Hold the abacus, remember the time value of money

This post was written in 2012–2013 and reflects thinking at the time. For current views and topical discussions, please see recent articles.

A lot of people commenting on the economy make simplistic assumptions about how rational individuals should behave. Below is an example of that, in the shape of a flawed comparison between two telephone pricing schemes.

I read a curios article today ("The cheap iPhone is already here, if Americans can do the math") about a deal that Walmart is offering on the new iPhone 5. The deal is this: you pay a non-subsidized handset price of $650, and get unlimited data for $45/month. The second cheapest deal from AT&T is $200 upfront and $85/month, for 1GB of data. "The math behind these plans isn’t very complicated", writes the author Zachary M. Seward. Walmart's deal is $1,730 over two years, whereas AT&T's is $2,240, hence Walmart's is 23% cheaper. The author then goes on to say that, by not rushing to take advantage of the deal, the American public is being irrational. They should "dust off their abacuses and recognize a discount for what it is".

I would argue, however, that the math is (slightly) more complicated than Mr Seward suggests, the discount is smaller than he thinks, and Americans less irrational than he thinks. What the "simple math" forgets is the time value of money. Money today is worth more than the same amount in two years' time. This is of course Finance 101. On a discounted cashflow basis, the difference between the two deals is bound to be smaller. What is the correct discounting factor though? For individuals this depends largely on the rate at which they are able to borrow.

Ever since 2008, credit has been tight. A lot of people cannot obtain credit at all, while others pay a high interest rate. Assuming a "typical" credit card rate of 25% annualised, AT&T's deal is $1,733 in today's money over two years, whereas Walmart's is $1,481 still less, but only by 16% rather than 23%. The two deals become equal in value only at 57% ($1,152 in today's money). Most people who can borrow at all, can probably borrow at a lower rate than this. Let's remember, however, that individuals, unlike firms, maximise not expected profit but expected utility. Hence a person's discounting factor reflects not just the cost of borrowing but the subjective expectations of future income and the confidence they feel in the future generally (including the likelihood of losing their job).

In sum, for a large proportion of the American public the high cost of credit and the uncertainty about future incomes can make it perfectly rational to eschew a seemingly cheap deal that is heavily front-loaded. This may well explain the lower than expected take-up of the Walmart deal.

BP "Russia's" in where Shell fears to tread

This post was written in 2012–2013 and reflects thinking at the time. For current views and topical discussions, please see recent articles.

BP has swapped its 50% stake in TNK-BP for c.20% of Russia's NOC Rosneft. The Rosneft stake may well be under-valued by the markets and represents an excellent investment for BP. This is a result of Bob Dudley playing by the rules and not trying to pull the fast one on the Russians, which was the undoing of Shell a few years ago.

Firstly, apologies for the bad pun in the title...

I have written not long ago about BP's long courtship with Rosneft. Now we are about to see a marriage of sorts, with an equity swap of BP's 50% holding in TNK-BP for 18.5% of Rosneft's stock (plus cash). In parallel, Rosneft will be buying out the consortium of Russian "oligarchs" who own TNK-BP's other 50%.

Much has been written about this in mass media since the deal was announced on Monday, so I wasn't going to add my own two pence' worth of wisdom. However, media commentary has included one motive that to me appears to be plain wrong. It is said that BP acquired Rosneft's shares at a 12% premium to the share price, while usually shares-and-cash deals attract a discount on the share element. What this ignores, though, is that Rosneft, while being a quoted company, is an NOC so cannot be measured by the same criteria.

Rosneft's P/E ratio is estimated around 7.2 for 2012; BP itself, despite the negative investor sentiment ever since the Macondo disaster, is estimated  to close 2012 with 7.8. Shell has a 2012 estimate of 8.1, Statoil of 8.3, Chevron 8.6, and ConocoPhilips 10.1. (By contrast, another Russian oil major Lukoil is expected to close the year on 4.5 for ADR.)

What this illustrates is that most of big Russian companies have been traditionally under-valued in the markets. There have been good reasons for that, such as historically volatile political, regulatory and fiscal environments. However, the last 12 years have been an era of stability on all those fronts. I would argue that BP's 20% investment in Rosneft (it already had a 1.5% stake) is its least risky asset. Compare it with a field in offshore West Africa or any asset at all in the US. Which would make you lose more sleep?

This deal is a vindication of Bob Dudley's long-term strategy. For years he has doggedly pursued collaboration with sovereign oil interests in Russia, even when he, as then the CEO of TNK-BP, was being thrown out of the country at the instigation of his oligarch "partners". That doggedness has now paid off and the company has completed the re-focusing of its long-term strategy. Compare this with the shambles that Shell got itself into a few years ago over its own Russian investment, Sakhalin 2.

Having pushed through an outrageously one-sided production-sharing agreement with the Russian government in the mid-1990s, Shell thought that it didn't have to play by the rules. Costs were being inflated to show low profitability; localisation requirements on procurement were being ignored; environmental impact was being disregarded. When a few years later Russia acquired a functioning government, all this quickly came to an end and Shell, threatened with having its licence revoked, was forced to sell its interests to Gazprom.

By contrast, Bob Dudley understands the rules of the game and recognises that in order to take, an investor also needs to give. I feel this will be a good deal all around, which opens new opportunities for BP in the Arctic, Russian Far East and the Caspian, as well as joint projects with Rosneft in other parts of the world. Well done, Bob.