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FrontPoint Quarterly Investment Research

Three Men in a Boat
4th Quarter, 2005
Partner, Portfolio Strategist (203) 622 5410 Michael@fppartners.com

Michael C. Litt

Summary In our research piece The Great Compression, issued at this time last year, we explored the low level of risk premiums then available from a variety of financial assets. As risk premiums have remained low and in some cases tightened further, we wanted to revisit and extend our research. The objective of this paper is to explore how dynamics between Asia, petrodollars and the Fed are affecting investor behavior and the global financial markets. Our research for this piece has led us to conclude that our earlier findings underestimated the pervasiveness of secular forces driving risk pricing. China, petrodollars and the Fed are now three men in a boat. While two members of the crew, China and petrodollars, are pouring liquidity into the SS America, the Fed is rapidly bailing. Our investigations are intended to better understand what is driving the crew members’ behavior at present and the prospects for that behavior changing in the near future. We believe the following issues to be most relevant: • • • • •

China’s emergence as a capitalist nation and the recent change in valuation of its currency Differing perspectives on the world’s ability to meet its crude oil and natural gas needs Japan’s emergence from a deflationary psychology Investor behavior in response to pressures on traditional pension plan economics The twilight of Alan Greenspan’s nearly two decade tenure as Chairman of the Fed

As always, our intention is to inform and challenge the Chief Investment Officer at global pension plans and endowments in making strategic decisions. The findings presented in this piece will describe near-term catalysts that are likely to reverse the current compression dynamics. We will examine specific implications for the types of asset and risk exposures that large institutional pools of capital will want to seek and avoid over the next 3 to 5 years. Our conclusion is that failure to make strategic adjustments in the coming quarters is likely to prove costly for sponsoring organizations.

 

Exhibit 1:
5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 Jan-99

Real Interest Rate on 4/15/28 TIPS

Jul-99

Jan-00

Jul-00

Jan-01

Jul-01

Jan-02

Jul-02

Jan-03

Jul-03

Jan-04

Jul-04

Jan-05

Jul-05

Source: Bloomberg.

Dangerous Currents Institutions are under enormous pressure to take on additional risk, thanks to current investment realities in the financial markets. Exhibit 1 indicates that real rate bonds in the US continue to offer investors less than 2.0% real returns based on CPI. Exhibit 2 shows that our measure of the propensity of large pools of capital to take on more risk - the Liability Gap - also remains at an extreme level, near -500 bps. Historically, deterioration in this measure has led to risk seeking-behavior by investors, notably in the periods leading up to 1987 and 1999. The issue today is not so much further deterioration in the liability gap as it’s persistence at an extreme level. At the same time, the yield premium available for moving from a 2-year to a 10-year rate commitment in US Treasury bonds is now less than 25 bps, as the US yield curve has flattened substantially in 2005. In justifying these return premiums, market participants are being led to believe that the concept of full employment in the US economy is no longer relevant to costs, given the endless supply of cheap labor available from India and China. Therefore, consensus now presumes that long-duration fixed-income instruments should structurally offer a lower risk premium.
Exhibit 2:
8% 6% 4% 2% 0% -2% -4% -6% -8%

The Liability Gap*

Source: GM & the U.S. Treasury

* The liability gap for a US pension plan is the difference between the ten-year US Treasury and the FAS 87 expected rate of return on pension assets. The measure utilizes the liability gap for GM’s pension assets since 1980. We use GM as one real world example of the issues every pension plan currently faces, and not to highlight any risks present at GM in particular.

Ja n N -80 ov Se -80 p8 Ju 1 l M -82 ay M -83 ar Ja 84 n N -85 ov Se -85 p8 Ju 6 l M -87 ay M -88 ar Ja 89 n N -90 ov Se -90 p9 Ju 1 l M -92 ay M -93 ar Ja 94 n N -95 ov Se -95 pJu 96 l M -97 ay M -98 ar Ja 99 n N -00 ov Se -00 p0 Ju 1 l M -02 ay M -03 ar Ja 04 n05

2

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We believe the current environment is very different from that of the late 1990s. indicates that speculative capital had moved into various currencies ahead of the announcement. Citigroup’s Asia team sees the PBOC making further revisions in 2006. We can expect the reported US trade deficit to be 5. “floating” is a bit too strong a term to describe the exchange rate between the Chinese and US currencies subsequent to this policy change. The RMB and all other Asian currencies would need to move by 40% or more in order to affect the trade imbalance materially. there is a trade deficit with China and it is growing. the lack of disclosure as to the basket’s composition or individual weightings gives little visibility as to the timing or magnitude of future revaluations. That fixation appears to satisfy their need to feel adequately risk-averse. Today.The low level of incremental return being paid for taking on risk has migrated to other markets. Investors see “bubbles” all around them. But make no mistake about it . the combination of low real rates and narrow credit spreads inherently stimulates the global economy. FrontPoint’s Hong Kong-based Asia Pacific portfolio manager. The new mechanism essentially re-pegs the RMB to a basket of currencies beyond just the dollar. Credit spreads. Nonetheless. It is for precisely these reasons that liability-driven investors continue to experience surplus deterioration. and oil appears to have found an equilibrium level above $60 per bbl. Today’s emerging market debt risk premiums depend on the recent surge in global economic growth. instead. Katrina and Rita came ashore in the Gulf of Mexico.higher if oil prices move up to $80 per bbl and stay there. The central focus regarding China’s revaluation has been on its potential for lowering the cost of US imports from Asia and hence reducing the US trade deficit with that region. and it is probably best to view the relationship as having moved from fixed to “managed. but it largely ignores the true nature and magnitude of risks being taken within financial portfolios. they ignore a history of shifting political agendas after large sovereign debt issuance by these emerging market nations. freight and insurance costs. Actually. 3 FrontPoint Partners  . Meanwhile. US subsidiary sales back into the US. Does It Float? The move to a “floating” value of the Chinese yuan (RMB) against the US dollar by the People’s Bank of China (PBOC) on July 21. Simultaneously. In the latter stages of our research process. The US trade deficit will continue to grow. 2005. Indeed. although their extent is widely debated. was widely anticipated. certainly less than the 5%-10% upward move discussed throughout the first half of 2005. when asset values were driven by unrealistic assumptions regarding future growth in technology and telecommunication earnings. Fed chairman Alan Greenspan cannot raise short-term interest rate targets fast enough. probably disappointing some speculators.5% in 2006. drifted down once again in response to low real and nominal bond yields. over the near term. but are not limited to. However. especially in Asia. serving as a reminder that change is the only real constant.this revaluation will not affect the trade imbalance.” The shift to a managed float was consistent with the Chinese government’s objective of maintaining tight control over its currency value. A number of former Treasury and Federal Reserve Bank officials have pointed out the imperfections in the Commerce Department’s measure.0% of GDP in both 2005 and 2006. not only with China but with the rest of the world. after being shocked in the second quarter of 2005. China will run a trade surplus of 5. we anticipate any move will probably be at the lower end of that range. 6. and over 7% in 2007 .5% to 6. and the ability to reasonably measure physical goods imported but not services exported. in both absolute terms and relative to GDP. perceptions of risk are diminished by the presence of temporal excess liquidity. James Soutar. The yield advantage on emerging market debt is now below levels seen just prior to the Russian default crisis in 1998. The initial revaluation of a little more than 2% was modest. These shortcomings include. Forecasts range between 5% and 10%. The reality is that the US trade deficit is overstated.5% of GDP in 2005.

China experts indicate that the man on the street in any given province desires capitalism far more than he does democracy. of course.0 1990 1991 1992 1993 1994 1995 1996 Global GDP Growth 1997 1998 1999 2000 2001 2002 2003 2004 2005 Source: World Bank. even though Europe and Japan have been conspicuously absent from the equation. without taking protectionist measures.5 1.000 6.0 1. China and India have each embraced more capitalistic social and economic philosophies. 4 FrontPoint Partners  .000 11. Why? Chapter Six of the National Security Strategy (NSS) of the US is titled “Ignite a New Era of Global Economic Growth through Free Markets and Free Trade.000 26. Even in the face of a growing trade deficit. the current US administration is likely to allow that level to be reached over the balance of this decade. Exhibit 4 shows that the acceleration of the US trade deficit has accelerated global growth in recent years. Global GDP ($Bil) US Current Account Balance (LH) Global GDP (Year 2000 Dollars) (RH) 31. as the world’s reserve currency supplier.5 0. One can see from Exhibit 3 that global growth has recently shifted into higher gear.” In this context.000 12 /3 1/ 19 12 72 /3 1/ 19 12 74 /3 1/ 19 12 76 /3 1/ 19 12 78 /3 1/ 19 12 80 /3 1/ 19 12 82 /3 1/ 19 12 84 /3 1/ 19 12 86 /3 1/ 19 12 88 /3 1/ 19 12 90 /3 1/ 19 12 92 /3 1/ 19 12 94 /3 1/ 19 12 96 /3 1/ 19 12 98 /3 1/ 20 12 00 /3 1/ 20 12 02 /3 1/ 20 04 Source: Napier Investments.5 4.000 1.5 3. Such growth is.000 16.0 0. Sino-US interests are aligned on growth and security matters. Exhibit 3: 4.000 21.0 2. The shift by the two most populous countries toward a more capitalistic social philosophy is having a positive impact on global economic growth. consistent with US security objectives. must incur a trade deficit in order for the developing nations to continue financing their growth.5 2.Yet it is probably in the interests of the US to allow the Chinese managed currency policy to take its time in reaching an equilibrium level. Ron Napier at Napier Investments has convinced us that the US. Exhibit 4: 1000 800 600 400 200 0 -200 -400 -600 -800 US Current Account vs.0 3.

We expect any number of investment opportunities in China to follow a similar pattern. The strategic importance of the shift to a managed currency relationship between the country with the largest population and that with the largest economy is what it signals. concurrent with recapitalization. Exhibit 5: Surging Chinese Materials Demand Source: Morgan Stanley Research 5 FrontPoint Partners  . and capital deployment to that region will require a good deal of selectivity. This is being done to facilitate the transfer of a modern credit culture. Each time the RMB is revalued it will signal assurances of near term grwoth by Chinese officials. Over the past decade. China must develop its own consumer economy. China’s the banking system is plagued by a legacy of lending practices that have created a high percentage of nonperforming loans. By signaling confidence in their domestic economy through periodic revaluations. Iowa. The growth objectives required to transition 300 million people from an agrarian economy into the “working middle class” . But these events will not be of material importance to investors. including a larger role for mortgages.We can anticipate political rhetoric from Washington regarding the trade imbalance with China. Paramount on the PRC government’s agenda is the state of the banking system and its ability to foster growth in the nascent consumer economy. but we are less convinced that they will prove to be prudent investments for non-strategic minority holders with anything less than 10-year time horizons. rather than from the traditional policy loans to state-owned organizations. A trip to China by President Bush will be in order. followed by a 2%3% revaluation of the Chinese currency as a parting gift. Future loan growth will increasingly come from consumer lending. We believe that such strategic positions make a lot of sense for the likes of HSBC.are substantial. exacerbating pricing pressure for many key raw materials. the story in Asia has been strong revenue growth and flat to negative earnings growth. As is well known. This is worth noting for investors. The Chinese government is now allowing major foreign banks such as HSBC to acquire strategic stakes in the large domestic banks. unless protectionist measures result. confidence by Chinese officials that this is in the best interest of China.already estimated at 300 million . Exhibit 5 indicates the inordinately large percentage of demand that China now represents for certain commodities in relation to its share of global GDP. especially during congressional elections. Chinese officials recognize that they cannot meet those objectives solely by being Asia’s final assembler for goods sold at the Wal-Mart in Cedar Rapids. the Chinese will influence global commodity and capital markets. The system’s fragility necessitates continued levels of loan growth.

begun to influence financial markets significantly. who oversee FrontPoint’s energy-related investment activities. Treasury / Oil Correlation Source: UBS Into the Well Oil and gas supplies have. nominal bond yields in the US and the price of crude oil have moved in tandem.The currency revaluation signal is particularly important for two assets that are in short supply. 6 FrontPoint Partners  . one expects to see pronounced backwardation (forward prices lower than spot) in oil prices during spikes in spot prices. Readers with less interest in the liquid energy markets can in good conscience skip to the last of the five sections. The presumption was that the inflationary impact of oil prices was captured in nominal bond yields. Ross Collins and Ellis Eckland. by way of their price inelasticity. A team at UBS has looked at the long-term relationship between these two assets. it now appears that bond yields are moving inversely to the price of oil. Exhibit 6 shows that very recently this relationship has disengaged. Tim Flannery. developing a view of the commodities’ future impact on a variety of investments. if anything. Historically. We believe that oil and US Treasuries are being governed by similar and connected global capital flows that are keys to understanding the current investment landscape.S. Dragons and Tigers. George Shiau.” which contains an adequate summary of the more detailed discussion. “Feeding Eagles. namely crude oil and US Treasury bonds. The next five sections will explore oil supply and demand dynamics in some detail. Historically. have made a number of interesting observations regarding oil this year. Exhibit 6: U. The team prepared Exhibit 7 to show that the backwardation discount has been steadily diminishing in forward oil prices since 2000 at sub-cycle peaks.

7 FrontPoint Partners  .Exhibit 7: 10.0% 1/25/05 . not speculators.64/bbl -20.$37.$37.59/bbl Discount to Front Month -10.25/bbl 9/15/05 .$49. Perhaps producers needed backwardation to disappear before they could make the long-term investments required to add production capacity. For instance.20/bbl -40. a state normally reserved for periods when spot oil is trading below average prices because of temporary supply overhangs. in order to induce investment.$49. possible explanations include a lack of physical storage capacity. the falling backwardation discount was an early indication of an increasing supply/demand imbalance. Oil entering contango at $50 per bbl.$64. price inelastic at present. or producers signaling doubts about adding to future production levels. data from the NYMEX does not corroborate this explanation. a potentially important marginal supply.0% 5/4/05 .13/bbl -50. may require forward confidence of $45 per bbl. regardless of one’s choice of explanations. inadequate supply of natural hedgers on the production side. The issue of why backwardation has diminished is complex. driving up the price of oil in the futures markets. We are convinced that the “speculator” argument for the appreciation of oil is simply populist theory and does not hold water. In retrospect. since the bulk of net positions over the past year have been held by hedgers. however.0% Crude Backwardation at Peak Oil Prices Crude Backwardation at Peak Oil Prices 0. not less.$50. A fourth possibility sometimes discussed is a geopolitical risk premium that did not exist in the past. the oil strip was in contango (spot prices lower than forward prices). it is illogical for backwardation to disappear permanently from the oil strip.$34.. especially during price spikes.0% 3/12/03 . Instead. As shown in Exhibit 8. in the form of commodity funds.13/bbl 7/15/05 . Many have argued that this forward pricing phenomenon was due to speculators. is a strong indication that this may be the new low price. oil sands.0% 10/26/04 .17/bbl 11/29/04 . Given that oil appears to be more.76/bbl -30. commercial users of crude and refined products appear to have been hedging input costs more aggressively.0% 3/7/00 . when oil hit $50 per bbl. The fact is that oil normally trades in backwardation because demand is inelastic and there is a value to immediate possession that results in the spot price trading at a premium.$58.$55.0% 0 2 5 Years Ahead on Forward Curve 3/7/2000 9/20/2000 3/12/2003 10/26/2004 11/29/2004 1/25/2005 5/4/2005 Source: FrontPoint Utility & Energy By early 2005.83/bbl 9/20/00 .

Exhibit 8: Oil Futures Speculative Trading Activity Source: UBS Outside Saudi Arabia and Iraq. In addition. even crude oil production should grow. 95% in the US and close to 90% in Asia. Russian production growth over the prior decade may have reflected completion of the easiest remediation projects left over from the collapse of the Soviet Union. the issue of centralized planning in oil exploration and production management looms large in the oil price equation. Exhibit 9: (%) 100 90 80 70 60 Refinery Utilization U. there currently appears to be little excess capacity left in OPEC’s oil delivery reservoir. The situation in Russia has been somewhat of a surprise recently. as can be seen in Exhibit 9. but also that existing reserves there are being permanently damaged by hydrocarbon injections. after being the primary engine of nonOPEC supply growth over the last few years. Meanwhile. even at current production levels. 50 Europe Asia 1980 Source: First Reserve Corporation 1990 2000 2010 8 FrontPoint Partners  . even at historically high oil prices. Russia has apparently hit the wall in boosting its oil production. and it is perceived as a major contributor to oil’s current high price.S. The current shortfall is largely driven by political actions and tax structures that discourage incremental investment in Russia. In Iraq we believe not only that supply has been disrupted. These capacity utilization rates are higher than they were in the past and point to continued tight markets and price sensitivity for refined products. refinery utilization rates are projected to be near 100% in Europe. As we shall see.

Hans Feringa. Oil in contango encourages inventory building. Exhibit 10: Tanker Rates and Crude Price Tanker Rates and Crude Price 80 70 60 50 40 30 20 10 0 10/3/2000 10/3/2001 10/3/2002 10/3/2003 10/3/2004 1/3/2000 4/3/2000 7/3/2000 1/3/2001 4/3/2001 7/3/2001 1/3/2002 4/3/2002 7/3/2002 1/3/2003 4/3/2003 7/3/2003 1/3/2004 4/3/2004 7/3/2004 1/3/2005 4/3/2005 7/3/2005 US WTICrude Tanker Rates Source: Bloomberg. This was painfully obvious in a recent cover story in the New York Times magazine by Peter Maass. largely because of lower-than-expected shipments from the Persian Gulf.The FrontPoint team has also observed that supertanker freight rates have fallen sharply in 2005. head of tankers at Stolt-Nielson. titled “The Beginning of the End of Oil. But the OPEC countries do not disclose production rates and inventories. But Exhibit 10 shows that oil has continued to rise even as tanker rates fell sharply. which is what the OPEC producers in the Middle East claim is causing shipping rates to fall. We can see from Exhibit 11 that US inventories have in fact surged during the period in which oil has been in contango.” Saudi officials gave Maass so little information about their future production rates that he was left to rely largely on a method of gauging oil reserves known as Peak Theory. points out that tanker rates normally fall on a lagged basis after the price of crude oil itself falls. Exhibit 11: Rising US Crude Oil Inventories in Response to Contango Source: UBS 9 FrontPoint Partners  . FrontPoint Partners.

approaches the problem of an oil production peak from both a micro and anecdotal perspective. Based on the same methodology. Ken Deffeyes. Exhibit 12 shows the decline in both discoveries and average field production. Peak Theory has been garnering a good deal of attention. Since that time. The fact is that demand has been growing at 2% per year since 2000. Even if Ghawar has not begun to decline. various experts have applied his equations in making fairly accurate predictions about peak oil production in individual countries. King Hubbert. Peak Theory holds that the rate of global oil discoveries and production follows a logistic (bell-shaped) curve. which he points out numerous times.1950s 1950s 1960s 1970s 1980s 1990s 100 0 Source: Simmons & Company. Exhibit 12: 600 Declining Discovery Rate & Field Size Average current Production Per Field Number of Discoveries 35 30 25 20 500 400 300 15 200 10 5 0 Pre . After that point. while estimated production levels have been growing at less than 1%. there are not enough hard facts available for Simmons to model future oil production for Ghawar or the world. Matthew Simmons. in the wake of Katrina. concentration of global production from these fields. requiring a good deal of expensive remediation to hold production flat. some geologists have produced estimates that the world has reached. will invariably begin to decline. has gone so far as to project that oil production will peak on or around Thanksgiving of 2005. a Princeton University geology professor and author of Beyond Oil.At the risk of oversimplifying the actual mathematics. Like other super giant oil fields -. In the end. claiming they cannot get global production above the current level of 84 million barrels per day (mbd). Demand is projected continue to grow at roughly the same rate for the balance of this decade. This mathematical relationship was first utilized by M. the apex of its cumulative production curve. the increasing water cuts from that field are a clear sign of lower productivity.including Prudhoe Bay in Alaska and Forties in the North Sea . Crude Polemics With oil hitting $70 per bbl.the world’s largest field. their old age. Ghawar in Saudi Arabia. Boone Pickens. global production will begin to decline. Hubbert’s Peak Theory today largely rests on anecdotal evidence. and the absence of new super giant field discoveries to replace them. reaching 94 mbd. the founder of Simmons & Company International. in 2010. working as a geophysicist at Shell Oil in 1956. 10 FrontPoint Partners  . One proponent is T. He is currently kicking dirt in the direction of Crown Prince Abdullah and Vladimir Putin. or soon will reach. Because of the lack of available data. His prediction turned out to be remarkably accurate. the founder of Mesa Petroleum. which came onstream in 1951. Simmons’ papers focus on the lack of fieldspecific production data for the world’s super giant fields. Hubbert predicted that oil production in the US would peak in 1970.

Prior to the discovery of oil in east Texas there was a similar panic in the early 1920’s. Russia is expected to produce well over half of the incremental gain from the non-OPEC suppliers. and as a result we cannot go into great detail with respect to its findings. current limits on the world’s refining capacity give the Saudis scant incentive to act. The CERN report is private. Peter Jackson and Robert Esser at CERN have compiled a detailed report titled “Worldwide Liquids Capacity Outlook to 2010 -. Exhibit 13: 25 WTI / Maya Spreads 20 15 $/bbl 10 5 0 2 2 2 3 02 03 2 2 3 3 03 4 04 20 0 20 0 20 0 20 0 20 0 20 0 20 0 20 0 20 0 20 0 20 0 20 0 20 0 20 0 20 0 20 0 20 0 20 0 20 20 20 20 0 20 0 20 20 05 4 4 4 2 3 3 5 4 5 5 2/ 7/ 1 5 9/ 6/ 3/ 8/ 3/ 0/ 8/ 5/ 8/ 4/ 3/ 0/ 0/ 5/ 5/ 4/ 5/ 2/ 7/ 5/ 1/ 9/ 0/ 1/ 2/ 2 4/ 2 10 / 12 / 6/ 1 5/ 2 8/ 1 1/ 2 7/ 1 3/ 2 9/ 2/ 2 11 / /3 4/ 2 8/ 1 10 / /3 12 Date Source: Bloomberg. For example. especially as actual production levels evolve over the next five years. according to most analysts. Daniel Yergin. The problem is that Russia is already falling well short of its expectations for 2005 production levels. According to Yergin. Yergin points out that the current oil supply panic is the fifth in history.On the other side of the argument is Cambridge Energy Natural Resources (CERN) and its founder. Based on this chart. It may be worth possessing for a fuller understanding of the counterargument to Hubbert’s Peak.5 mbd to a total of 101. The problem for the Saudis is that the marginal supply they can put on the table is a heavy/sour grade of crude versus a light/sweet grade. this indicates that the grade of crude oil required by the current global refining infrastructure is incompatible with the available supply required to meet 2% annual growth in global demand. this panic. Colin Campbell.Tight Supply or Excess of Riches?” Their analysis concludes that barring unforeseen supply disruptions. Actual production levels for Iraq. Our contacts among the shipping concerns suggest that inventories in the Persian Gulf may not have grown. it appears that someone is already putting additional supply of heavy/sour into the market. If Jackson and Esser are correct. Ross Collins prepared Exhibit 13 showing that the spread between West Texas Intermediate (light/sweet) and Maya (heavy/sour) has been both volatile and increasing for the past two years. FrontPoint Partners. These sources point out that in the past. oil prices will end up well below recent levels during the second half of this decade. a noted Hubbert’s Peak expert. previously called global oil production to peak in both 1989 and 1995. 11 11 5/ 1 6/ 1 1/ 2 3/ 2 6/ 0/ FrontPoint Partners  . via new discoveries and improvement in the longevity of existing fields. Mexico and Venezuela also appear to be well behind publicly announced targets. liquids capacity could expand by 16. well above the estimated demand of 94 mbd. will be resolved through the application of new technologies that will make current proven reserves appear ultraconservative. like its predecessors. At a minimum. and that the drop in shipments is due to falling production rates rather than inventory buildup. At present the world has insufficient capacity to refine heavy/sour grades of crude.5 mbd by 2010. As in the recent past. lowering the relative price for that grade but doing little to moderate the price of West Texas Intermediate. The two sides of this argument couldn’t be farther apart. the Saudis have responded to higher oil prices by raising production to head off any permanent damage to the demand side of the equation. Thus.

led by the OPEC nations. oil prices have not increased in current dollars. most of the world’s remaining abundant oil reserves reside in countries whose resources are both state-controlled and state-developed. as Simmons and Yergin both note. and second. To some degree. Today. which often pass through to the NOC or government. The average real price of oil between 1986 and 2002 was actually below that of the 1974-to-1978 period. The second type of arrangement has largely evolved in countries with limited or technically difficult reservoirs. The only exception was a brief price spike during the invasion of Kuwait in 1990. Viewed from this perspective. Exhibit 14: 16 14 12 10 8 6 4 2 0 Jan-70 Jan-72 Jan-74 Jan-76 Jan-78 Jan-80 1970 $ Producer’s Perspective and Oil Prices 1970 $ Jan-82 Jan-84 Jan-86 Jan-88 Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Source: NYMEX. where the majority of production is owned by a NOC but Western investment is tolerated (examples include Venezuela. where production is solely controlled by a national oil company (NOC). nationalized their oil industries and assumed the assets of the Seven Sisters. This changed in the 1960s and 1970s as successive countries. FrontPoint Partners. But looking at this same chart in 1970 dollars shows the perspective of those required to commit capital to develop new opportunites. The NOC may not want to maximize net present value by thoroughly developing oil 12 FrontPoint Partners  Jan-04 . But such arrangements generally limit the upside in returns that might materialize from commodity price appreciation. We generally feel good. Given their role as primary sources of government revenue. and quite volatile. What they see is the depressed real price of oil. where the resources may be uneconomic to develop without Western technology. Ecuador. a NOC’s motives may be quite different from those of an independent company operating in a purely capitalistic context.Motivations Past and Present We are conditioned to looking at any chart of oil prices over the past 35 years from a consumer’s perspective. Yemen. There are generally two types of arrangements: first. NOCs also serve political and social interests. the economic motivation to explore and develop new oil fields has been limited by the commodity’s low and volatile average price realization. it take billions of dollars and 5 to 7 years to bring new capacity online. This fact is relevant for investors because. Oman. The problem is found in developing nations sitting on the bulk of the world’s remaining petroleum reserves. There is another and perhaps more troubling structural impediment to supplying the world’s daily oil requirements. as in Saudi Arabia and Mexico. Investments by foreign companies are generally governed by production-sharing contracts that guarantee a minimum return to foreign investors. Indonesia and Syria). because until recently. the lack of investment spending over the past two decades has contributed to the current shortfall in supply. Historically. Consequently. the forerunners of today’s Super-Majors. the major oil companies dominated exploration and development of reserves.

Kornai’s is considered the best thinking on how and why central planning leads to a variety of shortages. as well as the recent renegotiation of existing agreements. makes the hurdle rate for new investment that much higher. This situation continues even in a period of record oil prices. The objective of sustaining power leads centralized planners to become increasingly disconnected from the events on the demand side. central planners subsidize production of specific goods over the short term to achieve to political goals. Pemex has also been used to finance non-energy-related development initiatives within Mexico. There is often a parallel degradation in both human rights and responsiveness to the society’s economic needs and demands. In his 1980 book Economics of Shortage. In the short and medium term. Often. Besides being a permanent revenue source within the government’s operating budget. Political demands for cash have become so great that Pemex’s operating business has essentially been starved of capital. Reserves at Cantarell have been depleted over time. Venezuela and Russia).. As a result.reserves. While NOCs in the Middle East. The control of resources by NOCs. Thus. and generates more than 50% of Mexican production. the Hungarian economist János Kornai explored the systemic flaws in central planning that resulted in endemic shortages of goods and services in his native Hungary and throughout the Soviet satellite states.g. behind only Ghawar. they manifest themselves as persistent shortages in global energy supplies. but rather guarantee a sustainable ongoing political agenda. Furthermore. the temporary boost from the nitrogen injections is coming to an end. In the early 21st century. they are the exceptions. all oil development is managed by the state monopoly. Pemex appears to have limited ability to replace that production. Over time these disconnects lead to misallocation of capital and resources. whether as a result of royalty revisions or sanctity of contract issues. higher prices don’t necessarily spur higher investment. there have been numerous cases of governments renegotiating contracts and raising oil-related royalties in response to higher commodity prices (e. Mexico was able to stabilize and even increase production slightly through nitrogen injections that maintained reservoir pressure. Malaysia and in a handful of other countries are proficient at integrating high-quality management and technology. economic and in many cases military power become highly concentrated. and production at Cantarell is poised to decline at 15%-18% per year going forward. very little has been done to 13 FrontPoint Partners  . Mexico sits upon what are believed to be bountiful offshore reserves in the Gulf of Mexico and is currently one of the world’s largest oil producers. Mexico’s NOC cannot even do routine maintenance on existing production facilities. in countries that allow independent oil companies to participate in development. In the second half of the 20th century. Now. But this method boosted current production at the expense of reserve life. Kornai cites numerous historical instances in which political. such shortages were visible on grocery store shelves in the East Bloc countries. Pemex. Often. Cantarell is the world’s second-largest oilfield by production. and production levels began to decline around the turn of the century. has reduced exploration prospects for private oil companies. An uncertain investment environment. Mexican oil assets are protected from foreign ownership in the Mexican constitution. While romanticists portray Marxism as workers taking control of society and the economy on a cooperative basis. despite aggressive projections for new fields. While Pemex has multiple deepwater prospects and some new fields that have been on the drawing board for many years. In this way a central planning structure can lead directly to economic shortages. thanks to discovery of the super giant Cantarell oilfield in 1971. private interests simply do not have access to the best fields from either a geological or a financial perspective. oil may be getting harder to find in part because central planners control future opportunities. 21st Century Central Planning Mexico provides us with a glimpse into how NOC ownership affects extraction and management of a country’s oil reserves. thus. causing shortages of those and other goods in the medium and long term.

Feeding Eagles. in China’s case. Kornai’s analysis carries significant weight in the debate over future oil supply. as Kornai has pointed out. Chavez verbally offered subsidized heating oil to between 7 million and 8 million low-income households in the US for the winter of 2005-06. per day. Dragons. In response to this price cap. Venezuelan President Hugo Chavez has indicated recently that the agreements with the private operators will be renegotiated. Venezuela is the world’s fifth-largest oil exporter and the fourth-largest supplier of oil to the US. it should be remembered that largesse of this sort does not come without a cost in the medium term. it is artificially suppressing Chinese demand for refined products. Although the price cap is gradually being increased. gas lines appeared on the New Jersey Turnpike recently when it was disclosed that stations along that roadway sold gas based on an averaging mechanism that was lagging the market price by 50 cents per gallon. or the potential for confiscation of property should they be given that access. as suppliers refuse to import. Gas prices in Venezuela are approximately 3 cents per liter. offered to explore and develop the more difficult heavy/sour grade opportunities in the western portion of Venezuela under a taxation and royalty agreement that was subsequently revised in Caracas’ favor. Recently. Tia Juana and Cabimas fields. Chavez offers similar subsidized arrangements to Venezuela’s Latin and Central American neighbors. Bachaquero. but it is estimated that number has now dropped to 1. Subsidizing current consumption results in shortages later. But most westerners are not aware that there are gas lines in China today.develop either identified or prospective fields. BP. Most of its oil resources are managed by the national oil company. Shell. and Tigers Over the past decade. With production declines and continued demand to fund government programs. While one must applaud Chavez for his humanitarianism. 14 FrontPoint Partners  . When the Chinese motorist works his way through the line to the pump. PDVSA’s properties had been producing 3 mbd. among others. and domestic producers attempt to export as much as they can to the world market.5 mbd. Demand for refined petroleum products clearly remains both inelastic and. where oil has been reasonably cost-effective to extract. Crude oil may be increasingly subject to the “Economics of Shortage. Similar events are now taking place in Russia. he is allowed to purchase only a limited amount of gasoline. thanks to a government-mandated price cap on refined products. In fact. Meanwhile. the Mexican petroleum sector is likely to enter a period of protracted decline. This NOC controls the large Laqunillas.000 bbl. cash flows available to develop these opportunities are likely to decrease in the future. A few years back. Essentially. Similarly. perhaps somewhat artificially suppressed.” even if CERN’s projected oil reserve potential becomes a reality. the private interests’ production has grown from nothing to just under 1 mbd. in the western projects. PDVSA. Chevron Texaco and Repsol. which holds Chinese retail prices well below world market rates. China National Oil. the private interests can either leave or agree to an arrangement giving PDVSA a 51% to 80% controlling interest in those western properties. refineries in Singapore and elsewhere ship their gasoline supplies to countries paying a market price. or 12 cents per gallon. Without foreign capital and a change in the constitution. representing 10% of CITGO’s production capacity. which has refineries in the US that currently process 664. China and the US together accounted for 60% of the growth in oil demand. One would assume that Yergin’s vision of technology boosting future oil production does not include lack of access to the best opportunities by interests with capitalistic motivations. PDVSA owns CITGO Petroleum.

At the same time. but Chinese oil companies will likely continue their acquisition strategies abroad to secure the resources required to achieve the country’s economic growth objectives. as it turns out.Exhibit 15: Average Oil Consumption to GDP Ratios in countries and China Source: UBS China. CNOOC’s attempt was unsuccessful. A similar dynamic is projected for India. This explains CNOOC’s recent pursuit of Unocal. there has been a notable increase in the percentage of US debt held by foreigners. While there is some evidence that the aging demographic plays a part. As risk premiums have come down in fixed-income markets. with production capacity already running well ahead of projected demand. The world is now realizing all that had been hoped for when the Berlin Wall fell in 1989. consumes almost twice the amount of oil per unit of GDP than do the G-6 nations. compounded by the inherent inefficiencies of centralized planning. the command and control economics that govern the world’s oil supply have entered political retrograde in many of the countries with the best supply opportunities. that aging demographics are necessarily driving this investment phenomenon. in China’s case. a unit of growth in China is more costly to global oil reserves than a unit of growth in the developed countries. In any country. another factor is the overall lower level of technological integration one would expect in a developing country. confirms that the fastest demand growth from these types of accounts is for yield-oriented funds. it is a risk-aversion response to the loss of wealth over the past five years. Unfortunately. in the face of demand driven by a global compounding of capitalism. These supply constraints are relatively intractable and will result in sustainable high prices for oil and gas. More probably. as one would expect in the presence of large and increasing trade deficits. as shown in Exhibit 15. We are not convinced. however. CitiStreet. the evidence is more conclusive that growth in demand from foreign entities is causing the compression in real interest rates. the second-largest custodian of 401(k) accounts in the US. 15 FrontPoint Partners  . Thus. and that share continues to grow. it has been pointed out that as the developed-country populations age there will be a secular rise in demand for yield-oriented financial assets. Enter the Conundrum The Federal Reserve has raised interest rates 11 times in 15 months yet long term US rates have not changed. this measure depends partly on travel distances. This has implications for the value of energy assets and is relevant to investors. Automobile sales are currently growing 50% year-over-year in China. China represented 3% of global demand for oil a decade ago but now represents 8%.

Dec.Apr.Dec. It coincides with the point when the relationship between oil prices and bond yields reversed field. Exhibit 17: Chinese Producer Source: China National Bureau of Statistics.Apr.Dec.Apr. thanks in part to the cost of the war in Iraq. China’s growth and the relationship between the oil price and bond yields.Apr98 99 99 99 00 00 00 01 01 01 02 02 02 03 03 03 04 04 04 05 Percentage of US Debt Held by foreigners Source: U. It was also at this time that the backwardation discount in the oil strip began to dissipate sharply. It turns out the fastest growth in demand for US Treasury securities from foreigners is coming from China and the OPEC nations. who recently joined FrontPoint’s Portfolio Strategy team.Apr. points out that over the past 12 months the supply of US Treasuries has increased by roughly 7. Exhibit 17 shows that Chinese industrial production ratcheted up from an annual rate of 10% to 17% at about this time. Morgan Stanley Research Anthony Wong.Dec. petrodollars appear to be competing 16 FrontPoint Partners  . and a lack of fluid convertibility for the yuan. There appears to be an uncanny connection between the re-importation of liquidity into the long-term US debt instruments.Apr. as seen in Exhibit 18.Apr.5%.Aug.Dec. The magnitude of China’s trade imbalance with the US.Aug. is resulting in larger purchases of long-duration US dollar financial assets.Aug. Exhibit 16: 30% 28% 26% 24% 22% 20% 18% 16% 14% 12% 10% Dec.Aug.Exhibit 16 shows when the percentage of US debt held by foreigners began to accelerate.S.Dec. Simultaneously.Aug. which have increased by 43% and 39% respectively year over year.Aug. Treasury.

8 Debt/Equity ratio to less than 0. after 1997 Asian companies began to institute a secular decline in financial leverage. from an 0. This fact is important for investors seeking opportunities where the hidden risk lies in the potential for improving shareholder value through a capacity to add financial leverage or pursue anti-dilutive measures. Exhibit 19 shows the ROE. EBIT/Sales. Ben Bernanke suggested that a “savings glut” in Asia was the source of the liquidity pouring into the SS America. China’s current savings boom has a great deal to do with its demographic profile when viewed from Modigliani’s perspective and may go a long way toward explaining Bernanke’s observed savings glut. While that policy has failed to result in further birth rate reductions in rural areas. Ten-year Bund rates are now hovering just over 3%. ROE and Sales/Assets have accelerated while Debt/Equity continued to fall. The liquidity pool has few alternatives to US debt. after the overall birth rate had already fallen from 3. In between those two is a generation of savers. there is an unusually large saver demographic from births in the 1940s through the 1960s in relation to the under26-year-old non-saver group from the one-child era. with falling debt and better cash flow.25%. Recent data indicate that this demand has broadened out to both mortgage and corporate debt. though they need to be adjusted somewhat for the paucity of social safety nets such as pension and healthcare plans.2 per family. In China. This means that among the more affluent. Over time. Franco Modigliani postulated a savings life-cycle in which the young save very little. 17 FrontPoint Partners  . This means that China and petrodollars no longer have just a secondary effect on credit markets through their compression of nominal base rates. This has resulted in powerful improvements in cash flow based on operations and not financial leverage.8 by 1979. Savings rates are high in Asian countries at present. Treasury. Average Growth Rate of Last 12 Months of Treasury Purchases 12 Month Year Over Year Growth in Treasury Purchases (YoY%) JAPAN China Total Asia OPEC UK Total Foreign Holding Total Public Debt In a March 2005 speech. At the same time there has also been a “savings” phenomenon among non-Japan Asian companies in the period since the 1997 currency crisis in that region. resulting in lower than expected long-term interest rates. as economic conditions in Europe continue challenging and the European Central Bank has developed its own unique strain of lockjaw with regard to interest rate policy.3 at present. Sales/Assets and Debt/Equity ratios of the MSCI Asia ex-Japan universe of companies.S. and the old spend down their savings. live births in China’s wealthier urban areas have fallen to 1. More recently. Ten-year Japanese government bonds offer a yield of 1.in the same yield pool. a “one-child policy” was instituted in 1979. Clearly. Asian corporations have themselves become savers.4 per family in the 1960s to 1. Exhibit 18: 50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% Source: U.

when Americans were checking the prices of their internet and telecommunications stocks just as religiously. Savings rate statistics do not include housing.2% annualized total return generated by the S&P 500 for the seven years ended June 30. Greenspan has pointed out that the low nominal rates on financial assets are linked to the low level of savings rates currently. they would have no choice. Real interest rates below 2% and prospects of a depreciating currency may be well worth the risk in support of the world’s best customer.7 14% 0. The US consumer has essentially reallocated his net worth away from the low real returns in bonds and the 2. has been a good credit risk. It would behoove that organization . 2005.to do everything they could to ensure the purchasing power of their No.Exhibit 19: 18% Decreasing Debt.6 12% 0. We looked at that chart and imagined a customerdriven business whose single largest client generated more than two-thirds of revenues. 1 client. in the case of Asia and OPEC . the same was true late into the 20th century. the US consumer. Unfortunately. Consumers religiously check home prices in their neighborhoods and continue to increase their capital spending to improve their assets. since their alternative would be to replace that customer with the next largest.4 6% 0.or organizations. Predictions of the consumer’s imminent demise have proven incorrect time and time again. The US consumer currently represents 70% of the world’s consumption deficit. showed us the chart in Exhibit 20. So far that customer. even as the savings rate (excluding housing assets) has fallen to less than 2% of US GDP. Increasing ROE’s in Asia 0.8 16% 0.3 4% 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 0. but the US consumer views it as an important part of his overall portfolio and net worth. 18 FrontPoint Partners  . the US consumer has invested rationally up to this point.2 ROE EBIT / Sales Sales / Assets (RHS) Net Debt / Equity (RHS) Source: Citigroup The World’s Best Customer Stephen Roach. primarily against their rapidly appreciating homes. Households have been able to cover their consumption growth with collateralized debt. Morgan Stanley’s Chief Economist. In fact. Spain. Given the recent returns of the stock market and expected real returns on bonds.5 10% 8% 0.

marked by boom and bust cycles. Vince Daniel. These eight states exhibited higher real estate price volatility. as well as having a secondary affect on related segments of the US economy. which showed a 0. Morgan Stanley Research Karl Case and Robert Shiller have looked into the US consumer’s most important asset in their paper. of FrontPoint’s Financial Services team. homes in California and Massachusetts were actually more affordable in 2003 than they were in 1995. This is relevant for investors. He. “Is there a Bubble in the Housing Market?” The paper does not simply conclude that real estate is overpriced because transaction prices are higher. The authors make a strong case that the interest rate sensitivity of the economies in the seven states is high. While the database does not point to the consumer’s imminent collapse. note the direct and indirect job growth related to single-family real estate. Case and Shiller point out that thanks to lower mortgage financing costs. San Francisco and Boston. At the end of any boom cycle. which clearly indicates that the average rate in housing price growth has recently diverged to twice that of wage growth nationally. including agents. Liquidity flowing into the boat is perpetuating the price divergence of this asset in relation to income. along with Case and Shiller. in seven of those states. 19 FrontPoint Partners  . The paper focuses on the historically high correlation of real estate prices to income growth in 42 of the 50 states in the US. An example among those 42 states is Wisconsin. increasing prices and the resulting levels of wealth reinforce a sense of security. as well as California and Hawaii. despite rapid price increases. Even a traditionally nonglamour city such as Milwaukee showed expectations of 11. expectations of future price appreciation were nearing their 1988 peaks. Case and Shiller trace the real estate story to its source in an exhaustive manner and find that in 2003. But in six Northeastern states. income growth alone could not account for the movement in real estate prices. mortgage rates carry a good deal of weight in a multivariate regression analysis of housing prices. Daniel believes that reliance on housing values is increasing. mortgage bankers and construction workers has been quite important to the US economy.7% annual appreciation in housing prices. It is important to note that this gap opened up in the two years subsequent to the data used in Case and Shiller’s paper. which is often the basis of commentary on the topic.99 correlation between housing prices and income growth. This implies a much higher return on equity given the amount of leverage inherent in single-family real estate. In 2004 the Gross State Product (GSP) for those states in aggregate accounted for 30% of overall US GDP. monitors consumer behavior via a proprietary database.Exhibit 20: Global Consumption Deficit Share Source: IMF. As it turns out. Daniel showed us Exhibit 21. Expectations were for 13% to 15% annual appreciation in what Case and Shiller refer to as the “glamour cities” .Los Angeles.

There is likely to be a great deal written about Alan Greenspan’s tenure as Federal Reserve Board Chairman as his retirement in January 2006 approaches and in the years ahead. despite post-hurricane pleas for tempering any hawkish intentions. For his part. Greenspan held that productivity growth in the US had risen to its highest level in three decades. a level that could support lower unemployment without igniting inflation. After investors had convinced themselves that the internet would shortly rival the telephone. To this day. yet he is bailing liquidity from SS America with the energy of the youngest ensign. At that time. 20 FrontPoint Partners  . it made a subtle but important shift on its language in regarding inflation. 125 years after the latter was invented. especially with regard to inflation. namely the continuing presence of deflation in Japan and the prospect of little or no real economic growth in Europe. and that the natural cycle of booms and busts is best dealt with in its aftermath rather than to prevented a priori. Greenspan believes that it is not the Fed’s core responsibility to attempt to moderate investor behavior. When he took office. but he was right. 2005. his response was influenced by exogenous factors. His flexibility stems from an unwillingness to hew to any single economic model in setting policy. These actions – one obvious. In addition. Whether he was lucky or smart is still debated. At the September 20. Net Wage Growth Source: FrontPoint Financial Services. and his mop took the form of two and a half years of zero real interest rates. the other nearly imperceptible . During the mid-1990s Greenspan clashed with a number of his Fed governors who had been schooled in more hawkish pursuits under Volcker. detractors refer to him as “Easy Al. We are unlikely to do justice to his legacy here. Meet the Bailer The third member of the crew. many viewed him as a weak replacement for Paul Volcker. His pragmatism is based on his willingness to accept the notion that factors influencing both the US and global economies are subject to change.” a state thought to accelerate general price inflation. Greenspan exceeded expectations largely on the strength of his flexible pragmatism. is an experienced ship’s captain nearing retirement. unemployment was running well below its “natural rate.Exhibit 21: Annual Home Price Growth (Per Home Price Index) vs.took place despite a dissenting vote from one of the ten FOMC members. Easy Al got out his mop to swab the deck. meeting of the FOMC. Voices from this quarter routinely claim he personally caused the internet bubble. To some extent. that cycle ran its inevitable course. the Fed increased the target federal funds rate by 25 bps.” by way of describing the decisions he based on his view. Fed Chairman Alan Greenspan.

25% and stays there. Many dismiss the spike in inflationary pressures as a short-term phenomenon.7%. With GDP growth running at 3%-4% and low financial risk premiums providing continued stimulus.0%. That view’s marginal utility value has deteriorated. it seemed logical that a neutral policy target for short-term rates amounted to something on the order of 2% in real terms. In recent speeches he has subtly emphasized the financial system’s durability in response to dislocations. They will increasingly monitoring inflationary expectations. as Ben Bernanke has pointed out. based on continuation of the current dynamics. weakening economic data would bring an end to the tightening cycle. our hunch is that Greenspan deems these expectations to be increasingly relevant in his policy considerations.25% by year end 2005. The London Times pointed out recently that the newly wealthy in Russia. Subsequently. the Fed will be more. This is not in the market and is thus relevant for investors. In addition.8% and 7. anticipated 5-year and actual 1-year consumer expectations.Dead Reckoning In The Great Compression we reckoned that by the end of 2005. China and India are already accelerating price increases for luxury brands. 21 FrontPoint Partners  . In light of consumers’ current inflationary expectations. aggressive in targeting a neutral policy stance for short-term interest rates. fiveyear forward expectations are up to 3.6%. Our rationale was that the Fed had determined the US economy had steered clear of deflation. So long as subsidization of the world’s most important customer continues. can be more aggressive in its short-term interest rate policy given the compressed level of long-term interest rates. we believe that Greenspan has shifted his focus to an issue rapidly becoming more relevant than is the PCE deflator. the highest level observed since 1997 when 10-Year Treasury yields were between 5. They would move in a “measured” fashion toward a neutral policy stance. We expect the 5-year consumer expectations number to move up from 3. as it is now consensus.25%.0% and 2. Note that this implies the 10-Year US Treasury’s real rate of interest is already below 1% at current levels. the Fed would need to increase its shortterm rate target to between 4. observers speculated that within a month or so.0% by the end of 2006.1%. That is to say. The Fed may now be further away from achieving its neutral policy target than it was when we wrote our piece in late 2004. less so current economic or inflation data. In each of the latter cases. lumber and other key materials. Greenspan is preparing the markets for events that are likely to follow from an evolving short-term interest rate policy. At that time the PCE deflator stood at 1. the Fed will be accounting for the other two crew members’ impact on liquidity in the boat. the Fed has not even reached a zero real interest rate policy yet.5% over the next 12 months. consensus will have proven correct. and the question is what happens next. The University of Michigan survey of consumers now shows that the median expectation for one-year forward-looking inflation has reached a 15-year high of 4. lead us to believe otherwise. combined with Chinese demand for cement. not less. and we assumed the Fed’s policy actions had given it visibility on modest increases to between 2. The Fed. its flexibility and its ability to persevere in the face of creative destruction.50% and 6. But the message from 5year oil forwards. or 200 to 250 bps below its historical average. From his experience in sluicing out productivity gains in the US long before the data were conclusive. aluminum.1% to at least 3. However.0% and 4. a neutral policy stance on short-term rates calls for a target between 5. Exhibit 22 indicates where real short-term interest rates have been over the past year relative to the PCE deflator. each time the FOMC raised its target by 25 bps. If the Fed increases rates in November and December to 4. Our rationale is as follows.

The one fly in the ointment is that Greenspan will not be around to complete the lift. With all eyes focused on the real estate bubble. or of a dark horse emerging for the Fed chairmanship. Alan Greenspan does not believe he should try to manage investor behavior. is indirectly influence behavior within its central policy objective. Martin Feldstein. For those who think long-term rates would already have reacted to an inflation threat. of Mich. But the Fed knows that would only reinforce the actions of the other two crew members and accelerate inflationary pressures. Fed Funds vs. This will be accomplished by increasing yields on short-term paper. However. There will no shortage of second-guessing at the first sign of stress in the system under a new chairman. 1-Year U. When Greenspan took office in 1987. Ben Bernanke and Glenn Hubbard are the leading candidates to replace him. The Fed is very much aware of the implications its policy will have for real estate in the seven states that display a high coefficient to mortgage rates and a history of boom and bust cycles. as we have discussed. We believe that Greenspan intends to execute a lock-and-lift on the long end of US yield curve. Current levels of implied volatility in interest-rate-sensitive assets do not reflect these realities. Currently. 22 FrontPoint Partners  . Conventional wisdom is that if the Fed sees the slightest slowdown in the economy. where it can better control its impact on the economy. 5-Year U of Mich.Exhibit Exhibit 22: 22: Fed’s Fed’s Current Current Real Real Interest Interest Rate Rate Position Position 6 5 4 Real Fed Funds (%) 3 2 1 0 -1 -2 -3 -4 Ja n00 Ap r-0 0 Ju l-0 0 O ct -0 0 Ja n01 Ap r-0 1 Ju l-0 1 O ct -0 1 Ja n02 Ap r-0 2 Ju l-0 2 O ct -0 2 Ja n03 Ap r-0 3 Ju l-0 3 O ct -0 3 Ja n04 Ap r-0 4 Ju l-0 4 O ct -0 4 Ja n05 Ap r-0 5 Ju l-0 5 Fed Funds vs PCE Deflator Fed Funds vs. numerous risks and opportunities within financial asset portfolios are all but being ignored.com. While Greenspan is somewhat off-limits at this juncture. We do know that the financial markets have grown confident in Greenspan’s ability to deal with crisis. making it more attractive than long-term high-grade bonds and mortgage securities. University of Michigan The Fed knows it can affect the other two crew members’ actions only indirectly. a new Fed chairman will be fair game. recall that consensus on short-term rates at year end 2005 is already equal to the 10-year Treasury yield. we are not sure the low risk premium embedded in bonds takes into account his replacement’s arrival. We cannot and will not handicap the odds of one being selected over the other. it will halt its “measured” policy of increasing short-term rates. the media were not the aggressive pack hunters they are today. Current position based on anticipated 5-year inflation expectations Current position based on actual 1-year inflation expectations Source: Inflation Data. What the Fed can do. The Bush administration is looking less at who can execute this particular lift than at who will be least problematic in terms of its political agenda. however. Speeches by various Fed members have been littered with reminders that they do not consider their mandate to include insuring the current value of privately held real estate. and. The Fed’s goal will be to entice the other two crew members’ liquidity into the short end of the yield curve.

corporate pension plans are moving rapidly to lock in the longest duration they can convince the US government to issue. Warren 23 FrontPoint Partners  . At the same time. The market will continue to believe that the Fed is responding to short-term economic data. The difficulties facing liability-driven investors were eminently visible when Delta and Northwest filed for bankruptcy on the same day. Bonds will continue to rally for a period. reducing volatility between assets and liabilities at this time would appear to be imprudent. to better match the movement in the value of their liabilities. With the 10-year Treasury now offering what we believe to be a 1. With real interest rates at 300-year lows on UK gilts and similar real yields on US Treasuries. Both had seen the assets in its pension fund fall well behind the present value of liabilities. The pension system is responding to the current uncertainty as Bernoulli would have predicted. and so will the Fed’s resolve to raise rates.including oil and the US dollar (vs. the US Treasury indicated that it is doing so partly in response to increased demand from institutions with long-duration liabilities. Exhibits 23 and 24 depict the deteriorating pension fund circumstances at Delta and Northwest. Corporations are at risk of making poor investment decisions in the name of smooth quarterly earnings reports.Delayed Reactions Chinese money supply growth accelerated recently to 16% year over year. Individuals. As a result. consistent with industrial production growth. but some of his observations remain relevant in the 21st century. Indeed. namely corporate pension plans. Commodities . are instigating funding and accounting rules that will encourage this behavior. This appears to be a more logical explanation for their change in behavior than a shift in the overall investment habits of an aging demographic. For a long-duration-liability-driven investor. the Euro & Yen) – will strengthen. measured by the level of surplus in the pension system. as CitiStreet has pointed out. Each time the Chinese adjust the yuan upward against the dollar. and the PBOC has indicated that it is comfortable with the rate of monetary expansion. and the end of tightening will always appear to be just around the corner. buying a risk-reducing asset with the prospect of earning over 4. While China’s GDP growth has moderated slightly.depending on whether one believes the unions or management . For these reasons. they will indicate confidence in domestic economic growth. when US Treasuries offered real interest rates in excess of 4. long-term rates will initially continue to defy historical valuation metrics. in line with Bernoulli’s predicted pattern of risk aversion. Amid this pension maelstrom. in announcing the return of the 30-year bond to its funding package.to make their required payments into pensions. Matching liability duration was a good strategy during the internet bubble. This line of reasoning will at some point evolve into how and when the Fed will prop up the US housing market. It has become almost de rigueur within the airline industry to stuff unfunded pension liabilities into the technically insolvent PBGC.0%.0% in real terms was worth strong consideration. are seeking yield-oriented funds for their retirement funds. Bernoulli’s work predates any funded pension plans.0% real interest rate. and both airlines were either unwilling or unable . regulators are implementing changes to pension funding and accounting that are also risk-averse. despite frequent speculation to the contrary. as traders are conditioned to the liquidity being poured into the boat from Asia’s central banks and petrodollars in response to economic strength in China. fearful of further problems at the PBGC. largely in response to accumulated deficits. German and Fench pension plans and insurers have done the same recently. Regulators. The 18th century mathematician Daniel Bernoulli observed that individuals are risk-averse in the face of uncertainty. deteriorates. This risk compression cycle cannot easily be broken in the near term. James Soutar believes that its economy gives little indication of slowing dramatically. meanwhile. the Department of Labor and Financial Accounting Standards Board are recommending that funding and accounting principles for defined benefit pension plans be marked to market. and liability-driven investors should fasten their seat belts for more of the same: surplus deterioration. moving to a more risk-averse asset allocation as its wealth. large corporate plans have been increasing their exposure to long-duration fixed-income instruments.

This thesis relies on assumptions of rapid growth. with similar wealth gap repercussions. Given the high cost to the global oil reservoir of China’s energy inefficiency. Thanks in part to the AARP’s powerful lobby.000. political intransigence regarding Bush’s funded Social Security pension proposal means the US is likely to face a situation similar to France’s. In his view future retirees will essentially have debt and equity exposure to growing economies that will finance their golden years. he cites the ability of retirees in Florida to live off the labors of people in the other 49 states. But it is clear that 24 FrontPoint Partners  . and recipients of a pay-asyou-go system alone. The second problem with this solution is that while funded pension schemes allow for economic transfer of wealth across borders through debt or equity ownership. who can avail themselves of opportunities in fast-growing countries. France is already at a stage where the cost of financing the pay-as-you-go retirement system of the existing retiree population weighs heavily on the shrinking labor pool. By eliminating the proverbial Polish plumber’s ability to immigrate to France.7% per capita growth rates for personal income in China and a similar rate in India. Paris has further shrunk the labor pool tasked with shouldering pay-as-you-go retirement costs. perhaps even dream of shorting those bonds to corporate pension plans.Buffett will assuredly be laughing himself to sleep tonight as he rolls this one over in his mind. Siegel’s view of the future implies an increasing retirement wealth gap between those with funded pension schemes. Inevitably. By way of example. including 1.500 French workers. The non vote against the European Constitution by the French was in effect a oui vote for the welfare state. It is difficult to know with any precision what impact retirees may have on financial markets in the future when they sell their portfolio holdings to finance consumption. such countries will have to reduce or eliminate cost of living increases for pay-as-you-go recipients and eventually reduce benefits on a nominal basis in order to retain their workforce. including 7. This was clear in France recently. Exhibit 23: Pension Obligations Surplus Deterioration $10 $9 $8 $7 $6 $5 $4 $3 $2 $1 $0 2000 2001 2002 2003 2004 $2 $0 2000 $6 $4 Exhibit 24: Pension Obligations Surplus Deterioration $14 $12 $10 $8 Total Obligations Asset available Total Obligations Asset available 2001 2002 2003 2004 Source: New York Times Source: New York Times Another Man’s Labors In his recent book The Future for Investors. Jeremy Siegel argues that retirement costs in countries with aging populations will be financed in the future by younger workers in developing nations. generation and consumption efficiencies. The French are very publicly trying to reverse HP decision on the French workers. Pay-as-you go systems rely on a closed set of workers to finance any country’s retirement costs. after HP announced a global headcount reduction of 18. Countries in France’s position will struggle to find a balance between increasing retirement related taxes on companies like HP and its employees and keeping jobs within their borders. pay-as-you-go systems will not accrue the same benefits. meeting these growth rates would require significant technological advancement in terms of energy extraction.

In these ways corporate employee defined contribution retirement accounts will transfer a substantial amount of wealth to public funds. This is relevant for reasons that Rob Arnott has pointed out. The danger lies in the assumption that the price of risk is being permanently impacted by these demographic forces. With an increasing percentage of nonunion employees transitioned to flexible. With the baby boomers nearing retirement en masse the value of their cumulative liability is accelerating while the financial asset markets are offering some of the lowest risk premiums in history. The former ratio concerns itself with the annual inflow and outflow of capital into a pay-as-you-go system. it will hasten the decline of union membership. distribution and administrative charges. The second implication is that the mutual fund complexes. or in fear of this phenomenon are likely to be misguided. cost certain defined contribution plans it will increase the perceived cost/risk of union labor. will control a greater portion of the financial asset pie through defined contribution plans. This is relevant for investors. foundations and endowments 25 FrontPoint Partners  . This is relevant now as globalization is decreasing the diversification benefits available across traditional asset benchmarks due to increasingly common investor bases and economic ties between countries and companies. There is likely to be a great deal of populist theory on this point in the near future which will in effect be a misdiagnosis of the liquidity pouring into the boat. Corporations will immunize liabilities and largely fix retirement costs at defined contribution match levels. This will serve to increase the level of positive alpha available for redistribution to active process managers and hedge funds. where there exists an increasing number of retirees in relative to active workers. Changes to this rule would allow defined benefit plans more leeway in managing their asset liability relationship. oddly enough. Asset allocations made either in response. Public funds will. This is quite perverse as it is the unions and Senator Edward Kennedy that are currently trying to block the amendment to the prohibited transaction rule in Congress. Defined benefit plans have historically acquired higher quality lower cost asset management services than can a defined contribution system. The aggregate present value of the pension liability in the US is now the largest it has ever been as a percentage of GDP. First. Events currently evolving at Delphi and the auto industry in general may bring about speculation regarding the death of the defined pension plan. Requiem for the Company Pension Plan There is the potential to confuse the current risk premium compression with a secular decline in real interest rates brought about by the aging demographic in developed countries. there is an important difference between the future ratio of retirees to laborers and the rapid escalation in value of a final pay pension liability as a worker nears retirement. The accelerating value for a final pay retirement liability reduces room for error in the performance of the asset side of an asset-liability balance sheet. which display near perfect correlations to benchmarks. In addition. While it is a subtle point. The victim of these confluences is going to be corporate defined benefit plans. especially so for liability driven asset pools. reduced by fees. There will be two important implications stemming from the social failure of the defined benefit plans in corporate America. there is currently very little ability or economic motivation to deliver competent advice to defined contribution participants in managing their retirement liability. as indexation has an inherently negative alpha due to a preponderance of market capitalization weighting schemes and their lack of a rebalancing discipline.consumption issues related to the reduction in net wages and the overall workforce in countries reliant on closed pools of labor to support pay-as-you-go retirement systems will affect the value of securities and widen the wealth gap in those countries. These conclusions will be reached at precisely the moment in time when the factors resulting in these economic pressures are reversing themselves. end up more similar to Harvard and Yale in their asset management practices than will corporate plans.

including the deployment of $3 trillion in savings and reforms to the healthcare system. large-capitalization Japanese companies are showing little top-line growth. largely thanks to on improving labor market conditions that are driving domestic consumption growth. who oversees FrontPoint’s Japan Fund. That amendment would improve the diversification restrictions arising from the prohibited transactions rule for US corporate and Taft-Hartley plans. especially in the presence of upward inflation steadily eroding the consumer’s deflationary psychology. The unexpected landslide victory by Prime Minister Koizumi against the political blockade that had kept Japan inert will lead to changes in Japan. Blinded by Convention The inflationary waves about to wash up on the shores of the US will not have the same impact on the other side of the Pacific. The shift is taking place at a time when Japan’s economic cycle is in an upswing. need to pick up the pace. For these reasons. A portion of that wealth transfer will also be captured by service providers within the defined contribution system. Paolo Guarnieri. intrinsic value divergence may be greater in Japan than anywhere else at this time. Current convention in asset allocation will be costly over the medium term. believes people are likely to underestimate Japan’s potential as it emerges from this environment.with higher active process exposures. This is one of the factors telling us that the Fed will. His landslide victory shows that something fundamental has changed in Japanese psyche. China and its neighbors will initiate discretionary currency revaluations. Even Japanese pension plans underweight their domestic equity market as a result of 26 FrontPoint Partners  . This same population. the Japanese essentially announced that they would welcome major changes. FrontPoint’s Japan team has noted that valuation models assume asset growth in Japan of 0% and Cash Flow Return on Investment (CFROI) of 4%. Investors today have very little experience in assessing a developed economy emerging from a protracted period of deflationary psychology. Japan will be the biggest beneficiary of a pickup in global inflationary pressures. or for all companies. In the face of these same inflationary pressures. Here’s the scenario: US and European pension plans stay with their 60/40 or 40/60 mix and their implied nationalistic bias towards US or European equity exposures. But inflation is not necessarily a bad thing for all countries. Union membership may be the greatest victim of all. Historically. Japan has been down so long that quantitative models have essentially memorialized these assumptions as form of consensus. At present. as it occurs so infrequently. Japan’s culture did not encourage the kind of radical moves proposed by Koizumi. Fully half a generation of Japanese workers has known nothing but declining wages and deflationary expectations. in its role as a consumer. This phenomenon appears to be sustainable for a decade. which has negatively influenced perceptions of macroeconomic conditions. They are using these cash flows to reduce dilutive equity instruments. Japan has suffered under deflation ever since its real estate market began its long steep decline 16 years ago. is what makes the Japanese opportunity so interesting from our perspective. No such restrictions exist for foreign corporations which will result in a competitive advantage relative to US corporations which continue to offer defined benefit plans. if anything. They will have partially brought about their own demise by blocking the amendment to the prohibited transaction rule currently sitting before the labor and finance committees in Congress. The truth is that the savings and insurance portions of a restructured Postal System will sell JGBs and buy an estimated $250 billion to $400 billion worth of Japanese equities. these same companies are experiencing record levels of cash flow through cost and debt reductions. It has been assumed that to support its aging population. This is quite relevant for investors. But as in the US during the late 1980s and early 1990s. Japan will sell equities to buy bonds. adding to inflationary pressures in the US. By voting as they did.

Investors should investigate Asian equities that have exposure to an increasingly wealthy local consumer in countries with the ability to moderate inflationary pressures through upward currency adjustments. but extreme volatility in this regard. Assets will continue to be reallocated toward high-efficiency. largely on the back of financial service and yield-oriented names. By contrast. value stocks are currently trading at some of the highest levels observed relative to growth stocks. Japanese equities. Real return bonds would be preferable by far for asset class silo constrained organization.a decade and a half of surplus abuse. Pension plans extending duration to match liabilities will inadvertently be doubling up on interest rate risk at exactly the wrong time. Others Swim The most vulnerable assets in the world are those with US dollar interest rate and short interest rate volatility sensitivity. Meanwhile. Credit-sensitive issuers with near-term borrowing needs will be required to pay higher risk premiums. These include 21% of the S&P 500’s weighting in financial stocks. offer a relatively attractive risk-return proposition.duration fixedincome instruments. Marty Liebowitz and Michael Peskin at Morgan Stanley remind us constantly that equities have historically shown statistical duration of only three to four years. and mortgage-backed securities. But over the next three to five years these are likely to result in above-average opportunity costs. real estate and financial segments. These factors will in turn affect the US real estate complex and as a result the consumer. the experienced duration of equities is likely to be high. especially for institutions attempting to dampen the negative impact on their illiquid credit and real estate investment pools. Convention in response to regulatory changes will thus be very costly for many liability-driven investors. According to Citigroup. REITs. especially in the seven states with high regression coefficients to mortgage rates. The risk in Asia will be cyclical retraction of liquidity and investments there will require selectivity as to time of entry as well as long time horizons. Some Sink. Relative value investing will enjoy a more welcoming environment. Private equity investors will want to consider the underleveraged non-Japan Asian markets as perhaps a more attractive place to deploy capital under the right circumstances. In fact. In the environment we are about to enter. especially those focused on that country’s consumer. A new variant of the barbell strategy is available through combining the long growth and long volatility strategies. as well as misallocation by strategy type within absolute return portfolios at present. US plans will actively manage their bond exposure against a Lehman Aggregate bond index. Long volatility strategies should be strongly considered. and defaults on 2003-2005 vintage high-yield debt deals will increase. There is likely to be increased price dispersion in markets generally. a factor that has been weighing heavily on return generation for alpha-dominant strategies over the past three years. Yet many growth stocks possess characteristics suited to an inflationary environment. long. Worse. This will be especially true for companies with lower than optimal debt-equity ratios. near-term corporate earnings objectives or regulation will overwhelm even convention. the siren song of low volatility has resulted in lower than optimal allocations to these diversifying investment processes. Investors are likely to increasingly view this secotr as a growth rather than a value exposure in the face of central planners controlling marginal supplies. and plans will shift into the longest available duration fixed-income strategy. While the energy sector has seen 40%-50% returns in 2005 any pullbacks in this sector on growth fears should be viewed as buying opportunities. Such a portfolio’s prospects for outperformance will rest squarely on the back of an overweight in mortgage-backed securities and their inherent short interest rate volatility exposure. again operating according to convention. Inflation favors companies whose products or brands allow for pricing power in the face of rising input costs and nominal interest rates. Strict adherence to such investment protocol will normally produce mediocrity in asset performance. low-correlation absolute return strategies where they can be sourced at a reasonable cost. Failure of the amendment to 27 FrontPoint Partners  . which will somewhat reduce the attractiveness of certain organizations in China relative to the rest of Asia.

This research report is prepared for general circulation and is circulated for general information only. FrontPoint does not offer or provide tax or legal advice and the topics discussed should not be taken as tax or legal advice. there are promising economics in such enabling technologies. Investment capital might begin with a means of assisting the Middle East producers with their heavy/sour refining issues.change the prohibited transaction rule in Congress will permanently disable corporate and union plans from accessing this diversification tool creating an opportunity for others. There is no guarantee that the views and opinions expressed in this article will prove to be accurate. The challenge will be finding qualified VCs who can deploy the capital and subsequently give relevant guidance to these nascent energy technology companies. we do not guarantee their accuracy and any such information might be incomplete or condensed. At a time when risk premiums are at historic lows. Any estimates of future returns are not intended to predict performance of any investment. In the end. most investors will not see the events in the boat playing out clearly. implying that technological advancements will be required even under the most aggressive estimates for energy supplies. The Chinese will require incremental technology improvements to their energy consumption efficiency in order to achieve their employment objectives. projection. and recipients must make their own investment decisions using their own independent advisors as they believe necessary and based on their specific financial situation and investment objectives. It does not have regard to the specific investment objectives. investors need to focus on what is relevant over the medium and long term and realize that on most days nothing relevant happens. forecast or estimate set forth herein. The information and opinions in this research report are prepared by FrontPoint Partners LLC (“FrontPoint”). Real estate is for at time not going to act like a real asset in terms of providing inflation protection but as an interest sensitive asset due to a liberal application of low cost debt. these incremental efforts will result in a collective knowledge base leading to scalable and renewable alternative energy sources. At some point. and these same productivity gains have caused the materials economy to hit a wall. Although these statements of fact have been obtained from and are based on sources that FrontPoint believes to be reliable. over the next two decades the economics of incremental improvements to existing technologies will likely produce superior return on investments. information technologies have resulted in powerful productivity improvements. The global economy is not yet service-based. or for a university that is presumed to exist in perpetuity. Past performance is not a guarantee of future results. modify or amend this report or otherwise notify a reader thereof in the event that any matter stated herein. financial situation and the particular needs of any individual who may receive this report. These structural fact requires that investors revisit convention with respect to their illiquid assets. The Wall Street Journal recently carried an article about venture capitalists competing with one another to invest in any entrepreneur with a communications or information technology proposition. There is good reason to believe that investments leading to incremental improvements in existing energy technologies would be a better choice for illiquid capital allocations in the coming decade. While breakthrough energy technologies will eventually be a reality. or any opinion. changes or subsequently becomes inaccurate. Investors are urged to speak with their own tax or legal advisors before entering into transactions in which the tax or legal consequences may be a significant factor in the investor’s investment decisions. Tim Flannery. FrontPoint has no obligation to update. Opinions. Income from investments may fluctuate. These short-term reports are by and large not important for investors managing assets against long-term liabilities. As Greenspan foresaw in the 1990s. The strategies discussed in this report may not be suitable for all persons. as they succumb to the tide of short-term data. Our Utility & Energy portfolio manager. The CERN report warns that supply growth will be challenged in the 2010-2020 period. has observed that on most days nothing really happens. 28 FrontPoint Partners  . Any trading strategies discussed in this research report may or may not be applied by FrontPoint or any of its investment teams for their investment strategies. This research report is not to be construed as an offer to buy or sell or a solicitation of an offer to buy or sell any financial instruments or to participate in any particular trading strategy in any jurisdiction. This report contains statements of fact relating to economic and market conditions generally. estimates and projections in this report constitute the current judgment of the author as of the date of this report and are subject to change without notice. but prices move around anyway.

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