OIL – What’s Cooking?

Look at the highlighted rows in the following tables. As regards WTI (West Texas Intermediate) and Brent the large contago or forward premium is the order. Further the difference between the near/front month contract between WTI and Brent shows a $10 difference. This is staggering. It may also be noted that the differential in the December contracts are minimal.

For those who may not be clear on the difference between WTI and Brent:

“Since the Eighties, WTI has ruled the global crude oil market. As it is produced and refined in the US, the world s largest consumer and importer of crude oil, it has been widely accepted as the best indicator of global demand-supply. Nymex WTI contract is the largest market for this crude oil.

Brent oil is pumped out from the North Sea and shipped to Europe, Russia and parts of Asia. Oil from Europe, Africa and the Middle East flowing to the West tends to be priced relative to this oil, i.e. it forms a benchmark. However, large parts of Europe now receive their oil from the former Soviet Union, especially through Russia.

Traditionally, Brent traded at a discount to WTI because it is less light and less sweet.”

From the charts below it can be seen that the differential between the near/front month contract between WTI and Brent started appearing toward the end of 2008. Also note the Dec09 contracts have shown very little differential.

So what’s cooking?

One explanation that I have come across is:

“…it is becoming more expensive because the North Sea oil fields are getting depleted. But that doesn’t explain its premium over WTI. On the other hand, WTI was clearly over-supplied. The problem was created by the very nature of the WTI market. The WTI market has a large number of independent producers who sell their crude based on posted price. The oil is then brought into Midland and sent to either towards the Gulf Coast refining areas or towards Cushing, Oklahoma. Cushing is an oil-trading hub and the delivery point for NYMEX light sweet crude oil futures contracts. Due to pipeline logistics, once the oil flows outwards from Midland towards Cushing, WTI can only go in one direction: towards Chicago.

So if refineries in Chicago want less oil, you can’t divert the oil towards other places where there might be more demand. In the last three months, several factors led to large supplies of oil flowing into Cushing.”

However, demand for crude has come down as it is reported that the refineries off take has fallen given that the refining margins are wafer thin or negative. This has reflected in the pump prices going up.

Now what’s happening in Cushing? NYT explains:

“A year ago, oil producers and refiners could not move their products fast enough to meet growing world demand and chase rising prices. Now, with demand and prices slumping, they are sitting on 327 million barrels at tank farms around the country, particularly at Cushing, Okla., a major storage hub and a crossroads for pipelines. That is more than 40 million barrels more in storage than this time last year, and more than 30 million barrels higher than the five-year average. The mounting buildup has come during the last 100 days or so, as consumption of oil fell behind imports and domestic production”

In this context note that:

“The International Energy Agency predicted that the worsening global economy will leave demand at 85.3 million barrels a day _ 0.6 percent lower than 2008. Demand last year is estimated to have slid 0.3 percent.

The IEA says it lowered its forecast because it has nearly halved its estimate for global economic growth to 1.2 percent.

U.S. petroleum deliveries _ a measure of demand _ fell 6 percent to 19.4 million barrels a day last year, with declines for all major products made from crude, according to the American Petroleum Institute.

The Organization of Petroleum Exporting Countries has also lowered its energy demand forecast for 2009, saying in its January report that it expects world demand for crude will fall 180,000 barrels per day in 2009 from the previous year.”

The demand destruction is further evidenced by the fact that:

“From the Indian Ocean to the South Atlantic to the Gulf of Mexico, giant supertankers brimming with oil are resting at anchor or slowly tracing racetrack patterns through the sea, heading nowhere.

The ships are marking time, serving as floating oil-storage tanks. The companies and countries leasing them for that purpose have made a simple calculation: the price of oil has fallen so far that it is due for a rise.

Some producing countries are trying to force that rise by using the tankers to withhold oil from the market, while traders are trying to profit by buying cheap oil now to store and sell at a higher price later. Oil storage has become so popular that onshore tank capacity is becoming scarce.

…noted that a trading company could buy oil at the spot price of nearly $40 a barrel, store it and sell a contract to deliver it in a year for about $60. “You pay between $6 and $10 a barrel to store it, and you can make $10 a barrel,”... “That’s why Cushing is filling up rapidly and people are leasing tankers...

… With storage tanks filling up onshore, private and national oil companies, refiners and trading companies are storing another 80 million barrels aboard 35 supertankers and a handful of smaller tankers, the most in 20 years, according to Frontline Ltd., the world’s largest owner of supertankers.

The different players have different reasons for storing oil, whether onshore or offshore.”

As to why the futures are trading at such premiums the reasoning is that:

“…OPEC has announced 4.2 million barrels a day of production cuts since September, moves that investors have so far ignored. But markets may be anticipating those output cuts will start to tighten oil supplies later in the year,…

“The OPEC production cuts are going to take time to widdle away the build up in inventories," ... "But if compliance is high, that could support prices looking further out..."

Coming back to the question of WTI and Brent the question that arises is: “How can oil around the globe be priced by a small US location, which doesn’t have a safety valve to deal with a few million extra barrels of oil?” or should Brent become the benchmark as I understand it has no such logistics related bottlenecks. And therefore is Brent now reflecting a truer picture?

The jury is still out on this.

Disclosure: No Positions

Copyright © 2008 Tradesense

Will Asia Provide Diversification?

Having looked at the possible developments in China, the latest news out of rest of Asia is also not good. Factory output in Japan fell more than 8% in November the biggest drop in 55 years. It is also expected that Toyota may report the first ever loss since WWII. According to a Bloomberg report:

“Japan's economy will probably shrink at an annual 12.1 percent pace this quarter (ended Dec 08), the sharpest drop since 1974, as exports collapse,…

… “We expect negative growth will continue for a fifth straight quarter to the April-June period of 2009.

Companies surveyed said they planned to reduce output a further 8 percent this month and 2.1 percent in January. Exports slid an unprecedented 26.7 percent last month from a year earlier.

The data prompted other economists to revise their GDP projections. Bank of America Corp. now predicts an annualized 6.5 percent contraction from a 2.7 percent drop previously estimated.”

Yen at around 90 to a dollar is on a 13 year high and has accentuated Japan’s export woes.

As US and European consumers cut back on spending it is hitting countries like Taiwan and Thailand apart from China & Japan. Excess capacities have been built and unless the situation in US stabilizes the capacities in these countries are going to find it extremely difficult. If the US stimulus does not work for some reason then these countries are going to find it extremely difficult. As US moves from a leveraged and credit based society to a cash flow based, the absorption of the excess capacities may also take time.

Competitive devaluation may also start. Japan has already indicated that it plans to take steps to counter the rising Yen. It said

“…Japan was ready to intervene in the foreign-exchange market for the first time in four years. With the nation’s economy already in recession along with the U.S. and Europe, the surging yen is adding to pressure on exporters…”

Most Asian countries except Japan are expected to see a disinflation or a low inflation and not a deflation. According to a Morgan Stanley report:

“...we highlight that Singapore and Indonesia lie at the two extreme ends of the inflation spectrum. The open nature of Singapore’s economy makes it most vulnerable to build-up of slack, and hence lower pricing power. Moreover, the correction in the real estate cycle is likely to show up in CPI as rental contracts reset with a lag. In the 1998 and 2001 recessions, when GDP growth was -1.4% and -2.4%, respectively, there were three to four quarters of deflation. We expect negative inflation toward 2H09.”

Countries that have economies driven by deficits are the one that will be most affected as global liquidity shrinks and flow of foreign capital reduces compared to the leveraged era gone by.

It appears that diversification strategies will not be easy to implement even in 2009.

Disclosure: No Positions

Copyright © 2008 Tradesense

China’s Possible Hard Landing

We continue with our watch list.

China showing any signs of bottoming out is a function of how its exports perform. Reports say

“…China’s growth may have slipped to 5.5 percent last quarter, the weakest pace in at least 15 years, as recessions in the U.S., Europe and Japan cut demand for exports, according to Shanghai- based Industrial Bank Co.

The Purchasing Managers’ Index rose to a seasonally adjusted 41.2 in December from 38.8 in November… A reading below 50 indicates output contracted.

A measure of export orders rose to 30.7 from 29 in November. The output index jumped to 39.4 from 35.5. The new-order index rose to 37.3 from 32.3. November’s levels were the lowest for each of those indexes since the survey began in 2005. …

The economic slide may intensify pressure on the central bank to keep cutting interest rates after five reductions in three months and as the government rolls out infrastructure spending...

…forecasts the key one-year lending rate will fall by at least 81 basis points from 5.31 percent in the first half of this year.”

Earlier it was reported that Chinese exports were down over the past year, the first year-over-year decline since 2001.

The $584bn.China stimulus is expected to start having some impact from the second quarter. But the main factor would be the expected revival of the western markets after the second quarter which would then give a fillip back to Chinese exports. If this for some reason does not happen or is delayed than we may see some serious dumping by China causing prices worldwide to fall and adding to the deflationary trend. This could lead to protectionist tendencies to increase leading to a global slowdown in trade with attendant political and economic consequences.

The politics of trade is likely to increase as it is reported that:

“Obama’s advisers are considering including a “buy American” provision in the economic-stimulus legislation that the incoming administration has made its first priority.

“We are reviewing the buy American proposal and we are committed to a plan that will save or create 3 million jobs, including jobs in manufacturing,” said Jen Psaki, a spokeswoman for Obama’s transition team.”

Experts also opine that one needs to watch the effect of this downturn on China’s labor intensive industries than the capital intensive ones as the unemployment numbers will be largely a function of this. Current urban unemployment is reported to be at 9.4%. Export sector employs about 50mn. of which 4mn. or so have been laid off. It is estimated that any fall of GDP growth rate below 5% can bring in a social unrest. According to a Time report:

“At a December speech, Premier Wen Jiabao confessed to being particularly worried about unemployed workers and university graduates. Even the head of the country's Supreme Court warned judges to take social stability into mind when passing rulings. Overseas, too, worry swelled about just how deeply China's fragile social compact might be shaken by the experience of economic hard times for the first time in 30 years. The Obama administration should have a contingency plan for "what we would do if there's a major collapse of the political order," Roderick McFarquar of Harvard, one of the world's most respected China scholars, recently told a reporter. (See photos here of China on the wild side.).”

China’s downturn can affect certain other neighboring countries too. It is in a way the assembly plant of component and part imports from Japan, South Korea etc.

Hard landing of China could therefore have far reaching effects.

Disclosure: No Positions

Copyright © 2008 Tradesense

Euro-Zone & UK - Show Time

We continue with our watch list albeit I’ am not captioning it so.

Euro-zone has put together its own stimulus package. Given that the nature of the union where each country has its own typical problem and the political setup has to address its own constituencies it will interesting to watch how the union overcomes these issues keeping its common interest in view. DB research observes:

“At their recent summit the EU heads of state and government adopted the European Economic Recovery Plan put forward by the European Commission in late November. The 27 member states aim to raise 1.2% of GDP, or EUR 170 bn, to fight the recession in Europe (another EUR 30 bn will come from the EIB). The member states are free to choose instruments from a fiscal tool box in order to stimulate growth in their (national) economies. The EU has merely a coordinating role. This approach makes sense for two reasons: one is that the economic problems in the member states have quite different starting points. For instance, the United Kingdom and Spain are confronted with a serious crisis in the real estate sector, while Germany has to grapple with a slump in foreign demand. The other reason, though, is that in a single market with close economic ties it is vital that national measures do not cancel out the efforts of other member states and that these other members do not remain idle in hopes of benefiting from the economic policies implemented by their partners.”

Time Magazine has made a timely observation:

“The euro's 10th anniversary will see the euro zone take on a 16th member, Slovakia. Eight other central and East European countries have set the goal of joining within the next six years, including Poland, whose political establishment dropped its longtime opposition after a recent run on the Polish zloty. The euro has found some other unexpected converts too, thanks to the financial crisis. The Danes voted against joining the euro zone in 2000, but they are set to hold another referendum in March. Iceland — not even an E.U. member — is pondering "unilateral euroization" after seeing its krona plunge nearly 80% against the euro in September and October.

And the biggest prize of all, Britain, is said to be warming to the euro … recently claimed that London is "closer than ever before" to euro-zone entry and that "the people who matter in Britain" think it should join. That may be overstating things a bit, but a report by research group Chatham House warns that as the euro zone grows, the U.K. risks being excluded from "deeper intra-E.U. economic consultation and coordination, including in areas of significant national interest, such as financial market regulation."

It doesn't help that the pound is wilting. Two years ago, one euro was worth just £0.65. Now, humbled by bank crashes, government bailouts and a collapsing housing market that has forced massive interest rate cuts, Europe's currency is within a pence or two of parity with the pound. "The debate has changed from a total fantasy in the U.K.," … "The political obstacles still remain strong, but it has changed the perception of the U.K. as the perfect system."

…financial crisis has been a defining moment for the euro, but he cautions against too much praise. The euro is still some way from dethroning the dollar as a global currency; just 27% of global foreign exchange reserves are held in Euros compared with 62% in dollars.”

This development could be a key one to keep a tab on as it may have repercussion on majority of the asset classes.

We also need to see how the ECB responds to the US ZIRP (Zero Interest Policy). The ECB has already indicated that it will do what is necessary.

“The economy may be even weaker in 2009 than the ECB’s prediction of last month for a contraction of about 0.5 percent … The Frankfurt-based central bank will “act appropriately” and has room to do so if the slowdown threatens price stability, which the ECB defines as inflation just below 2 percent in the medium term …

The inflation rate fell to 1.8 percent last month, beneath the ECB’s target for the first time since July 2007, according to the median of 20 forecasts given by economists before a report scheduled for release in the coming week.

“If, in our assessment, the risks to price stability change further in the coming months, monetary policy could be eased further and we will act appropriately…
Bank of America Corp. is among those anticipating the economy will be weaker than the ECB projects this year with a forecast for a 2.5 percent contraction. They expect the ECB to cut its benchmark to 1.5 percent this quarter…”

Also BOE recently cut its policy interest rate by 0.5% to 1.5% - its lowest in the 314 years history. It noted that consumer spending has “weakened” the outlook for investment has “deteriorated” and the availability of credit has “tightened further.” The fact that it did not cut more aggressively as US did it appears is because it feels that with GBP’s massive depreciation import led inflation will check deflationary pressures while helping its export economy. Also its fiscal stimulus package is to be supported by a deficit that would be about 8% of GDP. It may therefore did not move to ZIRP and has kept the rate based handle. Beyond ZIRP would be quantitative easing – BOE buying government debt and releasing money into the system – which it feels may accentuate the inflationary pressures. It is also possibly looking to go slow to see if it can avoid the pains of reversal of the quantitative easing (by not adopting it) when shooting interest rate could create different set of problems to handle.

Further moves by BOE and the UK government will be based on to what degree its slight optimism (as reflected in policy action) fails. As Economist explains:

“The outlook for 2009 is dispiriting. Despite the fillip from the temporary reduction in value-added tax, consumer spending will fall sharply. Households will retrench as unemployment rises and those with jobs fear they may lose them. Spending will be hit, too, by weak stock markets and shrinking housing wealth. House prices fell by 15.9% in the year to December, according to Nationwide Building Society.

The economy will also be clobbered by cuts in capital spending. Since the prices of homes still have a long way to fall, housing investment will remain depressed. Businesses are already cutting their capital programs, with more to come in the year ahead. Capital Economics is predicting that GDP will fall by 2.5% in 2009, the biggest annual decline in the past 60 years.

A common cause of these downward pressures on the economy is the banking malaise, which has undermined equity and property markets and curtailed the routine provision of finance to business. That makes it all the more ominous that banks are expecting to restrict credit still further. A survey by the Bank of England published on January 2nd found that lenders had reduced the availability of credit to both households and companies in the three months to mid-December and expected to curb it still further in the first quarter of 2009."

Reports say that after criticizing UK for its inane Keynesian approach, Germany is backtracking is likely to announce a stimulus (estimated at euro 50bn.) backed by deficit spending. This expert observes:

“But the modest deficit-spending will do little to prevent a contraction of 2-3% in Germany’s GDP and will add to government debt. Here there was a warning on Wednesday. An auction of 10-year government bonds met with poor demand. The Bundesbank retained a third of the bonds it had planned to sell. Longer-term interest rates may be driven up.

The warning might better be heeded by the US and UK than by Germany itself. Germany’s budget is close to balance. The UK and US have projected deficits of about 8% of GDP which might easily get worse. The UK government plans to sell £146bn in debt this year. Are investors ready to take it?”

Euro-Zone & UK’s show time is fast approaching.

Disclosure: No Positions

Copyright © 2008 Tradesense

Market Impact: 2009 Watch List – Part 10

When the US treasury bubble bursts….

What will dominate?

The good news: “…When the Treasury bubble does pop, it will likely be a sign that the economy is turning around and that credit is more available again, experts said. People will sell off their Treasury holdings because they think that stocks and corporate bonds will offer better returns….”

The Bad News: “... investors could lose money even on super-safe Treasuries. A swift increase in yields would send prices plummeting. For every 1 percentage point increase in yield on a 10-year note, investors would see a corresponding 7 percentage point drop in value…This would leave investors in a tough bind - either hold onto a note with yields that could be far lower than the market rates at the time or sell it at a steep loss.”

As Economist notes

“The dilemma is just as acute for government-bond investors. The example of Japan shows that bond yields can stay low for a long time. Ten-year yields of 1-2% could well be possible. But if Japan is not the template, then those yields will look ridiculous; we are heading for a world in which fiscal deficits are exploding and governments seem to be competing to depreciate their currencies. If 2009 does see an equity-market rally, it is likely to be accompanied by a government-bond-market slump.”

There are observers who feel this is not a bubble yet and that Fed will sustain this rally. Bubbles don’t happen when many call it so - the sign would be when a number of new treasury funds are floated.

As the rescue progresses the cost of government borrowing will increase (every one agrees that such huge amounts cannot be borrowed overnight) and that it may crowd out other borrowers is a real risk. It will also increase the interest cost for businesses which might also find liquidity tight once again. If the government limits the cost of borrowing than it puts a lid on how much stimulus and other packages can do.

Monitor how this tradeoff progresses.


Disclosure: No Positions


Copyright © 2008 Tradesense

Market Impact: 2009 Watch List – Part 9

What corporate bond market does?

Economist explains as to why corporate bonds should probably rally before a genuine rally in equities begins.

“A further dilemma is whether corporate bonds will rally before equities. That would seem logical, given that bonds have a prior claim on corporate profits. In addition, companies seem likely to run their businesses for the benefit of bondholders rather than shareholders, cutting dividends to save cash, for example…there may be a selection problem: weak companies have tended to borrow, and there are very few AAA-rated companies these days. Many of the most heavily-geared companies are in the portfolios of private equity groups, rather than on the quoted market.

Nevertheless, it is hard to see how stock markets can find a bottom if corporate-bond spreads are still widening. In turn, it is hard to see corporate bonds stabilizing without a return to some kind of normality in the money markets, with banks and companies able to borrow freely again (albeit not quite as freely as they did in 2006). So, Libor is the key to a market bottom.”

Explaining the point that corporate bonds should see a rally before a real move upwards in equities a CLSA report explains:

“It is unrealistic to expect any rally in equities without there first being a rally in corporate bonds. At the four great bottoms, the price of BAA corporate credit rose before the price of equities rose.

In 1948, bond and equity markets were distorted by government caps on treasury yields and excess-profit tax on corporate profits.”

Source: Business Week

Source: CLSA

However one has to wait and see how the corporate bond market responds to poor earnings and cash flow reports over the next two quarters. Surprises may call for downgrades and the corporate bond market may reassess the risks again and price it in. This obviously would be negative for the equities.

Disclosure: No Positions


Copyright © 2008 Tradesense

Market Impact: 2009 Watch List – Part 8

What are US Tips and Treasury yield spreads indicating?

By subtracting the yield of TIPS (Treasury Inflation Protected Securities) of a particular maturity from the yield of an ordinary Treasury note/bond of the same maturity, you obtain the implied annualized inflation over the time to maturity.

TIPS yield Curve (%)

Treasury Yield Curve (%)

Source: www.treasury.gov

As seen above the market is indicating a deflationary picture over the next five years. As of 5th January this expectation was over a 7 year period. How this expectation changes over 2009 will be interesting to monitor.

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Copyright © 2008 Tradesense

Market Impact: 2009 Watch List – Part 7

How the US savings rate grows?

“Americans are starting to save again rather than relying on capital gains to do their saving for them. The government says Americans set aside $260 billion from their disposable incomes in October, up from about $70 billion a year earlier. That's a step in the right direction for the long term, even though it intensifies the short-term downward pressure on the economy because consumers aren't spending.

The effort to save more amid weak income growth and tight credit will prevent consumers from providing their usual oomph to the recovery. As a result, businesses will not be as quick to expand.

The fall in oil and commodity prices saw disposable income improve and has pushed the savings rate to 2.8% which is an improvement from the 2005-07 figures of less than 1%. The refinancing of the mortgages at lower rates may also help in this process and can also be used to retire credit card debts."

Source: Business Week

This may appear as a negative factor from a consumer spending point of view as in many of the past downturns they have provided the push for recovery as they could borrow at low rates to lend. However in the current context given the individual leverage levels and falling income levels the psyche may not allow such a process.

Source: HSBC

The positive is that it will help soften the effect on the cost of stimulus that has to be paid at a future date. An increasing savings rate will help cushion the leverage risk that the US as a country has and is likely to see a substantial jump in the near future. Increase of this rate to the long term average of 7 to 8% will augur well for the future. How the US consumers tradeoff, is a must watch.

Disclosure - No Positions

Copyright © 2008 Tradesense

Market Impact: 2009 Watch List – Part 6

How US Retail landscape shape up?

“…This spending slump, which started in early 2008, has already claimed a number of retail casualties. Prominent national chains such as Linens 'n Things, Steve & Barry's, KB Toys, Whitehall Jewelers and Shoe Pavilion have gone out of business.

Still others such as No. 2 electronics seller Circuit City are barely surviving, hoping to find a lifeline while in bankruptcy protection.

But after suffering one of the worst year-end shopping seasons in decades - November and December combined can account for half of merchants' annual profits and sales - experts predict that many more chains will disappear.

The International Council of Shopping Centers estimates that chain store closings could exceed 3,100 in just the first half of the year…..another 73,000 stores will close in the first half of 2009."

Need to watch as to what happens to the bailout retailers are pitching for.

Disclosure - No Positions

Copyright © 2008 Tradesense

India's Enron - Satyam

Just a diversion from our watch list continuation as Indian market was hit by a scandal where a respected (till yesterday) Chairman of the company Satyam Computer Services (NYSE:SAY) resigned on Wednesday, saying profits had been inflated over the last several years. The Indian market tanked as a result and the Indian IT sector - specially the services sector, may see tremendous pressure. So will the Indian auditing/accounting fraternity. It appears India will soon have its own Sarbanes-Oxley equivalent.

The ramification of this is that there could be many other companies both in India and other markets that would have stretched itself due to peer pressure and Street pressure and have cooked their books. Now in times of stress many companies and promoters are not able to find the cash to continue hiding. While others who did well genuinely may be tempted to cook books in these times of stress.

In a sense this has watch list implication that we have been discussing. Look at the Audited Annual Reports due for 2008 carefully to find apparent signs of window dressing. Banks would be the most vulnerable.

Following is the text of his letter, which was released by the Bombay Stock Exchange.

Note: references using Indian numerical system of crores and lakhs have been converted to Western system.
-------------------------------------------------------------
To the Board of Directors
Satyam Computer Services Ltd.

From B. Ramalinga Raju
Chairman, Satyam Computer Services Ltd. January 7, 2009

Dear Board Members,
It is with deep regret, and tremendous burden that I am carrying on my conscience, that I would like to bring the following facts to your notice:

1. The Balance Sheet carries as of September 30, 2008
a. Inflated (non-existent) cash and bank balances of 50.40 billion rupees ($1.04 billion) (as against 53.61 billion reflected in the books).
b. An accrued interest of 3.76 billion rupees which is non-existent.
c. An understated liability of 12.30 billion rupees on account of funds arranged by me.
d. An overstated debtors position of 4.90 billion rupees (as against 26.51 billion reflected in the books)

2. For the September quarter (Q2) we reported a revenue of 27.00 billion rupees and an operating margin of 6.49 billion rupees (24 pct of revenues) as against the actual revenues of 21.12 billion rupees and an actual operating margin of 610 million rupees (3 percent of revenues). This has resulted in artificial cash and bank balances going up by 5.88 billion rupees in Q2 alone.

The gap in the Balance Sheet has arisen purely on account of inflated profits over a period of last several years (limited only to Satyam standalone, books of subsidiaries reflecting true performance). What started as a marginal gap between actual operating profit and the one reflected in the books of accounts continued to grow over the years. It has attained unmanageable proportions as the size of company operations grew significantly (annualized revenue run rate of 112.76 billion rupees in the September quarter, 2008, and official reserves of 83.92 billion rupees). The differential in the real profits and the one reflected in the books was further accentuated by the fact that the company had to carry additional resources and assets to justify higher level of operations -- thereby significantly increasing the costs.

Every attempt made to eliminate the gap failed. As the promoters held a small percentage of equity, the concern was that poor performance would result in a take-over, thereby exposing the gap. It was like riding a tiger, not knowing how to get off without being eaten.

The aborted Maytas acquisition deal was the last attempt to fill the fictitious assets with real ones. Maytas' investors were convinced that this is a good divestment opportunity and a strategic fit. Once Satyam's problem was solved, it was hoped that Maytas' payments can be delayed. But that was not to be. What followed in the last several days is common knowledge. I would like the Board to know:

1. That neither myself, nor the Managing Director (including our spouses) sold any shares in the last eight years -- excepting for a small proportion declared and sold for philanthropic purposes.

2. That in the last two years a net amount of 12.30 billion rupees was arranged to Satyam (not reflected in the books of Satyam) to keep the operations going by resorting to pledging all the promoter shares and raising funds from known sources by giving all kinds of assurances (Statement enclosed, only to the members of the board). Significant dividend payments, acquisitions, capital expenditure to provide for growth did not help matters. Every attempt was made to keep the wheel moving and to ensure prompt payment of salaries to the associates. The last straw was the selling of most of the pledged share by the lenders on account of margin triggers.

3. That neither me, nor the Managing Director took even one rupee/dollar from the company and have not benefitted in financial terms on account of the inflated results.

4. None of the board members, past or present, had any knowledge of the situation in which the company is placed. Even business leaders and senior executives in the company, such as, Ram Mynampati, Subu D, T.R. Anand, Keshab Panda, Virender Agarwal, A.S. Murthy, Hari T, S.V. Krishnan, Vijay Prasad, Manish Mehta, Murali V, Sriram Papani, Kiran Kavale, Joe Lagiola, Ravindra Penumetsa; Jayaraman and Prabhakar Gupta are unaware of the real situation as against the books of accounts. None of my or Managing Director's immediate or extended family members has any idea about these issues.

Having put these facts before you, I leave it to the wisdom of the board to take the matters forward. However, I am also taking the liberty to recommend the following steps:

1. A Task Force has been formed in the last few days to address the situation arising out of the failed Maytas acquisition attempt. This consists of some of the most accomplished leaders of Satyam:, Subu D, T.R. Anand, Keshab Panda and Virender Agarwal, representing business functions, and A.S. Murthy, Hari T and Murali V representing support functions. I suggest that Ram Mynampati be made the Chairman of this Task Force to immediately address some of the operational matters on hand. Ram can also act as an interim CEO reporting to the board.

2. Merrill Lynch can be entrusted with the task of quickly exploring some Merger opportunities.
3. You may have a restatement of accounts' prepared by the auditors in light of the facts that I have placed before you.

I have promoted and have been associated with Satyam for well over twenty years now. I have seen it grow from few people to 53,000 people, with 185 Fortune 500 companies as customers and operations in 66 countries. Satyam has established an excellent leadership and competency base at all levels. I sincerely apologize to all Satyamites and stakeholders, who have made Satyam a special organization, for the current situation. I am confident they will stand by the company in this hour of crisis.

In light of the above, I fervently appeal to the board to hold together to take some important steps. Mr. T.R. Prasad is well placed to mobilize support from the government at this crucial time. With the hope that members of the Task Force and the financial advisor, Merrill Lynch (now Bank of America) will stand by the company at this crucial hour, I am marking copies of this statement to them as well.

Under the circumstances, I am tendering my resignation as the chairman of Satyam and shall continue in this position only till such time the current board is expanded. My continuance is just to ensure enhancement of the board over the next several days or as early as possible.

l am now prepared to subject myself to the laws of the land and face consequences thereof.
(B. Ramalinga Raju)

Copies marked to:
1. Chairman SEBI
2. Stock Exchanges

Source Yahoo.co.in

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Market Impact: 2009 Watch List – Part 5

How the financial health of the Big Three progresses?

With a 35% drop in sales reported by the big three auto companies the financial stress on them has only increased further. This will have its impact on employment as production is reduced. According to NYT G.M.’s chief market analyst, Michael C. DiGiovanni, said that the automaker was predicting industry sales of 10.5 million to 12 million vehicles for the year.

They recently received federal loans which provided some confidence to the market. The US automaker bailout is trickier than it may appear. The conditions that have been imposed - as an expert observed - are “structured for bankruptcy”. By end of March they will to prove that they are viable. By this time they need to negotiate with their creditors to have their debt modified or reduced by two thirds at the minimum. They also need have new agreements with their vendors with new conditions more favorable to them. The compensation and benefits of workers and executives also needs to be lowered. Putting all this together they need to show that they are viable. And if they are unable to deliver they need to repay the loan. This, most observers doubt if can be achieved in such a short period. This would be then a pre-packaged bankruptcy. Their only hope is for Obama to show them leniency.

The key questions are:

Will a pre-packaged bankruptcy be considered to allow them to renegotiate their outstanding loans and work out better arrangements with their dealers and the United Auto Workers?

How much will government interfere in the running of their businesses?

How will the government make it easier for them to do business? E.g. addressing the fifty-state fuel economy and exhaust emission regulations.

Signs of how long the government is willing to stand by these companies given that the whole process to stabilize may require anything between 3 to 5 years and may require upward of $100 bn. over this period.

Will all three be supported equally or the government might want to weigh which has the best chance? It could impact many shareholders which are pension funds and college endowments. It could feed the unemployment numbers also in a big way.

Will a higher federal gasoline tax be imposed to make people move to more fuel efficient cars?

GMAC, the lending arm of GM received $6bn.rescue package which was received by the market with bullishness. As one expert summarized:

GMAC is however not so well capitalized for it to push lending in a big way. Fed while approving for it become a bank holding co. has also asked it improve its capital adequacy by raising $30bn. Of the $6bn., 1bn. is going to GM to subscribe to GMAC rights issue. It has 5bn. of TARP money. For the balance capital requirement (apart from the $9bn. it had as of September) it concluded a debt for debt-and-preferred exchange offer, the deadline for which it had to extend several times. It says enough bondholders swapped their debt for it to meet the Fed’s capital requirement, but that doesn’t leave it with a huge amount of excess cash to leverage into new loans, or act as a buffer against future losses. The fear is that it may have to make more trips to make to the government as it is still loosing money.

There is a fear therefore that GMAC may add to the taxpayer bill further and there a pre-packaged bankruptcy would be a wiser option.

Watch the events unfold keenly as it will have massive ramifications from a market point of view.

Disclosure - No Positions


Copyright © 2008 Tradesense

Market Impact: 2009 Watch List – Part 4

How Quickly US home prices stabilize?

Needless to say a very important factor as the genesis of the current crisis is attributed to the bubble this sector. It has seen a record decline of 18% in October08 on a year on year basis. As observed:

“The 20-city S&P Case-Shiller index has posted losses for a staggering 27 months in a row. In October, 14 of the 20 cities set fresh price decline records.

…Housing problems are at the core of our economic problems," … "yet, of the government interventions made during 2008, few were focused on housing."

Foreclosures have been worrisome

"October was really the first month to feel the full brunt of the credit crunch," ... "Up until the Lehman Brothers [bankruptcy filing on September 15], everyone felt relatively optimistic.

Plus, in many of the free-falling cities the majority of real estate sales consist of distressed properties such as foreclosed homes and short sales. These houses tend to sell at a steep discount to the rest of the market, and when they account for a large proportion of all sales, they can exaggerate the depth of price declines.”

Mortgage modifications have not helped

“…a recent report issued by the U.S. Comptroller of the Currency (OCC) found that 53% of borrowers who had their mortgages modified in the first half of 2008 were already at least two months delinquent again. The report covered 60% of the outstanding primary mortgages.

Modifications that don't involve some kind of principal reduction or somehow lower payments substantially "just don't work very well…We need to see lenders get much more aggressive when it comes to loan modifications.”

The effect of lowering interest rate need to reflect in new home sales

“…And although interest rates are currently extremely low - the 30-year fixed-rate averaged 5.14% … that's doing more to help people refinancing existing mortgages than it is to help new home buyers.

"Buyers still have to have a 20% down payment," … "and, in this environment, it can be hard to meet that criterion."

Experts observe that the tumble in homebuilding is expected to bottom out by midyear, but house prices will fall an additional 9.8% by yearend 2009, after a nearly 20% decline in 2008.

At the current levels the latent demand would surely be there. However no body would want to buy and see their equity go down. Therefore price stabiliszation would be the driver for home buying to start in right earnest. Keep you ears to the ground!


Copyright © 2008 Tradesense

Market Impact: 2009 Watch List – Part 3

How will US Unemployment rate pan out?

“…This to be seen in the context that consumer spending makes up about 70% of the U.S. economy, and as the credit crunch has dried up Americans' borrowing ability, they're relying on income more than ever for buying power, ...”

The Context:

“…While there was some cheer when the Labor Department said initial filings for state jobless benefits fell to 492,000 for the week ended Dec. 27, a decline of 94,000 from the 26-year high of 586,000 claims a week earlier as against economists expected jobless claims of 575,000 (according to a consensus survey by Briefing.com).

…It's the first time claims were below 500,000 since the week ended Nov. 1, when the government reported 481,000 initial claims. So far this year, job losses have totaled 1.9 million.

The prior week, which ended Dec. 20, saw the highest number of jobless claims since Nov. 27, 1982, when initial filings hit 612,000.”

The adjustments to this figure:

“…seasonal adjustments have become increasingly complicated, a problem compounded by abnormalities like extended auto plant shutdowns.

"All seasonal patterns are out of whack," … "We have to look at data over several weeks, and in that case you still see pretty large uptick in the overall trend."

Over the past four weeks, new unemployment claims have risen to an average of 552,250 a week, down 5,750 from the previous week's unrevised average of 558,000. The four-week moving average is designed to smooth out some of the week-by-week fluctuations in the statistics and provide a wider view of the job market.

The number of people continuing to collect unemployment benefits increased to 4,506,000 in the week ended Dec. 20, the most recent data available. That was a jump of 140,000 from the previous week's revised level.”

The key point to note is that:

“…periods of economic contraction usually occur one or two quarters before a labor downturn. That lag means "the ugly job state we've seen will likely be even more severe next year,"…

Last month, 60% of U.S. CEOs said they expected to cut workers in the next six months, according to the Business Roundtable.

Current expectation of official unemployment rate is expected to peak in the range of 8 to 9% by early 2010. One has to closely monitor any signs/indicators of the situation worsening or improving before the official figures reflect it.

Copyright © 2008 Tradesense

Market Impact: 2009 Watch List – Part2

When will credit flow start in right earnest?

Much of the funds infusion into the banks is being held as cash and is as large as $1 trn. While the credit situation has improved over the last two months it is still tight by relative standards. Banks coming out of this self imposed discipline will be the key to make money move/circulate. How much ever money the Fed pumps into the system unless it circulates the desired effect will not be there.

This reluctance to lend is both psychological (the anchoring of a recent experience) and strategic as these institutions, post infusion of funds, have probably just about restored their capital adequacy. Now they also have a fear that the projected recessionary/deflationary scenario will create loan losses and they need sufficient strength at that time to raise further capital to ensure capital adequacy. Also with the raging unemployment and falling real estate prices any further lending may lead to good money going after bad money.

In the current context, any sign of weakness will result in downgrade by other banks/institutions as counterparty risk will be considered higher. This has its own chain effect.

This then becomes a circular problem as inadequate credit availability in turn reinforces the recessionary/deflationary forces. The thrust required to move out of this orbit -the 'escape velocity' has to be provided by the stimulus packages and massive government spending. Assuming that these packages work and bring back employment and consumer spending, it will put businesses back into business and in turn improve the asset/loan quality of banks. This comfort will then give banks the confidence to lend in right earnest.

Also covering default risk in the CDS market itself has become risky and the only insurance that anyone would trust today is that of the government or if it government backed.

There are other implications too. As a NYT article observes

“A big worry is the future of securitization, a key mechanism of modern banking that enables banks to bundle loans and bonds into securities for sale to investors. This crucial market is moribund now that many of its creations have plunged in value. Some question when, or if, certain areas of securitization will revive.

Securitization, which works like a shadow banking system, has radically changed banking and the credit markets in recent years. Three decades ago, banks supplied $3 out of every $4 of credit worldwide. Today, because of securitization, that share has dropped to about $1 in $3.
Unless financial companies can securitize debt — which, in turn, depends on investors’ willingness to buy the bundled loans — credit will remain tight even if banks resume lending.”

Thus as and when the credit market unlocks the level of overall level of credit will not be the same as was experienced in 2006–07. The leveraging capability of all institutions will be drastically reduced either voluntarily and/or by market forces and/or by legislation. The aggressiveness to lend will be lacking. Modest growth objectives will be set. Many of the large banks have government in them and will find interference in the name of checks and balances.

How long will such packages take to show tangible results and provide the ‘escape velocity’ to the banks, given the political process (as touched upon in my previous post) is anybody’s guess?

Copyright © 2008 Tradesense

Market Impact: 2009 Watch List – Part1

In a background where top economist have given little credence to the idea that the U.S. economy is going to recover in the next six months over the weekend, I thought it may be appropriate to visit the important impacting factors that will shape the markets in 2009. The main focus of course will remain on the US economy. We start with the stimulus package that the market appears to be so bullish about.

How quickly will the US stimulus package be approved?

Source: Society Generale - Cross Asset Research

The stimulus package expected to be announced during this month is one of the key drivers of optimism today. Seasoned observers however feel that it will take a while before the package is passed and it will have its own speed bumps. Given the amount likely to be involved (estimates are close to a trillion dollars) the process they feel will be theatrical with a lot of face saving.

"…These debates typically play out with the party in charge seeking far more than it wants. Then it drops demands and both sides declare victory with a compromise. We expect this battle to play out that way as well..."

What kind of stimulus package is approved and how it relates to the assessed depth of the recession will be keenly observed. Remember nobody today has a clear idea how long the recession may last (current wise thinking is till mid 2009) or how deep it is likely to be. The nature of package will itself have a causative effect on the perception of the longevity of the recession/deflation.

How effective will it be?

The approval of the package is no panacea. There will be a number of issues to ponder over. The clarity of objective is very important, other wise one can loose the way easily. To quote:

“… to win a war, it's a good idea to map out or at least have a sense of the endgame before deploying the troops. That is, lawmakers must think about establishing yardsticks, curbs and deadlines for the money.

Otherwise, there's a risk that the historic recovery package morphs into a boondoggle that mortgages the nation's future by adding hundreds of billions to the deficit while creating a hard-to-tame bureaucracy.”

Obama is also aware of that this could turn out to be black hole and a clear exit strategy is required otherwise today’s momentary happiness will turn out to be a long term sorrow story. How the growth on spending once started will be controlled is far from clear.

"...We're going to be focusing on the budget, to make sure that even as -- in the short term, we deal with the potentially $1 trillion-plus deficit that we're going to be inheriting and we are trying to jumpstart the economy, that we're also in the medium and long term looking at how we can get on a path of fiscal responsibility and sustainability,…" - Obama.

Another key issue: How will success be measured? Employment will be a lagging indicator and may not allow for quick course corrections.

And the Challenge:

“…Allow politicians to take billions of dollars of your money and dole it out to other politicians, who then give it to other government administrators. All of whom ask you to trust that the funds will be spent wisely…”

Tax Cuts: How effective will it be?

“Generally speaking, economists say, permanent tax breaks boost the economy more. Why? Because consumers feel freer to spend it rather than save it since they know it's a sum they'll get every year.

Vice President-elect Joe Biden said last week the stimulus tax cut would be a "down payment on the tax relief that we promised for the strapped middle class." So the promise of permanence may have its own stimulus effect. But considering that Congress hasn't weighed in on the issue, there's no guarantee.”

What happens to TARP & its cousins?

A Market Watch report says

“…lawmakers are expected to enter a new round of wrangling over the uses of the $700 billion Troubled Asset Relief Program. The Bush Administration's decision to extend the financial system bailout money to automakers pushed total TARP payouts past $350 billion. The Treasury Department must now convince Congress, which is at odds over the best uses of TARP, to release the second half of the $700 billion.

The House Financial Services Committee will hold a hearing Wednesday on uses of the TARP. Separately, Treasury Secretary Henry Paulson is scheduled to speak on the government-sponsored mortgage agencies.”

The prediction is

"...by the time all is said and done, the Troubled Assets Relief Program (TARP) funding will go well beyond $700 billion. President Obama will request, and Congress will approve, another several hundred billion in aid. Much of that will go to homeowners, although airlines will probably get a slug of cash as will auto parts makers.”

Watch out for the black hole syndrome.

Copyright © 2008 Tradesense

Happy New Year!

Wish you all a wonderful and prosperous 2009.