Tuesday, June 10, 2014 - Equity Party in the Wormhole

Equity Party in the Wormhole
by Sinclair Noe

DOW + 2 = 16,945
SPX – 0.48 = 1950
NAS + 1 = 4338
10 YR YLD + .02 = 2.63%
OIL - .22 = 104.19
GOLD + 7.90 = 1260.90
SILV + .13 = 19.29

The Dow Industrial Average hit another record high close; the fourth consecutive record. How did the Dow manage to move higher? Who knows? It wasn’t a big move but any positive results in a new record. How now Dow? Maybe it has something to do with the Federal Reserve and the other central bankers vacuuming up all the toxic detritus from the world of finance, pushing rates to sub-zero; leaving investors with little choice but a move to equities. Maybe global corporations have found a way to squeeze extra value out of a bone dry economy. Maybe the major indices have entered a cosmic wormhole devoid of common sense.

Today’s case in point is Uber, which is an app designed to connect riders with cars and drivers; which sounds a lot like hailing a taxi, but this is different because you can hail the taxi and pay the taxi with your smartphone; which means it’s software that eats taxis. Uber is different mainly because it is worth about $18 billion; which means it is worth more than most of the companies in the S&P 500 index. It’s an equity party, and for now at least, nobody is turning out the lights.

Friday’s jobs report was run of the mill; the economy added 218,000 jobs and the unemployment rate held steady at 6.3%. Today, we get a positive follow-up from the Labor Department, saying there were 4.7 million hires in April, the most since June 2008. By comparison, before the financial crisis, we averaged about 5.04 million hires per month. And workers’ opportunities look to be improving, too. There were 4.46 million job openings in April, the most since September 2007, up 17% from a year earlier.

OPEC is meeting in Vienna this week. The oil production cartel, which controls about 40% of global oil supplies, has imposed a 30 million barrel-per-day production ceiling for all 12 members’ output for the last two years. And the current price range of $100 to $110 a barrel seems to be the sweet spot; not too high to reduce demand; not too low to cover costs and national budgets. North American crude oil production is expected to be a major topic of discussion.

Estimates of North American oil supply have increased to 18.5 million barrels a day from 18.2 million six months ago, driven by US production at 11.4 million barrels a day. In 2012, the International Energy Agency (IEA) forecast that the US would outpace Saudi Arabia in oil production thanks to the shale boom by 2020, becoming a net exporter by 2030. The forecast was seen by many as decisive evidence of the renewal of the oil age and the end of peak oil. Not so fast.

This week, the IEA released its World Energy Investment Outlook which says that US oil production, drawing largely from the Bakken in North Dakota and the Eagle Ford in Texas, will peak around 2020 before declining. The US government’s Energy Information Agency recently downgraded its assessment of the Monterey Shale oil fields by 96%. The shortfall will make the US, and countries in Europe looking to import from America, increasingly dependent on Middle East supplies.

The report states: "… there is a risk that Middle East investment fails to pick up in time to avert a shortfall in supply, because of an uncertain investment climate in some countries and the priority often given to spending in other areas."

The IEA report reveals that over 80% of oil company investment is going into making up for exhausted fields where production is in decline. The agency also calls to ramp up investments in renewables and increasing efficiency, along with regulatory reform to incentivize investments, as part of the package. This is where we are headed.

Warren Buffet’s Berkshire Hathaway has been expanding its utility business in Nevada and Canada; and Buffet plans to increase the investment in renewable power. At the Edison Electric Institute’s convention in Las Vegas yesterday, Buffet said, “We’ve poured billions and billions and billions of dollars in retained earnings, and several billion of additional equity, and we’re going to keep doing that as far as the eye can see.”

Berkshire Hathaway Energy has $70 billion in assets and more than 8.4 million customers worldwide, according to its 2014 brochure. It has more than 34,000 megawatts of power generating capacity owned or under contract. Wind, solar, hydro, geothermal, and other renewable plants account for about a quarter of capacity, representing about $15 billion.

Yesterday Buffet said: “There’s another $15 billion ready to go, as far as I’m concerned.” Unlike other utility-holding companies, Berkshire Hathaway Energy retains all of its earnings. That probably will continue, Buffett said yesterday, estimating that the unit could reinvest about $30 billion into its business in the next decade.

Investments in renewable energy will be needed as the US seeks to reduce its reliance on fossil-fuel generation. Electric utilities face cuts of 30% in carbon dioxide emissions by 2030 compared with 2005, based on proposed regulations issued by the EPA on June 2.

Yesterday we talked about a Merger Monday. It has been a busy year for mergers and acquisitions. Some of the deals are all cash, as many corporations are sitting on piles of cash; but many deals are still done the old fashioned way, with leveraged lending. The Wall Street banks are more than happy to overload companies with too much debt for the simple reason that it is one of the most profitable forms of loans for the banks. Banks’ fees on US junk-rated loans stand at $4.9 billion so far this year, a year-to-date record and up 10% from the same period last year.

The Federal Reserve, the Office of the Comptroller of Currency, and the FDIC have issued guidelines to restrict banks making loans in deals like leveraged buyouts that would leave a company with debt levels that are more than 6 times its annual cash flow. Wall Street banks immediately started looking for loopholes, and the newest trick is to issue bonds that would split the overall debt load between a holding company and its operating subsidiary.

Companies typically borrow at the operating company level through loans. Since the loans can be secured against the company's assets, they are cheaper than other options. They can also borrow through the holding company by issuing bonds. Payments on those securities are made from the cash that remains after the liabilities of the operating company are met, making them riskier than operating company loans.

Many holding company bonds are structured as payment-in-kind (PIK) notes that pay interest by adding to the outstanding principal rather than returning cash to the bond's holder. Such bonds are expensive for the issuer and the risk involved makes the investor universe limited, but the market has been growing as investors chase yield.

We’ve seen this story before. You may recall the case of the $48 billion leveraged buyout of Texas power utility Energy Future Holdings in 2007, the biggest LBO in history. The deal's $40 billion debt was equal to 8.2 times adjusted EBITDA (earnings before interest, tax, debt and amortization). Energy Future filed for bankruptcy earlier this year, one of the largest bankruptcy cases ever.

For now, the banks are violating the 6 times annual cash flow limit, most of the time, but it’s a tactical decision. Three longtime banks for private equity firm KKR snubbed a request for a $725 million buyout loan for Brickman over concerns it was too risky to pass muster with US regulators, in spite of the firm’s strong track record of leveraging up and then reducing debt quickly. Others banks are trying to guess how big the fines could be, and weighing that up against the fees for underwriting such deals.

Welcome to the wormhole.