The Breaking Point

by James Dale Davidson

  A Short Seller Explains

  One person who did make a point of trying to understand Enron’s books was James Chanos, the famous New York short seller. Chanos provided his view of Enron in testimony to the Securities and Exchange Commission in 2003, essentially explaining that he believed Enron had been bankrupt for years:

  The first Enron document my firm analyzed was its 1999 form 10-K filing, which it had filed with the SEC. What immediately struck us was that despite using the “gain-on-sale” model, Enron’s return on capital, a widely used measure of profitability, was a paltry 7% before taxes. That is for every dollar in outside capital Enron employed, it earned about seven cents. This is important for two reasons; first, we viewed Enron as a trading company that was akin to an “energy hedge fund.” For this type of firm, a 7% return seemed abysmally low, particularly given its market dominance and accounting methods. Second, it was our view that Enron’s cost of capital was likely in excess of 7% and probably closer to 9%, which meant from an economic point of view, that Enron wasn’t really earning any money at all, despite reporting “profits” to its shareholders. This mismatch of Enron’s cost of capital and its returns on investment became the cornerstone for our bearish view on Enron and we began shorting Enron, common stock.7

  His view was amply ratified by evidence that came to the surface after Enron collapsed. The pertinent point here is that proof exists to demonstrate that Enron had, in fact, been bankrupt for many years. Yet Enron’s stock price shot straight up during 2000, rising from $43.44 on January 3, 2000, to as high as $89.63 on September 18, 2000.

  Of course, no one understood what Enron was up to. Its accounts were intentionally complicated to disguise the fact it was losing money. These shenanigans went almost unnoticed because Arthur Anderson, one of the world’s foremost auditing firms until that time, had given Enron a stamp of validity. And don’t forget as well, Enron was always announcing impressive, though fictitious, earnings. This whole fake picture was further disguised in a gilded frame when Enron was repeatedly hailed as perhaps the leading company of its time. Fortune magazine named Enron the “Most Innovative Company in America” for six years in a row, from 1996 to 2001—the very year that Enron filed for bankruptcy protection.

  This relates directly to the “idiot principle of deflation.” (I am not correcting Nielson’s grammar; if he wants to put it that way, let him.) Just as Enron’s share price could skyrocket notwithstanding the fact that it was actually bankrupt, so the IOUs of the bankrupt government can go up in value, as they have been.

  The $9 Trillion Deflationary Short Squeeze

  Nielson unknowingly highlighted a crucial element in this dynamic in his rant in “Hyperinflation Cannot Be Prevented By Debt/Deflation.” His exact words were, “Our bankrupt governments literally borrowed every unit of currency into existence.” Yes, it is a characteristic of our fiat money that it is mostly borrowed into existence. This is precisely what makes deflation more likely.

  Every dollar that is borrowed into existence is a de facto “short” position. Like a short stock position, the borrowed dollars must be repaid. When selling short stocks, you must be alert to the danger of a “short squeeze” that could oblige you to buy back the shares you have sold at a loss. While professional investors have different standards for judging the risk, they generally agree that the higher the open short interest rises, as percentage of the total float, the more likely it is that a short squeeze will develop, driving the price of the underlying instrument higher. Of course, where the dollar is concerned, the short interest is at least 90 percent of the float—far higher than is ever seen in even the dodgiest stock.

  As of August 13, 2015, there was $1.38 trillion cash in circulation. The other nine-tenths of the money supply was borrowed into existence.

  The Fed Darkens the Shadows in the Shadow Banking System

  Part of the black magic of QE was the fact that dollars created in the United States were multiplied as dollar-borrowers morphed into so-called nonbank banks and created cascading layers of dollar debt. This has occurred on a truly massive scale, much of it in emerging markets (EMs), particularly in China.

  As it happened, there was a special attraction in exporting the easy money conjured up by QE to countries where local interest rates were higher than the invisibly low rates or zero interest rate policy (ZIRP) dictated by the Fed. In effect, by creating the formula for a profitable carry trade, in which borrowers could use dollar funding to invest at home and profit from the spread between dollar and local interest rates, the Fed gigantically multiplied the world’s shadow banking system.

  As the Economist reported in March 2015, stock of dollar debts owed by nonfinancial borrowers outside the United States had grown by 50 percent since the financial crisis of 2008, reaching $9 trillion—EMs accounted for half of that amount. Dollar-denominated loans in China went from $200 billion in 2008 to more than $1 trillion in 2015.8

  In effect, the Fed helped finance the huge credit bubble that artificially inflated Chinese economic growth in recent years. Since 2008, private debt in China has grown by at least 80 percent of stated GDP. Data on China’s shadow banking system leaves much to be desired; it involves obscure interlinkages with the official banks and a bunch of trusts, wealth management products, money market funds, and loan-guarantee companies, along with entities of various description deploying foreign-currency borrowings. The Economist puts Yangzijiang Shipbuilding “at the forefront” of shadow banking.9

  In 2010 alone, private debt in China soared by 35 percent of reported GDP, as the Chinese credit bubble became the biggest in history. According to McKinsey, China’s debt nearly quadrupled from 2007 to mid-2014, rising from about $7 trillion to almost $28 trillion.10 Since 2008, Chinese banks loans have expanded by 50 percent more than the combined total of money created by the Federal Reserve, the European Central Bank, the Bank of England, and the Bank of Japan.11

  The unprecedented magnitude of China’s credit bubble supported a fixed investment orgy that could not have been better designed to set the deflationary trap that has now begun to spring shut on the global economy. About half of Chinese loans are directly or indirectly tied to China’s vastly overbuilt and overheated real estate market.

  I could deploy a number of charts to underscore the point that China’s credit bubble blown up much more than earlier bubbles in either the United States or Japan, much less the South Sea bubble or the Tulip Mania. But one astonishing and revealing statistic makes that point all by itself.

  China Used More Cement from 2011 to 2013 than the United States Used in the Entire Twentieth Century

  You have heard of the ghost cities in China, built out in every respect except without people. And you have no doubt seen TV reports recorded in vast, new Chinese shopping malls complete with top-brand anchor tenants but no customers. A marker of this fantastic overbuilding is the Chinese consumption of cement. They used 6.6 gigatons—a gigaton is one billion tons—in the three-year period between 2011 and 2013, almost 50 percent more than the 4.5 gigatons of cement the United States used to build its modern cities and infrastructure during the whole of the twentieth century.12

  That is a lot of cement.

  This credit-fueled building binge not only dwarfs the subprime bubble build-out of McMansions in the United States; it also helps underscore the deflationary dynamic that became so evident in world commodity markets after 2014.

  Build It, and They Will Come . . . or Will They?

  You see, it isn’t just cement that has been used to excess in China’s credit-ramped building binge. When the Chinese government decided to keep the measures of GDP soaring after 2008, they launched a massive, one-off infrastructure build, financed by an increase in debt that ranged somewhere between $21 trillion and $25 trillion.13 Money on that scale bought more than just cement. Lots of other raw materials were sucked into China’s historic building spree—the equivalent of erecting one thousand World Trade Centers each year. Among other things, this
also sucked up a lot of steel and copper, and China accounted for 45 percent of the increase in world oil demand.

  While some of the empty towers and shopping centers were flipped to investors as the bubble expanded, the trusting Chinese investors who bought must have been bummed: empty apartments, offices, and shopping blocks could not possibly pay their way. As David Stockman put it, this was “the most massive malinvestment of real economic resources” in history. The losses it engendered are radiating around the globe. An astonishing seventy million new luxury apartments stand empty in China.14 For perspective, note that there are 2,581,170 apartment units in New York. China’s empty apartments could house New York City twenty-seven times over.

  The Greatest Margin Call in History

  Of course, as the orgy of malinvestment inevitably slowed, demand for commodities receded from exaggerated levels. Consequently, prices of many key industrial commodities, including oil, have plunged, triggering margin calls, devaluing currencies, and spelling bankruptcy for many commodity suppliers and whole countries.

  Most of China’s construction has been for high-rise apartment complexes and office towers. In 2010 alone, total residential construction in China was an astonishing 25.8 billion square feet, while office construction totaled another 19.4 billion square feet. That equates to more than ten square feet of office space for every man, woman, and child in China in 2010, according to the Economist Intelligence Unit.

  Think about it. The call on commodity markets for such tremendous quantities of resources did not just constitute a passing bid-on-the-spot market. It gave rise to a whole additional layer of demand for the raw materials needed to build the mining machinery, earthmovers, drill rigs, refineries, power plants, steel furnaces, and mills, as well as the ships and tankers that were part of the logistics tail required to fill the demand for commodities at the gargantuan scale drawn forth in China’s credit bubble.

  The additional stimulus to malinvestment was all the greater in the case of a key commodity, copper. Why? Because geological limitations as evidenced by continuing declines in copper grades at Chilean mines (38 percent of world supply) made it difficult to even maintain, much less increase, production without massive capital expenditures. The Chilean copper company Codelco announced in 2010 that its production of copper would fall by 50 percent within a decade without an intensive CapEx program. This culminated in massive new investments to deepen mines and improve recoveries of metals, such as copper, that were in high demand in China’s building binge. Such programs became part of a worldwide capital-spending spree that has expanded capacity for many commodities far beyond what can economically service China’s now slumping demand, especially with new production coming on line from years of vast malinvestment in new capacity globally.

  Chinese Steel Capacity Now Twelve to Fifteen Times US Annual Consumption

  Consider the steel industry. Chinese capacity of about 100 million tons annually in 1995 soared to upwards of 1.2 billion tons today. Capacity has multiplied by twelve times over in just two decades—growth equivalent to twice the total world capacity in 1995. Compare this with estimates of current sell-through demand for steel in auto and appliance production, as well as replacement cycles for apartment blocks, office towers, ships, shopping malls, and rail lines in China. Not more than 500 million tons of steel would be required, and that is a huge amount. For reference, in 2013, the United States consumed 95.6 million tons of steel; China consumed 700.2 million tons.15

  A well-built skyscraper doesn’t need replacement on a short-term basis. In fact, engineers estimate that even without maintenance, a skyscraper should be good for half a century before it has to be abandoned or replaced.16

  Given the scale of recent Chinese fixed asset investment, there was no way it could continue unabated. Much of China’s recent gluttonous consumption of commodities involved one-off demand from the infrastructure boom, spurred by one of history’s more extreme credit expansions. It is unlikely to be repeated any time soon, if ever.

  China Meltdown Ahead

  At the very least, the wind down from this credit bubble will entail a significant depreciation of capital stock put in place to service the boom. But something much worse is in the cards. The research arm of Daiwa, Japan’s second biggest investment bank, put the prospect for a China meltdown in perspective. As reported by Zero Hedge in 2015, if China’s economy were to experience a meltdown, the world’s economy would more than likely be sent into a tailspin, creating an impact that could be the worst the world has ever witnessed.17

  In a 2015 Zero Hedge article, David Stockman pointed to the August 3, 2015, bankruptcy filing of Alpha Natural Resources as a “metaphor for the central-bank enabled crack-up boom now underway on a global basis.”18 Alpha Natural Resources is a US public company that produces coking, or metallurgical (met), coal. Forbes reported that the company “was overwhelmed by big debts it had accumulated to finance the purchase of coal mining assets.” Alpha achieved a market cap of $11 billion in 2011 when it acquired Massey Energy for $7 billion. That seemed like a bargain at a time when prices of met coal inflated by the Chinese infrastructure bubble reached $340 a ton. As I write, the price of met coal has plunged by 87.5 percent to $42.50 per ton, and ANRZ is worth zero.

  The collapse in met coal prices bagged another corporate victim when state-owned Longmay Group, one of China’s biggest met coal miners, announced that it would cut 100,000 jobs—40 percent of its 240,000 person labor force. Excess capacity drives down prices. Today’s met coal price is only one-eighth of the price at the 2011 commodity peak. As commodity prices fall, it becomes ever more of an adventure for the leveraged borrowers to repay their debts. Like Alpha Natural Resources, many of them won’t.

  Debt contracted to discount cash flow from the sale of met coal at $340 per ton became unpayable when increased production and weakened demand drove the price of a ton of met coal down by 87 percent. No wonder Alpha Natural Resources went broke and Longmay is firing 100,000 workers. It is the fate that awaits much of the world as the unsustainable credit-based spending winds down.

  The Titanic Sinks Again?

  Meanwhile, the collapse of Alpha Natural Resources could have a parallel on a larger scale in Glencore, PLC, the UK-listed trading company. Glencore plays a pivotal role in trillions of derivatives as what may be the biggest commodity trading counterparty. With $30 to $35 billion in debt and scant possibility of paying at current commodity prices, Glencore’s credit default swaps have blown out to a record 757 basis points as I write, hinting at junk status to come.

  The company’s half-year 2015 results showed $6.5 billion in earnings before interest, taxes, depreciation, and amortization (EBITDA). Note, however, that according to the company itself, EBITDA drops by $1.2 billion for every 10 percent drop in copper prices. Also note that Glencore’s outstanding bonds have slumped to record lows. For example, the GLEN €1.25 billion notes due March 2012 sunk to €0.78. With Glencore bonds following the copper price down the chute, a credit downgrade would hardly be a shock. It could entail significant follow-on consequences for the fragile financial system.

  Glencore’s trading business requires large tranches of short-term credit to finance commodity deals. It could ill afford to lose its investment grade status, as this could trigger demands by its counterparties to deposit higher collateral—a requirement that the cash-strapped company would be hard-pressed to meet.

  As Glencore demonstrates, the linkages between commodity prices and the tottering edifice of global debt are many and complex. Hence you have the current deflationary market dynamic. The credit bubble, augmented by the $9 trillion global carry trade stimulated by QE, has induced a wide spectrum of malinvestment in commodity production as well as the infrastructure of commodity export, including ships and ports. As increases in commodity supply—in the wake of massive CapEx stimulated by artificial Chinese demand in recent years—collide with weak demand, prices for many crucial commodities have plunged, drastically undermining
the value of commodity assets. Note that $9 trillion is greater than the economies of Germany and Japan combined. No small sum.

  To further illustrate the capitalization effects of plunging commodity prices, consider Glencore’s experience with the Cosmos nickel mine in Australia. As Glencore scrambled to clean up its balance sheet in June 2015, it sold Cosmos for $19 million. Glencore’s Xstrada subsidiary purchased that mine for $2.6 billion in 2007, when nickel was trading for $32,000 a metric ton on the London Metal Exchange. As I write, the price of nickel has slumped to $9,835 per ton. The 70 percent fall in nickel prices brought on a 99.3 percent fall in the value of the mine.

  The Era of Bubblenomics Draws to a Close

  History’s greatest debt supercycle is coming to an end. That is what the noise and grumbling in today’s news disguises. You can expect a deflationary collapse proportionate to the excesses that preceded it. The $9 trillion global short position, contracted on the collateral of a commodities supercycle that peaked years ago, will continue to unwind. That means you can expect most natural resource prices to continue going south. They will plunge until they are lower than production costs for the marginal producer. Then they will overshoot further on the downside until they fall below the cost of production of the low cost producer. Then, when almost everyone is bankrupt, the bottom will be in.