“Yet for all its conflict and complexity, there has often been a “oneness” to the story of oil, a contemporary feel even to events that happened long ago and, simultaneously, profound echoes of the past in current and recent events.”
- Daniel Yergin, The Prize
Post World War II, global production of oil surged from 9 million barrels per day in 1945 to 40 million barrels per day in 1970. Saudi Arabia and Iran were eager to monetize their vast resource potential – “Nobody could have lifted enough crude to satisfy all the governments in the Persian Gulf during this period,” said George Parkhurst of Standard Oil of California. A wave of Soviet Union exports flooded the market; US Senator Kenneth Keating remarked, “It is now becoming increasingly evident that [Khrushchev] would also like to drown us in a sea of oil if we let him get away with it.” In 1956, major oil companies struck oil in Algeria and Nigeria. And in 1959 Standard Oil of New Jersey “hit the jack-pot” at the Zelten field in Libya.
Consequently, the real price of oil sank 40 percent between 1960 and 1969. Howard Page, Middle East Coordinator for Standard New Jersey said of the glut, “Oil was available for anybody, anytime, any place and always at a price as low as you were charging for it.”
In the late 1950s, President Eisenhower found himself in a precarious position. Though the US was still the world’s largest oil producer, the plethora of cheap, foreign barrels encroached on the competitiveness of domestic, independent producers. Oil imports rose from 15 percent of the domestic production equivalent to 19 percent between 1954 and 1957 alone.
Congress urged Eisenhower, who morally opposed protectionism, to curb imports. One geologist wrote to then-Senator Lyndon Johnson, “no sense in bankrupting every independent oil man in Texas for a few Arabian princes.” Eisenhower resisted and criticized the “tendencies of special interests in the United States” that were “in conflict with the basic requirement on the United States to promote increased trade around the world.” Begrudgingly, however, Ike caved, and on March 10, 1959 he signed into law a mandatory quota on imported oil equal to 9 percent of domestic consumption.
Eighteen months later, representatives from Saudi Arabia, Venezuela, Kuwait, Iraq, and Iran gathered in Baghdad. The Organization of Petroleum Exporting Countries – OPEC – was established. Market intervention certainly has its unintended consequences. While I don’t assert that Eisenhower’s import quota was the sole motivating factor for OPEC’s birth or that OPEC would not exist absent the policy, it was of considerable influence. In fact, Daniel Yergin, Pulitzer Prize winning author of The Prize: the Epic Quest for Oil, Money, and Power, called Eisenhower’s import controls “the single most important and influential American energy policy in the postwar years.”
“Profound echoes of the past” resonate in President Obama’s June 23rd decision to release 30 million barrels from the US’s Strategic Petroleum Reserve (SPR). The attempted market intervention was (allegedly) prompted by the loss of Libyan supply and OPEC’s failure to officially raise production quotas in its most recent meeting. Even though the contentious OPEC meeting failed to quell the IEA’s supply concerns, the Saudis were explicit in their intention to raise production by 1.5 million barrels per day regardless of the Iranian-lead OPEC decision – more than enough to replace the lost Libyan output.
Market participants quickly called out the IEA action for what it was: a haphazard attempt at price manipulation as global growth slows; after all, the agency’s press release stated: “Greater tightness in the oil market threatens to undermine the fragile global economic recovery.” Thus, while Eisenhower sought higher oil prices to protect US producers from the actions of oil exporters, Obama seeks lower oil prices to shield US consumers from the same foes.
Geopolitical tensions in the Middle East have, of course, put a premium on crude oil; Brent – the world’s light, sweet benchmark grade – rallied from $102 per barrel to $114 per barrel in February alone. But mention of US monetary policy is warranted in the oil price discussion. After the Fed announced QE2 in late August 2010, oil prices moved 20% higher before you ever “Googled” a map of Tunisia. The excessive liquidity injected into financial markets via the Fed’s bond-buying programs spurred investment into real assets, particularly across the commodity complex.
And while Fed Chairman Ben Bernanke often cites stock market appreciation as evidence of QE’s success, he attributes commodity price inflation merely to “transitory” supply and demand fundamentals. It would take a previously unforeseen level of accountability for Bernanke to admit that his policies are in part responsible for higher food and energy costs, while wages and employment are “frustratingly” stagnant.
In his semiannual report to Congress on monetary policy earlier this year, Bernanke commented on rising oil prices: “We will continue to monitor these developments closely and are prepared to respond as necessary to best support the ongoing recovery in a context of price stability." The traditional tools of monetary policy are interest rates, the monetary base, and reserve requirements; but does the Fed now sell oil too? While Bernanke was likely consulted, no, he didn’t make that call. Still, the Fed’s bond-buying program ended on June 30th and the US Department of Energy (DOE) was auctioning off emergency crude reserves the very next day. Next up: the USDA will be planting corn in our national parks…
But what has been the impact of the SPR release thus far? Well, Brent plummeted from $114 to $105 within two days of the announcement, though quickly recovered all of that loss. The Brent futures curve went into contango for the blink of an eye before returning to backwardation. The RBOB gasoline futures curve never budged and the front-month contract is now trading above its pre-SPR release price. In the immediate-term, the oil market intervention did very little; on a longer duration, the IEA may have sparked the next leg up in the commodity.
Most notably, the IEA’s decision to release reserves after the Saudis announced their intention to fill the Libyan supply shortfall calls into serious question Saudi Arabia’s spare capacity and oil quality. Not only that, but eventually the IEA will have to enter the market as a buyer to refill the reserves; oil is not as easily produced as fiat currencies. And the fact that the SPR auction was “substantially oversubscribed,” according to the DOE, does not suggest that the world’s largest energy companies believe oil prices are heading lower.
Government intervention in free markets often has unintended consequences, and, as a result, in the long-run consumers will realize an undesired outcome: higher oil prices. For the only lasting impact that the IEA’s reserve release will have is that the agency’s greatest worry – inadequate supply – is more of a reality than the market previously thought.
The chart below outlines our TRADE (3 weeks or less), TREND (3 months or more), and TAIL (3 years or less) quantitative setup for WTI crude oil. We will manage risk around these levels as government intervention inspires increased price volatility. We are currently short oil in our Virtual Portfolio as it is immediate-term TRADE overbought.
Our immediate-term support and resistance levels for oil, gold, and the SP500 are now $90.51-98.11, $1, and 1, respectively.
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At the beginning of the year, I laid out my coffee strategy: long SBUX and PEET; short GMCR. OK, so I’m 2 for 3, but the miss on GMCR was a big miss.
Back on 2/15/11, I posted a note titled “WHY SBUX SHOULD BUY PEET”. I said that “PEET’s is one of the best positioned, small-cap growth names in the restaurants/coffee space. Unfortunately, the surge in coffee prices is an overhang, but not a deal-breaker to the growth story. We would use any commodity concern-induced dips as an entry point.”
Year-to date PEET’s is up 45.3% and now trades at 15.6x EV/EBITDA, which represents a nice premium to the QSR group at 13.3x. At best there is $3 or 6% up side from here. There is some logic that now suggests that suggests that KFT is perhaps best-suited to acquire PEET, although SBUX remains a potential candidate.
Here is the Mosaic theory behind the rational for KFT to buy PEET’s:
1. The coffee category is a very important for KFT and losing the SBUX business is big blow. To date, KFT has yet to articulate a strategy to replace the lost SBUX business. Late last month, KFT said it would delay the launch of Gevalia coffee in U.S. retail stores by five months until January citing “robust demand that raised supply concerns.”
Hedgeye - What if they are rethinking the coffee strategy and questioning what might be the best solution? Gevalia could be great brand but, the Peet’s brand has real appeal on the West Coast and a growing presence in the East.
2. Shareholders of KFT don’t like the idea of the plan to replace Starbucks with Gevalia. In short, it’s too costly and risky. The analyst community has already factored in a loss of the SBUX business and upfront costs behind the investments in Gevalia.
Hedgeye - the unwinding of the investment in Gevalia in favor of an accretive acquisition of a strong brand and could add between $0.05-0.10 to KFT EPS.
3. Perhaps not coincidentally, the Gevalia delay comes days after Trian (Nelson Peltz) announced a stake in KFT. Also, Trian is a top ten shareholder in PEET and has history of buying KFT and strong arming buys of existing holdings. Think Cadbury!
Hedgeye - no comment.
4. KFT wants to reinvest the $750mm from SBUX in the coffee category.
Hedgeye - Trading out the Starbucks brand for Peet’s is the best use of cash for KFT shareholders.
PEET is great company with one of the better secular growth stories I am aware of. I would not be surprised if the company gets bought out, but current prices suggest that much of that thesis may already be in the stock.
One last thought: the best thing that could happen for the DNKN IPO is a deal in the coffee space!
Conclusion: The Pheu Thai’s victory in the recent parliamentary elections paves the way for aggressive populism in Thailand over the long-term TAIL. To the extent such policies are implemented successfully, we can see a strong argument for being long-term holders of Thai equities. On the contrary, any slip-ups by the young prime minister and her party will likely result in a long-term bull market for Thai inflation and interest rates.
On Sunday, Yingluck Shinawatra watched her Pheu Thai party win 265 seats in Thailand’s 500-seat parliamentary election, giving her the title of Prime Minister – the first such honor for a female in Thai history. What’s in store for Thailand under her rule may not be so heartwarming; rather, it may be downright inflationary – particularly if she lives up to her billing as her brother’s “clone” (Thaksin Shinawatra, May 20, 2011).
Indirectly led by her older brother and exiled former leader Thaksin Shinawatra, the Pheu Thai party has made its populist intentions very clear from day one. Using promises of aggressive crop-price fixing, tablet PC giveaways, high-speed rail initiatives, and a new city, Yingluck and Co. were able to mobilize the support of Thailand’s lower class, which mostly resided in the country’s less urbanized north and northeast regions (~52% of Thailand’s 67M people). Also included in the Pheu Thai’s populist promises was a +36-89% increase (depending on province) in the minimum wage to 300 baht ($9.84) per day. That dwarfs the +2.4% average YoY gain since 1998, with the largest increase (+9.1%) coming in 2007-08, according to the Thailand Development Research Institute.
We can’t say for sure how quickly such policies will be implemented; only that rushing to complete them in short order is very likely to provide a substantial amount of upward pressure on Thailand’s consumer price inflation. In a perfect world, Yingluck and her fellow lawmakers will have time to gradually implement such populist initiatives. Unfortunately, the Thai political scene is far from perfect, with routine insurrections and oft-violent demonstrations a norm within the streets of Bangkok. We are of the view that the ruling coalition (299 seats split between the Pheu Thai and four other small parties loyal to Thaksin) will be under increasing pressure to deliver on its lofty campaign promises from the start. As such, we remain bullish on Thailand’s CPI and expect that series to make higher-highs over the long-term TAIL.
Such a case is not without precedent in Thailand. In fact, under Thaksin’s former rule (premier from Feb. 9, 2001 through Sep. 19, 2006), populist fiscal policies ranging from a debt moratorium for farmers (~35% of population) to fuel and electricity subsidies supported a +570bps increase in Thailand’s YoY CPI rate during the Thaksin regime from February ’01 to its May ’06 peak. Easy monetary policy out of the Bank of Thailand also contributed to the pickup in Thai inflation rates during Thaksin’s stint as prime minister.
Perhaps learning from the policy blunders of previous Bank of Thailand boards, current central bank members have openly expressed concern about the potential for expansionary fiscal policy to supply upward pressure on Thai CPI growth rates and downward pressure on Thai GDP growth rates. In the speech accompanying its latest rate hike, assistant governor Paiboon Kittsrikangwan plainly stated, “the central bank is concerned that populist polices in the election will affect inflation and economic growth.” We share their concern, and, as such, we remain bullish on Thailand’s short-term interest rates over the long-term TAIL.
Digging deeper into the Thaksin’s administration, we see that his expansionary fiscal policies were indeed able to reduce poverty on both an absolute and a relative basis. According to World Bank statistics, from 2000-2004,Thailand’s national poverty headcount ratio fell from 20.7% to 11.5%, while the share of income earned by the bottom 20% of earners increased from 5.85% to 6.1%. That was supportive of a -0.7pt decrease in Thailand’s GINI Coefficient (a measure of income equality) from 2000-2004 to 42.5 (World Bank).
Such gains were not without costs, as growth in both government expenditures and tax receipts far outpaced previous and subsequent administrations. Still, “Thaksinomics” (as his policies have been popularly dubbed) were able to grow the Thai economy enough to reduce the country’s gross sovereign debt burden -1,583bps to 42% of GDP by his forced removal from office in late 2006.
For now, it looks as if Thailand’s political elite and military will let the Pheu Thai have its way. A recent shift to a more neutral stance out of the military and former Prime Minister Abhisit Vejiajiva’s late Sunday night resignation after conceding defeat in the election paves the way for a peaceful transition of power – an outcome we’d argue the market is anticipating based upon our proprietary quantitative analysis of the benchmark SET Index.
As always, political instability remains a near-to-intermediate term risk in Thailand, though certainly not at the level we once perceived it to be. The real risks to the Thai economy lie over the long-term TAIL and they are generally regarding the implementation of a second round of “Thaksinomics”. For now, we’d be predisposed to wait and watch for more color on the new regime’s strategies, but we can certainly see a case whereby the successful implementation of such pro-growth policies proves bullish for Thai equities over the long-term TAIL.
By “successful implementation”, we mean in a way that encourages sustainable consumption growth and job creation with limited impact on inflation. It remains to be seen whether or not the young Yingluck can pull that off. At the bare minimum, we would not want to be short-and-holders of Thai equities (or any equities for that matter) due to the likelihood that the market bids up Thai economic growth. If we’ve learned anything over the last few years, it’s that investors are generally much less willing to distinguish between sustainable, organic growth and short-to-intermediate term, stimulus-driven growth en route to price discovery.
I have never seen so many restaurant companies trading at 10x EV/EBITDA or better.
Every day I open my industry valuation models and, of late, I have been amazed to see the number of companies trading at double digit EV/EBITDA multiples. As of today, there are ten companies with that distinction. In the past, a double digit cash flow multiple was reserved for those companies that demonstrated 15-20% unit growth or had an international presence that made it look more like a consumer multi-national.
Coming out of the Great Recession, the industry is being revalued despite some serious headwinds. The double digit valuations are being achieved despite rampant food inflation, which has traditionally has caused investors to flee from the space (especially the more mature names).
This is also inconsistent with traditional measures of future demand like consumer confidence, which has flat-lined since 2009. More importantly the small improvement in consumer confidence since bottoming in late 2008 has been driven by the expectations component which is now rolling over. Not surprisingly, we are now starting to see personal income and spending roll over too.
While overall demand for eating out is holding up, all of the restaurant companies that are valued by the street with double-digit cash flow multiples have seen same-restaurant sales slow on a one-year basis. Looking at two-year trends, however, paints a more positive picture. Two-year average trends are improving and much of the decline in one-year comps may be due to difficult compares.
On the positive side, restaurant companies have not been raising prices as aggressively as supermarkets and reduced spending on other more “durable” categories is helping maintain the consumer’s frequency of eating out. The industry is not overly levered and the cash flow generation, dividend yields and high margin franchises business models of some of the more mature companies are very attractive.
With this being said, when trying to justify a revaluation of a business or an industry, there is an acute risk of stretching the facts. The rolling over of consumer expectations is a concern for me, as are the peak multiples being awarded to restaurant companies at the present time.
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