A money creation theory of offshore asset recovery…

The reason we are less enthused by companies which rely on tangible assets such as buildings or manufacturing plants [Ed: or rigs/jackups/ships?] is that anyone with a big enough budget can easily replicate (and compete with) their business. Indeed, they are often able to become better than the original simply by installing the latest technology in their new factory. Banks are also quite keen to lend against the collateral of tangible assets under the often illusory view that this gives them greater security, meaning that such assets can also be financed easily with debt, or as we call it, ‘other people’s money’. Debt is provided to such companies both cheaply, and with seeming abandon at certain times in the economic cycle, with often perilous results.

Smithson Investment Trust, Owners Manual

High confidence tends to be associated with inspirational stories, stories about new business initiatives, tales of how others are getting rich…

Akerlof and Shiller, Animal Spirits

…the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than on a mathematical expectation, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits — of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.

Keynes, Chap 2: The State of Long Term Expectations, in The General Theory

While quite ready to change my opinion, I have, at present, a strong conviction that these two economic maladies, the debt disease and the price-level disease (or dollar disease), are, in the great booms and depressions, more important causes than all others put together…

Some of the other and usually minor factors often derive some importance when combined with one or both of the two dominant factors.

Thus over-investment and over-speculation are often important; but they would have far less serious results were they not conducted with borrowed money. That is, over-indebtedness may lend importance to over-investment or to over-speculation.

The same is true as to over-confidence. I fancy that over-confidence seldom does any great harm except when, as, and if, it beguiles its victims into debt.

Irving Fisher, The Debt Deflationary Theory of Great Depressions

… the modern debt-deflation process encompasses falling asset prices, debt repayment difficulties, a reluctance to lend, a financial crisis, the impact on the banks, and the inter-dependency of the financial system…

Wolfson, Cambridge Journal of Economics

Financial illiteracy is a recipe for debt, default and depression, whose effects appear to feedback on each another in a vicious spiral.

These individual costs are amplified when they are aggregated up to the macro level. How people’s expectations evolve – their degree of optimism or pessimism, exuberance or depression – is crucial for determining their individual decisions. It has long been recognised that these expectations can be shaped importantly by others’ expectations. For example, “popular narratives” can emerge which shape collective expectations among the public – optimism or pessimism, exuberance or depression – and which can then drive aggregate economic fluctuations…

At a macroeconomic level, the work of George Akerlof and Robert Shiller has looked at the popular narratives which emerge during periods of boom and bust.  Using words extracted from newspapers, they find the prevailing popular narratives about the economy have played a significant role in accounting for the heights of the peaks and depths of the troughs during macro-economic booms and busts. Public expectations, embedded in the stories they tell, are a key macro-economic driver.

Andrew Haldane, Bank of England, Folk Wisdom

Last week the Deputy Governor of the Reserve Bank of Australia gave a speech titled “Money – Born of Credit?”, in this speech he outlined an important, yet underappreciated fact, of modern economies: deposits in bank accounts are caused by loans. A lot of people think that by putting money in their bank account they are giving the bank the ability to make a loan, but actually in a systemic sense it is the other way around: the money in your account is the result of banks making loans that end up as deposits in your account. In case you think this is some bizarre, and wrong, economic tangent, the Bank of England has an explanatory article “Money creation in the modern economy” which states:

In the modern economy, most money takes the form of bank deposits. But how those bank deposits are created is often misunderstood: the principal way is through commercial banks making loans. Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.

The Chief Economist of Standard and Poor’s summed it up in this article:

Banks lend by simultaneously creating a loan asset and a deposit liability on their balance sheet. That is why it is called credit “creation”–credit is created literally out of thin air (or with the stroke of a keyboard). The loan is not created out of reserves. And the loan is not created out of deposits: Loans create deposits, not the other way around.

This ability of privately owned banks to have the power of money creation is not often discussed. To many economists, although generally not those working at banks, this is a privilege where the ability to ‘privatize the profits and socialise the risk, is most flagrant and should perhaps be regulated more. The ‘Exorbitant Privilege‘ of the private sector. There is significant evidence that financial and banking crises have indeed become more common since the move to deregulate the financial system and credit creation that became especially strong post the end of the Bretton Woods era (post 1973).

If you are still reading at this point you may be wondering where I am going with this? The answer is that the implications for an industry like offshore, an asset-backed industry where values were sustained by huge amounts of bank leverage, are important for understanding what a “recovery” will look like. The psychology and ‘animal spirits’ of the commercial banks is likely to matter more than any single factor in dictating when an asset price recovery will be. Given that the loan books are closed to all but tier 1 borrowers, and contracting overall in offshore sector exposure, this would appear to be some way off.

Part of “the boom” in offshore since 2000, barring a short and sharp downturn in 2008/09, was the increasing value of rigs and offshore support vessels, but important too was the willingness of banks to lend against 2P reserves (Reserve Based Lending). This was a pro-cyclical boom where because everyone believed the offshore assets and reserves were worth more than their book value banks were willing to lend significant amounts of money against them. There was a positive and logical narrative of a resource-contrained oil world to unlock the animal spirits, it wasn’t irrational per se. As these assets changed hands banks created deposits in company accounts, they literally created “money” out of thin air by believing that the assets were worth more than they were previously. It is no different to a housing boom, and the more money the banks pumped in, the more everyone believed their assets were worth more (as the deposits grew). Ergo a pro-cyclical credit boom combined with an oil price boom. The demand for oil, and its price, has recovered, and this will affect the amount of offshore work undertaken, but the negative effects of an asset price boom will take longer to recover.

Right now the banks aren’t creating any new money for the offshore sector, collectively they are actually destroying it. When banks refuse to lend on ships or rigs no deposits flow through the system. Money from outside the system stops flowing into the offshore sector from the banks. Values and transactions are supported by the economic earning potential of current assets and the amount of equity and debt raised externally by funds. None of these “creates” money as banks do. These funds are “inside” money.

As an example last week Noble purchased a jack-up from a yard in Indonesia and was granted a loan by the yard selling the unit (a Gusto unit pcitured above). A piece of paper was exchanged and credit was created for the $60m loan of the total ~$94m price. Neither firm has any more money than they had prior to signing the loan contract. Credit isn’t the same as money… had a bank been involved (simplistically) it would have credited the yard with $60m, created a debt of $60m for Noble (a debit), and created an asset for $60m on its balance sheet. This money would have flowed from outside the offshore industry. The total value of the transaction would have been the same but the economic consequences, particularly for the liquidity of the yard, would have been very different. It is safe to say the reason this didn’t happen is because no bank would lend the money under similar terms. Relief rather than animal spirits seems a more likely emotion for this transaction.

It is not just the offshore contracting companies but also the E&P companies that are suffering from reduced bank credit and this is affecting the number of projects they can execute (despite a rise in the oil price). Premier is currently raising funds for the Sealion project, as part of this Drilquip has been given the contract for significant parts of the subsea scope, and they have provided this on a credit basis. In past times Premier would simply have borrowed the money from a bank and paid Drilquip. Now Drilquip has an asset in how much credit it has extended Premier but in the hierarchy of money that is lower than the cash it would previously have had, and it has to wait for Premier to sell the oil to pay it, and take credit risk and oil price risk in the meantime. Vendor financing is not the panacea for offshore because unlike banks vendors can create credit, but not money, and these are two fundamentally different things. There is a financial limit to how many customer Drilquip can serve like this. Collectively this lowers the universe of potential projects for E&P companies, and therefore the growth of the industry, that can be achieved. Credit creation is essential for an industry to grow beyond its ability to generate funds internally.

Another good example is the Pacific Radiance restructuring. Here the proposed solution, that I am enormously sceptical of, is that a new investor comes in allows the banks to restructure their loan contracts/ assets such that they can get paid SGD 100m in cash immediately while writing down the size of the loan. The equity and funds coming in are funds from the existing stock of money supply, they are not additional liquidity created by a belief in underlying asset values and represented by a paper loan contract and a growth in the loan book of the bank. While the new funds are adding to the total stock of money available to the offshore industry the bank involved is taking nearly as much off the table and you can be sure they won’t be lending it back to the sector. And thus the money stock and capital of the industry is reduced. Asset values remain low and the pain counter-cyclical process continues.

When you see companies announcing asset impairments and net losses that flow through to retained earnings this is often merely accounting of the banks withdrawing money from the sector and the economic cost of the asset base not being in tune with the amount of money available to the industry as a whole. It is also seen in share price reductions as the assets will never pay their owners the cash flows previously forecast.

In a modern economy this is normally the transmission mechanism from a credit bubble to a subsequent economic collapse: the ability of private sector banks, and only banks because of the system can create “money”, to amplify asset prices and cause sectoral booms on the way up and reduce the money stock and asset valuations on the way down. Why this happens is a complex topic and cannot be tackled in a blog, but it has clearly happened in offshore. Just as it has happened in housing booms, mining booms, ad infinitum previously. The dynamics are well known and are accentuated in industries which have had a lot of leverage. Much work was undertaken following the depression of agricultural prices in the 1930s, a commodity like oil which fluctuated wildly but the tangible backing of land allowed banks to supply significant leverage to the sector. Irving Fisher, quoted above, was famous for predicting that the US stock market had reached a “permanently high plateau” in 1929,  but his understanding of debt dyamics from studying banking and the US dustbowl depression transformed our understanding of the role of credit and banking.

[This explanation crucially differentiates between inside-money and outside-money. I am making a distinction between money generated inside the offshore sector and outside. By inside money I mean E&P company from expenditure, credit created amongst firms in the industry, and retained earnings. Outside money is primarily bank credit and private equity and debt funds. But whereas private equity and debt funds must raise money from the existing money stock only bank created money raises the volume of money].

In offshore the credit dynamics have been combined with the highly cyclical oil industry and allows optimists to believe a “recovery” is just possible. But a recovery scenario that is credible needs to differentiate between an industrial recovery, driven by the amount of E&P projects commissioned, and an asset price recovery, which is essentially a monetary phenomenon.

A limited industrial recovery is underway. It is limited by the availability of bank credit and the huge debts built up in the previous boom by the E&P companies, and their insistence that shareholders need dividends that reflect the volatility risk of the oil and gas industry. It is also limited because of the significant market share US shale has taken from offshore. But the volume of offshore project work is increasing. This is positive for those service firms who had limited asset exposure, and particularly for the Tier 1 offshore contractors, as much of the work being undertaken is deepwater projects that are large in scope.

But an asset recovery is still a long way off. There are too many assets for the volume of work in the short-run and in the long run it will be very hard to get banks to advance meaningful volumes of credit to the industry. Companies can write loan contracts with each other that represent a value, but banks monetise that immediately by providing liquid funds and therefore raising the animal spirits in the industry, whereas shipyards lending money to drilling companies need them to generate the funds before they can get paid. The velocity and quantity of money within the industry become much smaller. Patience and animal spirits make poor bedfellows.

Bank risk models for a long time will highlight offshore as a) volatile, and b) risky given that a bad deal can see even the senior lenders wiped out completely. Like all of us banks fight the last crisis as they understand it best. Until banks start lending again the flow of funds into the offshore industry will mean the stock of assets that were created in more meaningful times are worth less. In a modern economy credit creation is the sign that animal spirits are returning because it raises the return to equity (and high yield) providers.

In the boom days leading up to 2014 money and credit were plentiful. The net result was a vast amount of money being “created” for the offshore sector and a lot of deposits being created in accounts by virtue of the loans banks were creating to companies in the offshore sector based on their asset value. Now the animal spirits are no more and a feeling of caution prevails. The amount of money entering the sector via higher oil prices and private equity and debt firms is much smaller than was previously created by the banking sector. Over time this should lead to a more rational industry structure… but a repeat f 2014 days is likely to be so far away that the market at least has forgotten it…

As The Great Man said:

We should not conclude from this that everything depends on waves of irrational psychology. On the contrary, the state of long-term expectation is often steady…[but]…We are merely reminding ourselves that human decisions affecting the future, whether personal or political or economic, cannot depend on strict mathematical expectation, since the basis for making such calculations does not exist; and that it is our innate urge to activity which makes the wheels go round, our rational selves choosing between the alternatives as best we are able, calculating where we can, but often falling back for our motive on whim or sentiment or chance.

Oil as a declining industry…

Like all good Op-Eds (and blogs) this one in the FT started yesterday with a big headline and with some punchy quotes:

The time to stop investing is not today. But that point is coming. The industry needs to be clear that its future is one of long-term decline — whilst returning increasing sums of cash to investors. There is a possibility that the industry over-invests as we reach that point of peak demand, leaving an oversupply that persists for a long time. Fighting for market share in a declining market would be even worse.

Everything in life is relative (well if you are a post-modernist anyway) and the authors are not saying to stop investing tomorrow or that oil is dead: merely ex-growth as an industry.  The message is about E&P companies not having a good record at investing in alternative energy sources so encouraging them to return the cash to fund managers (who do apparently?).

We think oil companies can have a positive part to play in our future world of energy — as a cash generating engine that can be used to power the transition when the time comes, and we urge the industry to make a clear commitment to this future.

You can dismiss it as another view that will simply ensure that prices are higher in the future, I guess the question then becomes how far and how high? Or you can take the views seriously as the representatives of one of the UK’s largest fund managers and realise that it is part of a wider secular shift in thinking about business models for E&P companies that require less CapEx and less redundant capacity. I think it just shows how much pressure CFOs/Directors are under to return cash to shareholders all the time and how much harder it is for smaller E&P companies with good project ideas to raise money.

Regardless or your view this is becoming a popular one amongst the actual owners of some companies so it is worth not writing off indiscriminately. The investment narrative isn’t all “growth at any cost”, or future production volumes, which is a marked shift from previous periods where statements like “all the easy oil has gone” doiminated.

In a good interview here Spencer Dale, BP Chief Economist highlighted that

Because of natural decline, there is going to be a huge need for investments to keep supply at pace with demand, even if oil demand were to peak relatively soon.

“For a company like BP, that has a key role in our strategy. Continue to invest in oil, because the world will need that investment, but make sure to invest only in low cost, advantaged oil to make sure that we are robust for this more competitive environment that we think is going to emerge over the next ten to fifteen years.”

That strikes me a very different dynamic to previous eras and will have a huge impact on E&P project developments which are also consistent with the shareholder wishes highlighted above.

New ship Saturday…

Yet again UDS seemed to have pulled off an amazing feat, right after becoming the greatest DSV owner and charterer in the world, with a record 4 out of 4 (or maybe 5) DSVs on long term charter, they appear to have Technip, McDermott, and Subsea 7 quaking with fear as they look at helping a company enter the deepwater lay market:

UDS Lay vessel.png

This is a serious ship. Roughly the same capability as the Seven Borealis.

Seven Borealis

Although the Seven Borealis  can only lay to 3000m, not the 3800m UDS are looking at. As depth is really a function of tension capacity then I guess they will have a significantly bigger top tension system than the Seven Borealis as well?

I can see why you would go to UDS if you wanted to build a pipelay vessel significantly more capable than any that the world’s top subsea contractors run. Sure UDS may never have built a vessel of such complexity, and actually haven’t even delivered one ship they started building, but they have ambition and you need that to build a ship like this. Not for this customer the years of accumulated technical capability, knowledge building, and intellectual competency, there is nothing an ex-diver can’t solve.

UDS is building vessels the DSVs in China. The closest the Chinese have come (that I know of) to such a vessel is HYSY 201:

HAI-YANG-SHI-YOU-201.jpg

But that only has 4000t system? No wonder this new mystery customer, who I assume is completely independent of the other customers that have chartered their other vessels, wants to up the ante. The HYSY 201 cost ~$500m though, which is quite a lot of money to everyone in the subsea industry, apart from UDS.

The last people I know who went to build a vessel like from scratch were Petrofac. There is a reason this picture is a computer graphic:

Petrofac JSD 6000.jpg

To do this Petrofac hired some of the top guys from Saipem, a whole team, with years of deepwater engineering experience… And when the downturn hit Petrofac took a number of write offs, and even with a market capitalisation in the billions, didn’t finish the ship. To be fair though, they hadn’t engaged UDS.

But I think the reason you go to UDS “to explore the costs”, you know instead of like a shipyard and designer who would actually build it, is because they appear to have perfected the art of not paying for ships. So if you go to them and ask for a price on an asset like this chances are you get the answer: the ship is free! It’s amazing the yard just pays for it. Which is cheap I accept but ultimately the joy-killing economist in me wonders if this is sustainable?

Coincidentally I am exploring the costs of building a ship. I have just as much experience in building a deepwater lay vessel as UDS. On Dec 25th 2017, with some assistance from my Chief Engineer (Guy, aged 9), we completed this advanced offshore support vessel, the Ocean Explorer,  from scratch!

Ocean Explorer.jpg

Ocean Explorer Lego.jpg

Not only that I had take-out financing for the vessel in place which is more than UDS can claim at this stage!

Now having watched Elon Musk launch a car on a rocket into space (largely it would appear to detract some appalling financial results, although far be it for me to suggest a parallel here) we (that is myself and my Chief Engineer) have designed a ship: It will be 9000m  x 2000m, a semi-sub at one end to drill for oil, a massive (the biggest in the universe) crane to lay the SPS,  j-lay, s-lay, c-lay, xyzzy lay in the middle, and two (Flastekk maybe?) sat systems at the other end in case we forgot something, and to make it versatile. Instead of launching a car into space we are having a docking station for the space shuttle in order to beat the Elon Musk of Singapore. It is also hybrid being both solar powered and running on clean burning nuclear fusion. Not only that the whole boat works on blockchain and is being paid for with bitcoin. The vessel is also a world first having won a contract forever as the first support vessel for Ghawar field. We are also committing to build a new ship every week forever.

I expect to bask in the adulation on LinkedIn forever once I announce this news, and it will feel like all the hard work was deserved at that point. I am slightly worried about the business model as my Chief Engineer asked “Won’t we have to get more money in for the boat than we paid for it?”. When I have an answer for that trifling problem I will post the answer.

The Economics of Constraints and (Really) Deepsea Diving…

It’s a poor sort of memory that only works backwards.

Lewis Carroll, Alice in Wonderland

In historical events what is most obvious is the prohibition against eating the fruit from the tree of knowledge.

Leo Tolstoy, War and Peace

One of my frustrations with offshore/SURF is that despite the mathematics of engineering and economics being the same, both are really optimisation problems, there is precious little of the latter influencing the former in offshore. A classic case of this came in Frontrunner today where there was an attempt at a serious discussion about diving below 300m. Now I accept that this is technically possible, lots of things are technically possible, for a billion dollars you can probably get NASA to take you on holiday to the moon, but because not that many people want/are able to spend a billion dollars on such a holiday there are very few companies offering this as an economic choice. If money is not a constraint then you have few constraints, but in economics and business money is always a constraint.

Diving at up to 600m is definitely technically possible, but it would be economic lunacy. Don’t get me wrong if I was an equipment supplier I would want to believe it was possible as well, but that doesn’t make it viable. There are so many realistic economic and organisational constraints on this I can’t be bothered going into them all, but here are a few, all of which are complete showstoppers:

  1. There is no market: the list of marginal field developments that could be made viable between 300-600m of water if a DSV could be used is minimal, even on a global basis. Most shelves drop off completely below 300m and there simply no proof that there are suitable reserves that could be tapped by this technology
  2. In order to service this (non) market you would have to build a 600m capable DSV completely at risk (which is admittedly what UDS claims to be doing), budget $160-185m, then prove the technology and procedures, which will be months of testing and practice dives etc, and only then be ready to sell it, all the while burning vast amounts of risk capital. Then you would need to get a bunch of global oil companies to change their entire HSE approval process, which will take years, and get this to coincide with a project approval process. This strikes me as an enormous barrier because even if you could prove this worked there is no demonstrable evidence of the long-term health effects on the divers and you risk creating an abestos like residual legal claim on the oil companies (as the diving contractor may be bankrupt) for approving this. And then, and only then, years after building a 25 year asset and burning through working capital you might, just might, win a project competitively tendered against an ROV solution. That is without going into IMCA, class, various regulatory agencies etc. All this for a project whose financial upside must by definition be capped at what a comparable ROV service could deliver the project for. So a venture capital investor has no possible way of making a returns in the 100s of % to cover the risk. Literally nuts.
  3. ROVs are currently oversupplied and operating below their capital cost, and are likely to for an extended period, so not only would this harebrained plan have to compete for work against the above constraints it would have to with competitors who will be selling at below economic cost

If you speak to divers who go below 250m they will tell you the joints hurt and they really notice the pressure. It is not a popular depth to dive at. Subsea 7 and Technip now have special dive procedures in place for anything over 200m and there is enormous resistance to diving over this depth level even if you could prove what it costs. Changing this organisational inertia for marginal benefits only just don’t represent a viable economic time/cost trade-off.

This is just a classic case of someone trying or thinking of doing something because it is technically possible not because there is any economic rationale to it. The idea is so DOA from an economic perspective it doesn’t bear serious analysis.

SOR also make the following highly questionable claim:

Sources close to the scene, suggest BP’s huge west of Shetland Quad -204 redevelopment might have cost a third of the total bill if the project could have used divers. [Emphasis added].

Now the best estimate of the costs I have is £4.4bn ($5.7bn), but that includes drilling, fabrication, control modules, a FPSO etc. Traditionally the SURF installtion scope is 10-15% of the total project budget, so at best what I think SOR mean is they could have saved 1/3 of this… so maybe 5% of the total budget. But that is a pretty minimal saving in the scheme of things and exposes the installation to a lot more weather and other operational and contractual risks. For a 5% saving on the overall cost you would have exposed yourself to having a minimal choice of assets to complete the task and run the risk that all future OpEx operations would have to be done by divers (i.e. no ROV handles) and that needs to be factored in to the total economic cost.

[But if I am wrong I am happy for SOR to publish some more detailed information to correct my erroneous logic and I will happily publish a correction having been suitably educated].

But again the Quad 204 cost statement avoids the economics of this situation: if Quad 204 was going offshore in 2014, when every North Sea class DSV was operating at capacity the job would probably have cost more because DSV rates were at a premium. Re-bid the job now and you might get a different answer. Markets are dynamic not static. So there “might” have been a saving, but there is a much smaller North Sea class DSV fleet than ROV fleet that “might” have been busy, or it might not, and the saving would have been dependent on that. And surely the losing contractor would have gone back and offered to make such a substantial saving? But whatever the situation it would not have transformed the economics of a project the size of Quad 204 as suggested.

Interestingly the whole Frontrunner is relatively bullish on diving. Although, frankly any previous investors in vessels backing MEDS would be amazed if their ability to get hold of a vessel should be seen as a sign of confidence in  the market given the losses they have suffered on the Altus Invictus and Altus Extertus (disclosure of interest: I was a Director of one such company). I don’t think SAT diving is going to go away, that isn’t what I am arguing at all, but until significant CapEx projects involving DSVs return to the North Sea then the market on any reasonable basis remains over-supplied and day rates and utilisation levels will remain under huge pressure.

SOR has been at the forefront of reporting the creditors involved in the rescue of Bibby Offshore and I’d be interested to know if they have a consulting relationship with any of the bondholders who they have named? Either someone very close to the deal is speaking to them or they are working on this deal… And you would really have to believe in a degree of bullishness about diving that isn’t grounded in current market reality to buy into the Bibby deal at current value levels…. And frankly any financially rational actor would be more than a little nervous now Boskalis have the Nor vessels… contracts for small DSVs in Brazil won’t save the North Sea market…

I am wondering if a lack of clear economic thinking has permeated the deal for the investors, maybe they have been blinded by perceived benefits such as 600m diving, because when you have to get management to warrant that:

  • Within the next 7 days, Bibby Offshore will appoint an independent consultant on behalf of the noteholders to support management on the ongoing cash flow management and transition of the business to the new shareholders.

you clearly don’t have a great handle on the business or what you plan to do with it. This could well be a classic situation of the “Winners Curse” in M&A.

At the time I had worked with two seperate hedge funds who were also looking at the deal. We valued the business at ~.08 – .15 of the outstanding bonds (£14.0 – 26.5m) reflecting the new working capital required. Different people have different perceptions of value and therein will lie the answer to who makes money on this deal. A 2 x North Sea DSV operation, focused only on being a low cost operator, was the plan. In order to get to a bigger number you need to back a platform business to expand. No one outside of the large contractors has made diving work on a global basis as there are no economies of scale and procurement is all regional and follows different standards. So in order to recover £115m Enterprise Value York & Co., are backing a subscale, loss-making business, in an industry that is consolidating with large competitors, in a market with huge cost pressures. Traditionally that has been a poor route to value creation… but it is also true that counter cyclical investments generate huge returns. The hard part here is that because of the lead times for projects (which are well documentted), and Bibby’s own investment documents show, this is a market forecast to grow at CAGR c. 7%… roll the dice…

Dimon calls (unspecified) time on Bitcoin mania…

“I can calculate the motions of the heavenly bodies, but not the madness of people”

Sir Isaac Newton (who invested £3500 in The South Sea Company and sold out at £7000; he then re-entered the market and lost £20 000).

 

“[T]here shall be one coinage throughout the realm”

An Anglo Saxon rule dated to Athelstan, c. 930AD

So Jamie Dimon (CEO of JP Morgan Chase & Co), probably not a reader of this blog, also thinks Bitcoin is a bubble:

I’m going to be really clear in this one. Forget the blockchain, that’s a technology… But… the currency isn’t going to work. You can’t have a business where people can invent a currency out of thin air and think the people buying it are really smart. It’s worse than tulip bulbs, OK?

Note use of the word currency not money. Banks create money out of thin air as The Bank of England agrees. And private money creation has a long intellectual tradition in economics, with Friedman asking the question “Does the Government have any Role in Money?”. And there are less extreme examples: in 1970 during the Irish Bank stike even cheque clearing closed down and Irish pubs and supermarkets continued to “cash” cheques as they passed like money throughout the system for over six months and cheques were cashed by pubs as if the banks were open.

Currency on the other hand is a unit of account given the force of state backing and can be used to settle tax obligations. As soon as there is a threat to the tax base or the control of money the government will extinguish that threat: clearly the more authoritarian the bigger the threat and the quicker they will act.

What is clear is that Bitcoin is a bubble. There is no intrinsic value in it and the price and it is clearly only worth what someone else will pay. I love this quote:

When Stanley Druckenmiller, who managed George Soros’ $8.2 billion Quantum Fund, was asked why he didn’t get out of technology stocks even earlier if he knew they were overvalued he replied that he thought the party wasn’t going to end so quickly. In his words “We thought we were in the eigth inning, and it was the ninth”. Faced with mounting losses, Druckenmiller resigned as Quantum’s fund manager in April 2000… Julian Robertson, manager of the legendary Tiger Hedge Fund, refused to invest in technology stocks since he thought they were overvalued. The Tiger Hedge Fund was dissolved in 1999 because its returns could not keep up with returns generated by dotcom stocks.

A Wall Street analyst who has dealt with both managers vividly summarized the situation: “Julian said, ‘This is irrational and I won’t play,’ and they carried him out feet first. Druckenmiller said, ‘This is irrational and I will play’, and they carried him out feet first.”

Dimon has history on his side. Sooner or later this is going to end badly. Currency creation is a prerogative of the state as is the ability to tax and the two are inseparable. As Redish notes:

Numismatists believe that the earliest coins were produced at Lydia (now Western Turkey.  in the mid-seventh century BC. The coins were made of electrum, a naturally occurring alloy of gold and silver. They had a designon one side and were of uniform weight but had a highly variable proportion of gold. In an influential article, Cook (1958)  argued that these coins were introduced to pay mercenaries, a thesis modified by Kraay (1964) who suggested that governments minted coins to pay mercenaries only in order to create a medium for the payment of taxes. Both interpretations stress the role of the government in the introduction of coinage.

Something that has worked for thousands of years and used to keep governments in power and is crucial to the tax base isn’t going to be usurped by an unkown computer programmer, a bunch of gun nuts (who don’t want to pay tax), drug dealers (who don’t want to pay tax and get caught (crime clearly has a major impact on Bitcoin valuation)), and a bunch of fintech guys (who don’t want to pay tax and have no sense of economic history). Something Ross Ulbricht could testify to.

Boats, Bitcoin, and (Asset) Bubbles…

[W]hereas gambling consists in placing money on artificially created risks of some fortuitous event, speculation consists in assuming the inevitable risks of changes in value.

H.C. Emory

 

“In order to pay out profits, the South Sea Company needed both to raise more capital and to have the price of its stock moving continuously upward… And it needed both increases at an accelerating rate, as in a chain letter or a Ponzi scheme.”

Kindelberger, Manias, Panics, and Crashes. 1986

 

“But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?”

Alan Greenspan, 1996

This is a bit different from my usual postings at the moment, but the overarching theme of this blog, from the name onwards, is economic history, the relationship between banking and the economy,  and investment and asset bubbles. One of the reasons the subsea market interests me so much, aside from obviously having worked in it, is that the latter stages of the 2014 boom were clearly the denouement of an investment bubble.

I have been interested in Bitcoin and other crypocurrencies from the standpoint of monetary economics and history. For those who want a primer on money and cryptocurrencies there is a good post here. I think they are basically an asset bubble with no discernable differences to Dutch tulips in terms of intrinsic value (there is a great article here on the Dutch Tulip Bubble that makes clear it really was irrational). There are also at least 842 crypotcurrencies, which looks like the IPO board of 1999, and you can now do an Initial Coin Offering (ICO)! I think this is a technology induced investment bubble where the distributed ledger technology combined with the token coin aspect is creating the hype. The distributed ledger technology is beyond my full comprehension, although from my basic knowledge it strikes me as a powerful technology, (although its worth noting that it is overloaded and transactions and there is a backlog) and that the Bank of Canada having assessed it:

 [t]he bank reached that conclusion after a closely watched year-long trial code-named “Jasper,” which sought to determine whether the technology, known as DLT, could be used to improve the performance of Canada’s wholesale interbank payment system.

“A pure stand-alone DLT wholesale payment system is unlikely to match the net benefits of a centralized wholesale payment system,” the Bank said in a report.

So mine is hardly an original opinion as Bitcoin prices are extremely volatile and rose to a new high this week of over USD 4000 but the case for the defence is here if you are interested (I don’t agree with it). It seems really simple that on a limited base of coins as the price has risen more people are simply betting it will rise more.

The hard part of an investment bubble is of course spotting it beforehand and defining exactly what one is? This defintion is commonly accepted:

Bubbles are typically associated with dramatic asset price increases followed by a collapse. Bubbles arise if the price exceeds the asset’s fundamental value. This can occur if investors hold the asset because they believe that they can sell it at a higher price to some other investor even though the asset’s price exceeds its fundamental value.

There are  two kinds of asset price bubbles:

  1. Unleveraged ‘irrational exuberance’ bubbles
  2. Credit boom bubbles with a positive feedback loop.

The reason the internet boom ended with a whimper was that it was equity financed. A large number of VC funds and investors took equity risk and lost. Technology induced investment bubbles are not new; the most obscure one I have found yet is the British Bicycle Mania (1895-1900) when share prices of the associated companies rose over 200% over the period, and were divorced from earnings potential.

In comparison offshore (and shipping) was leveraged credit boom and these are more serious “because their bursting can lead to episodes of financial instability that have damaging effects on the economy“. The reduction in shipping loan volumes I discussed earlier are an indicator of that and as Mishkin outlines here is what happened in offshore and shipping (in addition to the underlying dropping dramatically in both):

[a] rise in asset values, in turn, encourages further lending against these assets, increasing demand, and hence their prices, even more. This feedback loop can generate a bubble, and the bubble can cause credit standards to ease as lenders become less concerned about the ability of the borrowers to repay loans and instead rely on further appreciation of the asset to shield themselves from losses.

At some point, however, the bubble bursts. The collapse in asset prices then leads to a reversal of the feedback loop in which loans go sour, lenders cut back on credit supply, the demand for the assets declines further, and prices drop even more. The resulting loan losses and declines in asset prices erode the balance sheets at financial institutions, further diminishing credit and investment across a broad range of assets.

Again this is no recent phenomena and asset heavy industries are particularly susceptible: the railway boom of the 1840s was based on partly paid shares (“derivative like”) and as the author notes:

[t]he use of leverage can exacerbate both the boom and bust in asset price reversals, and it may be wise for policy makers to continually monitor changes in the use of leverage.

If you want to see a microcosm of this look no further than DVB Bank where losses in offshore effectively wiped out the entire tier 1 capital of the bank.

Bitcoin is an ‘irrational exuberance’ bubble and clearly into the realms of behavioural influences as its utility as a currency is minimal, exlcuding black market transactions, and it flutuates enormously as a store of value. Normal state issued paper (“fiat money“) can settle tax obligations and from this its a core part of its value derives, it is impossible to see the state giving up this prerogative. Bitcoin is a technology inspired bubble without any fundamental economic value. 

The core attraction, if you believe the Bitcoin adherents, beyond the obvious anonymity is the apparent stability of the base unit as there is a limit to how quickly new units are “mined” and an overall cap on many cryptocurrencies including Bitcoin (21m units). And indeed one valuation methodology for the currency bases it as a % of all black market transactions. The monetary system being emulated is the gold standard (with nomenclature of mining clearly being no accident) where national currencies were exchangeable for gold (at its peak). The gold standard failed, precisely because the monetary base was too inflexible, and led to and exacerbated the Great Depression.

 

That isn’t to say there isn’t a place for local monies and that they cannot help economic growth. Local currencies, such as the Bristol Pound, exist in the UK. Maybe Bitcoin can serve a similar functional value for the ethereal world.

The interesting thing for those with only passing knowledge of the subject is that this is a monetary system that is being created in relatively short order but because of its open source nature, and the specialised technical knowledge required to enter it, means it is dominated by computer programmers. Yet the Bitcoin system is actually very similar to a crude medieval monetary system and if you want to see how economic history can add some value to a current debate this is a good example. Medieval money systems had a relatively fixed base of currency as The Commercial Revolution was just beginning and much of the coinage used was reminted from Roman times with mining out insufficient to affect the overall supply level until the “New Silver” from Freiberg was found and started moving to Venice. So a lot like bitcoin the money supply expanded only very slowly.

One of the key drivers of the Bitcoin price rise recently has been the split of Bitcoins to Bitcoin cash and there has been a fight between those for and against the split along the lines of preserving coin value and purity versus the need for transactions and the increase in value that will come from acceptance. The Bitcoin cash split comes by splitting the size of each Bitcoin such that it can be mined independently as smaller file sizes containing a number of transactions. The technical innovation is also that it speeds up processing but it also makes it available for micropayments. This is very similar to how medieval mints operated by exchanging larger coins for smaller coins and the difference in the exchange ratio was the seignorage to the mint – although Bitcoin exchanges are private whereas mints were the domain of the King.  The small denomination split is well known to economic historians: In 1956 Cipolla noted:

‘Every elementary textbook of economics gives the standard formula for maintaining a sound system of fractional money: to issue on government account small coins having a commodity value lower than their monetary value; to limit the quantity of these small coins in circulation; to provide convertibility with unit money. . . . Simple as this formula may seem, it took centuries to work it out. In England it was not applied until 1816, and in the United States it was not accepted before 1853.’

This became known as ‘The Big Problem of Small Change‘ which observed that since medieval times during episodes  of inflation small coins disappeared from circulation as they were made up of the exact proportion of value in metal of the larger coins they represented. Small coins frequently disappeared from circulation and made transactional commerce difficult for micropayments (in the current Fintech jargon). The same problem occured during ‘The Great Inflation’ in the United States (1967-1982) when copper coins disappeared from circulation as they were worth more as scrap. It is a great paradox in economics where more money generates rising prices but rising prices generate a shortage of money.

The problem that the Bitcoin cash “fork” in the chain (as it known) is trying to solve is the “penny-in-advance” constraint where “small denomination coins can be used to purchase expensive items, but large denomination coins cannot be used to buy cheap items’. Over time, until the invention of “token” money for small denominations smaller coins depreciated more relative to larger over time. The Bitcoin solution is to develop Bitcoin cash which represents a monetary fraction of a Bitcoin and forks into a seperate chain in the blockchain and in this respect is similar to:

the gradual debasement of the denarius between AD 800 and AD 1200 [that] was not fiscally motivated,but was a reasonable response to economic expansion that exceeded the growth of monetary metal

This was also found in Venice where the :

debasement of imperial pennies by Italian mints from the ninth century to the twelfth has usually been attributed to the greed and completion of local lords, but it probably was in the public interest, because it met a growing need for coin that arose from the increased use of markets and the general expansion of trade.

Bitcoin cash may prove that technology that can solve some of the issues that took medieval monetarists such a long time to work out. Mint technology advanced making forgeries harder and in this case the Bitcoin cash is an exact unit of Bitcoin. But the Bitcoin cash fork is still going to have the same problem that different chains forks over different exchanges and locations still need to be brought together at a common rate to transact. I don’t see it but there is no doubt that in medieval times changing the types and value of coins changed welfare outcomes. So there is a sound economic basis for the Bitcoin split, the question is who will benefit from the changes. Like the mints the Bitcoin exchanges are privately owned and I suspect welfare benefits will accrue disproportionately to them.

Like all economic issues there is not universal acceptance of the solution to the Big Problem of Small Change. An excellent paper here argues that at times small coins experienced periods of munificence as often as scarcity and that the value of large demonimation coins is the “dollar-in-advance” problem where small coins are impractical for large puurchases due to high transaction costs (i.e. verification and clearing).  The other problem with the “Big Problem” is that it may have been small because actually credit was common and debts were settled in kind or when they reached a certain limit.

The distributed ledger technology is also reminiscent of private clearing of notes that used to take place amongst banks when private money was more common. Research into the antebellum Suffolk Bank by the Minnepolis Fed (and others) concluded that there was a natural monopoly in note clearingand explains why clearinghouses and banks such as Suffolk developed that ties into the technology of argument the Bank of Canada. 

The increasing number of cryptocurrencies seem to mimic the early period of US banks where notes were privately issued and traded at a discount depending on the perceived regulatory effectiveness on the state in which they were domiciled or the strength of the bank issuing the currency (in an era prior to depsoit insurance). An extremely readable 20 page history of how complicated it was for the US to actually get a national unit of currency is here (and highlights some of the challenges for the Euro).

Bitcoin strikes me as technology being done because it can (as opposed to the blockchain technology behind it which is clearly powerful), and because, like selling tulips in the 1630’s, it is extremely profitable for some people. Is it an advance? I don’t think so, it adds nothing to the utility of money, doesn’t seem to make the economy more productive and offers the possibility of eroding the tax base. I have made this note here to mark how my views change over time more than any other reason and I will be interested in how this evolves.

I’d rather be lucky than smart…

and these people were clearly both…

For the past year, Google’s car project has been a talent sieve, thanks to leadership changes, strategy doubts, new startup dreams and rivals luring self-driving technology experts. Another force pushing people out? Money. A lot of it. 

Early staffers had an unusual compensation system that awarded supersized payouts based on the project’s value. By late 2015, the numbers were so big that several veteran members didn’t need the job security anymore, making them more open to other opportunities, according to people familiar with the situation. Two people called it “F-you money.”