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.

The polar bears can rest easy, for now...

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

The Stockman gas condensate project goes on hold, as investors lose c.$400 million each

Remember the"war of words" over mineral rights in the Arctic a few years ago? The story went like this: while the commercially viable reserves elsewhere are peaking or declining, the Arctic harbours untold riches of oil and gas, which are now becoming accessible due to global warming. Therefore, all the countries with an Arctic coastline (the United States, Canada, Denmark, Norway and Russia) felt obliged to grab as many square miles as possible. Now it looks like all the excitement was a bit premature.

For many years, one of the biggest potential E&P projects in the Arctic was the Stockman deep-sea gas condensate field in the Russian sector of the Barents Sea. The investment thesis was based on bringing the gas to shore, liquefying it there in an LNG plant, and transporting the LNG by tanker to the US (at the time, Henry Hub prices were quite tasty). Initially, Gazprom, which holds the exploration licence, planned to go it alone. Then, after the scale of the capex requirement and the technical complexity had become clear, it invited western oil companies to come in as partners. Eventually, Norway's Statoil and France's Total joined the consortium, with Gazprom keeping 51% of the interest.

For years, things have been suspiciously quiet, and now we know why. The consortium has been officially disbanded, the three partners having lost over $1.2 billion between them on feasibility studies and such like. The Statoil representative has insisted that the project remains technically feasible, but "the commercials needed to be better defined". What it looks like is that the cost estimates have spiraled beyond the parties' willingness to invest, at least for now. I also suspect that the decline in US gas prices, due in no small part to the increased production of shale gas, has also played a major role.

With this flagship project hitting the buffers, expect the "race for the Arctic" to slow down considerably. Incidentally, this should give the US an opportunity to re-enter the fray in a much stronger position. Unlike the other four "Arctic nations", the US is not at present a party to the Law of the Sea Convention. Should the US sign and ratify it before the other players take a fresh look at the opportunities in the Arctic, it will become a major force to be reckoned with - in this area, it is not one at present.

Back to the gold standard? You are having a laugh...

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

The US can't afford to go back to the gold standard - it needs fiat money to service its huge debts

It's a truth universally acknowledged that the international financial system is broken is some fundamental ways. Many blame the huge increase in money supply (and, linked to that, of cheap credit) since the early 1990s for the over-heating of the global economy that culminated in the 2008 crisis. Since then, while the full economic collapse feared at the time has been averted (at least for now), many of the leading economies are suffocating under the weight of debt, accumulated both in the run-up to 2008 and in the "quantitative easing" afterwards. In many senses, the cure has been worse than the disease.

Against this background, the Republican Party is considering returning to some kind of a gold standard system for the greenback. While the stated commitment to a saner monetary policy is laudable, is the suggestion itself a credible one?

Let us remind ourselves what happened in the 41 years since the US abandoned the gold link and introduced a fiat currency. In 1970, the last year under the gold standard, US federal debt was 28% of GDP, whereas for 2012 it is estimated at 74%. With the individual states included, the public debt was 102% of GDP in 2011. Of the industrialised countries, only Japan and PIIGs had more. Also, given the size of the US economy, we are talking some truly astronomical numbers. In a normal economy, this mountain of debt would result in pretty high interest rates, leading to a full-blown depression (as it has done e.g. in Greece and Ireland), and possibly riots in the streets. In reality, though, 3-month Treasury Bill yields have been hovering just above zero since 2008, and are projected to remain there for the next couple of years.

The reason for this is the liberal printing of fiat money by the Federal Reserve System. Unlike Germany in the early 1920s, hyperinflation has not been the result because the US dollar is the world's main reserve currency, so foreign investors have been happy to soak up trillions of freshly printed dollars to buy Treasury Bills, still considered to be a "safe heaven". Of course, this leads to escalating debt, which needs to be serviced, etc. Eventually the bubble will burst - but not quite yet. Returning to the gold standard would prick the bubble immediately and bring the whole sorry edifice crumbling down. Even the most ideologically-driven Republicans are not "brave" enough for that.