Mea Culpa

First mea culpa, this blogging on a regular basis is a lot harder than it first appears. How Leo Kolivakis at Pension Pulse can do it every day is beyond me. As it used to say on my old school report – “Must try harder”

Second mea culpa, I also got the Ukraine situation badly wrong – the worst I foresaw was what euphemistically gets called “Collateral Damage” and we are certainly beyond that now.

Despite the situation having deteriorated farther than I anticipated, it hasn’t driven the markets down any farther. The attached chart of the Gazprom GDR shows that following the initial drop on the  invasion of Crimea it has mainly ignored recent events, although volatility has picked up. 

We have hung on to our basic positions in Russia, but more recently we have been “renting” stocks to take advantage of the volatility – buying small positions on down days they selling them out when they bounce; ideally we would be doing this as part of our option overlays, but there aren’t enough listed options on the GDRs.

Few precise details have emerged about the recent gas deal signed between Russia and China, but a couple of analysts who have run their slide-rules over what little we do know have suggested that it is at best a breakeven deal for Russia. Given that Putin was very keen to show the West that he has other choices of “friends”, it would not be surprising if China were able to drive such a hard bargain; in short, Gazprom remains a continuation of State policy by other means and as such will remain very “cheap”.

Some commentators have tried to use the deal to paint President Obama in a bad light – weak, ineffective, etc – the Realpolitik is that there is very little more he could do without Europe taking a stronger stand and there certainly doesn’t appear to be much appetite for that currently. Ironically, President Reagan warned of this kind of impasse when Western Europe first started negotiating to import Russian gas back in the 80’s

Now that Sunday’s Presidential Elections have returned the pro-European Petro Poreshenko things should calm down for a while. The forced closing of poling stations in several of the pro-Russian strongholds, such as Donetsk and Lugansk, only serve to legitimize a government that will probably be just as corrupt as the last one. It doesn’t make Russian stocks a screaming buy, but they should move slowly higher as things “normalize”

In recent weeks we have observed the Brazilian market get a bounce every time Dilma’s approval ratings drops, or word leaks out that preparations for either the World Cup or the Olympics are going badly; FIFA has said publically that the preparations for the World Cup are the worst they have ever seen, whilst the IOC has apparently informally approached the UK to see how quickly they could bring back on-line the facilities used last time around.

Congress has opened an investigation into the purchase of a refinery in Pasadena TX when Dilma was the Minister for Mines and Energy and Chairperson of Petrobras. The company was forced to acquire 100% of an operation they only wanted to acquire 50% of, paying out $1.25BN instead of their expected $360M, for an asset that was possibly only worth $42M. As a long-term follower of Petrobras, none of this surprises me.

Expectations of a first round win for Dilma have faded, although she is still currently expected to win in the second round. IF the Government is forced to introduce any kind of electricity rationing because of the poor rains, the October race will be wide open. Dilma, again in her previous role as Minister for Mines and Energy, intervened in the market to ensure that returns on investment were below those required to bring in new capital, so now the country faces a shortage of back up capacity and a $20Bn subsidy bill.

I remain confident that the World Cup will be a success, in the sense that it will happen, someone will win, and that people will have fun. Should Brazil get to lift the trophy again, they will probably deem it to be the greatest series ever.

I am happy to see the election of Narendra Modi as the new Prime minister of India. To call the Gandhi clan that has been at the core of India’s mismanagement for so long “tired and corrupt” would be an understatement. India needs someone who is not permanently trying to hold the poor back, but is actively trying to give them opportunities. Modi comes with baggage that is for sure, but he deserves the benefit of the doubt at this stage.

I used the bounce in many of the Indian names in my portfolio to cut back exposure, not because I doubt Modi’s abilities, but because I recognize that he has a herculean task ahead of him. Despite all the good wishes, we won’t know if he is actually going to be successful for quite a while as the vested interests fight to maintain their privileges.

Finally, I am surprised it took the Thai military so long to intervene in the dispute between the Government and their opponents. Given how the country has become increasingly polarized whilst the economy has slowly stagnated  - the State Planning Agency recently announced that the economy has slipped back into recession – it was only a matter of time before they stepped in. 

Unfortunately the coup isn’t likely to solve much of the underlying problem as they are too closely aligned with the “Blue Shirt” opposition of the urban elite. Perhaps they would have had more credibility if they had forced Suthep’s supporters NOT to have boycotted the Februa

So this is spring?

Spring is supposed to be the season of renewal and rebirth, from the Prague Spring to the Arab Spring, hope springs eternal. Here in Quebec we have one of the nastiest elections I have ever witnessed, and any green-shoots outside my front door were buried by today’s snowstorm.

I confess I felt a little uneasy suggesting the other day that spring had come to the Emerging Markets. It’s always so much easier to stick to consensus and let someone else tread on the landmines first. As Keynes said, it is better to fail conventionally than to succeed unconventionally…

Still, there is no better feeling than when you do get it right. 

I should also tip my hat here to Adrian Mowat at JP Morgan. He has been consistently counter-consensus on Emerging Markets this year, and I find his positive outlook very appealing.

Markets certainly took heart from the lack of escalation in Ukraine, recognizing that the annexation of Crimea is a done deal. One may not like Realpolitik, but sometimes it is the best we can do. Meanwhile, once it becomes clear that things are not going to get worse, the only sensible thing is to make the best of a bad situation.

I would, however, argue that the rally we have experienced in more than just making the best of it.

As I mentioned in previous weeks, Fed tapering hasn’t had any effect on the ability of countries to fund themselves, and they have already raised materially more than they did during the equivalent period last year.

The biggest of the “unknown unknowns” this year has been Chinese moves to increase uncertainty in trading of the Yuan. By allowing their currency to depreciate against the Dollar, and widening the trading band, the authorities have killed the carry trade – Borrowing USD and converting the proceeds into the Chinese currency to benefit from the ever-increasing currency. Because that borrowed money has to be paid back, it has pushed the dollar up and US interest rates down, countering much of the effects of tapering. The US 10 Year bond yields 2.72% currently, which certainly does NOT represent a huge hurdle for foreign borrowers.

More recently, S&P followed through with the ratings downgrade on Brazil that I discussed in one of my initial posts, and the markets did precisely nothing on the news. In fact they actually rallied. The lack of negative action may have been related to the change of outlook to stable, since everyone knew that the downgrade was inevitable.

It may also have been obscured by the news of a corruption enquiry at Petrobras concerning the purchase of an oil refinery for $1.2BN that was really only worth $40M. Although she is not directly implicated, President Rousseff was head of Petrobras at the time of the purchase, and it has dented her credibility as a technocrat. If she had the wool pulled over her eyes on this, what else has gotten passed her?

It is telling that an event that might derail Dilma’s election prospects should cause the markets to rally. It just goes to show how badly she is deemed to be running the economy.

Yet the fact that a corruption investigation is taking place is an incremental improvement, and people are starting to look for the incremental change, such as Petrobras admitting to analysts that the numbers in its revised 5 year CAPEX plans don’t add up, and they need to look at improved cost controls. They also made it clear that the Government will give them another price increase to close the import parity gap. At the turn of the year, both these pieces of news would have been taken negatively – Brazil continues to be run badly – now they are being interpreted as Brazil recognizing it is run badly and starting to do something about it.

So the focus on Brazil is switching to what happens after the elections. If Dilma stops mismanaging things but actually tries to repair the damage, what can she do without too much shoving and losing too much face?

Elsewhere, the improvements to the current account in Indonesia appear to be solid, and the expected winner of July’s Presidential Elections Joko Widodo appears ready to tackle two of Indonesia biggest structural problems, namely poor infrastructure and the huge amount of money wasted on the fuel subsidies. The first test will be parliamentary elections to be held in April, with early expectations that his party can double their seats to around 35%.

It would be overly optimistic to say that we are now living in the best of all possible worlds.

Thailand, unfortunately, appears to be bogged down in its never-ending psychodrama. The opposition Democrat Party can’t beat the Thaksin Government in the polls, so they are boycotting them and using the courts to tie the Government up in procedural issues in an attempt to discredit them in the eyes of their supporters. As far as I can tell, their policies look more like scorched earth than anything else, and I remain confused by the relative strength of the market.

Sadly the flicker of hope that was the new SICAD2 FX system in Venezuela already appears to be snuffed out, keeping the focus on the here and now.

Just to recap, Venezuela has 4 exchange rates, the official rate decreed by Chavez at 6.3/$, the secondary rate of 11 in SICAD, the new rate in SICAD2 of approximately 57/$, and the unofficial rate in the parallel market which is somewhere around 70.

The misalignments of the exchange rate is a major cause of the shortages of everything from pharmaceuticals to toilet paper; although vital medicines and food are supposed to be imported at VEB6.3, no-one is stupid enough to sell dollars at that price. SICAD was supposed to solve that problem by auctioning off $200M or so every week at a more realistic exchange rate. Unfortunately the market demanded more dollars than that, and the Government failed to deliver even the $200M. When the VEB11 rate was set it was already too strong, and the rampant inflation since then has only served to make the situation worse, hence the third tier.

SICAD2 was supposed to be unconstrained, with rates set by the market unhindered by the Government – a huge ideological shift by the highly doctrinaire administration.

The lower exchange rate would close the budget deficit but it would drive up inflation since so much is imported; a dangerous thing when people are on the streets protesting. Unsurprisingly, the Government appears to be backtracking already, and the rates in the parallel market are falling again as citizens scramble to protect their meager savings.

Meanwhile Air Canada has stopped flying to Caracas because they haven’t been paid; arrears to international airlines are believed to have reached $3.5BN or so at the old exchange rate, whilst the Government is expected to revalue those arrears to the new rate, meaning they will only ever get cents on the dollar.

Despite the blanket of snow outside, the noisy old raccoon that was jumping up and down on my roof last week tells me that spring is really here. The renewed focus on reforms and the possibilities of future Governments suggests the markets are feeling it too.

Getting a lucky break - follow up to my post on Petrobras pricing

Having talked about Petrobras's failure to establish a meaningful pricing policy,  I was fortunate enough to discuss with Sinopec (386 HK) their approach, especially in light of the liberalization of prices following the 3rd Plenum.

As I had posted earlier, the pricing adjustments announced at the 3rd Plenum were not as far reaching as the headlines suggested, as several firms had already moved to more transparent policies. In the case of Sinopec, they actually moved to an improved formula as of March 26th, including publishing the changes to their website. These changes were the 5th round of improvements to pricing since 1998.

The two key points this year were;
1) Import parity is now calculated on a 10 day moving average, down from 22 days
2) The automatic trigger was lowered from a 4% price move to RMB50/ tonne. At around 7.3 barrels/tonne and $100/ barrel, that equates to a readjustment for every 1% change in the price of oil currently.

Frankly, even if Petrobras adopted Sinopec's old formula, it would still be a huge improvement.

I also caught another break on Monday when Clément Gignac published a commentary in Canada's Globe and Mail of the end of QE and its affect on the US 10 year bond. Read the article for his methodology, but the final passage says it all,

"In a nutshell, when the Fed finally puts an end to QE, which should happen by the end of 2014, long-term rates should march up toward about 3.5 to 3.6 per cent, a rise of 75 basis points from current levels. But 10-year rates should only return to a more “normal” level of around 4.5 per cent when the Fed brings its monetary policy back to neutral, which would be in line with a Fed funds rate of about 2.5 per cent to 2.75 per cent."

Although he is slightly more "bearish" than I am (I see QE ending in 2015), I would still describe a rise in the 10 year yield to 3.5% as modest and accommodative. It is certainly not enough to derail long-term funding for Emerging Markets.

Ordem E Progresso

Brazil, as always, continues to fascinate and excite. This week they took several steps forwards and several steps backwards; to be honest I am still trying to count how many in each direction.

Petrobras, the State owned Oil Company held a board meeting where they raised gasoline and diesel prices 4% and 8% respectively. This is good, as far as it goes. These changes should add $3.7Bn to EBITDA and $2.3Bn to net income according to Merrill Lynch.

Unfortunately they didn’t bring the domestic prices up to international parity, so the large amounts of fuel Brazil imports is still being sold at a discount – about an other 8% for gasoline and 15% for diesel, again according to Merrill.

Apart from the direct effect this has on Company and Government revenues, it has serious knock on effects to other industries, such as the domestic ethanol industry - Brazilian cars are able to run on any mixture of ethanol or gasoline.

Ethanol for fuel is a genuine green industry in Brazil, since it uses sugar cane rather than corn. Sugar cane requires basically no fertilizer (derived from oil) to grow, and can yield multiple harvests a year. Brazil has established itself a world leader not only in the production of ethanol, but also the technology that allows vehicles to be so flexible. Having encouraged huge amounts of private capital into the industry, the Government is now pulling the rug out from underneath them by crushing profitability. As a result, Private Investors are going to demand even bigger subsidies from the state development bank (BNDES) to invest in Brazil in future – hence the heavy participation of BNDES in the recent airport auctions.

Net-net, the Government is handicapping its own financing abilities AND discouraging investments at the margin, hindering economic growth.

The board also failed to specify how and when farther adjustments would be made, only that they hoped to do it over the next 24 months. This was a great opportunity for the Government to show that they were in control of the situation, and they blew it.

Petrobras was recently downgraded, and S&P has the country on negative watch. I would argue that these failures to take decisive action make a Sovereign downgrade inevitable, possibly as soon as the next review in early 2014. Should the Government continue to run such incoherent policy, a second downgrade after the elections cannot be ruled out.

I, however, still think that a second downgrade would be unlikely and a serious over reaction. As much as the Government’s policies are incoherent, they are in no ways a return to the idiocy of the pre-Real Plan days. Losing investment grade would be a major blow to national prestige and seriously undermine the Government’s credibility. When push comes to shove, I believe that the Government will do just enough to stop things getting out of control.

They have also made it clear that they recognize the effect their policies are having on Petrobras’s Balance Sheet, and its ability to fund its huge investment program. Out have gone the platitudes that Petrobras is fine, in has come the recognition of the speed with which debt is now rising and the rapid deterioration of debt metrics; The company is talking more seriously of Net Debt/ EBITDA below 2.5X, whilst it is currently over 3.1X and set to rise farther.

Barring a Sovereign crisis, and there are absolutely no rational reasons why Brazil should have one even under the current mismanagement, we are probably approaching the point of maximum pessimism. My guess, and I emphasize guess, is that it should occur during the first half of 2014. Once the World Cup starts, things will coincidently get better slowly, as the competition proves not to be a disaster, and any back up in US 10 year yields due to Fed Tapering proves to be muted; Current 10 year yields are 2.82, up from 1.62% a year ago. That is already quite a significant de facto tightening, so it's hard to see Janet Yellen trying to push rates up much farther.

There was an other development that got much less attention, but which could be very significant in the long run, if it is followed up; Brazil actually jailed corrupt Senators!

One of the causes of this summer’s riots was frustration with the politicians who had been found guilty of bribery and corruption but were able to keep themselves out of jail through complex legal wrangling. The cynical view on the street was that it would “all end in pizza”, a Brazilian term meaning the bad guys would get away with it again. Now it seems the Supreme Court has had enough too, and has sent the most visible and important members to prison – José Dirceu and Jose Genoino – along with several others.

This may be just a one-off sop to appease the rioters, and once they get bored it will be back to business as usual, but there is a very strong movement to increase transparency in Government that appears to be having an effect. I am under no illusion that Brazil will suddenly become as corruption free as Canada, but every journey starts with a single step.

Such is Progresso!

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….