Saturday, February 28, 2009
China made a series of international investment in natural resources starting early February 2009. In early February, Aluminum Corp. of China (aka: Chinalco) invested US$19.5 billion in Australian mining giant Rio Tinto in exchange for $7.2 billion convertible bonds. If all the bonds are exercised, Chinalco will take up to 18% stake and 2 board seats in Rio Tinto. In addition, Rio Tinto can use the investment to repay part of its $40 billion debt generated by its acquisition of Canadian aluminum company Alcan Inc. in 2007. Then, a week after, in mid-February, China Minmetals Corp. launched a takeover bid of US$1.71 billion for Australian zinc miner OZ Minerals Ltd. This deal can help OZ Minerals refinance its US$560 million debt by the end of this month. On the other hand, China can increase its exposure to the zinc, a major material for anticorrosive coating for steel, to meet the potential rising demand of steel in the rapidly developing China after reversing course from the current economic downturn. In the same week, China Development Bank announced the completion of two international deals. First of all, China Development Bank reached a deal to lend a total of $25 billion to two Russian state-owned energy companies, OAO Rosneft and OAO Transneft, in exchange for an additional 15 million metric tons of crude oil a year for 20 years under the terms of the deal. Second, China Development Bank will finance $10 billion in Brazilian state-owned oil company, Petroleo Brasileiro SA (aka: Petrobras), for its deep-water oil reserves. With China’s financing, Petrobras will be able to pay for its oil and gas discovery costs. Recently, in late February, China’s Hunan Valin Iron & Steel announced that it will buy 16.5% of Australian iron ore miner Fortescue Metals Ltd. for US$770 million thus becoming Fortescue’s second largest shareholder. Fortescue will use the funds to expand its Western Australia’s operations. On top of gaining easier access to natural resources by investing in those companies, the key of those deals is to establish an international business relationship politically and strategically with the involved countries (Australia, Brazil and Russia). This approach will undoubtedly support a more rapid and robust economy in the continuing politic, social and economic reforms for the post-capitalism in China.
In addition to China’s international investments, Chinese government is also aware of the overcapacity in its domestic iron and steel industry. In response to the plunging demand of steel in China, in mid-February, Chinese government announced a consolidation plan in its steel industry – financed by China’s natural resources government-backed funds – by combining three major steel groups to stabilize iron and steel price and to reduce excess capacity by 24% in steel making capacity by 2011. The three groups are as follow: Baosteel Group Corp., Wuhan Iron & Steel Corp., and the combined group of Anshan Iron & Steel Group Corp. and Benxi Iron & Steel Corp. Furthermore, under the 4 trillion yuan stimulus plan released by China in late 2008, to encourage technological improvement in both sectors, the Chinese government recently approved a plan to help petrochemical producers and light industrial companies by increasing export-tax rebates, improving the energy-pricing mechanism, speeding up the expansion in its strategic oil reserves, and curbing coke production projects. By implementing this plan, China’s international investments will provide benefits to the material sector, which will also spill over to the industrial sector. In late February, China agreed to buy $15 billion of machinery, automobiles and food products from Europe. These investments include jet engines from Rolls-Royce Group PLC, cars from Jaguar and Land Rover, and railway equipment and olive oil. All these government spending and investment projects illustrated China’s determination in fostering its domestic economy and its reputation of helping the global economic recovery in the current financial turmoil.
While many countries are suffering from their shrinking balance sheets when they pumped capital into their domestic market, we can see that financially, China is well-prepared to turn itself into an economic superpower during this global financial turmoil. For example, in observing all these expensive deals, some may wonder if China has enough money to pay for them. However, according to Chinese government’s statistics, China will have sufficient “ammunition” for the investments. Even with a slowdown in China’s GDP in 2008, its current account surplus – the sum of foreign trade and income surpluses – in the end of 2008 still had US$440 billion. Moreover, with China being the biggest holder of the U.S. Treasury bill in the world, China does not have any credit risk exposure as the U.S. Treasury bill is seen by the global market as a default-free security. In addition, the current high demand in U.S. Treasurys will allow China to use them as a medium of exchange for its foreign investments.
In my opinion, China is making the right choices. Securing natural resources is only the first step of its economic expansion plan. By politically and strategically expanding through a better control on natural resources production, its price and quantity supplied can be stabilized. As natural resources are the basic raw materials of any given consumer and industrial products, securing the ownership of sufficient natural resources will increase China’s leverage in negotiating the production price of raw materials. The second step will be the industry consolidation that we saw. This consolidation not only stabilizes the production price but also limits its manufacturing output to better match the supply and demand equilibrium. Consequently, the flow of raw material will be controlled and price will not be depressed by excess supply, which will hurt raw material companies’ revenues. If I were China, my next step would be to secure a stable output of agricultural products. If China wants to expand its economy rapidly, it needs more labor, ensuring sufficient food source will minimize the adverse impact from natural disasters such as drought or flood which potentially leads to famine, depends on the duration and extent of the disasters. An adequate food supply will ensure a sustainable economic production in the long run. Once the economy starts recovering, the large amount of liquidity that was injected by the 4 trillion yuan economic stimulus plan last year will allow inflation to come in and lower the real money value. However, with the Chinese government controlling the appreciation of the Chinese yuan, it can slow down the rise in inflation more effectively together with a steady increase in its central bank interest rate.
In conclusion, China’s investment and consolidation strategies will be sustainable only if all the investment strategies and economic policies are interrelated and feasible based on the realistic economic environment. If successful, the combination of investments and industry consolidation strategies with the relatively cheap Chinese yuan will ultimately amplify the effect of the recovery in its economy and will boost its economic expansion.
Monday, February 23, 2009
Last week, British Petroleum PLC (NYSE: BP) announced a 50-50 joint venture partnership with Verenium Corp. (Nasdaq: VRNM) which includes committing $45 million in funding and assets to the joint venture company and building the world’s biggest biofuel facility in Florida. This facility will apply an innovative biofuel technology to ferment inedible plants such as grass or crushed sugarcane to produce cellulosic ethanol. The Florida facility will cost between $250 million and $300 million, will be completed by 2010, and expects to start its production in 2012.
By using a wide array of non-food feedstocks, such as agricultural waste instead of corn and sugarcane – the major raw materials in the conventional ethanol production method – this manufacturing method will reduce the price fluctuation in corn and sugarcane, etc. Moreover, this new ethanol production method not only generates a renewable energy source for the public in an efficient way, but is also environmentally-friendly by recycling the agricultural waste into energy production. Based on the biofuel’s production cycle, we can estimate a potential earning increase in agricultural companies, which can reduce its cost of agricultural production. Instead of paying a fee to dump the agricultural waste in the designated disposal sites, they can sell their agricultural waste to BP and Verenium’s biofuel facilities for a profit. This potential positive earning effect is yet to be reflected in the agricultural companies’ current stock price. If the whole process follows through, those agricultural companies’ stock prices are probably undervalued in terms of a 5-year outlook.
The ethanol can be used as a substitute for gasoline in fueling transportation vehicles. According to Verenium’s estimation, the Florida facility will make 36 million gallons of fuel a year and is aiming for a cost of $2 a gallon. However, the variable cost of the inputs might change depending on the production scale and demand of the market. The earnings of BP and Verenium depend on the price of the biofuel, which is affected by its close substitution, crude oil, and its complementary, cars that use biofuel. If the public has a positive perception to driving biofuel cars, then auto companies which produces cars with biofuel compatibility will gain a first-mover profit from this trend.
As we can see, BP and Verenium’s biofuel deal will create a chain effect to businesses and long term investments across several industries. If this next-generation biofuel is strongly welcomed by the public, we can expect more energy companies to jump onto the biofuel bandwagon and create another hot issue in the market.
Tuesday, February 10, 2009
As the price of crude oil has fallen sharply, gasoline which is derived from crude oil, has followed suit. To many drivers, especially commuters who drive to work every day, gas price contributes a large part of their monthly expenditure. Although the gasoline price has fallen from the peak of around $5 in the summer to about $2 now, drivers should implement certain hedging strategies so that they don’t have to worry about the spike of the volatile gas price again.
One way to do so would be an unreliable method of investing in gas companies such as Chevron, Exxon Mobile, etc. The profitability of these companies is partly derived from the gasoline sales at gas stations around street corners. However, unexpected corporate events also affect the stock prices which affect equity investors’ profit or loss. Therefore, since gas companies’ stock prices are not an accurate indicator for gasoline prices, this method has several weaknesses as a hedging strategy.
Besides using this indirect hedging strategy, we can use another method to directly hedge drivers’ gas expenses by investing in the United State Gasoline Fund (NYSE Arca: UGA). UGA is an exchange-traded fund (ETF) which seeks to track, net of expenses, the changes in percentage terms of the price of gasoline. This works because the retail gasoline price at the gas station is correlated to the gasoline future price traded in the New York Mercantile Exchange, with which gasoline futures are one of the most actively traded futures contracts and represent the primary US benchmark for gasoline prices. This ETF will invest in the futures contract on unleaded gasoline delivered to the New York Harbor traded on the New York Mercantile Exchange that is the near-month contract to expire. So why will investing in UGA stabilize drivers’ gasoline expenditure? If the price of gasoline futures rises, UGA price will rise as well, which will offset the increase in gas price.
Therefore, when another oil crisis or hurricane in the Gulf coast turns the oil market upside down and everyone is complaining abut the surge in gas price, you can just sit back without worrying about the high cost of pumping another gallon of gas.
Wednesday, February 4, 2009
If we look closely at McDonald’s business segments, we will find that in 2008, more than half of the total sales growth was attributed to the global sales from Europe, Asia-Pacific, Middle East and Africa, which amounted to 17.5% regional sales growth. The operating income in these areas also rose in double-digit proportions while the U.S. merely had growth of 8%, which was partly reflecting an increase in McDonald’s menu price. In addition, among all of McDonald’s business segments, Asia-Pacific, Middle East and Africa were the boosters of McDonald’s revenue in the fourth quarter in 2008 at 10%, which doubled that of the U.S.’s.
Another reason for McDonald’s strong sales growth is the sharp fall in commodity price in the second half of 2008 which significantly reduced its operating costs, including the cost of bread, potatoes, corn, etc. Moreover, the continued strengthening of the U.S. dollar in the second half of 2008 also benefited the conversion of foreign currencies’ into U.S. dollars from McDonald’s overseas businesses. This foreign-currency translation contributed an extra 2% increase to its earning from 2007 to 2008.
Although McDonald’s 2008 earning was impressive, it still faces some risks in 2009. For example, its business may be weakened by the strong U.S. dollar, as a strong U.S. dollar makes McDonald’s item prices relatively more expensive than those in the local restaurants in regions outside the U.S. Since food prices are volatile as they are vulnerable to changes in weather, an unexpected spike in food prices is possible at anytime of the year. Moreover, as many European and Asia-Pacific countries reported lower economic growth and employment rates, a drop in consumption expenditure may exert an adverse impact on fast-food chained restaurants such as McDonald’s.
Therefore, there is a chance that McDonald’s luck and management skills reflected in its strong earning in 2008 may not be able to be carried over to 2009. While applauding for McDonald’s success in 2008, investors should also pay attention to its downside risk.
Tuesday, February 3, 2009
What is Timothy Geithner doing as U.S. Treasury Secretary for U.S. President Barrack Obama? It seems like instead of trying to stabilize the global financial crisis, the only job he seems to be doing is instigating new conflicts with other countries and strategic partners. Several of his actions, including tax evasion, currency manipulation criticism and attempts to scapegoat other countries for the collapse of the financial market, have sparked controversy among the public about whether he is truly qualified to serve as a U.S. Treasury Secretary.
First of all, he failed to settle $40,702 in Social Security tax obligations between 2001 to 2004, until it was brought to the public eye.
Secondly, in late January 2008, he accused China its currency which deliberately preventing the Yuan from appreciating against the U.S. dollar, thus making Chinese goods relatively cheaper than goods in other countries, thus gives Chinese companies an edge over foreign competitors. However, according to a currency report, the Chinese Yuan has appreciated by 21% since July 2005, which shows China is allowing its currency to float in the foreign exchange market. In response to Mr. Geithner’s criticism, the Chinese Central Bank’s official said the currency manipulation charge is not only inconsistent with the facts, but also misleading about the reasons for the financial crisis. Furthermore, Chinese Prime Minister Wen Jiabao defended China’s currency policy, saying the strong fluctuation in different global currencies’ exchange rates is common and China should not take the blame from that. This currency criticism caused the interference of the White House to mitigate the furor when China and Russia criticized the U.S. of not taking enough responsibility in addressing the global financial crisis which started last year but only to blame other countries for causing this crisis.
Then, just one week after the Chinese currency manipulation accusation, Mr. Geithner suggested imposing stricter rules on the financial institutions asking for funds from the Troubled Asset Relief Program (TARP) which discouraged many qualified banks from accepting the Treasury’s funds. The new rules would require the U.S. Treasury to certify to Congress that each investment decisions are based on investment criteria and the health of the financial system, which aims at curbing the influence of lobbyists, politicians and others in determining which firms get bailout cash. In addition, the rules should cause more transparency since Treasury will have to explain why they are giving money to a specific company. These new rules are further complicating the financial system. While at least 50 banks that are qualified for aid, they have rejected the Treasury’s funds because they feel uncertain about the future requirements of the program which the U.S. may impose tougher restrictions on institutions that take government cash such as restricting their dividend payments, preventing them from acquiring other banks and expanding their businesses, and potential earnings dilution when government acquire convertible loans in exchange of the rescue funds. However, by declining the funds, these companies showed their investors that they have sufficient liquidity to operate its business without the government’s aid. It also shows that banks are starting to push back against increasing federal control of the banking system, raising concerns about the bailout’s effectiveness.
Since the financial sector suffered the biggest casualty, if the patients, who are the banks, are unwilling to take the medicine, which is the rescue fund, then the whole rescue plan will prove wasteful and unsuccessful. Therefore, Mr. Geithner should consider the effectiveness of his potential financial policies and rules to the banks before implementing them.