Category: Economics

Just reading the revelation that when the government manages a project, it will triple the cost that it should probably otherwise take to complete – the TMX expansion is running now at a $30 billion capital cost.

The government doesn’t care about the price tag – it’s just another reason to hand out the slush to favoured entities that managed to game the system. The government, despite being the owner of the project, actually doesn’t “pay” for these inflated costs! A simple economic analysis suggests that the pipeline will be so valuable as it is an inelastic service – the WCS differential to the USA vs. shipping it out to Asia will be very extreme, and this differential will be captured with pipeline tariffs. It will be the customers of the pipeline that are captive to the final cost – essentially CNQ, SU, CVE, etc. are paying another tax.

So how much does it cost to send oil out on the existing Transmountain? It is captured in the tolls and tariff bulletin.

A cubic meter of heavy oil from Edmonton to Westridge (just northwest of Simon Fraser University at the water) costs CAD$26, or about CAD$4.20 a barrel.

The TMX expansion will be increasing the flow of oil by 590,000 barrels a day. It is a guarantee that 100% of the available capacity of the pipeline will be utilized – there is simply too much demand for heavy oil to fuel the refineries in places like India, and companies will be able to receive near-Brent crude pricing on WCS.

590,000 barrels a day works out to 215 million barrels per year, assuming no pipeline outages (a false assumption – there will be maintenance periods which will eat into this amount). But let’s work with the theoretical maximum.

At the existing tariff, the incremental heavy crude will generate $900 million in revenues.

Now we look back at the TMX expansion. We have $30 billion in capital costs. Let’s assume the cost of capital is at 5% – pricing in a 180bps spread on “A” rated credit. That’s $1.5 billion/year in interest costs alone. (I am simplifying this considerably by ignoring the fact that there is some equity in the project, I am assuming it is entirely debt-funded – if you want to include equity returns, the revenues required goes even higher!).

In order to amortize this debt over the course of 30 years, the revenues that need to get applied directly to the debt is $1.9 billion a year. There are also other operating costs to running a pipeline (electricity, administration, maintenance, etc.), but the point is that they will need to collect at least double the rate than they are currently collecting in order to pay the debt on the capital costs.

I’m guessing with other administrative expenses baked in, you are looking at a tariff fee of CAD$9-10/barrel.

Brent is trading at US$75.50/barrel currently, while WTI is US$71.50 and WCS is US$51.

There’s about a US$20-24 differential that can be captured with an increased outlet to the Pacific.

However, at least CAD$5-6/barrel of that is going to get sucked up in pipeline costs due to the astronomical cost increases to construct the TMX expansion.

For comparison, the Enbridge Line 3 expansion cost about CAD$13 billion, and was 1000 miles in length. TMX is about 700 miles in length and is projected to cost CAD$30 billion. While the mountainous terrain is of course more difficult to work with, this is by no means a total mitigating factor the account for the cost differential – it is mostly a function of regulatory compliance, all entirely by design – the government does not have to pay for it.

If TMX was constructed for half as much, the incremental profits would go to the shareholders of the oil producers (minus the various taxes and royalties). However, in this instance, the surplus mostly goes to whoever was awarded the contracts – essentially another form of government spending that is “off balance sheet”. Sadly, this happens all the time, and is another example of how spending (which increases the GDP) does not necessarily generate productivity (the actual value you get by spending).

Bank of Canada, projected QT by year, assuming they maintain the existing trajectory:

2023 Bank of Canada Quantitative Tightening Schedule

Snapshot from January 9, 2023
Government of Canada Bonds ($368.3 billion) and Canada Mortgage Bonds ($7.7 billion)

Year	Amount	Pct
2023	$89,864,250,000	24%
2024	$55,880,720,000	15%
2025	$44,235,821,000	12%
2026	$37,432,059,000	10%
2027	$14,158,340,000	4%
2028+	$134,419,469,000	36%

 
US Federal Reserve, treasury bonds, with some annotations:

And, here is another important chart:

Covid masked up (intentional use of language!) what was probably going to be a recession. The overnight rate crisis was a huge signal that something was wrong in the financial world liquidity-wise and required the intervention of the Fed to keep things steady.

Today, the environment is different. The issue is that there is a general sense of foreboding. If this is sufficiently baked into pricing, then it will become a non-issue compared to the unknown unknowns that are not priced in (which could resolve to the better or worse).

However, one reason why I focus on the progression of QT is because it reflects the extinguishment of credit. There’s a couple analogies for this. One is slowly taking oxygen out of a room. Another is a poker analogy, which I will use the reverse – quantitative easing: imagine you are forced to play poker (a zero sum game) with a lot of other participants (every other person in the economy), but the dealer is consistently giving out chips to people (more chips go to the “preferred” participants such as government-connected entities). Eventually handing out these chips will permeate around the table (more likely to yourself if you demonstrate some skilled play in relation to the rest of the competition). With QT, the poker analogy is increasing the amount of “rake” (the amount of chips removed per game as a house take) and a logical consequence of this is that people (and asset prices) should become tighter.

These (QT, interest rates) are knowns, but when does it get to the point where things structurally blow up? Does it? This line of thinking would also suggest that fixed income should do better than not – although let me tell you, the prospect of lending the Government of Canada money for 30 years at 3.12% is distinctly unappealing.

The last snapshot of money supply is at the beginning of October 2022, but the trend is fairly obvious:

In particular, M2++ (the broadest form of money supply measurement) has gone from $4.392 trillion at the beginning of the year to $4.467 trillion on October 1, 2022. The growth is still positive but definitely shrinking – 1.7% for the first 9 months of the year. Indeed, the September 1 to October 1 snapshot showed a mild contraction.

This chart should not be surprising. The expansion of credit is reversing and the last time the country was really in this sort of situation from a monetary perspective was back in 1995.

1995 was an interest year from Canadian economic history. Perhaps refreshing one’s memory via a 2001 speech of the Government of the Bank of Canada at the time will assist.

This is going to make 2023 quite an interesting year.

For those not familiar with the noun scrip, look at the Wikipedia article.

Historically scrip was issued by large companies to physically remote workers, for usage in their own facilities. The Hudson’s Bay Company was a classic example of this. In some cases, company scrip was nearly as good as money.

Today in our 21st century, we have digital scrip in the form of Apple and Google Play cards, in addition to more generalized gift certificates and the like.

Cryptocurrency is another innovation which is functionally the scrip of those that voluntarily choose to engage in the transaction of such digital tokens.

Sovereign currency, such as the US dollar and UK Pound, historically used to represent a certain amount of gold or silver, but those days have long since passed. The fiat currencies we use are backed with a single promise, and that is the ability to pay taxes to the government. Other than this fundamental value, fiat currencies trade on the perception of value conveyed by their participants. While scrip definitionally is referring to non-sovereign currency, functionally speaking, the green, red and brown pieces of polymer we hand around is a form of scrip, albeit with more legal authority.

However, with the digitization of everything, we are witnessing the fragmentation of various scrip. We see increasingly sophisticated schemes by scrip issuers to incentivize various behaviours of the recipients.

One 20th century invention was the Air Miles concept – spend in a preferred manner and eventually receive enough to purchase a commodity “for free” that otherwise would be wasted – an empty airline seat.

On the advent of this came a whole plethora of reward schemes.

However, all of these schemes are subject to the issuer’s fiat. We have seen this in the sovereign context when a country decides to devalue a fixed-peg currency (just look at the Argentina Peso as a great example).

Also, nominally valued scrip is subject to the ravages of inflation. A Costco gift card purchased a couple years ago most certainly purchases a lot less today than it did when it was originally purchased.

It is interesting to note that strict gift cards (money for store credit) have legislative protection (at least in British Columbia) and must be held as a liability to the issuer in perpetuity.  Only monetary inflation of the underlying currency degrades the value of this scrip.

However, the story is different with reward schemes.  Similar to sovereign currency devaluations, owners can be spontaneously diluted. An airline seat costs more miles to purchase, or perhaps the availability of seating is less desirable.

Reward schemes are everywhere now, to the point where nearly every single major corporation out there with any retail presence has these annoying and low value (to the consumer) schemes to incentivize certain behaviours. The promoter of the program wants to pull off an Aimia (the payday is selling the accumulated customer data on the points program), while the end retailer wants to drive certain types of sales using scrip as incentive. It is nearly always to the detriment of the consumer.

In Canada, most recently I noticed the Freshco/Safeway/Sobeys chain (owned by Empire (TSX: EMP.A)) is subscribing to “Scene”, which was originally a creation of Cineplex (TSX: CGX) and Scotiabank (TSX: BNS) to give people free movies.

Other grocery stories, such as Save-on-Foods (Save on More) and Superstore/Shoppers Drug Mart (Loblaws/George Weston) (L.TO/WN.TO) have their own scrip schemes – PC Points.

Suncor (TSX: SU), via Petro Canada, runs a popular “Petro Points” scheme.

McDonalds (NYSE: MCD), and all the other fast food operations, which are “appifying” themselves, have their own arbitrary points system.

It goes on, and on and on, and the hapless consumer is plagued by the administrative burden of figuring out if any of this is worth the time/energy hassle to functionally get minor discounts off their aggregate purchases.

What’s great from the company perspective is that you can effectively be your own central bank and decide to pull the rug on your customers whenever you want without any recourse by those holding the scrip.

Nothing illustrated that better than Starbucks (Nasdaq: SBUX) pulling off a “Christmas surprise” on their rewards program.

Their original scheme was that for every dollar you purchased stuff at their stores, you would receive two stars. Accumulate 50 stars and get a free coffee. Accumulate 150 and get a free fancy drink.

Effective in February, they announced that this will now be 100 stars (a 100% inflation) and 200 stars (a 33% inflation), respectively.

What’s funny is that when the inevitable blowback came on Twitter, the generic response was:

Hello, we continually want to update the Starbucks Rewards program so that we’re meeting the changing needs of our members while ensuring we’re still able to deliver some of the benefits members know and love.

Learning the language of corporate-speak is a reason why I would perish in a corporate communications role. The dishonesty would drive me insane.

The reality is that I am sure there was a cottage industry of people banking Starbucks scrip and this liability (in addition to future liability) needed to get whittled down in the face of a rapidly escalating cost environment.

Fortunately, I do not subscribe to many of these schemes, but as scrip systems continue to get more and more fragmented, there may be less of a stimulatory effect on the consumer, resulting in a dimunition of such schemes as they aren’t going to be nearly as lucrative as the original scrip schemes were.

However, for now, definitely the lesson is if you’ve been accumulating scrip, it’s generally good to spend it as you get it.

The ultimate test of this theory will be when sovereign nations start to centralize currency distribution via the speculated central bank digital currency (CBDC) scheme. It will be politically inevitable that CBDCs will eventually be tinkered with in a manner similar to corporate reward schemes. “Buy ESG-compliant product XYZ for 20% less CBDC dollars!”, or “Donate to Ukraine and receive a 10% tax credit off of your capital gains tax on your next disposition of Russian corporate debt!”, etc.

Initially, the rollout of CBDCs will be a straight replacement for currency, but just like how the Income Tax Act has been perverted beyond all reason, the currency itself will be tinkered around with for political reasons to incentivize certain behaviours.

The difference between adding complexity to the Income Tax Act and adding complexity to your nation’s sovereign currency is that a currency derives value from being fungible and universally accepted.  A “rewards scheme” CBDC will inevitably chip away at this, which will ironically depreciate the value of such currency.

It makes me wonder if barter is going to make some sort of comeback.

In today’s edition of “everybody has to be a closet macroeconomist to invest in this market”, we have the following speech from the Fed with the following payload in the last paragraph, and the bold-font is my own:

“Monetary policy affects the economy and inflation with uncertain lags, and the full effects of our rapid tightening so far are yet to be felt. Thus, it makes sense to moderate the pace of our rate increases as we approach the level of restraint that will be sufficient to bring inflation down. The time for moderating the pace of rate increases may come as soon as the December meeting. Given our progress in tightening policy, the timing of that moderation is far less significant than the questions of how much further we will need to raise rates to control inflation, and the length of time it will be necessary to hold policy at a restrictive level. It is likely that restoring price stability will require holding policy at a restrictive level for some time. History cautions strongly against prematurely loosening policy. We will stay the course until the job is done.”

This is the so-called “pivot” that everybody was waiting for and markets exploded in reaction – the fed funds curve shot down, long-term bonds went up (yields down), “risk-on” stocks ramped up (check out AMC!), etc, etc.

This likely means that the December 14 Fed announcement will involve a rate hike from 3.75-4.00% to 4.25%-4.50% and perhaps another quarter point up on February 1st. At this point, the statement of “moderate the pace” does not really matter since January 2022 to today has been the sharpest interest rate acceleration for nearly 40 years.

In Canada, the December 7 announcement will likely involve a quarter point increase to 4% from 3.75%.

There is this implicit notion that stamping down on demand through the monetary policy levers will result in decreased inflation.

My question is on the supply side. Skilled labour, land titles, and imports of stuff from China (aside from the common discretionary goods that you typically see at the entrance of Costco – let me tell you those 60 inch televisions are damn cheap!) are not increasing in quantity.

You can actually infer this from a couple places.

One is walking into the dollar store. While $1 is now a distant memory of the pre-Covid era, what you can get now for $1.25 at the local Dollarama (TSX: DOL) is even less than before. Mind you, there is a reason why they’re trading at nosebleed valuations – customers will still pay up because they can’t afford it anywhere else!

The second place to make some inferences is Amazon. I’ve noticed the typical bulk re-marketed imports from China (ones that aren’t destined for Dollarama, an amazing retailer that Amazon-proofed itself) becoming significantly more expensive than a few years ago. A good example is reasonable-quality bike lights. There are plenty of others.

Of course, going through Costco or Amazon is not representative of a whole economy, but they are two small data points to consider. It leads to the narrative-breaking question of – what if monetary policy cannot cure consumer price index inflation? What if the central banks level off their interest rates, and wait for the effects to come in, and inflation does not wane?

I’m not saying this will happen, but rather that the narrative of the central banks once again going into a loosening mode to cause the markets to skyrocket in value might be premature.

There are a few other cross-currents I would like to illustrate.

One is challenging the assumption that higher interest rates will stomp down on demand, especially on consumer goods. The Bank of Canada has made considerable efforts as of late to try to avoid ‘entrenched inflation expectations’, especially around avoiding the wage inflation spiral. However, if the mentality of inflation is already in the minds of many, logically speaking this would mean to purchase real goods before the price of it increases… due to inflation. Every time I walk through Costco (always a mad-house), I wonder how much purchasing goes on with this psychology in mind.

Another item missing from the equation is the effect of quantitative tightening. While banks still have plenty of reserves stored up in central banks, there is a slow and steady liquidity withdrawal from the market. One positive tailwind is that government fiscal situations have improved with the inflation and hence there is less competition for financing when the governments to go the bond market to roll over their debt.

Finally, the omnipresent yield curve inversion. It is extremely inverted.

30-Year Canadian yields peaked at 3.7% back in October. Today they are at 2.9% (an investor in a long-term bond ETF like XLB would have made a quick 15%). However, today, a fixed income investor has to decide whether to get 4.3% out of their 1-year money (or even higher if you go GIC shopping) versus a lower long-term rate.

This reminds me of the scenario in the early 80’s where an investor had a choice of taking 20% for 1-year money, or 15% for 30-year money. Emotionally it feels very difficult to take the lesser 15%, but these people would have made out very, very, very well with that decision.

Something makes me think that today is a similar situation.

However, 2.9% is a really low, and nominal, rate of return. The game has fundamentally changed since the early 80’s and we are forced into the asset market casino to keep up with inflation instead of being able to rely on fixed income for sustenance. In the early 80’s if you invested a million dollars in those 30-year government bonds, you have a $150k cash stream for 30 years, plenty enough to live on even after taxes. Today, that same investment yields $29k/year, which in terms of purchasing power, can’t even buy you a Toyota Corolla these days.

This is not a good sign. It is a sign of an economy that is really struggling to make returns on capital. It is why banks have such gigantic reserves at central banks at the moment – it is too risky to lend.

There are a lot of cross-currents and this is confusing me. Normally for investing you want to ensure that your sails are facing the macroeconomic winds and right now I have a limited read on the situation. In terms of portfolio action, I am comforted that cash once again is giving something, but my appetite for risk at the moment is quite muted.