Submitted by Leo Kolivakis, publisher of Pension Pulse.
It was a bullish start for markets on the first trading day of August. On Monday, the S&P 500 broke above 1,000 for the first time in nine months and the Libor rate dropped to a new record low.
I noted that Bank of America (BAC) keeps grinding higher and KeyCorp (KEY) seems to be breaking out now. Other stocks that caught my attention were Southern Copper (PCU) and the US Oil Fund ETF (USO) which also seems to be breaking out.
Watch oil and copper shares closely here. Any signs of a global economic recovery will drive the price of these shares much higher. There may be other things going on in oil market apart from pure speculation.
In an interview with The Independent, Dr Fatih Birol, the chief economist at the respected International Energy Agency (IEA) in Paris, said that the public and many governments appeared to be oblivious to the fact that the oil on which modern civilization depends is running out far faster than previously predicted and that global production is likely to peak in about 10 years – at least a decade earlier than most governments had estimated.
So on a bullish day for markets, it was interesting to read this Reuters article which states that FTSE 100 pension schemes turn to bonds as deficits soar:
Pension schemes sponsored by the UK’s top 100 firms have significantly upped their exposure to bonds since 2007, in what consultant Pension Capital Strategies said is the sector’s largest investment U-turn in over 20 years.
In the June year, FTSE 100 pension funds upped their bonds exposure to 49 percent, from 41 percent a year ago, PCS said on Monday, adding the 2009 allocation level was 40 percent higher than two years ago, when average bond exposure was 35 percent.
The shift towards bonds is partly due to growing concerns about provisions demanded by The Pensions Regulator, which is encouraging pension trustees to be increasingly prudent.
“In particular the regulator is seeking that when companies get into difficulties, the trustees should respond by toughening the assumptions used to calculate the pension scheme deficit,” PCS said in a statement.
It described the move towards bonds — and away from equities — as the pension schemes’ largest year-on-year investment about face in more than 20 years.
PCS estimated that by the end of the second quarter, FTSE 100 pension funds had accrued a 90 billion pound ($150.7 billion) deficit, up 82 billion pounds year on year.
“Within the next two to three years the large majority of pension assets will be in bonds as companies move towards the final end game of offloading pension liabilities and the winding-up of pension schemes,” PCS Managing Director Charles Cowling said in a statement.
Consultant Aon put the top 200 UK companies’ pension deficit at 72.8 billion pounds at end-July, warning that could spike to an unprecedented 110 billion pounds in the next few months.
PCS is a unit of Jardine Lloyd Thompson Group.
There you have it. Even though stocks are blasting higher, some pension plans are taking advantage to shift assets into bonds. Could this spell the end of the giant experiment?
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Makes The Equitable Life look prescient!
So much for all the talk of "money sitting on the sidelines" waiting to re-enter the stock market. Is this the mark of the top?
Leo:
Cogent, thought-provoking post.
The US public, which has been underinvested in bonds vs stocks on an historical basis, has been ignoring the stock runup and getting lots more money into bonds. Contrarians would say: therefore buy stocks; I suspect it's reversion to the mean, as your long-term data in the link suggest.
Could the heads of some of these pension funds believe as I do, and that is that the current run-up in commodities and equities prices is pure wind, having nothing to do with underlying values?
I liked what Tim Duy had to say today (see today's Links):
Incoming data continue to confirm the cyclical turn in the US economy. But that cyclical turn is supported by a massive amount of government intervention, in and of itself a testament to the fragility of the recovery.
I don't want to get into arguing about oil prices. I agree that the long-term prospects are great. But as Yves has pointed out here many times, the current supply and demand fundamentals do not support the current price. And don't most traders have a much shorter-term time perspective than 10 years? What makes the oil prices even more dicey is that OPEC (Saudia Arabia, forget about all the rest of the prodigal children) can intervene at any time to control supply, and that is a political decision, adding an extra layer of unpredictability.
But the decision on the part of the U.S. and other governments as to whether to continue the liquidity which is driving the equities and commodities markets is also a political decision. Stock prices are also heavily dependent on political outcomes.
As an example of just how disconnected the markets have become from any underlying value, let's take a look at an energy stock. I do this because in the past you have indicated that you look favorably upon energy stocks.
Let's look at Chesapeake Energy (CHK). At the end of 2008 the natural gas, Chesapeake's principal product, was selling for$5.61 per MCF. Chesapeake's stock at the time was selling for about $16 a share. Last week natural gas was selling for $3.40 per MCF. But in spite of the fact that the underlying commodity that Chesapeake sells has gone down by 40%, its stock price has increased by almost 45%, to today's price of about $23 per share.
Let's dig a little deeper. At the end of each calendar year and as part of the annual report, energy companies calculate and report what they call PV-10. PV-10 is the value of the company's proven reserves, in the case of Chesapeak almost 100% natural gas, multiplied by the selling price on Dec. 31, less projected future production and development costs, all discounted at a rate of 10% to yield the present net value of the company's proven reserves. Chesapeake had a PV-10 on Dec. 31, 2008 of $15.6 billion. The price used to calculate PV-10 was %5.61.
Chesapeake also reported $14.2 billion in debt.
(continued)
What do you think the PV-10 calculation would yield using $3.40 per MCF? It would fall disproportionately to the price of natural gas, a 40% decline, for two reasons:
1) Since many of the operating and development costs are somewhat fixed, they would not have fallen as much as the price of natural gas, and
2) Many of the reserves are proved undeveloped. That means that they are pretty sure the natural gas is down there, but the wells to tap it haven't been drilled yet. Since the cost to develop (drill) and produce those reserves is greater than $3.40 per MCF, it would be a losing proposition to drill those reserves at $3.40, so they can't be counted.
So Chesapeake's PV-10 could now be only $6 or $7 billion. But Chesapeake has $14.2 billion in debt. Sure, Chesapeak has some hedges in place. And sure, if one takes a look at Chesapeake's web page they cite all kinds of reasons why the natural gas price just has to recover by this time next year. But what if it doesn't? And by this time next year the hedges will be nearly all gone.
So, if natural gas prices don't recover by this time next year, what I see is a corporation in a world of hurt, with $6 or $7 billion in assets and $14 billion in debt, with not enough cash flow to service that debt.
A lot can happen in a year, but as of today there is absolutely no indication that the natural supply and demand situation is improving. The best indication of what is going on I believe is given by the storage data, because this incapsulate both supply and demand:
http://www.eia.doe.gov/oil_gas/natural_gas/ngs/ngs.html
As you can see, the natural gas in storage has broken out of its traditional range and just keeps getting greater and greater.
How many other independent oil and gas producers are in the same boat as Chesapeake?
How many companies in businesses other than oil and gas production are in the same boat as Chesapeake?
How many other companies are there that the only thing currently allowing them to pay their bills are their deriviatve positions?
And how many other companies, if the real economy doesn't improve before those derivatives play out, are going to be insolvent and not able to pay their bills?
"There may be other things going on in oil market apart from pure speculation."
We will see new weekly figures tomorrow, but the last ones for July 24 showed a surplus in US inventories of 51.5 million bbls. So yes, forget greenshoots, forget peak oil, the current price of $71.54 is all about speculation and is twice what it should be.
As for the IEA, they have been notoriously slow off the mark in terms of peak oil. Peak oil is not 10 years off. Peak oil is now. It just happens to be a plateau. Something in the 85-87 million bbls/day is about the best we can hope for and even then the decline off the plateau will probably hit considerably sooner than 10 years.
Downsouth, I don't really follow natural gas, but it is my understanding that last year Levin got an amendment passed that increased reporting requirements in that market and this may have eased off speculation in it. In a "screwup" which may not have been a screwup, Levin failed to include oil markets in his bill so opacity and speculation still reign there.
As for the Saudis, they have cut back some in their output but last year when oil spiked there was the myth going around that all the Saudis needed to do was open up the spigots and flood the market to bring down prices. The problem is that Saudi overcapacity is vastly overstated. Last year they had only a limited excess capacity to draw upon and most of that was tar-like sludge. And of course as we see in this year's speculative spike, even an oil glut has no effect on prices.
Add to this that oil companies are playing games with refineries and it looks like everyone is in to make a quick score off a battered, and fearful public.
There is a lot of speculative fervor driving energy prices higher but all that liquidity has to find a place somewhere, be it energy futures or alternative energy stocks.
So while some pension funds are moving into bonds, others are stuck chasing equity indexes much higher.
cheers,
Leo