, and that includes legal, regulatory and recovery risks. After all, we are fundamental credit analysts.

As an aside, the professional fees for LBI’s liquidation were USD 1.18BN; while those for LBHI’s continuing Chapter 11 process so far total USD 2.56BN, both according to calculations made by the Liberty Street economists.

The Awbury Team

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