The Inquisitive Mind

Earlier this week I had written an article reviewing the proposal to increase the tax Big Oil companies pay on their profits, if they do not invest in alternative and cleaner energy resources. This article dwells further into that issue, especially with regards to the role of Big Oil companies and their ability to balance their shareholder’s interest against our national interest.

Governments Role in the Free Market

Free market advocates (I am one), believe the government should have a minimal role in managing how any market operates. The winners and losers in any market should be determined purely by market forces, with the government not taking any sides. However, in the real-world, there are very few markets which are truly free of the influence of the government.

The world’s financial markets provide a striking example. Even though the restrictions on the movement of capital across the globe are perhaps at the lowest level ever, the sentiment in the financial markets is heavily influenced by the decisions of central bankers. Bonds issues by the United States Treasury continue to be safe-havens of last resort with the 10 year bond yielding around 4% even when inflation threatens to explode. The Federal Reserve continues to play a vital role as a lender of last resort, trying its best to prevent a collapse of the financial system.

All over the world, industries deemed to be vital to national interest are under some form of government control. In the United States companies providing basic utilities like electricity, natural gas, telecommunications, public transportation etc. are regulated by Public Utility Commissions (PUC) of individual states to provide ensure a reliable supply and stability in prices. These industries are deemed to be essential to the basic functioning of a modern economy and protecting them from the extremes free-markets can take is considered essential. Reducing the uncertainty associated with their availability and pricing, allow other segments of the economy to function better, and increase our overall prosperity.
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Crude Oil’s relentless march towards the near term spike target of $150 is now threatening to send the Global Economy into a recession. Big Oil companies (Exxon-Mobil (XOM), Chevron (CVX), Royal Dutch Shell (RDS.A), BP (BP) and ConocoPhillips (COP)) are in the thick of the controversy as the rising price of oil has seen their profits sky-rocket. Congress smells an opportunity to cut the Federal Deficit and score election year brownie points, and is pondering legislation to impose windfall taxes on Big Oil companies. As expected these bills did not garner enough support to even get to a vote in the Senate and break the Republican filibuster.

Many conservatives and pro-business commentators are aghast at the thought of taxing excess profits. Big Oil companies have increased their public relations campaign against any windfall taxes. Their supporters point out the following:

1. The profit margins of Big Oil companies are not very high compared to other large corporations. Karl Rove recently published an opinion piece in the Wall Street Journal where he dismissed the claims of excess profits by focusing on the fatter profit margins in the technology industry (between 14.5% and 27.5%) versus those in Big Oil (8.3%)

2. Big Oil companies control just 10% of the world’s crude supply. They buy the rest of the crude in the open market and pay market prices.

3. Taxing Big Oil profits will deter them from making future investments in developing new fields which will further exacerbate the supply squeeze.

4. And finally the fundamental principle that in a capitalist society, the government has no business to determine how much profit is too much.

In this article I will explore the broader context in which the oil industry operates with a focus on our Government’s energy policies.
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The spike in the price of crude in May is having the anticipated effect of arousing the Congress in this election year. Earlier this week, Congress passed a bill with veto-proof margins to suspend intakes into the Strategic Petroleum Reserves till crude oil prices go under $75/barrel and stay there for ninety days.
Enron Loophole: Position Limits

Close at the heels of the SPR bill, the current Farm Bill has provisions which will plug the so-called ‘Enron Loophole’ which allows speculators to bypass regulations regarding position limits enforced by the Commodities Futures Trading Commission [CFTC]. The bill again passed with a veto-proof majority.

This bill empowers CFTC to monitor trading on electronic platforms, like the Atlanta based Intercontinental Exchange (ICE), which presently is outside the purview of the CFTC. ICE, and other similar exchanges, will have to limit the number of contracts a single investing entity can own and will require large traders to report their positions.
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The Yahoo!-Microsoft merger saga has taken a new twist with the revelation that the activist investor Carl Icahn has built up a major stake in Yahoo. Mr. Icahn owns about 50 million shares of Yahoo, investing more than a Billion dollars of his own money.

Proxy Fight: Complete Slate of Directors
Mr. Icahn will try to replace the entire board of directors at Yahoo with his nominees. The Wall Street Journal reports that Mr. Icahn has hired D.F. King a proxy company, to facilitate the solicitation. The move to seek a complete slate came as some surprise since typically activists investors have a much easier time getting shareholder support for a partial slate of directors.

Since the Yahoo Microsoft takeover saga has been going on for more than three months now, it is likely that a significant number of Yahoo shares are now held by merger arbitrage funds that will be eager to see the deal closed. Further given the premium Microsoft was willing to play, and the deterioration in Yahoo’s competitive situation, even non-activist shareholders are likely to press for the consummation of the deal.

Yahoo’s Competitive Situation
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Crude Oil rallied to a new intra-day high of $126.98 today, before pulling back to close the session close to $126/barrel. The trigger for the rally was a International Energy Agency report that the stockpiles of distillates in Europe were down 6.7% in March over the same time year ago. Last week’s EIA’s report had shown a similar reduction in US distillates stockpiles, with a 2.6% year to year decline. Heating oil, a proxy for distillates, rallied to a new high, with the June contract closing at $3.6989; heating oil prices have doubled over the past year and are up 40% year to date.

All the News is Bullish
It is clear that the market has an incredibly bullish tone after Goldman Sachs’ call for a super-spike which could take oil to as high as $200/barrel in the next 6-24 months. The market is focusing only on the good news and ignoring anything bearish.

Today’s rally came in spite of news that IEA had again cuts its forecast for demand for crude-oil (to 1.03 million bpd); the current estimates for growth of oil demand are more than 50% less than the forecast put out in July, 2007 (2.2 million bpd). The IEA expects a further reduction in the forecast as high crude prices, and a slowdown in the developed economies are likely to cut demand further. There is even talk of reduced demand projections in the non-OECD oil importing countries (emerging economies), since the cost of subsidies is sky-rocketing and can no longer be sustained by their respective governments.

Even in oil exporting countries, where gas often sells for less than a $1/gallon, the government is bearing the cost of lost export revenues at prices which are almost an order of magnitude higher. Iran, OPEC’s second largest oil producer, imports 40% of its gasoline.

Iran & Venezuela: Flag Bearers of the $200 Oil
Another factor contributing to the rally was a news report which suggested that Iran was seeking a cut in its crude oil output. This news of impending cuts was later refuted, though the Iranian spokesman did confirm that some discussions had taken place.

Earlier this month, Iran’s oil minister had made statements that disruption in Nigeria and the weak US dollar meant that crude oil could reach $200. Not the one to be left out, Mr. Chaves of Venezuela had declared that oil would hit $200 if the US attacked Iran.

Both Iran and Venezuela rely on their oil exports to fund their local economy; a fall in oil revenues can have a drastic effect on their ruler’s ability to continue to rule.

Goldman’s Long Term Projection: $75 in 2012?
Lost in the bullish talk of $200 oil was Goldman’s notes about demand destruction. The same report which predicted the super-spike also said that by 2012 the price of crude oil would fall to $75 normalized. Goldman expects the current euphoria to lead to a spike in crude oil prices, which will spur new supply development and also lead to permanent demand destruction.
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Oil surged above $126 today. Speculators are buying options on oil reaching even $150 in the next two weeks. The speculative fervor was fanned by a Goldman Sachs report that oil might spike to $150 or even $200 in the next six to 24 months. Oil had reached the $120 level and then fallen back to close to $110 as the Fed signaled the end of the rate cuts cycle and the Dollar rallied against the Euro. The report came in just in time to revive the Oil bulls as the short dollar-long commodity play was being unwound.

The surge comes at a time when OPEC said that the oil markets are well supplied and unlike what is reported by many observers, there is at least three million barrels per day of spare capacity available. OPEC chief went on to say:

“Crude oil movements indicate that some member-countries are unable to find buyers for their additional supply,” he said.

Commodities as an Asset Class

Over the past few years a number of new financial instruments have come out which allow the average investor to add commodities to their portfolio. Investments in funds which track commodities have increased to $250B, up $71B from the start of the year. The ETF USO which buys US oil futures contracts has about $620M in assets and currently holds 5016 oil futures contracts corresponding to more than five million barrels of crude oil. These investments are all speculative; the holders of USO never intend to take possession of the crude oil.
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Oil prices reached an all time high, reaching an intra-day high of $123.79 today. The weekly IEA report showed that crude oil and gasoline inventories had gone up significantly more than predicted. The crude oil inventory was up 5.65 million barrels, or 1.8 percent, to 325.6 million barrel, about four times more than what analysts had been predicting. Gasoline also showed a greater than expected increase, while distillates like diesel were lower.

Many analysts are surprised at the current spike in oil prices since many of the factors which were thought to contribute to the rise in oil prices had reversed. The US Dollar has rallied against the Euro over the past two weeks as the Fed has signaled an end to the current interest rate cuts. The supply situation has improved. Even the rebels in Nigeria signaled a willingness to end attacks if former President Jimmy Carter agrees to mediate.

Why the Spike?

The spike in oil is being attributed to a report from Goldman Sachs which discussed the current supply and demand situation. The report noted that while oil supply growth and spare capacity is limited, the demand from emerging economies of India and China shows no sign of slowing down. The report says that it is likely that we will see a major spike in the price of oil, as high as $150-$200 in the next 6-24 months as rampant speculation about supply-demand mismatch creates a bubble and pushes oil prices to stratospheric levels. The report goes on to suggest that speculators are doing the rest of the world a favor, by accelerating the price increase, which will force governments to act and reduce the demand, leading to a subsequent decline in oil down to $75-$100 level.

One reason why Goldman’s prediction might come true is that a lot of emerging markets like Indian/China, which are the growth drivers on the demand side, have fuel subsidies in place. As a result the increase in the price of crude is absorbed by their government and not passed on to the end consumer. Unlike the developed world, there little price elasticity in the demand for oil in these countries. The governments are already worried about inflation and are reluctant to pass on the increase in oil prices to deter demand growth.
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Microsoft surprised no one with their unsolicited offer for Yahoo! in January 2008. What surprised some Wall Street observers was the premium Microsoft was willing to pay for Yahoo’s then share price. At that time the $31/share offer represented a 62% premium over Yahoo’s then share price of $19.18. What surprised the same observers was that, even that premium was not enough to sway Yahoo’s board in Microsoft’s favor. It will help to take a step back and put the offer in its historical context to understand the action of different players.

Yahoo’s History: Massive Fortune Swings

Long term Yahoo stock holders are no stranger to massive swings in its stock price. As one of the pioneers of the internet age, Yahoo’s legacy is enshrined in history.

One of the first darlings of the internet, it saw its stock price rise to stratospheric heights of $120+ at the peak of the .com bubble only to collapse to less than $5 in 2001. Since then the stock has recovered, reaching a high of $40+ in 2006, and traded as high as $34 last fall. The stock price fell significantly over the past six months as the Nasdaq sold off on the fear of an economic slowdown. Further, Google’s continued dominance and the failure of Yahoo’s internal initiative created further downside.

According to Alexa, the most popular web-sites in the world are: yahoo.com, google.com, youtube.com, www.live.com (Windows Live), and msn.com. Based on Microsoft’s earnings reports, its online division is still not profitable even though they have the #4 and #5 web-sites in the world. Yahoo on the other hand, strongly lags Google when it comes to monetizing its traffic.

Yahoo’s Future: Is Growth Possible?

Yahoo detractors believe that the inability of Yahoo to monetize the eye-balls shows that it should not continue as an independent company and share-holders should accept Microsoft’s generous offer. The Yahoo supporters believe once Yahoo starts taking more drastic actions, including strategic partnerships with other firms, it will be quite easy to monetize the traffic and boost the share price. The online revenue model is highly levered and once the fixed costs are accounted for, a bulk of the revenue after the cost of sales falls to the bottom line. A 15% increase in average monetization per visitor, can almost double Yahoo’s earnings.
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The past two weeks have been full of earning report, and more significantly, earning surprises. While the stock market has been on a roller coaster ride many investors have been on the sidelines, confused by Wall Street’s reaction. Traders are making merry; buy the dips, sell the rips seems to be working really well. In this context I felt it was important to see how individual investors can profit from limitations of Wall Street.

Wall Street is a bonus driven environment where time horizon stretch to the end of the current quarter (for management fees) and the current year (for trading bonuses). Any perspective beyond that gets little mindshare in this uncertain markets. I in this article I will focus on what is happening in the internet space where Google, Yahoo and Microsoft are duking it out.

Google Beats by a Mile

Google reported its financial results Wall Street on April 17, handily beating the consensus earnings estimate of $4.52/share by 32cents/share. The stock reacted by making a $75 move the next day and has tacked on another few percentage points since then. Google has risen almost 25% from its mid-March lows, though it is still about 28% below the high set late last year. During this period the company has not issued any statements which could have justified the massive price swings.

Private Equity Model and Wall Street Analysts

It is not too hard to figure out why Wall Street goes through such massive sentiment swings when it comes to Google. Unlike a majority of publically traded companies, Google does not offer forward guidance about its financial results. Google sees Wall Street’s obsession with quarterly results as a distraction towards its goal of building a strong company and long term shareholder value. Similar sentiments are also shared by many private equity firms who believe that the focus on quarterly earnings artificially constrain public companies and hamper efforts to build stronger companies. Google operates under a private equity model while being a publicly traded company.

Since Google’s does not offer guidance, Wall Street analysts have to step out of their comfort zone when making projections about Google’s business prospects. Google business model is unique: it is a technology company while earns its revenues from advertising. Since Google has not faced an economic slowdown, there is very little historical data which can be used to estimate its performance in the current slowdown.
However, the magnitude by which the analysts were wrong is indeed surprising, especially since there are a lot of metrics which can be used to evaluate Google’s performance.

Wall Street’s Thesis on Google’s Eminent Collapse

The financial press was gaga over Google last fall, as it raced to new highs in the 700s. Henry Blodget, a master in attracting attention with outrageous projections, said that Google might go to $2000 (the fine print said in 2020).
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Sub-Prime Mortgages have been at the top of the air-waves for about a year now. The collapse of two hedge funds run by Bear Sterns started the procession. Numerous Wall Street executives have lost their jobs and banks have been writing down about $250B in losses attributed to products linked to sub-prime mortgages.

Last week two major the chief executives at two major Wall Street firms made some encouraging statements about the current situation. Goldman Sachs’ CEO Lloyd Blankfein feels that the markets are probably in the late stages of the credit crisis though he did not predict when exactly the crisis will end. Morgan Stanley’s CEO John Mack was more definitive in his statements. He used a baseball analogy to say that the sub-prime crisis is at the bottom of the eighth or the top of the ninth innings. He feels that the broader crisis will go on for a few quarters more.

These views are significant since both these firms made the headlines during the crisis. Goldman Sachs was adroit in circumventing the crisis and booked handsome gains in betting against the sub-prime mortgages. Morgan Stanley also bet against sub-prime mortgages but their strategy underestimated the magnitude of the problem and the firm ended up taking losses of more than $9B. It also led to the departure of an entire chain of executives from the MD leading the desk which made the bet all the way up to the company’s co-president Zoe Cruz.

Sub-Prime Rate Reset Shock: No Longer a Major Issue

A note by Morgan Stanley research has reduced the reset cash-flow step-up (extra payments needed after resets), by 50% from what they estimated last year. The lower interest rates are making a difference since the mortgages are no longer resetting to a significantly higher rate.
A bulk of the sub-prime loans were 2/28 ARMs which reset after two years to a rate equal to LIBOR (6m) + 6%. The initial so called teaser rates were in the range of 7-9%, significantly higher than what a prime borrow would have paid. During 2006 and 2007, the 6m LIBOR was in the range of 5-6%, which meant that after resets, the rate went up to 11-12%. With the housing market slowing down and a lot of home owners caught with little or no equity, the sub-prime borrowers could not refinance into better priced mortgage products and were stuck with monthly payments which were significantly higher than their original teaser rates. Sub-Prime borrowers whose mortgages reset during this period were stuck in between a rock and a hard place, and many were unable to keep up with their mortgage payments.
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