Sunday, 29 April 2012

China and the Middle Income Trap

An earlier post made the point that China, with a $7.2 trillion economy, no longer requires double-digit GDP growth to generate momentous amounts of economic growth - 6-7% will do just fine.  It isn't written in the stars, however, that the Middle Kingdom will enjoy that rate of growth over the medium to long-term.  One key threat to steady, sustained growth is the difficult transition to a mature economy, while avoiding the dreaded "middle-income trap" that has ensnared many fast-growing countries in the past.
China's economy has grown at 10% per year since the late 1970s by following a fairly simple formula: increasing inputs, especially labor and capital, and throwing them at an underdeveloped economy.  Moving hundreds of millions of people from the countryside into cities, and creating a modern industrial economy, required herculean capital expenditures.  Roads, railways, ports, buildings, dams, office towers, houses, apartments - constructing all of this architecture over the past three decades has been an amazing feat.  But half of China's population is now urban, and today's staggering levels of government spending cannot continue forever. 
However populous its citizenry, however vast its geography, China doesn't require infinite investment.  For the past 8 years, fixed asset investment has increased by a stunning 40% per year (1).  It now appears that some capital investment is motivated less by necessity and more by an effort to stimulate the economy.  This year, the government plans to build 5 million affordable apartment units, with a goal of reaching 36 million by 2015 (2), partly to keep growth from stalling.  Over the next decade or two, China must transition to an economy that's driven less by investment, savings and exports and more domestic demand.
There is reason for cautious optimism that China may be able to manage the transition.  First, the government fully understands the need to restructure the economy.  In fact, the government has been willing to limit unrestrained growth by raising interest rates and increasing banks' capital requirements, for example.  Second, several important market pressures are pushing in the same direction.  For example, wages and land prices, two key components of China's cost advantage, have increased sharply.  This will force labor to become more skilled and productive.  In addition, China's artificially low currency creates unwanted inflation and unhappy trading partners, but enables cheap exports; as it rises, it will increase consumption and decrease exports.
The transition requires increasing consumption even as investment as a percentage of GDP falls.  This will be tricky, but there is some low-hanging fruit.  For one, the country could put in place a more helpful social safety net, especially in the areas of health and education, so citizens spend more money instead of squirreling it away to guard against unforeseen developments.  This is helped by rising wages, which are a cost to employers, but income to employees.  With over $3 trillion in reserves, low deficits, and manageable overall debt, China also enjoys flexibility.  From today's relatively high interest rates, there is room to ease monetary policy, as well.
In a country as large, complex and fast-moving as China, it's difficult to make accurate predictions.  The country, to be sure, faces challenges.  Cutting unsustainably high asset investment while maintaining growth won't be easy, and there's a bubble in some areas of the property market.  However, the government has deftly managed the economy in the past, and is alert to the problems of the present and future.  Though this doesn't ensure success, there is hope that China can join neighbors Japan and Korea in the ranks of developed countries.  Let's hope the nickname "Middle" Kingdom continues to refer to geography, not income.
(2) Ibid

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Friday, 27 April 2012

Peter Tertzakian's ARC Energy Charts

ARC Energy Charts, produced and distributed - for free - each week, is among the most useful and timely sources of information about North America's energy industry.  The journal is largely the work of Peter Tertzakian, who serves as Chief Energy Economist of ARC Financial Corporation, and is the author of two highly-regarded books on energy-related issues.
Each edition, in the form of a PDF file, runs about a dozen pages, and includes:
  • A commentary summarizing recent trends and developments in the world of energy;
  • A table of statistics that includes year-to-date information on equity markets, and a variety of data on different grades of oil and natural gas;
  • A fascinating map that illustrates the North American natural gas grid;
  • An illustration of the investment, production costs and cash flows in the Canadian energy market, accompanied by related data;
  • About 50 charts that contain information about commodity price trends, currencies, differentials, inventories, consumption, rig counts, weather etc. 
In short, the journal provides a comprehensive range of data on North American energy.
As far as I can tell, most or all of the raw information is derived from other sources, but the journal is a handy way to get it in one place, and will save grateful readers from the hassle of collecting the data themselves.
To sign up for weekly delivery via email, visit

Update: As of mid-May 2012, Tertzakian began writing a regular column for the Globe and Mail.  His work can be found here.

Disclaimer: The host of this blog shall not be held responsible or liable for, and indeed expressly disclaims any responsibility or liability for any losses, financial or otherwise, or damages of any nature whatsoever, that may result from or relate to the use of this blog. This disclaimer applies to all material that is posted or published anywhere on this blog.

Thursday, 26 April 2012

China - A Hard Landing?

Investors have become almost obsessed with China's growth, jubilant when economic news is good, despairing when it's anything less than dazzling.  In part, this is understandable.  Since the brutal 2008-09 recession, US growth, though steadily positive, has been sluggish.  The Euro zone appears to be caught in the second dip of a double-dip recession, albeit this time a mild one.  Against this backdrop, China and the rest of the up-and-comers from the developing world are providing robust and reliable growth that is powering the world economy.
Skittish investors now fear that a main engine of global growth is slowing, with potentially dangerous consequences.  Responses ranged from disappointment to mild panic recently as China's first quarter GDP growth slowed to 8.1%.  Worse yet, the government has officially reduced its long-term growth target from 8.0% per year to a more manageable 7.5%.  Bear in mind that China has long grown significantly faster than its stated target.  Even taken at face value, though, are these more modest rates of growth really so vexing?
Perhaps not.  According to early estimates from the IMF, China's 2011 GDP was $7.3 trillion (USD) (1). From that base, even 7.5% growth, well below first quarter performance, would produce about $550 billion in added economic activity in 2012.  As a reference point, just this new growth is about the size of Sweden’s economy, and larger than the entire economies of Taiwan, Austria and Argentina.  Just four additional years at the same rate of growth and GDP in the Middle Kingdom will have ballooned to about $10.5 trillion by 2016.  Given how massive China’s economy already is, any sustained growth rate above 5-6% will ensure incredible opportunities for business, governments and workers.   Is that such a hard landing?   

Source: (1) IMF: World Economic Outlook Database, April 2012

Disclaimer: The host of this blog shall not be held responsible or liable for, and indeed expressly disclaims any responsibility or liability for any losses, financial or otherwise, or damages of any nature whatsoever, that may result from or relate to the use of this blog. This disclaimer applies to all material that is posted or published anywhere on this blog.

Tuesday, 24 April 2012

ATP Oil and Gas - Value or Value Trap?

Put simply, ATP Oil and Gas is wildly, grossly, shockingly undervalued...if it doesn't go bankrupt.  How high is the value?  How big is the "if"?
The Value
Most oil and gas producers trade at or near their net asset value (NAV) over time (NAV is typically defined as the dollar value of 2P reserves, plus cash and investments, minus long-term debt).  In ATP's case, however, there's a Grand Canyon-sized gulf between NAV and market value.  At year end 2011, ATP's 2P reserves were valued at $7.3 billion, NAV was about $4.4 billion, while market value is presently a mere $325 million or so.  NAV is around $85 per share, but the shares currently change hands for under $7.  What accounts for such a striking discrepancy?  In a word: debt.
Debt - The Big "If"
The company's debt load is crushing, and it's accompanied by large interest payments.  At year end 2011, overall debt was $2.935 billion, with net debt at $2.882 billion.  Interest expense for 2011 was $299 million.  The large amount of debt includes the confusing presence of royalties and overrides, which many investors detest.  Fortunately, the vast majority of the company's debt doesn't come due until 2015, and the obligations have no significant maintenance covenants.  The royalties and overrides pay out over time as the company produces.  Though expensive, they have the advantage of transferring some risk to third parties, and they don't mature in a large chunk as bonds do.  As long as ATP remains current on its interest payments, management has several years to resurrect the company and its stock.
From Here to 2015
At current production levels, the company stands no chance of retiring its debts, which would leave it with a range of bad options, including a massively dilutive equity financing or even bankruptcy.  But current levels of production are poised to jump sharply, and soon.  Indeed, there are several near-term catalysts, and the company's long-term future will become much clearer over the next year.
The Catalysts
1) Increased production from existing wells
At the recent IPAA conference, the CFO said that the company expects 4-7 mboe/day of incremental production in Q2 2012 from two workovers at existing wells.
2) Monetization of Octabuoy Platform
Management believes they will sign a deal in the next couple of quarters to monetize the Octabuoy platform, which is currently being constructed and is expected to be deployed in the North Sea in 2014.  The company has suggested that a deal could be worth several hundred million dollars.
3) New production at Clipper
Of the soon-to-come catalysts, new production at Clipper will have the biggest impact.  Better still, the odds of success on schedule are high: after all, the two wells are both drilled, completed and have been tested at 16.2 mboe/day (62% oil).  The company expects the wells, which will be tied into a third party production platform, to come online early in Q4 2012.
4) New production at Gomez
Drilling is predicted to begin on two wells at Gomez starting in late 2012, though they're largely first-half 2013 events.  Each well is estimated to produce 5 mboe/day.
If all of these efforts are successful, in about a year ATP will be a transformed company.  It would presumably be producing about 50-55 mboe/day.  Assuming the lower end of that range, and a $50 netback, the company could be earning $900 million in cash flow (pre-tax).  This figure is well above ATP's ongoing capex program, which will allow the company to begin paying down its heavy debt burden, and would "unlock" some of the interest payments and convert them to cash flow.  At minimum, the enhanced financial strength will likely allow ATP to refinance its debt, likely at a more palatable interest rate.
On surer footing, the company will be able to develop its properties at Entrada in 2013-14.  In 2014, the company will begin production at Cheviot in the North Sea.  Peak production at the Octobouy platform is expected to be 25 mboe/day of oil, plus 50 mmcf/day of gas.  If current exploration in Israel yields results, there will be tremendous potential in the future.  Though exploration brings high risks, especially for a company that usually only develops proven reserves, success could add significant reserves and production.  Indeed, the company believes it could double current reserves.  CFO Al Reese has said the company expects production to reach 80 000 boe/d by 2015.  Assuming a $50 netback, ATP would be generating $1.46 billion in CF per year (pre-tax) at that rate.   
If all goes according to plan, where could the company be by the end of 2015?  Assuming a modest 6x multiple on CF of $1.5 billion, ATP would command an enterprise value of $9 billion.  Assume further that the company still owes $1 billion in net debt, leaving it with a market value of $8 billion.  Assuming 64 million shares outstanding (up from 51 million today), the company's share price would trade at $125.  This is high, to be sure, but not outlandish.  After all, the other customary measure of value, NAV, currently values the company at $85-90/share, on the present 51 million share count.
The Smaller "If"s
For this "road map" to lead to a financially sound business and a high-priced stock, many things must go right; more accurately, many things that can go wrong must not.  Some of the "if"s that might go wrong include: hurricanes in the Gulf of Mexico, which can disrupt both drilling and existing production; the chance that another prominent spill occurs in the Gulf and cannot be swiftly contained; regulatory, legal and compliance challenges; the inevitable technical difficulties of drilling in the deepwater; swings in commodity prices; macroeconomic and financial turmoil etc. 
These potential pitfalls are not hypothetical, either: all of them have already affected the company, and in a big way.  In fact, these past few years the company has been living "Murphy's Law," where everything that can go wrong, does.  Still, the almost-in-the-bag catalysts, if realized, will buy time and flexibility to withstand the inevitable future challenges.  Offering further safety, the company could partially monetize its other two platforms (both have already been partially monetized), sell reserves, bring in partners etc.
To Invest or Not to Invest?
In my judgment, the odds that ATP files for bankruptcy by 2015 are less than 25%.  Being very conservative, however, let's assume that they're 1 in 2.  If the company executes, and enjoys a little good luck, as outlined above, the stock could realistically reach $125 over several years.  For safety's sake, assume a more modest $75, though.  Using those assumptions, and adjusting for risk, what's the stock worth?  A 50% chance of gaining $68.50 ($75 minus the current $6.50 share price) is worth $34.25, minus a 50% chance of losing the entire $6.50/share ($6.50 x .5=$3.25) = $31.  A nearly five-for-one return over several years would be welcome in anyone's portfolio.  But beware: ATP is an all-or-nothing stock, and there is a real chance that it could plummet all the way to zero.
Disclosure: At the time this article was published, the author was long ATPG stock and options

Sources: ATP 2011 10K, Corporate Presentations, available at

There's ongoing commentary on ATP Oil and Gas: a first quarter 2012 update; the arrival of a new CEO; the abrupt resignation of the new CEO; exploration success in Israel; workover success at Telemark; renewed fears of bankruptcy; imminent bankruptcy

Disclaimer: The host of this blog shall not be held responsible or liable for, and indeed expressly disclaims any responsibility or liability for any losses, financial or otherwise, or damages of any nature whatsoever, that may result from or relate to the use of this blog. This disclaimer applies to all material that is posted or published anywhere on this blog.