Monday Reading Links

A few articles worth your time:

From NY Times:
Merrill's Downfall
Lax Risk Controls Led to aggressive CMO and CDS deals

China's Problems with Slowing Growth
And aggressively fixing the problem, with a stimulus package worth $586 billion

From the New Republic:
Meet Tim Geithner, He Might be Your New Treasury Secretary
The NY Fed Governor is young, aggressive, and qualified.

The Propane to Crude Spread Gone Really, Really Wrong

Atlas Pipeline Partners reports 3q08 earnings. Lookie here at one of the disclosures (bold emphasis mine):

The Partnership's financial results for the third quarter 2008 include a $71.5 million cash derivative expense resulting from the completion of the early termination of approximately 85% of its crude oil derivative contracts that it entered into as proxy hedges for the prices it receives for the ethane and propane portion of its NGL equity volume. The Partnership funded this transaction through its June 24, 2008 sale of 7,140,000 common units for aggregate net proceeds of approximately $262.1 million, including a capital contribution of approximately $5.4 million from its general partner to maintain its aggregate 2% general partner interest in the Partnership. These hedges...became less effective as a result of significant increases in the price of crude oil and less significant increases in the price of ethane and propane. The Partnership terminated these derivative contracts during June and July 2008 at an aggregate net cost of approximately $264.0 million. The Partnership's $71.5 million cash derivative expense recognized during the third quarter 2008 resulted from July 2008 net payments of $93.6 million to terminate the remaining portion of these derivative contracts. The attached hedge schedule reflects the current hedge position of the Partnership, adjusted for the crude oil derivative contracts that were terminated in June and July 2008. As a result of the termination of these hedge contracts, the Partnership's future cash flow should more accurately reflect the revenues generated from its ethane and propane volumes produced in its natural gas processing operations.

Translation: Propane and Ethane are hard to hedge (due to liquidity), and there's lots of data showing that these commodities trade in a relationship with crude. So Atlas did a little cross commodity hedging (sometimes called a "dirty" hedge). But the correlation broke down this year, and they incurred significant unexpected losses as the percentage of propane and ethane to crude got hammered in the extreme volatility.

Price correlations have been breaking down everywhere in the energy sector this year. (As I have written in previous blog posts, Nasim Taleb is not surprised.) More on the breakdown of price correlations in an upcoming post. Interestingly, had management not busted those trades when they did, the losses would have come close to doubling. My philosophy professor always told me: "correlation does not imply causation." Likewise, Warren Buffett cautions to "be wary of geeks bearing models."

Helicopter Ben and the Economic Stimulus

Here are some interesting money supply comments from the Fed Chief. Apparently, he has no reticence to move the fed funds rate to zero, and has more tricks up his sleeve after that. (This is from a speech given in 2002.)

"As I have mentioned, some observers have concluded that when the central bank's policy rate falls to zero--its practical minimum--monetary policy loses its ability to further stimulate aggregate demand and the economy. At a broad conceptual level, and in my view in practice as well, this conclusion is clearly mistaken."

"But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost."

And they can drop those dollars to folks using helicopters.

Oil Megaprojects Get Sand in the Gearbox

This from RigZone:

Oil sands companies were the first to feel the pain of plunging oil prices and the credit crisis. Mining tar-like bitumen and shipping it to refineries costs more than extracting hydrocarbons from more conventional fields, bumping up the oil sands' price threshold. Analysts estimate some projects may need a long-term oil price of $100 a barrel or even higher to make a decent return.

The high upfront capital costs often lead to heavy reliance on the credit markets, especially for start-up firms with no independent cash flow. But this option has slammed shut amid the global liquidity crisis, and oil sands developers have already started rejiggering project plans as a result....

Five years ago, the capital cost of building a project that mined bitumen and processed it into high-quality crude was around C$40,000 per barrel of production, reckons Andrew Potter, a UBS Securities analyst. The same project today could cost C$180,000 per barrel, or around C$18 billion for a typical 100,000 barrel-a-day development....

"Companies indicated they were comfortable with costs around C$100,000 (per barrel of production) but when we started getting estimates of C$160,000 or C$180,000, then we heard a collective gasp," First Energy's Lacey said. "That's when investors put their foot down and said, 'Enough.'"

You know what they say...High prices cure high prices and low prices cure low prices.

Long-Term Weather Forecasts

Accuweather

Farmer's Almanac

NOAA

Price and Volatility Strain Dealers

The broader news media is starting to report about the challenges that price volatility has created for our industry:

Borrowed cash infuses nearly every step of the supply networks that bring heating oil from refiners to individual homeowners and businesses. For wholesale suppliers and door-to-door distributors, loans cover the weeks or months between when fuel is purchased and when it is sold to the next step on the chain.

Most companies managed to secure fresh loans to carry them into winter, despite the global credit crisis that has made it difficult for even solid businesses to borrow. But evidence is emerging that not every company succeeded.

"A lot are starting to bounce checks," said a trader at a wholesale heating oil supplier, who requested anonymity to protect the supplier's standing in the physical fuel market. "Credit lines are definitely strained."

Shift Happens

This is a presentation created by some Colorado high school teachers discussing the demographic and technological shifts the world is undergoing. If it doesn't surprise you at least once, email me and I will issue a written apology.

TGIN: (Thank Goodness it's November)

This via CNN:

"One of the most stomach-churning and fear-inducing months that stock investors have ever experienced comes to a close on [today].

As of Thursday's market close, the S&P 500 had plunged 18.2%, or 204.8 points, for the month.

That's the worst-ever monthly point decline for the S&P, and it's the eighth-worst percentage decline."

But let's look on the bright side. For one thing, the loose-money policies that were put in place this month by most every nation's central bank have kept the world's economy from imploding like a super nova. And, I caddied once for the Dali Lama and he told me "gunga, gunga, la gunga." So I got that going for me...which is nice.

IEA Part Deux: Return of the Permabull

It has been about four months now since the last time the IEA (International Energy Agency) has made a bullish commotion. During the protracted move higher, it always seemed that T Boone, Goldman, and the IEA took turns stoking the bull market. Goldman has rolled already (as I have previously noted) and T Boone has backed off his bullish drumbeat.

But here is the IEA's latest take. They are back at it again, discussing decreasing supply (due to the depletion of existing oilfields) and increasing demand from the Far East (due to the modernization of the economies of China and India). The text below is from the Financial Times:

Without extra investment to raise production, the natural annual rate of output decline is 9.1 per cent, the International Energy Agency says in its annual report, the World Energy Outlook, a draft of which has been obtained by the Financial Times.

The findings suggest the world will struggle to produce enough oil to make up for steep declines in existing fields, such as those in the North Sea, Russia and Alaska, and meet long-term de-mand. The effort will become even more acute as prices fall and investment decisions are delayed.

The IEA, the oil watchdog, forecasts that China, India and other developing countries' demand will require investments of $360bn (£230bn) each year until 2030. The agency says even with investment, the annual rate of output decline is 6.4 per cent.

Sequoia Capital's Take on the Current Environment

Sequoia Capital is one of the most well respected venture capital firms in the world. They have been involved with hundreds of companies...you might recognize a few. Apple, Google, Cisco, Yahoo, and YouTube are some of the more significant brands they helped launch. This is a 56-page Powerpoint slide show they showed their venture CEO's two weeks ago. There are lessons in this slideshow for all business men and women - whether you own steel tanks or your business model is technology based.

There are graphs in this analysis I have not seen anywhere else, and a great portion of it is worth your time.

Friday Fun

The recently released documentary King of Kong proves that real life is stranger than fiction.

See a clip here.

Do You Yahoo? Moody's Employees Did...

The folks at the ratings agencies are (in my mind) the culpable party behind this debacle. The investment banking community was just misled by blind overconfidence in a model. The ratings agencies that issued AAA ratings on bundles of crap securities are the group who really need a flashlight shone in their direction. And that is happening. Yesterday, the government began a public hearing regarding the ratings agencies role in the mess. A great post at the Financial Times' Alphaville blog shows how the hearings are must see TV (even more so than Mark Maguire and Raphael Palmeiro's perjury).

A conversation via instant messenger:

Thursday, April 05, 2007 3:58:42 pm EDT Shah, Rahul Dilip (Structured Finance - New York): btw that deal is ridiculous

Thursday, April 05, 2007 3:59:05 pm EDT Mooney, Shannon: i know right…model def does not capture half of the risk

Thursday, April 05, 2007 3:59:09 pm EDT Shah, Rahul Dilip (Structured Finance - New York): we should not be rating it

Thursday, April 05, 2007 3:59:17 pm EDT Mooney, Shannon: we rate every deal

Thursday, April 05, 2007 3:59:30 pm EDT Mooney, Shannon: it could be structured by cows and we would rate it

Thursday, April 05, 2007 3:59:54 pm EDT Shah, Rahul Dilip (Structured Finance - New York): but there’s a lot of risk associated with it - I personally don’t feel comfy signing off as a committee member

A presentation to the BOD of Moody's:

Ideally, competition would be primarily on the basis of ratings quality, with a second component of price and a third component of service. Unfortunately, of the three competitive factors, rating quality is proving the least powerful given the long tail in measuring performance. Were that the extent of the problem - that it is hard to measure quality and hence price and service are disproportionately weighted - it would pinch profitability, forcing rating agencies to spend more on service and take less in fees. But that is no different than for most other businesses and we can cope. The real problem is not that the market does underweights [sic] ratings quality but rather that, in some sectors, it actually penalises quality by awarding rating mandates based on the lowest credit enhancement needed for the highest rating. Unchecked, competition on this basis can place the entire financial system at risk....

Moody’s has struggled for years with this dilemma… For the most part, we hand the dilemma off to the team MDs to solve.

Reverse Oil Shock

Russia, Iran, and Venezuela are having trouble adjusting to cheap oil. This article is from today's NY Times.

“Now, the producers are experiencing a reverse oil shock,” Mr. Yergin said. “As revenue went up, government spending went up and expectations of a continuing windfall led to greater and greater ambitions. Now they are finding how integrated they are into this globalized world.”

A Conversation with Doctor Death

No, not Jack Kervorkian....Nouriel Roubini.

Beware, after listening to this guy I wanted to take several long cleansing breaths in an airtight garage (while my car was idling).

Charlie Rose's 50 minute interview with the economist currently experiencing his 5 minutes of fame is here.

The Foremost Expert on Monetary Policy

Is a 92 year old woman named Anna Schwartz. Here's another WSJ article worth reading, click thru here. Below are a few excerpts:

Most people now living have never seen a credit crunch like the one we are currently enduring. Ms. Schwartz, 92 years old, is one of the exceptions. She's not only old enough to remember the period from 1929 to 1933, she may know more about monetary history and banking than anyone alive. She co-authored, with Milton Friedman, "A Monetary History of the United States" (1963). It's the definitive account of how misguided monetary policy turned the stock-market crash of 1929 into the Great Depression.

Ms. Schwartz thinks that our central bankers and our Treasury Department are getting it wrong again....

To understand why, one first has to understand the nature of the current "credit market disturbance," as Ms. Schwartz delicately calls it. We now hear almost every day that banks will not lend to each other, or will do so only at punitive interest rates. Credit spreads -- the difference between what it costs the government to borrow and what private-sector borrowers must pay -- are at historic highs.

This is not due to a lack of money available to lend, Ms. Schwartz says, but to a lack of faith in the ability of borrowers to repay their debts. "The Fed," she argues, "has gone about as if the problem is a shortage of liquidity. That is not the basic problem. The basic problem for the markets is that [uncertainty] that the balance sheets of financial firms are credible."

So even though the Fed has flooded the credit markets with cash, spreads haven't budged because banks don't know who is still solvent and who is not. This uncertainty, says Ms. Schwartz, is "the basic problem in the credit market. Lending freezes up when lenders are uncertain that would-be borrowers have the resources to repay them. So to assume that the whole problem is inadequate liquidity bypasses the real issue."

How did we get into this mess in the first place? As in the 1920s, the current "disturbance" started with a "mania." But manias always have a cause. "If you investigate individually the manias that the market has so dubbed over the years, in every case, it was expansive monetary policy that generated the boom in an asset.

"The particular asset varied from one boom to another. But the basic underlying propagator was too-easy monetary policy and too-low interest rates that induced ordinary people to say, well, it's so cheap to acquire whatever is the object of desire in an asset boom, and go ahead and acquire that object. And then of course if monetary policy tightens, the boom collapses."