Revisiting Greek negotiating positions and more comments on capex and interest rates
This post will be a brief revisiting of three recent topics – Greece, oil capex, and Anglo-Saxon bond yields – due to recent news. The recent news reinforces my position regarding the potential for a deal in Greece. On capex reduction, the recent news in the oil sector is favourable to more benign outcomes but it does highlight the gravity of the situation. Finally, the interest rate cut in Australia highlights my view that Australia and New Zealand’s bond yield offer good risk/reward given the room for further cuts down the line.
First, on Greece, I wrote that the agreement we could see has two parts to it:
- No debt writedown: only maturity extensions and interest rate reduction. From the Troika perspective, a principal reduction looks to be a non-starter. Finland has said so, and the Germans have said so. They do appreciate that the vast majority of Greek debt is in public hands, meaning that contagion from a writedown may be limited. But I don’t think the ruling coalition in Germany could get approval on this in parliament or in opinion polls.
- Back-loaded austerity: although stimulus is the opposite of austerity, Syriza could still get some stimulus in the short-term if they commit to reforms and a plan that has the deficit and debt numbers moving toward the Maastricht criteria over time.
What the press is now reporting is a move in this direction. Here is the FT on the new Greek negotiating stance:
Mr Varoufakis told the Financial Times the government would no longer call for a headline write-off of Greece’s €315bn foreign debt. Rather it would request a “menu of debt swaps” to ease the burden, including two types of new bonds.
The first type, indexed to nominal economic growth, would replace European rescue loans, and the second, which he termed “perpetual bonds”, would replace European Central Bank-owned Greek bonds.
He said his proposal for a debt swap would be a form of “smart debt engineering” that would avoid the need to use a term such as a debt “haircut”, politically unacceptable in Germany and other creditor countries because it sounds to taxpayers like an outright loss.
The FT article is couched in pseudo-moralistic terms, suggesting that Varoufakis is taking an excessively confrontational approach which is rattling his negotiating partners and reducing Greece’s maneuverability. This is complete rubbish, of course. After all, I told you a month ago that a deal of exactly this nature was possible even before the show I produce spoke to Yanis on air. Here’s the verbatim quote from January 9th.
The second scenario is one in which Syriza wins and Greece negotiates a restructuring. I’m calling this the ‘Olli Rehn’ scenario because Rehn is the first European politician to voice support for this outcome. What I’ve been hearing is that some Troika debt interest rates could go as low as 0%, depending on targets that Greece hits in terms of its Troika program. The point here would be to rule out principal reduction, in particular because it would mean a loss of capital at the ECB and there are still huge political issues around the ECB’s taking losses. Losses on existing debt would expose the ECB to criticism that it was reckless when it bought Greek bonds during the initial crisis wave. And principal losses would also raise the recapitalization issue in Germany because a weaker central bank capital base is unacceptable politically to large parts of the European establishment. As a result of these political issues, lengthening maturities and reducing interest rates is the likely negotiating area.
Below is a video clip of the full interview we conducted with Yanis Varoufakis three days later – an interview that left me with the impression a deal was still available.
The FT article, then, is a perfect example of a biased media account, where the media insert their own bias into reporting a situation, altering the complexion of what we understand about a situation. Our role is to take in the facts and discern what likely outcomes are for investing and other decision-making. Reporting of this kind makes that job trickier. I think you should be very sceptical of all media accounts regarding Greece because this situation is fraught with a great degree of moral tension with many interested parties. The reality, however, is that some sort of agreement should be reached because the best alternatives to a negotiated agreement are very bad. No agreement means someone screwed up negotiating.
As I put it last week, “in the Greek situation, the alternatives for the Troika and the Greek government are very poor indeed. And this ensures that both parties will be willing to negotiate no matter what the starting position of the other side may be. Both the Greek government and the Troika interests know this and have made extreme statements, suggesting there is a red line that will blow up agreement. I believe this is just posturing because it is each party’s best interest to make a stark statement, knowing that negotiations are inevitable and unavoidable. This is not a reflection on what can actually be achieved in a negotiated agreement.”
On oil capex, what I wrote yesterday is that actual oil production falls are limited by the need of producers in North America to service debt. Elsewhere, oil production falls are limited by the need of various political regimes like Russia, Saudi Arabia, Venezuela and Nigeria for hard currency and for budgetary reasons. Perversely, the magnitude of the fall in prices decreases revenue so much that it increases the need to pump at full capacity. This is because budgets were predicated on much higher oil prices and countries need every penny they can get in the short-term until they can adjust their outlays to the new situation.
Capital expenditure is where the decrease in future production will come. And given the steep well decline rates in North American shale operations, we will see some decline in production even if we don’t hit shut-in levels south of the present oil price. Reuters produced a chart showing that oil and gas capital investment cuts are the sharpest since 1987.
In the last week we have seen a number of majors announce steep capex reductions – Gazprom, BP, Shell, Chevron and now also CNOOC:
CNOOC, the mainland’s dominant offshore oil and gas producer, has slashed this year’s project spending budget by 26 to 35 per cent from last year’s estimated outlay and vowed to cut costs and boost efficiencies after oil prices tumbled sharply.
It has budgeted 70 billion to 80 billion yuan (HK$88.9 to HK$101.6 billion) of spending on exploration, resource development and production, down from its estimated spending for last year, it said in a statement.
“With the decrease in capital expenditures, the company expects to achieve the whole-year targets by cost control and efficiency enhancement,” it said.
It has set a target for oil and gas production to reach 475 million to 495 million barrels of oil equivalent (boe) this year, 10 to 14.6 per cent higher than around 432 million boe achieved last year. Its target for last year was 422 million to 435 million boe.
Again, notice that capex reductions are not actually cutting production. They are decreasing the increase in production. What we are seeing, then is an end to new projects based on the high oil prices of the last decade. Production from conventional sources is not diminishing. The question then becomes, where is demand growth headed and how will the intersection affect oil prices over the near-term. I believe prices will stay relatively low, at least below breakevens for many shale producers in the $60-90. Any level below $80 a barrel is a tipping point that means defaults and debt restructuring. And the further we go down from $80, the worse it gets. Prices at this level for all of 2015 would be a catastrophe. $60 a barrel is manageable for more companies and $80 a barrel for more than half of the shale projects.
So that’s oil.
On the interest rate front, let me remind you of my position. In January I wrote the following about the convergence of safe assets toward zero:
“The closer a country is to zero on the short end and to zero term premium in medium- to long-term rates, the less flattening will occur. Japan is now at zero out to five years. There is not a lot of upside there. Switzerland is at 0.18% out to 10 years. Again, upside there is very limited indeed. But there are a number of countries with room for yield suppression which also have sovereign central banks and no foreign currency liabilities. These countries are the Anglo-Saxon countries. British 10-year bonds go for 1.54%. Canadian yields are 1.60%. US yields are 1.88%. Australian 10-year yields are 2.61% and New Zealand’s 10-year bond fetches a hefty 3.47%. While Switzerland’s 10-year bond has only 18 basis points of non-fear related compression feasible, New Zealand’s 10-year bond has more than 300 basis points to go.
“Right now, we are still in the midst of a global growth slowdown. And while there are some countries like Britain, Canada, the US, New Zealand and Australia, which have been outliers in terms of growth performance, the downward drift of oil and commodity prices, the lack of external demand, the lower rate of EM growth and the rebalancing in China is going to put inexorable downward pressure on nominal GDP growth in these countries. This will put downward pressure on future policy rates and help to make the convergence to zero trade most severe in these countries in 2015.
“I am not saying that New Zealand and Australia are the cleanest dirty shirts here. I am saying that safe asset yields are converging to zero and the most convergence will occur in the highest yielding, high rated safe asset countries. That favours Anglo-Saxon government bonds over others. And to the degree there is crisis, then investors will flee into safe assets and shun risk assets, hastening the move toward zero across the curve.”
Since I wrote this, the Reserve Bank of New Zealand signalled an easing bias that could see its 3.5% policy rate cut. The Bank of Canada unexpectedly cut rates. And now the Reserve Bank of Australia has also cut rates today to a record low 2.25%. The analysis in the Sydney Morning Herald makes sense to me:
The first observation to make about the Reserve Bank’s break from its year-long “period of stability” is that the central bank’s cash rate cut from 2.5 per cent to 2.25 per cent is unlikely to be an orphan.
The bank is cutting despite assuring the markets last year that it would signal a change more gradually, and will not have done so lightly.
It will continue to take the temperature of the economy, but is highly likely to follow this cut with another, setting a new cash rate low of 2 per cent by mid-year as it tickles demand that is staying weaker for a bit longer than it expected, and battles unemployment that is peaking higher than it expected.
The paper goes on to suggest that a sharp rate rise within a year is likely. I don’t see this. All of the forces coming down to bear on Australia from abroad make the country, with its high household debt level, very leveraged to debt service costs. And this means rates will remain low and go lower as long as global growth is slowing and commodity prices remain weak.
The rate cut is a harbinger of more cuts to come in Australia, New Zealand and Canada. I believe New Zealand will have the best performing long bond in 2015 of major developed economy government bonds. New Zealand and Australia are particularly attractive then from a convergence perspective as they have the most room to cut.
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