David Merkel

About the Author David Merkel

David J. Merkel, CFA — 2010-present, I run my own equity asset management shop, called Aleph Investments. I manage separately managed stock and bond accounts for upper middle class individuals and small institutions. My minimum is $100,000. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. From 2003-2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm, to the delight of employees there. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

Too Many Vultures, Too Little Carrion, Redux

I was surprised to find that I wrote another piece with the same title — 8.5 years ago, before the housing bubble crashed.  It was a short piece (with dead links).  Here it is:

I had a cc post over at RealMoney called Too Many Vultures, Too Little Carrion . The idea was that there’s too much money ready to rescue dud assets at present. Yesterday, Cramer had his own blog entry suggesting that the absorption of subprime assets at relatively high prices implied that the depositary financial sector is a sound place to invest. I disagree. In the early phases of any secular change, there are market players who snap up distressed assets, and later they find out that they could have gotten a better bargain had they waited.

The good sale prices for subprime portfolios is not a sign of strength, but a sign that there is a lot of vulture capital looking for deals. The true problems will surface when the vulture capital gets burned through or scared away.

That last paragraph is the “money shot.”  When there is too much vulture capital waiting to invest in distressed securities, marginal business concepts don’t get destroyed, clearing the way for a reduction in capacity, and healthy firms pick up the pieces.  At such a time, you have to wait until the distressed players get hosed, or get smart.

Today’s topic is the debt and equity of companies producing energy, or providing services to them, all of which get hurt by a lower oil price.  In the recent past, you have had marginal energy companies able to get financing amid decreasing opportunities for decent profits.  Thus the article at the Wall Street Journal talking about hedge funds losing money on recently placed bets on energy.

Aiding the financing of marginal companies can pay off if the companies will be profitable within a reasonable window of time, or, if you are trying to buy assets cheap for a reorganization.  But if there is too much capacity, and thus low prices for products, the profits after financing may never emerge, and the value of the assets may sag.

Let me talk about another group of oil companies on the global scene.  They are relatively high cost players with large-ish balance sheets that are presently pushing to recover market share.  Yes, I am talking about OPEC countries.  Not the national oil companies of those countries, but the countries themselves.

Think of the countries as the companies, because the companies themselves fund the government of these countries.  Consider this quotation from the Bloomberg article to which I linked, regarding one of the stronger OPEC countries, Saudi Arabia:

Saudi Arabia, the main architect of OPEC’s new strategy, will have a budget deficit of 20 percent of gross domestic product this year, the International Monetary Fund estimates. While the kingdom has been able to tap foreign currency reserves and curb spending to cope with the slump, financial assets may run out within five years if the government maintains current policies and prices stay low, the IMF said Wednesday.

Less wealthy OPEC members have even fewer options. The threat of political unrest is mounting in the “Fragile Five” of Algeria, Iraq, Libya, Nigeria and Venezuela, according to RBC Capital Markets LLC.

Think of the budget deficits that the OPEC countries have to fund in the same way you think about the debt service of a US E&P company.  The deposits of oil being produced may be low cost in and of themselves, but any profits go to cover debt service of the greater enterprise, and whatever is not covered, more will be borrowed, should the markets allow it.

What’s the longest that this game could be played?  Never say never, but I would be shocked if this could continue  to 2020.  That said, there are a lot of OPEC countries that won’t make it that far, and a lot of E&P and services businesses that won’t make it that far either.  Now, the countries could face severe political turbulence, but eventually, they will have to reduce what they borrow and spend.  That doesn’t mean the oil stops flowing, though a new government could decide to cut spending further, and save the patrimony (crude oil) for a better day.

The free market oil producers are another matter… they can go under, and production would likely stop.  The question is what side of the solvency line you end up on when enough production capacity is eliminated.  If you are still solvent, you will reap some reward for your fiscal rectitude as prices rise again, and the Saudis breathe a sigh of relief, congratulating themselves for winning a very expensive game of “chicken,” or, a Pyrrhic economic war.

As such, be careful playing in heavily indebted companies that benefit from higher energy prices.  That they are limping along should be no comfort, because those that they presently rely on for financing will eventually have to give up, much as those snatching up bargains in subprime had to give up when the financial crisis hit.

And for those watching the price of crude oil, this is yet another reason why Brent crude should remain near $50/bbl, for a few years.  It is the uneasy equilibrium where producers are both entering the market and giving up.  The Saudis don’t want it much lower — there are limits to the pain that they want to take, as well as impose on the rest of OPEC.