I was a little sleepy last weekend and we went out for lunch and I noticed something odd when I looked down at the restaurant.

I do not know much about modern dance but went to a show at Hubbard Street Dance on the north end of Millennium Park (right behind the cool music shell) and their facility has interesting colors and neon lights. I only had my crappy blog camera with me and took some photos. It reminds me of an updated version of the United Airlines connecting tunnel between terminals B and C at O’Hare.

For an hour I was in a small blind bird watching. There was no light inside the blind so we could see out but (supposedly) the birds couldn’t see inside. However, I am sure that the Atlantic Puffins knew we were there because they kept walking right up to the rocks in front of the blind just a foot or two away and eyeballing us, which was great.

I had a camcorder and while I am no great shakes as a photographer or as the video equivalent it was hard to make a bad movie with the Atlantic Puffins (and Razorbills) literally a couple of feet away. I had a web site for this briefly but because the movies take up a lot of bandwidth it was a pain to maintain and setup so I abandoned it. Recently I set up a You Tube channel (owned by Google like Blogger here) and started putting my movies up there, a couple a day, so that everyone can see them.

If you want a laugh or have kids I definitely recommend checking out the “Puffin Movies” channel over at you tube. The URL is http://www.youtube.com/puffinmovies and it is over on the LITGM side bar. Turn UP the sound because you can actually hear the little tick-tick-tick of the Atlantic Puffin feet as they walk on the rocks in front of you and the sound of their wings as they fluff and then fly off (they are really fast and I read that they fly up to 50 mph).

Cross Posted at LITGM

Recently I saw a comedy special by Nick Swardson, who played “Terry” the roller-skating gay prostitute on the sadly canceled Reno 911! show. In this unlikeliest of places I heard something that made me think… the comedian was talking about how blase we are today, about the special effects for a movie like “Transformers”. He said that if people from the 1950’s saw that movie their heads would explode while today in the 21st century we just take it for granted.

As I watched the effects and sound on the Muse show I thought about how much the sound quality, visual effects and stage quality (the stage components rose and fell independently in synch with all the laser and light effects) and how they would just blow away anything from the 60’s – 80’s. If you brought in the top shows from those years the artists and fans would just stand there, mouth agape as they watched something like Muse, with their integrated lights / effects / and sounds.

As some people (generally baby boomers) talk about how rock music was better in different eras they obviously aren’t considering how much vastly improved the concert experience has been made by modern technology, when properly done. Not only are the visual effects better, but the performers have better microphones and monitors and supporting technicians on hand. The effects in those eras probably only were effective if you provided your own chemicals in the brain as enhancements.

Cross posted at LITGM

Many of the dogs were in curlers of some sort as they prepared for the show but this one seemed particularly sad.

These two cracked me up – it was the “before and after” as the dogs prepared for the show. You wouldn’t believe the attention and effort that the owners lavished on these animals.

Here is a movie I made with all of my photos. If you can’t see the movie a link is here.
 
 

ILLINOIS, the second-lowest-rated U.S. state after California, will take bids on March 11 from banks seeking to underwrite $300 million of Build America Bonds and $56 million of non-subsidized taxable notes. The deal will finance school construction, according to John Sinsheimer, director of capital markets for Illinois. The state, which last sold Build America Bonds in a $1 billion deal on Jan. 28, is rated A2 by Moody’s, A+ by S&P and A by Fitch. A statutory requirement calls for 25 percent of all state debt to be bid competitively, Sinsheimer said. Banks led by William Blair & Co. will negotiate the sale of an additional $700 million in Build America securities in mid-March, he said. (Added March 2)

Not only is Illinois poorly rated from a credit perspective, we often don’t do a good job of selling the debt. This post described how a Chicago government entity issued bonds and sold them for an uncompetitive price, generating instant profits from the purchasers of that debt. You’d think that since the state of Illinois issues so much debt, at least we’d be good at it, but perhaps not.

Cross posted at LITGM

Texas is unique in that it is “walled off” from the rest of the USA on its own grid called ERCOT. To be technically correct, the Texas grid doesn’t include El Paso (I used to consult out at El Paso Electric) but that part of the state really is more like New Mexico, anyways.

Texas has a large percentage of wind power – 6% for 2009. The other sources of generation are about 20% for nuclear, 30% for coal, and 45% for natural gas. Per the article:

Texas… has 9,400 megawatts of wind-power generation capacity – more than all the power plants in Utah. Texas has more wind power than any other state… more than three times as much as California.

Power is generally dispatched in the following manner:

1) the grid control operator makes a request for how many megawatts of power that it needs for the next day
2) the various owners of generating capacity (wind, gas, coal and nuclear) submit their available power for the next day
3) the wind power is always taken because it has the lowest incremental cost, along with the nuclear power available as well as coal. Then natural gas is selected until demand is equal to supply, with older less-efficient “peak” gas plants turned off if there isn’t enough demand

The issue is that wind power can’t guarantee its available capacity. In general, if a generation owner “commits” to a certain amount of supply capacity and can’t provide the electricity, then that generation company is charged a penalty for failing to deliver.

In the case of wind power, the generation owners are not penalized if their promised power is not available. All of the other power providers (nuclear, coal and gas) face penalties for failing to deliver.

Coal, nuclear and gas operators must pay for their own backup if an operational or maintenance problem prevents them from delivering power as promised. But if wind generators fail to deliver promised power because the wind doesn’t blow, the cost of backing up wind power companies is spread among all the generators, state officials say. This puts an unfair burden on non-wind generators, says the gas faction.

This issue, the useful capacity of wind power (not its “rated” capacity), and who pays for backup capacity since the wind may or may not be blowing reliably on any given day, is a critical question. Wind in a way is “free riding” on the grid; wind is paid as if it is reliable, when in fact it isn’t, and then the other electricity providers de-facto subsidize wind (again, they already receive Federal and State subsidies) by not charging them for failing to deliver AND taking on their pro-rata share of the power needed when the wind farms don’t deliver.

Not only does wind power get a “free ride” on backup capacity, which hurts the gas generators, but the gas generators that DO run are also getting a lower per-unit reimbursement because the revenues are set based upon the highest “marginal” cost for electricity; on a given day when there is more wind only nuclear, coal and the most efficient gas plants will be online (along with the wind, which always is in the stack, depending on weather conditions) if there isn’t much demand, so not only do gas plants lose money from NOT being on but the gas plants that ARE on receive a lower price for their power. This concept wasn’t really touched upon in the WSJ article (it was better than most of their articles, but still had some holes).

This article is key to an understanding of wind’s impact on the grid; either wind operators should need to estimate their available power more cautiously (to ensure that they meet their commitments), or they should pay to have alternate power (in some reliable form, like natural gas) online.

It is interesting to see more and more articles such as this in mainstream papers such as the WSJ and the New York Times. They are starting to have some journalists that seem to know something about their topic, too.

Cross posted at LITGM

Vermont Yankee

Recently the state of Vermont decided not to allow the renewal of the license for the Vermont Yankee nuclear plant. This decision was made by the Vermont Senate not the NRC itself (the NRC has allowed all licenses to be extended that have been requested so far, I believe). The NRC originally licensed reactors for 40 years and can provide a 20 year extension; Vermont Yankee went live in 1972 and thus it will not be in use past 2012 unless the license is extended. Per this article, Entergy intends to fight the state decision:

Late Wednesday, the Vermont Senate blocked the company’s application for a 20-year operating license extension for its Vermont Yankee nuclear plant. Entergy said in a statement that the effort to win the renewal, “is far from over.” The power company said it’ll work to prove its case to the Vermont legislature, state officials and the Vermont public. Entergy may be forced to shut down the plant in 2012.

Of course this begs the question as to how Vermont will now get its power; this plant provided 35% of all power (according to the Wikipedia link above) for Vermont in 2006 and certainly losing a fully paid for, base load nuclear station is going to require a lot of expensive replacement power from other sources. Since Vermont is on the east coast and there is a heavy transmission grid there other power sources should be available, but this likely will have a rate impact on the citizens of Vermont when they begin paying a higher price for out of state power.

Entergy and Spinning off Nuclear Assets

The plant is owned by Entergy. Entergy is run by Wayne Leonard, one of the smartest guys in the electrical utility industry, who purchased this plant back in 2002 (here is a link to the original purchase announcement, before it officially closed, back in 2001). It isn’t a “done deal” yet that the plant won’t get re-licensed, but if so, it would be expected that this would be a financial negative for Entergy because they likely assumed that the plant would have been re-licensed (because they are routinely approved by the NRC) when they purchased this asset back in 2002. Entergy is also thinking of spinning off their nuclear plants to shareholders; this is smart because the value of the nuclear assets are impaired by the fact that they are owned by distribution companies; as a stand-alone asset, they can charge whatever the market will bear and the distribution company will have to pay up or go without; when they are part of an integrated utility you can only raise rates so much without causing yourself problems since you own both sides of the value chain.

The state of New York woke up and realized the problems that independent nuclear plants would cause. Per this article:

New York’s utility regulator said on Thursday its staff found Entergy Corp’s (ETR.N) plan to spin off six nuclear power units, including three reactors in New York, to a new company, Enexus Energy Corp, was not in the public interest. The New York State Public Service Commission said in a release it was considering other options, including changes to the transaction to improve the financial stability of the three New York reactors and provide benefits to ratepayers. The staff concluded that the level of debt needed to finance the Enexus spinoff “is excessive when the business risks of this new merchant nuclear plant enterprise are considered,” the agency said.

Conclusion:

The re-licensing of Vermont Yankee isn’t a done deal yet. It is likely that Entergy will continue to negotiate with the state of Vermont and they want some sort of additional clean up or concessions to allow the sale to go forward, or a guarantee of some sort of rate reductions below what could be charged as “market” rates. Like the state of New York, the states have to move while they still have some leverage (when the plant owners are changing the license or getting re-licensed by the NRC, which may or may not require state approval) because the Federal Government is pretty much approving everything right now without significant conditions.

Given that the states don’t actually believe that significant new capacity will be coming on line anytime soon, and that renewables haven’t made any sort of significant supply contributions to date, letting these nuclear plants charge whatever the market will bear will have ruinous impacts on utility customers because there is no viable competition on the horizon in terms of significant new plants. There has never been a better time to own a paid-off nuclear plant than right now.

Cross posted at LITGM

The fun part about the show isn’t the judging or the events, it is the fact that you can walk around and see all of the dogs being groomed and prepped by their owners before the show. It isn’t every day that you see 5-10 of every type of dog breed imaginable in fine form. Here is a you tube video I made last year at the 2009 show (I had a song to it but they stripped it out so the video is silent; if I actually knew much of anything about dogs I could narrate it).

Cross posted at LITGM

To give Interactive Brokers some credit, the ad was kind of “tongue in cheek” in that it was made to look like it was written on a napkin like the classic business plan but there were enough elements there to get me thinking about what an odd state of affairs this represented.

Just recently this model started coming under siege. The Fed recently began tightening interest rates, increasing the discount rate to 0.75% from 0.5%. While the Fed has been denying that this is part of a long term policy shift, the markets have started to feel otherwise, as markets went down and yields increased on government debt. This won’t directly impact the 1.25% that they are able to borrow for on the “napkin” today, but it seems to be trending that way, even if this is just a first step.

On the other side, 2 large European firms just cut their high dividends. Daimler Benz (DAI), manufacturer of Mercedes autos, suffered a loss and canceled their dividend, leading to a drop of 4.6% in their stock price in one day. Societe Generale, a large French investment bank, cut their dividend from $1.2 Euros to $0.25 Euros (a drop of 79%) and their stock also fell 7.2% in a day.

The question is – how can companies pay out such high dividends in a sustainable manner when there isn’t much growth in the world economy and many of them are in mature industries? While 2 stocks don’t constitute a balanced statistical survey, they show that dividends are a function of profits and long-term profit view and to talk about them in an “historical” view is backwards.

The other side of this is that investing for yield in such a volatile area as stock prices shows that not only did the long term value of the income stream from dividends drop significantly (in the case of Daimler it dropped to zero, and for Societe it dropped by 79%) but then you can also see the impact on the underlying value of the shares, which dropped 4.6% and 7.9% in ONE DAY.

Cross posted at LITGM and Trust Funds for Kids

The railroads of north central Arizona were all built to support Arizona’s richest copper mine located in Jerome, in the Mingus Mountains above Clarkdale. The Verde Canyon Railroad (formerly the Verde Valley Railroad, operated by the Santa Fe, Prescott & Phoenix Railroad,) was financed by Senator William A. Clark for $1.3 million dollars in 1911. Built miraculously in only one year, the 38-mile, standard gauge line from Clarkdale to Drake, AZ was constructed by 250 men using 200 mules, picks and shovels and lots of DuPont black powder explosives. Today, the same railroad would cost in excess of $40 million to build.

As always, I marvel at how fast these types of operations used to be built, in the days before government and lawyers strangled the life out of everything. I also doubt their “$40 million” figure, because you probably can’t build much of anything and get the permits to do so within our lifetime (the train line runs near a bald Eagle nest, which probably makes it impossible to construct anything).

If you have kids I really recommend this trip. It is not quite as good as the railway in Skagway, Alaska that I reviewed here but it still is a great trip (and a lot more accessible than Alaska). The trip is also fun because it is a bit of a “booze cruise” and they serve (OK) food but have a variety of alcoholic beverages and decent beers and local wines to choose from. Due to this on the way back (it is about 4 hours round trip) most of our rail car was snoozing. We also went in a first class car which I’d recommend – it was a bit more but the food / drink was better and it was roomier. You can also rent the caboose if you have a small party which sounds cool, too.

At this link you can see 2 videos from the trip:

1) in the tunnel – be sure to keep your hands in the car! It is fun in the darkness because there are no lights in the tunnel
2) changing of the engines – at Perkinsville they change the engine so that they move from the rear of the train to the front, it is cool because you can see them up close as they chug by

Cross posted at LITGM

Loan Guarantees and Financing:

One giant barrier to building new nuclear plants in the US is financing. We haven’t built a new nuclear plant in the US in decades so no one really knows what it will cost (and it depends on which design is chosen) but it is safe to assume that they will cost more than $8-10B each. Given that the entire market capitalization of most US electric utilities is smaller than this figure, as I discussed in this post in June of 2009, the idea that new nuclear plants would be built in large numbers was a pipe dream.

The Federal government (Department of Energy) was trying to assist by providing loan guarantees for these projects. I started reading through the Federal web site about what this really means and found this document which describes the arguments about 1) whether or not nuclear plants really qualified under this program because they aren’t really new technologies 2) how much equity the companies should be required to contribute to the project 3) various other data points that summarize the state of nuclear energy in the US (as of 2007, but still mostly relevant because not much has happened since then). If you are interested in nuclear power I highly recommend that you take a few minutes to download and read this PDF because it is filled with facts and opinions from the various actors.

The original proposed Federal loan guarantees were too small relative to the tiny equity capital available from possible players and the large, looming overruns likely to hit these projects. The Federal government seems to agree because they raised the amount of guarantees per this article:

Budget for the coming year would add $36 billion in new federal loan guarantees on top of $18.5 billion already budgeted — but not spent — for a total of $54.5 billion. That’s enough to help build six or seven new nuclear plants, which can cost $8 billion to $10 billion each.

When these items were discussed back in mid-2009 I noted that the only company listed as a potential candidate with financial strength to pull off one of these plants was Southern Company. Also as I noted, it was amazing to me that the “journalists” who wrote up that story couldn’t do the rudimentary financial research that would have told them that same thing. In any case, today they announced that Southern Company was going to be the first company to receive a Federal loan guarantee for $14.5B for 2 units to be built near their existing plants at Vogtle.

Financial Impact on Electric Utilities:

It will be interesting to see the impact of this effort on Southern Company’s financial statements and stock price over the years to come. It would seem to me that this would be a giant negative overhang because many negative things can occur (delays, lawsuits, spiraling costs, protests, etc…) and it seems unlikely that positive events will occur (on time construction, on budget, fast approvals, etc…). Even if it does come on line, it isn’t necessarily going to be a giant money maker – this will depend on the market for energy a decade from now when these plants start generating electricity.

I noted also that NRG, which is building a plant two units in Texas, seemed rather thinly capitalized to take on such a giant effort (and potential strain on their stock price). The Cities of Austin and San Antonio also started to awaken to the difficulties of financing these plants, as well as their own prior history of cost overruns. NRG is now negotiating various options to wind down the effort or complete the site with other partners, and has an excellent power point presentation that they put on the investor relations section of their site which both lays out the opportunity for “first mover” status with nuclear generation and the risks. Should the other partners continue to frustrate the project, note what NRG says on the bottom of page 8 on their slide (they are using all caps, not me):

NRG WILL NOT EXPEND FUTURE SHAREHOLDER CAPITAL IN A PROJECT THAT IS NO LONGER FINANCEABLE NOR WILL IT EXPOSE NRG SHAREHOLDERS TO THE BURDEN OF FURTHER DEVELOPMENT COST RISK SHOULD CPS CONTINUE IN A POSITION WHERE THEY CAN FRUSTRATE THE PROJECT

No Solution for Nuclear Waste:

The Federal government has officially abandoned the Yucca Mountain site in Nevada as a long term storage option for spent nuclear fuel. If you want to see a sad story of missed deadlines, useless bureaucratic stumbling, billions of wasted tax dollars, and most importantly wasting decades on a solution that was bound to fail, go to the wikipedia page and read through your government at work.

Now storage will have to continue at every individual site indefinitely, which means over 100 sites will need to stumble through this morass in their own fashion. Perhaps we could have come up with some standards or best practices for solving this problem locally, but instead we wasted billions of dollars and decades of wrangling on a “mega” solution that was never going to work. Don’t forget about this looming issue when you point to the illusory “renaissance”.

Failure to Disburse “Stimulus” Funds:

About a year ago I noted in this post that there weren’t “shovel ready” projects available for stimulus funding due to the near-impossibility of getting anything done in the US involving financing, legal issues and rights of way. As predicted, the Energy Department has not been able to spend their allotted stimulus money. According to this article:

Energy Secretary Steven Chu expressed frustration Thursday that most of the roughly $37 billion in stimulus money Congress gave his agency last year had yet to be spent, but said the agency could manage a new round of funding for clean-energy projects as part of an expected jobs bill. At a hearing of the Senate Committee on Energy and Natural Resources, Dr. Chu said his agency had handed out only a fraction of the authorized stimulus funds. According to the agency’s Web site, only $2.1 billion has been spent.

Now that same department which was unable to run a $37B budget is going to get a lot more money as the Federal loan guarantees for nuclear power also come under their responsibility. This does not appear to bode well.

We still are struggling to figure out what to do about “clean coal” here in Illinois. This article describes the over $1B spent on 2 proposed projects in Illinois, and all the years of wrangling as this project has gone on since 2003 and is far from completion.

Summary:

Key recent updates would be summarized as follows:

- new drilling technologies are making natural gas in the US cheaper, which makes other types of investment (nuclear, coal) less financially feasible
- while many companies were potential investors in new nuclear plants, only one (Southern Company) was really feasible, and they seem to be first out of the gate (woe to their shareholders, however)
- NRG jumped out first with their Texas plant but it is looking like they are going to pull the plug on that under-capitalized effort
- the Federal government is continuing to be completely inept in their activities 1) unable to disburse stimulus funds, as predicted 2) no plan for waste after abandoning Yucca Mountain 3) can’t figure out what to do about “clean coal” projects after spending over $1B in Illinois and 7 years to boot
- not covered here is cap and trade, which needs its own post to do it justice. It looks like the recent change in the senate will stop this in its tracks, but legal efforts to stop the EPA from implementing new draconian rules continues

If you are interested in energy policy and nuclear power I strongly recommend reading that PDF I linked to above from the department of energy site as well as the investor presentation from NRG related to their South Texas Project.

Cross posted at LITGM

This article from the Wall Street Journal is titled “Escape from Taxation” and reviews the negative impact on the state of New Jersey caused by ever-increasing state income tax rates. As you can see in the table, the highest marginal tax rate on income in New Jersey has increased from 2.5% in 1976 to 10.75% in 2009. New Jersey’s growth used to be in part attributed to its lower tax burden when compared to New York state; today that gap has been (mostly) erased and with it has gone inbound migration of wealthy individuals and corresponding growth.

There are different types of tax burdens and they can be mitigated to varying degrees. Federal income taxes cannot be avoided by moving between the states, but as a resident you “implicitly” choose your 1) property tax burden 2) sales tax burden 3) state tax burden 4) estate tax burden. When these burdens are considered in total, one way to measure the state’s competitiveness is “tax freedom day”, which is the day in the year when you have finished paying off your consolidated tax burden (state, Federal and local) and start earning money for yourself. In 2009, according to the Tax Foundation, this date for New Jersey is April 29, the latest in the nation with the exception of Connecticut at April 30. Note that even New York is ahead of New Jersey now, with a date of April 25 (down from a high of May 8 two years ago). And without being condescending, New Jersey has to have some advantage over New York in order to attract citizens.

Of all the taxes, however, state income taxes have the most perverse impact on entrepreneurial activity. High income earners, who can choose where they want to live and invest in businesses, look closely at the state income tax rate since this rate goes up with their earnings and there are alternatives where this tax can be completely avoided.

To put this in perspective – property taxes are interesting to the wealthy but not a source of tension to the degree that they’d move. Whether it is a few thousand or fifty thousand on their mansions that is a cost that they can modulate depending on the nature of the property they own and this is more of a ‘fixed cost’ that doesn’t increase with earnings. Sales taxes impact them to a lower degree because they consume less as a portion of their total income (and since they are mobile they can often avoid sales taxes on art and jewelry through creative purchasing). Income taxes, however, go up infinitely with their earnings and are viewed as a particular burden since they can be avoided completely merely by changing residency. Many states, such as Florida (cited in the article above as a big source of fleeing New Jersey citizens) have ZERO state income taxes; if you are earning millions this is a very significant difference in your pocketbook (relative to sales and property taxes).

High state income taxes will drive the wealthy out; this is a stone-cold fact and this article only shows the latest instance of this to be tracked, which is the out-migration of higher income earners from New Jersey. The net population loss doesn’t tell the whole story; rich individuals are leaving, and being replaced by poorer individuals. This will have a chain reaction on the state, since the level of state workers and services was set during the high water mark of the economic peak and cuts from there will be painful to implement (for the best example of this see Detroit which has a large number of city workers and rich deals for their salaries while the thriving economy that once supported them has long since drained away). Another impact is an estate tax in New Jersey at up to 16%; this also will be another push for the wealthy elderly to leave the Garden State (other than the weather, of course). Like the state income tax, this estate tax (beyond the Federal estate tax) can be avoided or minimized by moving to another state with more favorable rates.

Driving out the wealthy has additional follow-on effects; less new businesses being started (since they are the entrepreneurs), less money for local charities, and a “death spiral” effect where rates have to keep being raised on the remaining citizens in order to keep the level of state services constant (remember, the state workers all get raises every year, and all keep their jobs, even while your business cuts back).

The new governor of New Jersey has his work cut out for him; a stupefying state income tax rate, a virtually bankrupt state, and state workers used to receiving constant raises and gold-plated benefits and ready to oppose him at every turn.

New Jersey has to be made more fiscally competitive to nearby states or they will lose to them and then inexorably lose older and wealthy residents to other states with better weather and more favorable tax regimes. Of all Illinois’ problems, about the only thing Illinois does right is having a state income tax rate of 3%, which makes it very competitive with these sorts of states. Sadly enough, it is probably only a matter of time before this rate is raised, making Illinois competitiveness even poorer against the other states.

Cross posted at LITGM

Added Aqua in response to a comment on the Trump Tower. Obviously I took that photo in the summer because we haven’t had a nice sunny day like that for a while.

One good thing that came out of the Chicago real estate bubble…

Cross posted at LITGM

Natural gas has three main components, broadly speaking – 1) exploration / extraction 2) transportation 3) distribution. In general, natural gas is lightly regulated for exploration / extraction, has general principles for transportation (open access) and is pretty heavily regulated for distribution (local monopolies).

One critical difference between electricity and natural gas is that natural gas can be stored while electricity must be available at the specific time it is needed. Thus users and utilities can store natural gas and have it available for peak times, while the only way to meet peak load demand for electric utilities is to have units on line generating electricity during the hottest parts of the day or to “shed load” by pushing customers off-line to reduce demand.

Both electricity and natural gas are mostly consumed using North American (including Canadian) resources. While OPEC maintains an oil cartel, the fuel used to generate electricity (coal, nuclear fuel, gas) mostly comes from North America. While these resources can be transported across the ocean (for instance Japan imports virtually all of what it needs to fuel electricity) in the USA (and Canada) we have most of what we need for these industries. Until recently there wasn’t a practical way to bring in natural gas from regions that weren’t connected by pipeline, so we were bound to use North American resources.

Exploration & Extraction

The exploration and extraction of natural gas is a mostly unregulated industry (compared to electrical utilities, at least). The biggest constraint was that vast swathes of the US were placed off-limits for natural gas drilling due to environmental concerns. In the 1970’s, a moratorium was placed on new natural gas connections because it appeared that the US would run out of natural gas. However, improvements in extraction capabilities resolved that situation and wildcatters responded to higher prices by finding additional supplies.

Recently it looked as if we were going to run out of natural gas again. Futures prices on natural gas, which were around $2 / unit in the 1990’s, spiked to as high as $14 / unit in the winters of 2006-8 (prices are seasonal and typically move with the weather) but now are below $4 / unit due to the fact that massive supplies of natural gas have been located in shale formations as drillers redoubled their efforts in light of these high prices.

The natural gas industry, as we can see above, is able to use market forces to respond to price signals. Drillers used innovation and new technology to find new supplies which in turn brought down the high prices. If the extraction / exploration industries were heavily regulated and monopolized (like power generation), it is likely that they would just have utilized the high prices as an opportunity to reap large profits rather than to expand supply.

Transportation

Regulation of natural gas was profoundly impacted by FERC order 636 in 1992. At that point, the pipelines were forced to open their capacity to multiple bidders, including “end use customers” who were able to buy gas directly (through brokers) and have it transported to them directly. This order is generally credited with de-regulating the pipeline industry, once their “stranded costs” were recovered.

While there are many difficulties in building new pipelines from an environmental and cost perspective, generally the United States natural gas industry has been able to bring new pipeline capacity on line. This is different than the electricity transmission industry, where new capacity additions have been relatively minuscule. One big reason is financing – the pipeline companies can get end users to “subscribe” to pipeline capacity to fund development while there aren’t effective ways to “monetize” demand for transmission capacity in the still heavily regulated electricity sector. In short, a new electrical transmission line benefits everyone in terms of access to lower prices and improves reliability (because the grid is interconnected and load needs to be spread) but there isn’t an easy way to pay for these benefits.

Another improvement in transport is Liquified Natural Gas, or LNG. Cooling and compressing natural gas allows it to be transported on special tankers which can carry it across the ocean and into new markets. Many nations (such as oil producing nations) are awash in natural gas (sometimes they just burn it off as they extract oil) but they don’t have a way to get it to countries that can utilize it (such as the United States). LNG offers a way to do this, assuming you have a pipeline leading to the port and the LNG facility is built (they cost billions to build) and also that the LNG facility at the end country is interconnected with a pipeline that has available capacity. Here is a link to the physical location and capacity for the nine LNG terminals in North America. As you can see, they are concentrated on the gulf coast of the United States. The US has added LNG capacity, which is great because it allows for price competition from overseas producers and also (theoretically) allows US producers to ship their gas overseas, as well.

Alaska has huge amounts of natural gas. For years they have been considering how to get that gas to the “lower 48″ where there is high demand. This article from the WSJ titled “Latest Risk to Alaska Gas Pipeline: More Gas” (which is where the shale graphic above also came from) describes the effort to build and finance the pipeline. The two options are 1) build a pipeline to the coast and an LNG terminal which they could be exported, costing $26B 2) build a pipeline through Canada all the way to the lower 48 at a cost of $41B. The pipeline would take a decade to build – meaning that they would need a forecast of natural gas prices in the lower 48 in 2020 to finance this effort.

However, the shale gas boom has blown a huge hole in the economics of this pipeline. It is much harder to justify this giant investment at $4 / unit gas than at $14 / unit gas. Per the article:

“I think we’ve probably cost ourselves a few years, which allowed the shale plays to come in… we should have build this pipeline four years ago”

This is from the perspective of the State of Alaska – because once the pipeline is built the cost of extraction is low and the Alaskan natural gas would sell at the market price in the lower 48 (whatever that turned out to be) – but with the lower prices, you can’t finance this new pipeline at all.

Distribution:

Distribution is the least important element of the natural gas industry. This function is your local pipeline company, that has a monopoly on pipes because it doesn’t make sense to have 2 companies digging up streets and having parallel infrastructures (like it does for telecom). The local company pays for gas and passes it on to end customers, and pays the transportation costs (negotiated per FERC rules on open access) as well. They also finance the local pipeline distribution infrastructure. While you may pay a large natural gas bill – take a look at it – only the portion for local distribution and customer service actually goes to the local distribution company; the rest pays other elements of the supply chain (extraction and transportation).

Innovation has been pretty low in this sector of the industry, but really there isn’t a lot to do. When natural gas was at $14 / unit these utilities were feeling the brunt of customer anger, but now their situation is much more low-key. At $14 / unit there was a lot of interest in conservation and perhaps fuel-switching or use of other technologies (i.e. solar to heat water instead of natural gas) but this interest has waned lately at $4 / unit. Electrical utilities are spending billions on time-of-use meters but natural gas doesn’t have quite the same time-of-use issue because they can store capacities locally and inject them into the system at peak times (up to system capacities). Since the natural gas infrastructure is largely underground it is less subject to storm damage and other sources of outage when compared to the electrical industry, which suffers mightily from these sorts of outages.

Natural Gas and Electricity:

The falling prices of natural gas are having a profound impact on the electrical generation industry. At $4 / unit, natural gas is competitive with less efficient coal units and blows the renewables out of the water (except for hydro, of course, but you can’t build any more hydro in the USA due to environmental concerns). Natural gas is cleaner than coal and easy to construct and site, so it becomes the de-facto solution to our looming energy generation capacity crunch, as well. In other blog posts I predicted that new coal and nuclear plants were a figment of the media’s imagination for a variety of reasons, but the plentiful supply and low price of natural gas (due to these shale fields) is another stake in the heart (if one was needed) to any designs on new coal or nuclear plants.

The reaction of our non-regulated natural gas industry (exploration) to high prices and how they basically “solved” our energy problems (and will solve our electricity issues, per above) should be a text book example studied in all schools. This is what happens when markets are allowed to work as they should, and innovation responds to high prices as a market opportunity, in turn reducing prices down towards their historical norms. It didn’t come through MORE regulation, or jaw-boning rich capitalists, or NY Times op-ed pieces – it came through free markets and the belief in human innovation.

We got it half right, at least. For more info if you are interested go to this site, naturalgas.org, which seemed to have reliable information and links to other useful information.

Cross posted at LITGM

The specific elements of the investing plan are as follows:
- Interactive brokers can make margin loans at 1.25% annual interest. This LOW rate of interest is made possible by the country’s current super-low rate policy
- Some stocks are offering dividends as high as 5%. In the current low interest rate environment (you are likely to get 2% on CD’s & government paper, and almost nothing on your money market and bank deposits), that 5% rate seems very enticing, especially since dividends are taxed more favorably on individuals than interest income (dividends are as low as a 15% rate, while interest income is as high as 35%+)
- Interactive brokers will offer you LEVERAGE. By leverage, this means that they will LOAN you more money than you have in your brokerage account so that you can invest and magnify your returns, either UP or DOWN

Using this method, the specific “napkin” offer is as follows:

- You put up $100,000 of money in a brokerage account
- Using that money as collateral, you borrow $400,000, or 4X leverage
- Now you have $500,000 in your account to invest with
- Pick 5 stocks yielding 5% or more, and invest $100,000 in each stock
- Your stocks should then bring in ($500,000 * 5%) = $25,000 / year in income
- The interest on your $400,000 that you borrowed from Interactive Brokers costs you ($400,000 * 1.25%) = $5000 / year in expenses
- Your net income is $25,000 – $5000 = $20,000 / year
- $20,000 / year in income on an investment of $100,000 is a 20% annual yield, at a time when you can only earn maybe 2% risk free. This is a substantial return

The first thing people would ask is WHY Interactive Brokers would lend out $400,000 on a $100,000 investment at such a low rate? From a margin account perspective, Interactive Brokers doesn’t take much risk. Let’s say the value of all the stocks fall 10%. In this model, your portfolio value has dropped from $500,000 to $450,000. While your equity (investment) has shrunk from $100,000 to only $50,000, they haven’t taken a loss yet, because they can step in and liquidate your portfolio in the open market, take back their $400,000 (including the accrued interest to date plus any fees they want to charge), and hand you back your remaining cash. As long as they “pull the trigger” to liquidate the positions before it reaches the $400,000 mark (or nearby, so that they get their interest and fees), they will be made whole.

This example indicates the “down side” of leverage. When the markets go against you, and your equity component is but a sliver of your total portfolio, even small market moves can kill you. At some level this is what caused the banking crisis in late 2008; the large institutions had little equity capital and super high levels of debt (more than 30X their equity available, depending on what you count as equity capital), meaning that even a small crisis of confidence or repayment risk started to topple the entire structure. You might ask WHY these banks, whose depositors are guaranteed by the US government (FDIC) and who are so central to our financial system that they cannot be allowed to fail could leverage up so much, but that is grist for another post (failed regulation).

One question that I started asking as I stared at the napkin – how many quality companies are there out in the market that pay greater than 5% dividend yields? I am looking for companies with a reasonably strong share price and a history of paying high dividends, not companies that paid a modest dividend but whose stock price has fallen so far that it SEEMS like they offer a high dividend (these are unstable dividend payers who likely will lower their dividend at some point in the future).

Using the cool Google Finance stock screener, I put in a criteria of stocks with a greater than 5% yield, more than $1B in market cap, and that they couldn’t have had a 52 week return of worse than -20% (to screen out ones that have a big dividend yield because their price has been plummeting). I was surprised that there were a number of major companies offering such high yields, including:

- AT&T (T) at 6.62%
- Altria (MO) at 6.9%
- Southern Company (SO) at 5.38%
- Bristol Myers Squibb (BMY) at 5.2%

So at least there were a number of reasonable candidates for this sort of analysis. You can see how the value of a company paying out dividends this high would rise in our current minuscule interest rate environment. On a personal note, when an ETF specializing in dividend paying stocks, DVY, came out about 5 years ago – I jumped in right away, figuring that it would be a good play with the reduction in taxes on dividend payments to 15%. However, this fund essentially loaded up on financial firms, which were viewed as reliable dividend payers, and was socked during the financial meltdown when many of the components either vanished or were severely punished.

So far the “back of the napkin” has checked out – the real issue, however, is that we are mixing “apples and oranges” by seeking yield with a volatile assets. The 5 stocks (in this example) could easily drop by 10% in a narrow range of time, essentially making Interactive Brokers enact a margin call (they aren’t going to wait until you have zero equity in your account, at that point you’d be levered up 9 to 1). What you are betting on is that you can hold these assets and that they’ll trade in a narrow range (or up, a situation that we’ll get to next) for a reasonable amount of time, in fact at least a year or so in order to obtain that yield.

The flip side is that if stock prices go UP, you will have a bonanza on your hands. In addition to the 20% yield that you’d earn if you were able to hold for a year, you’d get gains on both your money and the money you borrowed. If stocks went up 10%, your gain would be ($550,000 – $400,000 borrowed money – $100,000 original investment) = $50,000 on a $100,000 investment, or a return of 50% (on top of the 20% yield you’d receive). This is the “magic” of leverage – I saw an analysis one time that compared the S&P 500 return against hedge funds and if you levered up the S&P 500 with this sort of margin you’d receive returns that would give the hedge funds a run for their money (they almost all use leverage, too).

The odds that this basket of stocks will decline by 10% or more, causing IB to liquidate your holdings to pay off the margin call, is pretty high. The yield play is really secondary to how long that you can avoid that sort of a down turn. On the other side, gains are very beneficial in this model. It probably doesn’t make sense to mix yield with leverage to this degree, unless you are a professional investor and this is only a small part of your broader portfolio.

The low interest rates that we have today encourage risk taking because the government has set the rates so low. With low rates, virtually any business model with any sort of return looks at least feasible on a napkin.

Personally, I was pretty impressed by the number of solid-looking companies paying such high dividends. Even with zero leverage, a 5% return is great, especially since the effective tax rate is 15% on these dividends (for now, at least, until the tax cuts are rescinded which is likely in 2011). The issue is that even a small market downturn will make that 5% return moot, if these stocks fall harder than a general corporate issue.

This ad certainly did make me think about a lot of things; the power of leverage; the ability of a low interest rate environment to make almost any business idea sound good; and what is driving these companies to such a high dividend payout ratio.

Cross posted at LITGM and Trust Funds for Kids

This is no way to run a state. This article in the Chicago Tribune describes the annual ritual:

The CTA made an offer today that its labor unions could refuse, and they quickly did: Give back a 3.5 percent pay raise this year in return for reducing employee layoffs and major cuts in bus and rail service that are set to begin Feb. 7.

The standoff threatens to cost 1,067 union and 100 nonunion employees their jobs as the CTA whittles away at a $300 million budget deficit that is caused mainly by tax-revenue declines linked to the recession.

But the public stands to feel much of the pain in less than three weeks when there will be longer waits between buses on 119 routes, 41 bus routes will have shorter hours and nine express bus routes will be eliminated.

Note – the unions aren’t being asked for cuts – they are being asked to give up scheduled pay raises. But of course they are balking at this; after all, why concede anything, when the politicians back down every time and just issue debt or raise taxes to cover it anyways?

No one knows how this will end; in the past the state always stepped in to throw more money at it, or come up with some sort of accounting or borrowing gimmick as a temporary fix, but our financial situation is getting more and more dire by the day.

For a while I was thinking of setting up a site dedicated to Illinois’ fiscal woes, but someone beat me to it.

IllinoisIsBroke.com describes the state of our state, which is of course very bad. This site puts most of the blame on our broken and underfunded pension system, which is a prime culprit.

It will be interesting to see how the game of chicken plays out this year since our funding options are drying up; some day this game has to end with the draconian cuts being implemented to wake people up to the situation.

Cross posted at LITGM

Oh no… the ice is breaking up… these non-native Canadian Geese, which don’t even bother to migrate but just hang out fat and happy… they could maybe be extinct in our lifetime (uh, probably not by a long shot).

This post describes what the rate of return means in practical terms, and why it is important.

One of the core elements of investing is the assumed “rate of return”. Along with your base investment (or amount that you are periodically adding, say annually), your time frame (number of years out you want to go), the “rate of return” is the percentage variable used to determine whether you will have enough to retire and / or meet your needs for a specific goal (such as will you have enough funded to send your child to college).

What is Rate of Return?

The rate of return is what you EXPECT to earn, in gains, each year. Typically this rate of return is highest for stocks, in the middle for bonds, and lowest for cash or cash-equivalents (short term money market, CDs, etc…). A sample plan might have stocks at 10%, bonds for 6%, and cash-equivalents at 2%.

A rate of return utilizes compound growth; thus $1000 for 10 years at a 10% rate of return does not give you $1000 + ($1000 * 10% * 10 years) or $2000 at the end of the period (ignoring taxes and transaction costs, which I will get to next), it gives you
about $2850, because you earn a return on your gains each year, so the gains compound. If you go out even further, to 20 years, you don’t go from $1000 to $3000 ($1000 * 10% * 20 years), you get $7400. Thus the part of earnings due to “compounding” (not just the base payment times the rate, for the time period) is $850 over 10 years ($1850 – $1000 = 850 / 1000) or 85% higher. The part due to compounding over 20 years ($6400 – $2000 = 4400 / 2000) or 220% higher.

Basically, ignoring the math, in general, the higher your “assumed” rate of return, the greater your assumptions on your ending value. It isn’t “linear” – it is “geometric” – so a 2-5% difference in assumptions makes a GIANT impact if you are looking out 20-30 or so years.

When I started out investing about 20 years ago in my first 401(k) plan, people thought 10% / year was a reasonable assumption for equity returns. I don’t know what the assumption on bonds / cash investments were, but let’s say that it was 6% or so. Under these plans, if you set aside a decent amount towards your 401(k) and your company made a decent “match”, you could easily see your amount available for retirement grow to a seemingly large and acceptable number, assuming that you put most of your money in stocks (since you were just starting out in investing).

Problem One – Losses

The first giant, gaping hole in the rate of return model is how to handle losses. Losses have a very significant impact on your portfolio, because your rate of return has to be MUCH higher to “dig” out of the hole. For example, if your portfolio loses 40% in one year (which happened to most of us in 2008), and goes from $100,000 to $60,000 ($100,000 * -40%), you just took a big hit. But then, your future growth has to be much higher in order to reclaim the ground you just lost. If you lose 40% one year, and then have 10.75% growth for 4 years, you just break even. However, you lost FIVE YEARS of future compounding (the year when you went down 40%, and the 4 years you earned 10.75%) just to get back to ZERO (where you started). Thus if you wanted to earn 10% a year for 5 years when you started (which takes you from $100,000 to $175,000), and you still want to get to $175,000 at the end of 5 years, then after your first “big hit” of 40% losses, you have to earn at a 23% for the next 4 years to 1) make up the loss in year one 2) to earn enough in all other years for them to get their “base” return, too.

So let’s go back to this (semi-real world) example again, in just dollars. You have $100,000 on 1/1/00. You are using what seems reasonable to you or me when I started investing (a 10% return assumption), which would have my balance at about $175,000 on 12/31/05, over 5 years.

In year one, ending 12/31/00, the market goes down 40%, leaving you with $60,000. Gulp. If the market goes up a bit more than 10% / year over the next 4 years (your original rate of return assumption), then you basically end up back near your ORIGINAL $100,000 balance, after 5 years are done. This isn’t good, you could have left your money in a guaranteed account and done about that well. You just made NO progress towards retirement or towards a college education account.

Thus in order for your portfolio to be able to afford some occasional large losses (such as we received in 2002 with the dot-com crash and in 2008 as the credit markets seized up), you will need to make FAR more than 10% the OTHER years in order to reach a target as high as 10%. In fact, you will probably need to earn something like 20% every OTHER year in order to make up the lost ground of years that have big losses.

Basically if you aren’t seeing a return of something like 20% / year in MOST years on equities, you aren’t going to make anywhere close to 10% when you factor in our frequent years when the markets take big hits. Not only do you lose DOLLARS (your balance declines 20% – 40% those years), you also lose TIME for future compounding and your rate of return is much smaller than it appears.

If you go back to 1990 and ran the S&P 500 for 20 years, you’d get an appreciation of around 6% / year. If you just run the last 10 years, you get negative appreciation (no growth). I realize that stocks have a longer term horizon than this but these are the relevant milestones within my life. The “net” of these two, in very simplistic terms – around 3%, given that you are putting money in “in increments” and didn’t just have a lump of money at the start of 1990 and watch it compound all those years.

Problem Two – Transaction Costs

I had a friend who used to live in Las Vegas. He always said that the fact that they had lavish facilities and gave out subsidized meals and drinks meant that the house had a big edge, and that they always won in the end. While this is common knowledge, actually seeing the scale of their vast casinos put this “edge” in perspective.

The same thing applies to the big bonuses and huge financial services industry that exists in the United States; to a large degree, these institutions exist and can pay bonuses because of transaction costs that they put on customers such as yourself that invest in the markets.

Since the time I started investing in the 1990s transaction costs have fallen a lot. It was common to pay a 5% “load” up front when joining a mutual fund, on top of annual expenses in the 1% – 2% range. Nowadays mutual funds with a load have become much scarcer and transaction costs have fallen into the 0.5% range if you shop around a bit. ETFs, which also have big tax advantages, have risen in power and they also offer low transaction costs since the cost to trade a share of stock has fallen over the years (for mutual funds you typically don’t pay a transaction fee to invest, but you do for ETFs). It depends where you shop and what other fees to take into account but nowadays an electronic brokerage like TD Ameritrade allows stock trading for $9.99, a significant drop from the $30+ dollars it cost “net” back when you had to call a broker by phone in the early ’90s. This reduction is even bigger in “real” terms when you factor inflation into account.

While transaction costs have fallen, they still add up, and they eat into your return. Your return now has to “make up” for the “loss” years (and time), as I noted above, but also at least 1% / year in transaction costs for equities (all in). You probably could do it for less depending on how you structure your portfolio, or it could be higher if you trade a lot.

Problem Three – Taxes:

Taxes also impact your earned rate of return. There are many kinds of taxes that hurt investors’ returns.

1) capital gains – when you sell something that has appreciated in value, you pay capital gain taxes, which vary depending on how long you held the asset. Currently, the US has favorable tax rates for assets held > 1 year, it is 15% – this would rise potentially to 20% when these rates expire in 2010 assuming this is not renewed. Assets held less than 1 year are treated as ordinary income, which is as high as 35%
2) taxes on dividends – each year dividends are paid out from many corporations; since dividends are subject to “double taxation” (the corporation pays dividends after tax has been applied), the US has a favorable rate for investors who receive taxes of only 15% on US corporations. This is scheduled to expire and may or may not be renewed; if not they will be treated as ordinary income, assume 35% or so
3) taxes on interest – if you receive interest income, it is taxed as ordinary income, assume 35% or so. There are exceptions to this, but they also cut into your return – municipal bonds are (generally) exempt from Federal taxes, but they make up for this by offering a lower rate (a municipal bond might offer 3% when a corporation would offer 4.5% for the same credit quality bond)

While you can defer taxes by using various plans 401(k) and defer gains on other plans (IRA), and also completely avoid taxes by using funds for designated purposes (529 college plans), in general as the saying goes, you can’t escape taxes. You can structure your portfolio in a manner to minimize tax impacts (i.e. put interest income in IRA funds, and low dividend ETFs in your after-tax brokerage), but you need to factor in taxes into your implied return. They generally take off at least 1-2% of your return, but like all else, it depends. But it isn’t zero and needs to be taken into account.

Problem Four – Investor Behavior

In order to “earn” the returns listed above, investors need to act rationally. Investors, historically, have NOT acted rationally. Investors tend to buy after a stock has risen (chasing returns) and they don’t re-balance their portfolio after gains. They need to HOLD on to stocks after big losses have occurred, rather than selling at the trough, so that they can be there when the stocks “roar back” and go past the losses incurred.

Investors also tend to minimize their re-investments in stocks when they go down; this is human nature – when something has bitten you (stocks for losses), it takes an iron stomach to invest MORE money in stocks again. But in order to earn the rate of return that stocks (theoretically) can offer, you need to buy low and sell high (through re-balancing, effectively).

While research on the impact of investor behavior is all over the map, in general the “average” investor does much worse than his “rational” or “theoretical” counterpart. This probably drops 1-2% (or more) off the return.

Conclusion:

In the article by Jason Zweig, he uses the term rate of return “net-net-net”. This means the REAL rate of return after transaction costs and taxes. Typically irrational investor behavior needs to be taken into account, too.

With all of this, that 10% rate of return is likely to be far lower; perhaps 5%, perhaps less. If you put those numbers into your model you won’t be retiring for a long, long time.

Cross posted at Trust Funds for Kids and LITGM