The Elected Dictator of the Former Republic of Turkey

Edward Tj Gerety IIIThe United States, United Kingdom and European Union must condemn the unruly way in which Erdogan exercised his power.

Even before the failed military coup, Turkey’s President Erdogan governed like a dictator who had the last word on all state matters.

The botched coup was nothing but, as he put it, “a gift from God.” He is using it to purge what is left of Turkey’s democracy and “cleanse” the army and judiciary in order to ensure the total subordination of all institutions to his whims.

For Erdogan, being elected was akin to being granted a license to trample and dismantle all democratic tenets to consolidate his powers and promote his Islamic agenda.

The roots of his power

His staying power rests on his uncanny ability to appeal to the underclass and his success in delivering the “goods” that nearly half of the population was in dire need of.

This includes access to health care, improved infrastructure, job opportunities and the promotion of Islamic values (in a manner that was unacceptable in the past) with which ordinary Turks could identify.

Nearly 50% of Turkey’s population benefited directly from these reforms and thus became ardent supporters of Erdogan. They are not concerned about the trampling of democratic rule, even though he has systematically robbed them of any rights that a democracy provides.

Shredding Atatürk’s legacy

One of the main reasons behind the coup was to stop Erdogan from completely destroying Turkey’s remaining secular and democratic pillars. These were established by Turkey’s founder Mustafa Kemal Ataturk in 1923.

Affecting regime change through a military coup is certainly not the preferred method. However, given how Erdogan gradually and successfully pillaged the country of all its democratic substance, a segment of the military felt it had little choice but to stage a coup to change the perilous path that Erdogan is pursuing.

This entire tragic episode might have been prevented if the Western powers, led by the United States, had been more outspoken in condemning the unruly way in which Erdogan exercised his power, especially in the past several years.

Instead, they kept emphasizing Turkey’s strategic importance, which played into Erdogan’s hands and which he fully exploited to his advantage.

Turkey’s role in hosting nearly 2.5 million Syrian refugees — and its ability to either stem the flow or open up the gates to allow refugees to flood European cities — further strengthened Erdogan’s hand.

He successfully exploited the EU’s deep concerns over the refugee crisis by making a deal that provides Turkey several major benefits that outweighed its obligations.

Totally unrestrained

Those who had hopes that Erdogan might just take heed of the coup and show some restraint in dealing with those suspected of being involved in it had those hopes quickly dashed.

He wasted no time in initiating a massive witch-hunt. Nearly 9,500 are currently facing legal proceedings, and around 50,000 soldiers, judges, civil servants and teachers have been suspended or detained.

Hundreds if not thousands will languish in jail under emergency laws that permit indefinite administrative detention without formal charges.

More ominously, Erdogan ‘raided’ higher learning institutions by barring all academics from any foreign travel even for scholarly purposes, while the state education council demanded the resignation of over 1,500 university deans.

Too well prepared

The vast number of people rounded up so quickly raises suspicions that these individuals had already been blacklisted. Erdogan was able to do so with a nearly 200,000-strong internal police force and intelligence units, who are extremely loyal to him.

Leave it now to Erdogan, who has emerged stronger than before the coup, to further intensify his brutal war against the Kurdistan Workers’ Party (PKK) and the Syrian Kurds, who are the U.S.’s allies no less.

Count on Erdogan as well to continue to refuse resuming negotiations with Turkey’s significant Kurdish community.

Perhaps the time has come for the EU and the United States to reassess their relations with Turkey. Their stance so far has enabled Erdogan to exercise free reign, even though his behavior has a direct and indirect impact on Western interests, both domestically and in the Middle East.

This is not the 1950s any longer

The United States cannot afford any member of NATO to squash all democratic rules with no consequences.

Moreover, Erdogan has demonstrated time and again a lack of loyalty and commitment as a NATO member. As so many other things, he uses it mostly in a cynical fashion, as a tool when it serves his purposes.

Turkey should be put on notice, as Secretary of State John Kerry recently stated, that NATO has a “requirement with respect to democracy… Obviously, a lot of people have been arrested very quickly.” He grimly added, “Hopefully we can work in a constructive way to prevent backsliding.”

Moreover, Erdogan should be warned that Turkey’s prospect of becoming an EU member will be a thing of the past if he continues to grossly undermine the principles of democratic governance, including the complete subordination of the judiciary to his political agenda.

Turkey on the shorter end of the stick

Though the US and the EU need Turkey in the fight against ISIS, Erdogan should be reminded that ISIS constitutes an even greater threat to Turkey than to Western interests.

Finally, Turkey should be pressured to resume negotiations with its Kurdish minority and bring an end to the war against the PKK. Not doing so further destabilizes the region at a time when the focus must be on defeating ISIS.

In that regard, Erdogan must understand that there will be serious consequences if he does not end his assault against the Syrian Kurds under the pretext of fighting terrorism (he conveniently accuses their military wing, the PYD, of working in conjunction with the PKK).

Whereas Erdogan viewed the failed coup as a God-sent opportunity to wipe out whoever is perceived to be his enemy, the United States and the EU must use this occasion to put Erdogan on notice.

History has shown time and again that totalitarian regimes come to a bitter end, and that, having removed virtually any and all restraints that remained on his exercise of power, he too will not be spared his day in court.

Istanbul shook but it is FAR from Down

Edward Tj Gerety

Istanbul is the city for me that will forever be connected with becoming an adult.  To finding my true inner ability to venture forth with no real safety net. There had been attacks near my former home in Taksim and that was disturbing but the attack at the airport drew memories and tears.

It was at this airport, that I stepped off the plane for the first time and went from child to adult.  I had arrived in a city that I did not speak a word of the language nor a true understanding of the culture.

I was determined to make it here … for if a 17-year-old could make it here they could make it anywhere (sorry Frank).

My time in Istanbul was one of my greatest hardships but also adventures.  Riding the overstuffed taxi buses to different parts of the city to strolling the universities that dotted the city landscapes.

For many the concept of the Soviet Union does not exist but getting my first pass card to us the USSR’s embassies library was exciting.  The Russians had Star Trek tapes but the American and British libraries did not.  I learned my Turkish by watching Captain Kirk first speak in Turkish with English subtitles (an oddity that the Russians didn’t have Russian subtitles sits with me even today).

The city is the New York of Eastern Europe, YES! Europe!

To attack this city is to attack the ideals of a secular state.

Though my Istanbul, my Turkey will rise from this, brush off the ash, as did New Yorkers did in 2001 and move forward.

This Rotation Looks Real

Dramatic reversals in market leadership have been the story of the year. But the risk-on rotation that began in early February looks sustainable, at least in the short run.

Market swings this year have been similar to risk-on/risk-off rotations over the last five years. The latest rally has helped U.S. stocks, high yield, emerging market (EM) equities and commodities erase sharp year-to-date losses. There are signs this rotation has legs.

Stocks have room to run

Market segments leading the rally still look cheap. Despite the stampede into value, global value stocks trade at around a 35% discount to the broader market, BlackRock analysis shows. This compares with an average 20% discount over the last decade. A weaker U.S. dollar, following the Fed’s more tempered rate-rise outlook, should help support EM and other risk assets. Many currencies have attractive values after multi-year declines.

The rally appears to be more than a technical bounce. U.S. data have improved enough to ease recession fears, and inflation expectations have picked up. The BlackRock Business Sentiment Index, which measures what corporate managers are saying about their countries’ economies, has improved since the start of the year.

Flows into global equity exchange traded products accelerated in March and are now in positive territory for the year, according to BlackRock research. Investors have started to reduce long-held under-weights in EM and commodity assets, our analysis shows, but we think there is more to come.

I like value, which has outperformed over the long run. Many BlackRock fund managers have raised EM allocations. Yet, I am not all in. Many things could go wrong. The Chinese economy and currency could slip again. U.S. growth could accelerate, forcing the Fed to tighten more quickly than expected and sparking a dollar rally. For a hedge, I like exposure to gold and inflation-protected bonds.
  • The Fed cut its 2016 guidance to two rate increases from four, signaling it was prepared to let the economy and inflation run a little hot.
  • The U.S. dollar weakened following the Fed news, boosting EMs, stocks and other risk assets.
  • Financial issuance in Europe shot up to a 15-month high, showing there is no bank funding crisis. Yet negative rates are a long-term headwind.

Preferred assets

First Quarter Data once again is Weaker — the reason is ???

Edward Tj Gerety GDPOnce again, the latest data shows the U.S. economy plodding through another weak first quarter but it may not be coincidence. After reviewing 30 years of the government’s gross domestic product data, the most followed measure of U.S. growth, suggests a longstanding problem of under-reporting Q1 expansion.

Over some time periods, in fact, first quarter growth is so weak it appears to be measuring a different economy altogether compared to overall growth and the three other quarters. The discrepancy raises the issue of whether investors and policymakers should bet on a second quarter rebound. The government releases its initial estimate for first quarter GDP on April 29.

Over the past 30 years, first quarter growth has been by far the weakest of the four, averaging just 1.87 percent while the economy has grown 2.7 percent. Several economists have  said if data were properly adjusted for seasonal variables, such a difference would not show up over a three decade span. They all found the results statistically significant.

“Q1 GDP growth tends to be the lowest of the four quarters,” said Tom Stark, manager of the Real-Time Data Research Center at the Federal Reserve Bank of Philadelphia.  He said that statistically, “the results seem fairly robust over a number of alternative samples.”

Brent Moulton, associate director for national economic accounts, said even though the data is adjusted for seasonal patterns, it can still show so-called “residual seasonality. BEA is currently examining possible residual seasonality in several series, which may lead to improvements in….the regular annual revision to GDP scheduled for July.”

Wall Street seems unaware of the phenomenon, or at least does not appear able to anticipate the Q1 effect in its forecasts. An analysis of separate data by CNBC shows that Wall Street has underestimated Q1 GDP 80 percent of the time since 1985, the most for any quarter and with often substantial misses.

The implications for policymakers and investors are potentially significant. A running average of GDP forecasts, shows the first quarter tracking at only 1.2 percent, a full point below the fourth quarter. As the Federal Reserve considers its first interest rate hike in nearly a decade, some Fed officials have said the recent weak economic data give them pause.

The reason for under-performance in the first quarter is ultimately unclear. GDP totals the value of all of the nation’s production and is revised multiple times over years. It is seen as a less-than-perfect measure. Data are seasonally adjusted by individual category while the number as a whole is not. It could be that some events that happen fairly regularly in the first quarter—such as really severe weather or declines in defense or business spending—don’t happen quite regularly enough to be picked up by seasonal adjustments.

First quarter data since 2010 has been especially depressed, averaging a paltry 0.62 percent while the economy grew 2.3 percent. Those are numbers more like Europe since the recession, not the U.S. The average is heavily affected by two quarters of negative growth, including a 2.1 percent decline last year. That decline was blamed on harsh weather across the nation, but economists still had trouble explaining its recession-like severity, coming after two quarters of strong growth and preceding two quarters of even stronger numbers.

And while economists could look out their window and see the lousy weather, they couldn’t predict the plunge in GDP in the first quarter of 2014 to minus 2.1 percent: The consensus estimate looked for a positive 1.1 percent, but that was a whopping miss of 3.2 percentage points. The Street was even worse in 2011, looking for 1.9 percent growth in the first quarter compared to minus 1.5 percent.

Average quarterly growth since 1985


But the data has shown that the problem is far more persistent than just the post-recession period.  If you remove the past five years from the analysis, you would still find the first quarter substantially weaker. Six of the 10 worst quarters for growth since 1985 have been first quarters, including a 5.4 percent plunge in the teeth of the 2009 recession. But even excluding all the negative quarters, Q1 still lags. Whether the economy is in expansion or recession, the first quarter is the weakest of the four.

By examining whether one or more sectors could be responsible for the first quarter’s under-performance. Matus found the effect especially pronounced in commercial structures, business investment and government. Stark looked at 11 separate categories of GDP and found Q1 the worst in eight, especially in exports and federal government spending. Only consumer spending seems immune to the Q1 effect.

The challenge for investors and policymakers is the extent to which they should look through first quarter weakness. Some of the growth that is not captured in the first quarter appears to end up in the second quarter, where growth runs 60 basis points above normal. That accounts for two-thirds of the under-performance of the first quarter. So it’s unclear if overall growth should be higher or if the problem is more an issue of when growth is counted.

What is clear is that the analysis presents a challenge to the government data collectors to investigate whether the process can be improved and help policymakers and investors make better choices, which could ultimately create better economic outcomes.

Vladimir Putin: The Antithesis of a Success Story

The annexation of Crimea may remain Putin’s only success in his Cold War against the United States.

USA_vs_RussiaFor more than a year, a typical evening news program on Russian television would open with a standard statement: “Tonight, we begin our broadcast with events in Ukraine.”

Then, the entire half-hour format would be devoted to the iniquities of the “Kyiv junta” and successes of the heroic Donetsk and Luhansk fighters, with little or no mention of what was happening elsewhere in the world or, for that matter, in Russia – as though Russians’ own country had fallen from the face of the earth.

In addition, several very popular talk shows hosted by famous TV personalities have been wholly dedicated to the task of maligning Ukraine, its people and its government.

The national fixation would seem strange, considering repeated official claims that the Russian Federation has no troops in eastern Ukraine.

A proxy war

But the truth is that the Russian government doesn’t believe it is fighting Ukraine. It is fighting in Ukraine and its real adversary is the West and more to the point, the Great Satan itself, Washington.

Vladimir Putin confirmed this yet again in the odious TV documentary “Crimea: the Path to the Motherland,” which aired across Russia last weekend, by calling the United States “the true puppeteers” of the Ukrainian revolution.

Anniversary celebrations of the annexation of Crimea in Russia have a distinctly hollow ring. An initial success in Russia’s war against the United States was achieved because, as Putin also admits in the film, he had insidiously planned the annexation of Crimea for a long time and because the Ukrainian army was completely unprepared to defend the peninsula.

After that, the war has not been going especially well.

On the contrary, all of Putin’s plans have failed. After the flight of buffoonish Viktor Yanukovych, Ukrainians have been able to elect a legitimate government and to build a stronger, battle-hardened military.

Ukraine’s economy is struggling, but it has not collapsed and bankruptcy is now unlikely, given the $17.5 billion aid package approved by the International Monetary Fund earlier this month. Slowly but surely, the Ukrainian economic system is undergoing the necessary reforms that have been delayed by a quarter of a century.

Meanwhile, Putin’s Novorossiya project, had envisioned annexing eastern and southern portions of Ukraine to connect by land to Crimea and to link with the breakaway Transnistria region of Moldova. The project has failed miserably, shrinking to the size of two small, lawless and starving “People’s Republics.”

Compounding failures

Outside of Ukraine, a wider war against the West has been going even worse.

The European Union shrugged off Gazprom’s bluff, demonstrating that Russia needs European customers for its natural gas much more desperately than Europeans need the gas to keep warm in winter. And all the while Europe continues to diversify its sources of supplies of natural gas — away from Russia.

When Putin signed a deal with the Chinese last year, offering them Siberian gas at fire sale prices, Russia’s European customers yawned.

Russia’s bellicose stance has done nothing to shore up international oil prices, either. Even though Russia produces around 10% of world crude oil, its price has been falling steadily since mid-2014 and is now plumbing fresh multi-year lows, with the Brent benchmark trading below $54 per barrel.

Last year, when the United States and its allies imposed sanctions on Russia, Putin banned food imports from those countries in return. But if he had hoped to damage their economies, it was a resounding flop.

Even the EU, Russia’s major trading partner, shrugged off those sanctions rather easily, finding new markets for its food products. Russia’s own economy, meanwhile, has been reeling. Food prices in particular have rocketed, and quality and selection have deteriorated sharply.

Anger met with indifference

Russia’s obsession with its war against Washington is in sharp contrast to Washington’s complete indifference to Russia. Back in 2004, a friend wrote an op-ed for the Wall Street Journal which they titled “Russia off the Radar Screen,” discussing how inconsequential Russia had become in world affairs.

But at least back then it was not “rising from its knees” and flexing its muscles. Now, the situation is different. Moscow has redrawn international borders and has started a war in Europe. Moreover, it has revived the Cold War and is spending its remaining rubles on building up its military.

Nevertheless, the American media continue to ignore Russia and its leader. Take recent events, for instance, when Putin had disappeared for more than a week, cancelling important international and domestic meetings. The Russian and Ukrainian portions of the Internet exploded with intense speculation.

Fantastical versions ranged from a stroke to a palace coup and from a secret visit to his girlfriend’s maternity ward in Switzerland to a descent to the underground nuclear bunker. In the United States, there has been some lazy speculation in the media on the subject of “Where is Mr. Putin?” but it was certainly not front-page news.

National Public Radio, the U.S. equivalent of the BBC, never even mentioned Putin’s disappearance in its hourly news summary.

Hollow threats

Now in the same Crimea documentary, Putin declared that if his annexation of Crimea had not gone smoothly, he was prepared to activate Russia’s nuclear forces. In retrospect, it was, potentially, the scariest nuclear crisis since the Cuban missile standoff more than half a century ago.

It certainly signals the return to Cold War rhetoric. Then, reappearing in public the next day, Putin also put 40,000 Russian troops and the Northern Fleet on full alert.

Not only did Wall Street stage a rally on the same day, but the DAX index of German stocks set a new record, rising above 12,000 for the first time ever – even though Germany, of course, is in the immediate proximity of the scary Russian Bear.

Putin’s attempts to do enough damage to the West to get noticed are reminiscent of Ella the Cannibal, a character in the Soviet satirical classic The Twelve Chairs (written, incidentally, by two Odessa natives, Ilya Ilf and Evgeny Petrov).

Having seen the picture of Miss Vanderbilt, the daughter of the American railroad magnate, on the cover of a French fashion magazine, Ella pulls all the stops to compete. She goes on a buying spree, severely straining her family budget.

Ella’s efforts are fairly innocuous. Not so Putin’s. He’s clearly determined to raise the ante until the world sits up and pays attention.

Watching Washington ignore his antics may be amusing, but it is also a little surreal and quite scary. It seems that the Russian president is not going to rest until Barack Obama calls him to the negotiating table.

Judging by how little attention has been paid to his efforts to date, it seems it will take no less than some form of nuclear blackmail.

It may be a far-fetched notion, but it could certainly happen. As Russian opposition leader Boris Nemtsov said in an interview not long before he was murdered on Feb. 27, “You should be aware that Putin is completely insane.”

Mr. Putin goes to India

Edward Tj GeretyWhen it comes to the much debated and much promised tilt to Asia, it seems that President Vladimir Putin is winning the game.

In the last six months, he has signed two major long-term gas supply deals with China. Major new pipelines are to be built from East Siberia – funded by the Chinese. In total, Mr. Putin has snapped up at least 20% of the Chinese market for the next two decades.

His next stop is New Delhi to meet the new Indian Prime Minister Narendra Modi. Another major energy deal will be signed, which will involve both Rosneft, Russia’s main oil producer, and Gazprom.

While the details are not yet public, it seems that Mr. Putin will be signing a deal which gives Russia a key strategic role in meeting India’s energy requirements for many years to come.

Mr. Putin starts with a weak hand

Without a doubt, Russia’s economy has been much damaged by the fall in oil prices. There also is the risk of further damage from the creeping impact of sanctions designed to punish Russian behavior in Ukraine. The ruble falls day by day and there has been a large exodus of capital from Russia.

The Russian economy remains dependent on oil and gas production and exports. The state budget is just beginning to be adjusted downwards, as it becomes clear that revenues in 2015 will not match the planned figures – all of which were based on world oil prices of $90 a barrel or higher.

This is a weak hand – but President Putin is playing it well. He knows the global energy market better than any western leader and has seized the opportunity. That is why he is signing large-scale, long-term deals with two of the very few countries in the world that are anticipating rising demand and hence an increasing import requirement.

From Russia’s perspective, the deals sacrifice price to market share. Mr. Putin is more interested in securing export volumes than in the price paid. As the Chinese and the Indians well understand, the world has moved into a buyers’ market.

In neither the Chinese or Russian case are the buyers frightened by the prospect of dependence on Moscow. They will have other supply lines and must be well aware that in a market of surplus gas, Russia cannot afford to risk its future by using supply as a political tool.

Asia is the market of the future

However, at a moment of strategic weakness, Moscow is in no position to impose political terms – a fact which makes the deals all the more attractive to the buyers.

Mr. Putin’s tilt to Asia is rational for a resource-dependent economy. With North America soon to be effectively self-sufficient, Asia is the market of the future.

Mr. Putin’s approach – cool and logical, reflecting the realities of the new global economy – contrasts with the complexities of the U.S. position. That position remains mired in past commitments to old allies such as Taiwan and in domestic political concerns over issues such as human rights. That is a topic one can bet President Putin never raises on his foreign trips.

More serious, though, is the continuing American reluctance to accept that the world as a whole has not become a U.S. sphere of influence. China, and now India, are significant powers which have to be treated as such. Lecturing to others is not a good basis for an effective foreign policy.

Mr. Putin goes to New Delhi not as a leader of a superpower, but as a salesman. As a salesman, you have to start by using what the customer wants and working to provide whatever is required.

To succeed in the tilt to Asia, the United States would do well to start by listening and by treating others as sovereign powers with interests of their own. If it doesn’t, it may find that the world is starting to organize itself without the United States.

Did you know these economic facts about China … with an intro.

chinaI remember back in the 1980s, as the Japanese were buying everything in the United States that was nailed down and a lot of other things that were (think Rockefeller Center). As a New Yorker, that day in 1989, was pretty solomon day, as it was suppose to be the end of American domination. Then the Japanese economy collapsed and in 1995 they were forced to sell and Old Glory was raised once again over The Rock.

“American was back, Baby!” was the rallying cry, as the Reagan legacy of pro-business deregulations really kicked-in and the US economy picked up massive speed with the birth and development of the Internet.  The American Dream was viable for anyone with a garage and a dream.  But as dad always use to say, “What goes up, must come down.” And on a dark day in March of 2000 the Internet went POP!

Less than two years later in the middle of New York’s Financial District two building came tumbling down and again the whispers started that the American Century were over. The stock markets were shut down and when they opened ten days laters so much red ink was flowing that accounting companies started buying red ink in bulk.  Then the Bush II’s administration put tax cuts into place and a quick recovery took place.  Once again, “America was back!” but 1995 was hiding in the economic good news.

In 1995, Bill Clinton’ signed the Gramm-Leach-Bliley Act, which repealed the Glass-Steagall Act,  a cornerstone of Depression-era regulation. He also signed the Commodity Futures Modernization Act, which exempted credit-default swaps from regulation. In 1995, Clinton loosened housing rules by rewriting the Community Reinvestment Act, which put added pressure on banks to lend in low-income neighborhoods. Economist predicted that these legislative acts would negatively impact the markets in eight to ten years.

Fast-forward to 2007 and the markets again go “puff.”  The American Dream was again … on life support and fading fast.

Then the United States elected President Obama promising that all this would change.  His administration along with a Democratic Congress passed the largest stimulus bill in history.  Which focused more on funding the sex lives of beetles and STD prevention than actual job creating projects.  This was followed by other economic policies that heavily regulated business including how rainwater was to flow off one’s personal structure.  The American Corporate Tax Rates became the highest in the industrial world.  Which made me think of the Smooth-Hawley Tariff Act in 1930.

This all gave rise to US companies moving out of the United States and to southeast Asia and this brings us to the Chinese Economic Boom.  The Communist State in October of this year, out did the Capitalists at their own game and restored the country’s former global economic preeminence.

So did you know?

  • Back in 1820, China was by far the world’s largest economy.
  • Two centuries ago, China’s GDP was twice that of India’s, the world’s second-largest economy at the time.
  • In 1820, China’s economy was six times as large as Britain’s, the largest economy in Europe — and almost 20 times the GDP of the still-fledgling United States.
  • On a per capita basis, China’s GDP in 1820 reached 84% of the global average.
  • By 1870, China’s per capita GDP had fallen by one third — to just 60% of the world average.
  • China’s economic decline in the second half of the 19th century was, in part, the result of the devastation of China’s agricultural lands following the Opium Wars and the Taiping Rebellion.
  • China also lost ground economically in the 19th century as Western nations grew wealthier from the Industrial Revolution.
  • As recently as 1980, China’s per capita GDP was equal to just 24% of the world average.
  • In the late 1970s, Deng Xiaoping began to implement market-based reforms that would lead to China’s economic modernization.
  • After two decades of rapid economic growth, China’s per capita GDP in 2000 was back up to 56% of the global average, almost where it stood in 1870.
  • After three decades of economic reforms, by 2010 China’s per capita GDP was equal to 103% of the global average.


BUT and life always holds a but … there is a housing and credit bubble building in China and the question is will its economy be able to handle it?
Maybe someday soon we will once again be proclaiming … “America’s back, Baby!’

The Numbers behind why shale oil prices are falling

Shale-OilWhy are shale plays getting hit so hard?

The short answer is, because oil is dropping. West Texas Intermediate has gone from $105 to $85 in three months.

But a large part of the problem has to do with the way shale drilling is financed.

Let’s say you own a shale company and you want to finance drilling a well in, say, the Bakken. You need $10 million (I am just using $10 million as an example). You have a demonstrated reserve value from the well of, say, $20 million.

Here’s how you might finance the $10 million deal. First, get a line of credit from a bank based on the value of the reserves. In turn, the lender becomes a secured creditor. Let’s say that based on a value of $20 million, a secured lender is willing to put up $5 million.

You can fund another $2 million from your own cash flow. Now you have $7 million.

For the remaining $3 million, you go to the high-yield debt market, which of course is an unsecured creditor.

Here’s what the deal looks like:

Secured creditor: $5 million
Cash flow: $2 million
Unsecured creditor: $3 million (high yield)
Total: $10 million
This is simplified, but you get the point.

Now, let’s look at what happens when oil starts to drop fast, which is exactly our scenario.

That secured creditor with the line of credit? He’s getting nervous, because now instead of reserves worth $20 million for your project, those reserves are now worth only, say, $16 million.

That’s a problem. The line of credit you will be able to get will drop because as the price of oil drops banks don’t want to lend as much

So, instead of $5 million, your secured creditor will only lend $4 million, and at a higher rate. Now you need $6 million more.

Another problem: because the price of oil is down, you can’t contribute as much from your cash flow, so instead of $2 million that you contribute, you can only contribute $1 million.

That’s $5 million total. You still need another $5 million, and now you have to go to the high-yield market.

Except the high-yield market is aware of your problems, and they want a higher interest rate too.

So here’s what this new deal looks like:

Secured creditor: $4 million
Cash flow: $1 million
Unsecured creditor: $5 million
Total: $10 million

This is a problem, because you are:

1) making less money from selling oil,
2) shelling out a lot more money in interest to your creditors.

As oil drops, you now run an increased risk of cash flow problems, and there is default risk in the debt.

So you are making less money, and your one cheap source of financing (the line of credit) is shrinking, forcing you to go to high yield.

You are in a debt spiral.

Get it? So, at what point does all this start to get problematic? That’s not easy to answer, because every company is different. There are different yields from different wells, and some have more gas than oil.

But there’s no doubt that things get a bit difficult for some producers when oil is in the low $80’s, which is where it is heading now.

And rather than differentiate between companies…which is what analysts are paid to do…there is a lot of indiscriminate selling. Oil vs. gas, doesn’t matter. Sell and ask questions later.

Here’s another point: the depletion rate is very high in these wells. You are literally squeezing oil from a rock. It can be on the order of 80 to 90 percent depletion over a couple years. So you have to constantly keep drilling new wells to meet the production quota.

And there really isn’t a lot of options. They have to drill, or they don’t have cash flow. And they still have to make the interest payments!

IPO fever is infecting Wall Street

IPOIPOs and Secondaries Surge

Alibaba’s (NYSE:BABA) IPO last week – which amounted to $21 billion in value – was the biggest in history. It was also wildly successful, as the stock surged by 38% on its first trading day. However, the US IPO market was already heating up before Alibaba’s debut: Q2 2014 saw the heaviest issuance since Q4 2007.

Recall that in spite of the fact that NBER later dated the beginning of the recession to Q4 2007, there was zero awareness that a recession might even be in store at the time. In October of 2007, shares in companies that would be bankrupt and in need of bailouts a few months later were still trading in the stratosphere (Fannie Mae’s common stock changed hands for $70, shares in mortgage insurer Ambac did likewise – the latter eventually fell to less that 2 cents). The opinion of the bien pensants at the time was that the “sub-prime mortgage credit crisis was well contained,” and the DJ Transportation Average even climbed to a new all time high in May of 2008. So Q4 2007 was definitely still a fairly good time to flog IPOs.

The time is even better now – in the wake of Alibaba’s IPO, 2014 is already all but certain to break previous issuance records. Here is a chart showing the pre-Alibaba situation as of Q2:

By Q2 2014, 160 IPOs had been issued – almost as many as in the 7 quarters Q1 2009-Q3 2010. 2011 and 2012 were relatively quiet years, but that has changed in 2013 as the market continued to surge. 2014 is well on its way to becoming a record year.

As PwC reported on the Q2 2014 numbers:

“The market for initial public offerings (IPOs) finished on a strong note late in the second quarter of 2014, recording the highest quarterly deal volume since the fourth quarter of 2007. Interest in new equity issues is expected to remain healthy heading into the third quarter, driven by continued investor demand for growth and a strong equities market environment, according to IPO Watch, a PwC US quarterly survey of IPOs listed on U.S. stock exchanges.

According to PwC, there were 89 public company debuts in the second quarter of 2014, representing $21.5 billion in proceeds raised. On an annual basis, this represents an increase of 41 percent over the 63 public listings in the second quarter of 2013, and a 63 percent increase over the $13.2 billion raised. For the first half of the year, there were a total of 160 IPOs, generating $32.4 billion in proceeds compared to 97 IPOs totalling $21 billion in the same period the previous year. The IPO market saw a spike in activity beginning in mid-June, with 25 IPOs (28 percent of IPOs) pricing during the final three weeks of the second quarter.”

(emphasis added)

Following on the heels of the successful Alibaba listing, the IPO calendar is brimful. 11 IPOs and 2 secondaries are coming to market over just the first three days of this week, 3 of which are quite large, at $460 m. (ICL secondary), $1.1 bn. (AVAL secondary) and $3.4 bn. (CFG/Citizens Financial IPO) respectively. One doesn’t get a $21 billion IPO every day, so Alibaba is not necessarily the yardstick determining what should be called “sizable.”

Alibaba on its day of listing – priced at $68/share at its IPO, it ended the day at $93.89.

How Many Offerings Can the Market Digest?

If the IPO activity in Q3 so far is any indication, the market is facing quite a big surge in supply. So far, IPO activity was easily outgunned by stock buybacks in terms of value, but the money that funds buybacks isn’t growing on trees either. Much of it is borrowed, so at the very least one has to find investors willing to buy the bonds corporations issue to finance some of their buyback activity.

This was not particularly difficult hitherto, given that the domestic US money supply has increased by a cool $5 trillion since early 2008 (another $300 billion and the increase will amount to 100% since then), courtesy of the merry pranksters at the Fed.

However, as we recently noted, after hitting a record high in Q1, stock buybacks actually retreated somewhat in Q2. Usually it is held that a combination of declining buyback activity and surging offerings could eventually weigh on the market.

However, while large stock buybacks definitely lend some support to the market by shrinking the overall share float, they always surge in conjunction with rising share prices and decline when share prices fall. So in a way they seem more effect than cause, as the managers of listed corporations apparently believe it is better to buy high rather than low, and the higher the better. Just as one can interpret large stock buybacks as bullish because they shrink the share float, one can state that a big surge in IPOs and secondaries proves that there is great demand for shares – after all, if demand were not exceptional, it wouldn’t be possible to price so many of them.

As with other investment assets, one cannot just employ a simplistic supply-demand analysis comparing new supply of stocks (IPOs) to the supply that is being retired (buybacks). After all, the vast bulk of the demand for stocks exists in the form of reservation demand, just as is the case with e.g. gold. Or putting it differently: the most important factor influencing the level of stock prices is the decision by current owners of stocks to either hold or sell at prevailing prices. The traders and investors at the margin who trade in the market every day are merely a mirror of the urgency of people to hold stocks rather than cash or vice versa.

It is not a case of demand exceeding supply, since demand and supply always balance – the number of stocks that are bought every day is exactly equal to the number that is sold. Rising prices only mean that buyers are prepared to pay more, and potential sellers aren’t prepared to sell unless they receive higher prices. This changing of hands of stocks and cash also makes all “money on the sidelines” arguments essentially useless. At the end of a trading day, the same amount of money is on the sidelines as at the beginning of it – only its ownership has changed (leaving aside the fact that additional money is created nearly every day by the Fed and commercial banks).

We would argue that a surge in IPOs and secondaries is indeed directly comparable to a surge in buybacks. Once it becomes extreme, it increasingly becomes a contrary rather than a confirming indicator. Along similar lines, the huge surge in margin debt that could be observed in recent years is also a confirming indicator until it hits extremes in terms of both absolute and relative levels (relative to market cap for instance). At that point, it becomes a contrary indicator.

The question is now whether it is possible to gauge what levels of buybacks and/or IPO activity can be called “extreme.” Unfortunately, there are no fixed yardsticks for this, given the continual change in the supply of money (which is almost always growing in the modern-day fiat money system, but not always at the same rate), as well as changes in the society-wide demand for money that occasionally happen.

So one has to consider all sides of the equation, and something that can be stated as a matter of empirical observation is that market peaks and peaks in IPO and buyback activity tend to occur after money supply growth has already been slowing down for some time. We are now in such a time period: money supply growth has begun to slow, while buyback activity has achieved a record in H1 2014 (in spite of the slowdown in Q2, both quarters together have produced a record half yearly amount), while IPOs and secondaries are obviously surging at breakneck speed at present, both in terms of the number of offerings as well as of the value issued. Unfortunately, this still doesn’t tell us when and from what level the market will succumb – it is merely another sign suggesting caution is increasingly warranted.


The surge in IPOs is best seen as a sentiment indicator. It is not so much the absolute number of IPOs or their value that is important, but the fact that they are surging at an ever accelerating pace and hitting new records. In addition, this happens while the market (in terms of cap-weighted indexes) is trading near record highs and the vast money supply growth that has supported the boom is beginning to slow noticeably. A simple supply/demand analysis like that published by firms like TrimTabs cannot account for the reservation demand factor. It will be a change in this demand component that will bring about the next major trend change.

Charts by: PcW and StockCharts

How to keep the King as an American!

AmericanKingFlagThe news that Burger King is planning on purchasing Tim Hortons of Canada to take advantage of the lower 15 percent Canadian tax rate should not surprise anyone. Free enterprise means that companies seek to do business in locations where the most profit can be kept. There’s nothing wrong with this perspective. Tax inversion is simply a variation on supply and demand. Economies are in demand that provide for low taxation.

I am not rigidly Darwinian in my viewpoint regarding capitalism; I do believe companies have a corporate responsibility to pay their fair tax share, particularly when they enjoy the benefits of what many believe to be the strongest economy in the world, the United States. Sure, they need to pay up, but there needs to be more progressive thinking about taxation of corporate revenues or we are going to read about tax inversions every week.

Perhaps what should be put in place is a quid pro quo perspective on job creation and taxation. This would be no different than the tax benefits given to companies that invest in capital expenditures. Create jobs and you get tax credits. Incentivize companies and they will come to the table.

Jobs to China? Maybe not if it pays to keep jobs here. Burger King to Canada? Maybe not if they hire more people here in the United States.

Here’s a thought on how this might work: Let’s say a corporation agrees to hire 1,000 employees. Those employees would create tax revenue for the federal government as well as tax deductions for the employing corporation. Instead of the government trying to receive a net increase in tax revenue, couldn’t the government give a credit back for the taxes paid by the hired employees? The net result would be a wash for the government but the overall economy would expand.

An expanding economy would mean more money circulates in the economic system. Given that the U.S. economy is 70-percent consumption, that should help move the U.S. economy forward and a virtuous economic cycle would create further economic growth. In the end, the government benefits because of increased taxation from sales. Increased economic growth means more Americans are employed and companies are not tempted to buy companies in Canada.

This tax plan would not be protectionist but instead positively encourage companies to do their part in spurring economic growth.

The United States economy is already managed enough as it is. With an interventionist Federal Reserve and a government insisting on massive regulations, free enterprise is already on ropes. This might be highly wishful thinking, but let’s not penalize companies for being creative in seeking higher profits. Let’s instead incentivize them to keep capital in the United States and a hire workers.