Up, Up, and Away!

Having criticized Brazil for the mishandling of the recent auction of Pre-Salt oil fields, it is only fair that I give them credit for the success of their latest auction of airport concessions.

As the FT reports,  Singapore’s Changi Airport, together with Brazil’s Oderbrecht group, paid $8.3BN to run Rio’s Galeão airport, whilst a consortium of Zurich and Munich Airports teamed with CCR to win the Belo Horizonte Airport concession with a bid of $790M.

This comes after similarly successful auctions last year for concessions to operate São Paulo’s Guarulhos, Viracopos in Campinas and Brasilia’s airport.

All the concessions were contested by a variety of consortia, comprising local and international players, and in contrast to the oil auction went for multiples of the minimum bid price. Current airport operator, Infraero, will remain as minority partner of all the projects ostensibly for investment purposes.

The success of these auctions shows just how profitable for the country well constructed concessions can be. The $9bn investment for the latest auction will help to close some of the budget deficit; the international portion will boost the Capital Account, whilst future expansion and improved efficiency will boost economic growth. All this comes at a time when people are worried about slowing growth and a widening current account.

Meanwhile Infraero, a pretty poor airport operator, is going to get instruction from some of the world’s best airports on how to do things better, and will have a strong financial incentive to follow that advice.

What are the opportunities that the winning bidders are buying?

The concession for Guarulhos last year stipulated increasing aircraft movements from 46 an hour to 56 an hour. Heathrow operates at 54 on a daily average, but operations are restricted between 23:00 and 07:00, so obviously operates at a much higher rate during the day. I assume the concession for Galeão stipulates similar increases.

Increased plane movements are not the only source for increased traffic. I am embarrassed to say, but I do not know if either airport is capable of handling the new A380. Having said that, my various journeys through both suggest not, as they struggled to handle even midsize jets. If carriers are able to use the newer bigger jets, passenger traffic would increase dramatically, yet the investment necessary to accommodate these jets adequately was way beyond Infraero’s capabilities.

Anyone who has travelled through Changi, Heathrow, or even Cancun will tell you that the opportunities for shopping at these airports is tremendous. From the ability to buy a decent meal before boarding the flight, through to buying an iconic last minute gift, you have a captive audience that is looking for something to help while away the time.

Some airports, like Heathrow, set a maximum return so shopping profits offset landing and parking fees, whilst others, such as Cancun allow the operator to keep both revenue streams. At first sight it looks like these Brazilian concessions fall into the later category, making them more valuable.

Finally, these airports suffer from the same poor reputation that all Brazilian ports do for freight handling, the famous gasto do Brazil. More efficient handling will allow for greater transportation of high value cargos; Heathrow handles about 1.5 Million tons of cargo a year.

So that’s the opportunity.

More recently several of the Canadian Pension funds (CPPIB and AIMCo),  have expressed doubts about the valuations that Alternative Investments including infrastructure deals are currently going for. They didn’t specifically mention these deals, but it would be reasonable to assume that they looked at them long and hard given their track records not only in infrastructure but also Brazil.

It would also be good to know how much these bids are dependent on BNDES funding, rather than commercial rates. The size and composition of the consortia means they should have no problem getting long-term funding rather than depending on the National Development bank.  Subsidized funding should be directed to projects that do not enjoy such access to long-term funds, whilst projects like this would be invaluable for helping develop and deepen local bond markets.

Finally, returning to one of the themes from my opening post, these deals show that the slow money that measures deal success over decades rather than months isn’t put off by short-term variations in exchange rates or the threat of QE tapering, to them that is just noise.

China’s 3rd Plenum Follow up

It seems appropriate that I should follow up on last week’s comments about the 3^rd Plenum in China, but first here is a nice short little video I found about this year’s correction in Emerging Markets.

RBC's Laurence Bensafi

I have never met the young lady, but I like her simple explanation – I find a lot of people try to make things too complicated just to justify there own existence, where as the simplest answer is often the best.

And on to China...

First of all I like the fact the FT put implementation risk front and center of its coverage. As I hope I made clear last week, implementation often goes counter to the intent of these meetings. I was particularly struck by the phrase “In Chinese policy circles, the 2002-2012 rule of President Hu Jintao is now referred to as a “lost decade” because of this striking disconnect between state policy goals and actual outcomes.”

Ironically it appears to be the follow up document released on Friday, rather than the official document from the meeting released on Tuesday that has attracted the most attention, not only for the speed with which it came out but also for the fact it appeared more direct. Sadly, I have yet to see a good reason as to why they followed up in this manner.

It is good that they have started to ease the one child policy. Urban Chinese of relatively modest means can afford the fines associated with having more than one child, but the brutal enforcement of this policy in rural communities and especially its warping of the gender ratio is a staple of Western tabloid newspapers and is a serious cause for concern for demographers. It has now been confirmed that China’s workforce is shrining and the population is starting to age. As policies go, I suspect this will be one of the easiest to implement quickly.

Improved property rights for farmers, even those who move to the cities, and improved residency rights for those who move to smaller cities sounds very encouraging, but again enforcement is going to be the key. Officials in these areas make good money by ignoring even the existing rules, whilst the calls for an extended phase-in suggest implementation wont be easy.

I was certainly happy to see talk of State owned Enterprises handing over 30% of their profits by 2020. Unfortunately, as we have seen with the likes of Gazprom in Russia, a lot of SOEs will simply hide profits by ramping up the capex spending. I do not doubt that we will see many of these companies opening lavish offices in London or New York. China is already losing huge amounts through capital flight and the slow phase in might actually encourage more of this in the short and medium term. Needless to say, I wont be holding my breath until I actually see some real change take place.

A move to more market based price setting makes sense, and if it is allowed to curb some of the SOEs at the same time, so much the better.

For me, I think it was important that they didn’t promise too much. Between the two communiqués there was sufficient for a determined Government to focus on without over promising, and enough to be ambitious if they can implement it.

Over all, if they can implement enough of these measures to reduce official corruption and its corrosive effects, that has to be a good thing.

If…

China Tea Leaves

When I was a child in the Industrial Midlands of the UK, my parents used to take us out for a Chinese meal as an occasional treat. At the end of the meal, my Mother would “read” the tea leaves at the bottom of our cups, inevitably predicting all sorts of exciting events in our futures.

I was reminded of this because today is the 3^rd Plenum of the 18^th Chinese Communist Party Congress taking place from the 9^th to 12^th in Beijing. I can already see pots of tea leaves being “read” with regards to its outcome; The FT is full of guest posts predicting all sorts of momentous things.

It is apparently during the 3^rd Plenum that the new leadership lays the groundwork for any reforms that they are planning for their 5-10 years in power. Favourable comparisons are being drawn to the 3^rd Plenum of Deng Xiaoping in 1978 where he established the reform agenda that launched China on its current growth path, and Jiang Zemin’s 3^rd Plenum in 1993 that push those reforms even farther.

Other leaders have been less bold, and missed the opportunity to advance reforms, even if they made grandiose announcements at their own 3^rd plena.

And there in lies the problem; whether in China or elsewhere, it is very easy to announced grand plans, but much harder to implement them. There is an old Chinese proverb, “The Mountains are high, and the Emperor is far away”, recognizing this.

It is also unfair of these commentators to cite any reforms by Deng as a precedent since he was such an extraordinary leader by both local and international standards. That would be like asking David Cameron to emulate Mrs. Thatcher, or President Obama to be another Kennedy.

Needless to say, I think the outcomes have been over hyped and I will be a lot more interested in any implementation of policy.

Last week when talking about Petrobras, I attempted to describe how the Government’s fortunes, actual and metaphorical, were intimately linked to its handling of the company. Since then, despite pronouncements that it has plenty of room to add more debt and is in fine shape to meet its capital expenditure commitments, the Government has introduced plans to reform the petrol subsidy that should easily add $4BN to the bottom line. Just the talk of this has reversed the slide in Petrobras’s share price, and if implemented, may go some way to preventing a possible Sovereign ratings downgrade next year.

China’s problems are arguably larger than Brazil’s, and will thus require a greater effort to change them. There is no single company in China where one can say, “if they mess that one up, they mess everything up”, so we will need to see a collection of policies rather than one single one.

Having said that, one reform that I would like to see would be to change the way State Owned Enterprises pay dividends. Currently they are too low and go to SASAC, the State Owned Assets Supervision and Administration Commission who then reinvests that money back into the companies it controls. It would be better to see that money go to the central treasury to fund many of the much needed improvements to the social safety net. Frankly, I am not that hopeful.

Either way, I will be taking any “major” announcements with a large pinch of salt.

I have a feeling that the old trader’s adage “Buy on the rumour, sell on the news!” could well be in order, followed by a nice cup of tea.

Big Oil, State Oil, Statoil

I appreciate that this is a blog about Emerging Markets, but it never hurts to reference a Developed Market success story, especially if it serves to show where a great opportunity has been missed.

I am a great admirer of Statoil. It is hard to imagine a better managed State Owned Enterprise (SOE) anywhere in the world. Here in Canada, Norway and Statoil are regularly invoked as the ideal models for Government handling of oil resources. Invariably, the people making that invocation then go on to propose a course of action diametrically opposite to that taken by Norway, underling just how hard it is the emulate them.

I mention this because Brazil and Petrobras have been showing us how not to do it.

Former President Fernando Henrique Cardoso started reforming Petrobras as part of the Real Plan. Its balance sheet was cleaned up to reduce Sovereign risk; product pricing was made more transparent to reduce subsidies; foreign capital was allowed to participate in exploration and production more.

These reforms helped to raise Petrobras’s efficiency and profitability, which in turn led to improved tax and dividend payments to the Government. Positive feedback meant that the improvements at Petrobras helped reduce Brazil’s country risk perceptions, lowering the cost of capital for Brazil and thus Petrobras. Although the company never rivaled Statoil in terms of efficiency, it was slowly moving in the right direction.

The discovery of the pre-salt resource changed all that.

Former President Luiz Inácio Lula da Silva (Lula) immediately took the resource nationalism route. All farther auctions were suspended, Petrobras was named the sole producer with mandated minimum participation in every field, and local content rules were set extremely high. Foreign Oil companies, including the ones who had been instrumental in developing Norway’s North Sea Assets, were reduced to mere sleeping partners.

I would doubt that would work in an advanced economy, so in a country renowned for its inefficiency and the “Gasto do Brasil”, he was being over optimistic – or worse. Petrobras had a well-deserved reputation for delivering projects late and over budget. Brazilian ports were at capacity, and the Government was dragging its feet over infrastructure expansion.

Several local firms had expanded capacity in anticipation that the auctions would lead to increased demand. By cancelling the auctions, the Government cancelled that demand, sending several firms to renegotiate with creditors, and others to put farther expansion plans on hold, so much for trying to promote local content.

The Government also carried out a “capital increase” to fund the development of the pre-salt, structured in such a way as to reduce minority shareholders participation in the company. Nothing compared to Chavez or Christina certainly, but enough to make many investors nervous, and starting a long period of underperformance by the stock, a core holding in Brazilian retirement funds.

Whilst we have been waiting for the auction process to restart, several things have happened.

1) Anecdotally, corruption at Petrobras has increased. We don’t know this, given the lack of prosecutions, but most political commentators in Brazil refer to it, and there have been several high profile corruption cases.

2) Petrobras’s Capex budget has continued to rise, needing more and more borrowing to fund it.

3) Finally, the company has gone back to surreptitiously subsidizing fuel sales, importing diesel at the world price and reselling it at the lower local price, in a vain attempt to keep inflation within the official targets. Over the last two years, the refining division has lost something in the order of $20 Billion on the subsidy. Compare this the Norway having some of the highest domestic gas prices anywhere.

So we have a country that abandoned its hard won reputation for pragmatism and reform. It has arbitrarily changed the rules after the event, disadvantaged its partners, and is now spending large quantities of money to suppress inflation, rather than deal with the root causes. How is that working out?

The October auction was expected to have 40 or so of the world’s oil majors attend, but in the end only 11 showed up, dominated by Asian SOEs that tend to be less price sensitive. When that many major firms walk away, and those firms that do participate are not technological leaders, you have a problem.

Petrobras is considered tapped out. Although total debt/ Equity is not excessive yet, it has been rising faster than its peers, and its current plans would make it very highly leveraged at a time when country fundamentals are weakening and demand for EM debt is under pressure. Perversely, it was probably helped by the poor auction result, given that it would have been even more stretched by any higher bids. It will have to fund the majority of the R$15 Billion signing bonus from the auction

Explore more PBR Data at Wikinvest

Explore more PBR Data at Wikinvest

The $20 Billion in lost profits by the refining division represents several billions in lost corporation and sales taxes to the Government, farther contributing to the deterioration in the Government balances. It is hardly surprising Moody’s downgraded Brazil and Petrobras within a day of each other in early October.

The lack of participation at the auction represents several billion in lost revenue, although we cannot quantify that.

And then there were this summers riots. The Government was forced to promise that more of the profits from the Libra field would be spent on education and social services to appease the masses.

One just hopes those profits stop being eroded by higher capex and higher debt service costs, after all, if Norway can do it….