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Tuesday, February 12, 2019

A Disconnect: Electric Vehicles and Cobalt and Copper Prices

Mike Smitka, Economics
Washington and Lee University

Some 80 battery EVs will be on the market by 2021. IF they sell at any volume, THEN demand for the underlying metals used in EV batteries, particularly lithium and cobalt, should rise. But instead prices have been falling for the past 12 months. So either traders aren't looking very far into the future, or they don't believe the EV revolution will actually occur.

First, the price of cobalt has dropped to about 1/3 of its peak of a year ago. Yet this remains a crucial component of battery cathodes for the lithium chemistries in current use. While the lithium spot market is thin and not where most trading takes place, those prices have also fallen (listen to the Global Lithium Podcast for details).

Cobalt Price from tradingeconomics.com, US$/metric ton
Lithium Price from tradingeconomics.com

The disjuncture surely isn't because investors aren't sufficiently forward looking. After all, the prices of both hit record highs in March 2018, as the Tesla stock fever took hold. Since then, however, the market has cooled – if not crashed.

One possibility is that there's a lot of metals production coming on-stream. That is, those close to the ground don't see a scarcity, rather they anticipate an increasing supply. That however is not what those in the mining industry are saying. While there's a lot of interest in brine extraction, none of those projects have started up. The geography makes that a daunting task – evaporating brine in a 4000m high desert remote from anything is a process fraught with challenges. Then the output has to be moved for refining. That refining is intrinsically expensive (you've a brine with Li and Na and K, all neighbors in the periodic table). According to insiders, capacity is not being added – again, listen to the GLP podcast. The various national governments also want to see that they get a share of the revenue, and so licensing is a drawn out process. In short, none of these are going to be producing much metal in the next 5 years. The same thing is true for hard-rock lithium resources in places such as Australia. Assessing the ore bodies, getting the permits, building the mine infrastructure, and building the refining capacity are all multi-year projects.

Cobalt is even more of a barrier. With the exception of a small mine in Tunisia, cobalt is a by-product of copper (and to a lesser extent, nickel) mining. However, the price of both of these metals has fallen, and mines are being closed, not opened. The best deposits are in the Democratic Republic of the Congo, which accounts for about 60% of global production. Much of the output includes metal from small, illegal mines employing child labor. While that may not matter for the Chinese market, it cuts into the amount available in countries with policies mandating ethical sourcing. Cobalt supply isn't going to grow in the next 10 years, and may even decline.

Copper Price from FRED
Nickel Price from FRED

the fall in prices ... must be a story of demand...

Thus IF the fall in prices is not a supply story, THEN it must be one of demand. Yes, interest rates have risen, and that ought to push commodity prices down. But the change in present value from discounting sales in 2022 at 3% instead of 0.3% isn't much – 3% compounded over 3 years drops the value 8.5%. That's a far cry from the observed 65% decline.

That leaves a decline in expected demand from EVs, which constitute the bulk of battery demand, and the fastest growing component. The main issue is that we now have increasing evidence that EVs don't sell. The GM Bolt, the Nissan Leaf, and the Renault ZOE have not been hits – though Renault to its surprise sells a lot of ZOEs in rural France, where home charging is practical. Ditto China, where BEVs sell in cities with high subsidies (including being able to jump the queue for license plates), and sell not at all elsewhere.

Then there's Tesla. Only in 2018 did the company reach cumulative US sales of 200,000 units [and hence the halving of the $7500 Federal individual tax rebate]. The Model 3 continues to garner news, but by Tesla's own admission it has tapped out sales in the US, and is switching its emphasis to exports to Europe and China. After all, the market for an expensive sedan is fairly small, particularly in a world in which demand is shifting to mid-sized SUVs. But while the target segment represents a strategic error on Tesla's part, the expensive part is common to all EVs. They just don't offer a compelling value proposition to consumers who don't care about fast acceleration, or about which drivetrain lies under the hood.

...people don't care what's under the hood of their car...

Part of the challenge is that, even with EVs in the mix, the fuel efficiency of vehicles on the road continues to improve. It's now possible to power a full-sized pickup truck with a 4-cylinder engine, thanks to improved turbocharging, fuel injection and computerized combustion timing, and a host of ancillary improvements such as lighter pistons, better piston rings and better bearings. Add to that improved body-in-white engineering with the mixed use of aluminum, magnesium, and varieties of high-strength steel, and modern vehicles can pass today's more stringent crash tests while holding down vehicle weight. (BIW improvements are of course available for BEVs.) Then there are today's 10-speed automatic transmissions, that leave the engine operating at its sweet spot more of the time. Meanwhile "light" electrification – electric fan and water and oil pumps, electric steering, start/stop systems, alternator power-boost systems, and potentially electric valves – are eliminating the parasitic drag of hydraulics and belts. As 48V systems diffuse, efficiency will continue to increase. Car companies, though, don't advertise these as "hybrids." But more and more, that's what people are actually driving. Again, people don't care what's under the hood.

For consumers, as Ed Dolan points out in a recent blog, fuel is a historically low component of the cost of ownership of a vehicle. Absent a carbon tax (or Persian Gulf war) that drives up the price of gasoline, the cost of batteries needs to fall below that of an ICE-powered car, given the perceived challenge of recharging on the fly. At present no such battery technologies are entering production, which means that they won't be available on a volume car in the next 8 years. Another alternative would be a change in consumer behavior, where households become comfortable with owning a small EV commuter car, and using short-term rentals for longer trips. In fact, people are opting for SUVs that can cover all usage cases, while short-term rental businesses such as ZipCar lose money.

...metals markets implicitly believe EVs are not the wave of the future...

To return to the main theme, I conclude that recent price movements in metals markets reflect a growing realization that battery electric vehicles are not the wave of the future. That will change if new battery chemistries prove out. But those chemistries won't use cobalt and may not use lithium. Hence sales of those metals into the EV market will remain small, and eventually disappear.

1. In some parts of the world, such as Brazil, this is complemented by the availability of biofuels and CNG competitive with petroleum-derived gasoline and diesel. Even with a carbon tax, there is no business case for a BEVs. Likewise work continues of fuel cells, which may prove a good match in countries that turn to storing intermittent "green" energy output as hydrogen. Particularly for readers in the US, it's easy to overlook the country- and region-specific variety in markets for motor vehicles.

2. Lithium-ion batteries are a poor match for utility-level energy storage, where on the battery side vanadium-flow technologies are already superior.

3. Having just visited suppliers and looked at their order books, MY2022 is basically a done deal. The validation - pilot production - volume production cycle for a new battery will take at least 5 years before it can be incorporated into a high-volume passenger vehicle. So as of early 2019 we're looking at MY2027 as the earliest date for the rapid expansion of BEVs.

Thursday, February 7, 2019

Tesla and Elasticities: An Economics 101 Lesson

Mike Smitka
Prof of Economics, W&L

An elasticity is a qualitative and quantitive tool to put bounds on real-world behavior. If a change in one variable leads to a more than proportional change in another, then the relationship is "elastic." Numerically, it's the ratio of percentage changes. Here I apply it to a simple but interesting case, Tesla's $1,100 price cut.

The demand for cars is not very elastic in price. There are lots of 300+ models to choose from in the US, from a variety of manufacturers and in types ranging from compact cars such as the Fiat 500 and the Smart to full-sized pickup trucks replete with towing packages and other options. Then there are performance cars, and most popular of all, small SUVs and crossovers, such as the Toyota RAV4 and the Honda CR-V. There's very little substitutability across vehicle classes; someone looking for a pickup truck does not cross-shop the Fiat 500. The price isn't terribly important. And so demand for any single model is inelastic – it can help sway the choice against a similar vehicle.

(Mea culpa: my wife drives that latter. I prefer a smaller sedan with a stick shift, in my case a Chevy Cruze. My son drives a Subaru Forester, bought used, and we have a F-250 pickup to handle the tasks of living in the woods.)

...a 2% drop in price leads to an 8% drop in gross revenue and a 60% drop in net profit...

For the Tesla Model 3, there are (at least according to afficionados) no similar vehicles. Someone either wants one (and has the money to make that happen), or they don't. A $1,100 difference in price, or a decrease of about 2% with average sales prices (ASP) of $50,000, won't lead to many more sales – if you can't afford a $50,000 vehicle then you probably can't afford one at $49,000. It might make a big of difference if you're comparison-shopping against a similar-sized BMW or Audi. Let me ere on the high side, and assume a 1.0 elasticity. That is, the 2% drop in price will push up the quantity demanded by 2%. As a result, total revenue for Tesla will be unchanged: the drop in price will be just offset by the increase in sales.

I ignore the impact of the phasing out of Federal tax credits. As of January 1st, those drop from $7500 to $3750 so net of the just-announced price cut by Tesla, the bottom line cost to US consumers has in fact risen by $2650.

But for a company with a parlous balance sheet, what matters isn't total revenue but profits and cashflow. Now Tesla claims a gross profit margin of 24%. They don't calculate that in the same way as other car companies – despite self-proclaimed industry-best margins Tesla has never earned a full-year profit. But for the sake of argument, and to keep numbers round, let's us 25%. Given an ASP of $50,000, they then have a gross profit of $12,500 per vehicle. And they've just cut that by 8%.

The bottom line is clear: if Tesla is extraordinarily lucky, they'll maintain total revenue. But they'll earn 10% less gross profit on that revenue. With automotive revenue of $6.3 billion, and a gross margin of 25%, they've gross income of $1.6 billion. Lop off 8%, and this falls by $126 million. So assuming nothing else goes wrong relative to 2018Q4, net income falls from $210 million to $80 million, or a 60% drop in net profit. While timing may affect that – lower sales in Q1 as Model 3s sit on ships en route to Europe, and then higher revenues in Q2 as they make their way to customers – the impact is permanent.

Note that at each step along the way I have rounded numbers in favor of a better profit number for Tesla. Tesla has also cut prices for Model S and Model X over the past 6 months, without any increase in sales. I don't try to factor that in, again to provide a more optimistic case for Tesla.

Saturday, November 24, 2018

Chinese Industrial Policy: an automotive example

In Japan, motor vehicles were few and far between in the 1950s, and in 1956 half of all vehicles produced were still 3-wheelers. Car production surpassed that of trucks only in 1969, and it was only from the mid-1970s that there were more cars than trucks on the road. Even in 1985 there were only 711,000 full-sized cars on the road. It was not a big market for higher-end vehicles.

But a November 22nd Bloomberg story on the (to date) counterproductive outcomes of the "China 2025" industrial policy leads me to address a different set up issues, whether automotive industrial policy makes sense. To do I switch back and forth from automotive historian mode to economic analysis.

In Japan, promoting the auto industry via import substitution industrialization was costly. That's one reason that there were so few vehicles on the road. Industrial policy imposed a cost not just on vehicle users, but on everyone who relied on logistics – which was, of course, everyone. And because there were so few vehicles, the postwar plans for highways and local roads got moved to the back burner. The Yokohama ring road was laid out in 1950, but completed only in 2005. The outer Tokyo ring was planned back in 1927, but not completed until 1985, and at only 4 lanes. The last segment of the inner portion wasn't completed until 2015. Some of the connecting roads and junctions are still under construction. (In Chinese, ring road is huánlù 环路; in Japanese, 環状線 kanjousen.)

Of course there's the contribution to the domestic economy. If it's being subsidized, through policies that allowed firms to charge prices far above international levels, then the contribution of that industry is smaller than that of non-subsidized sectors of the economy. That's made worse in this case by the negative externalities of costly logistics. The Japanese domestic auto industry likely wasn't competitive in the subcompact segment until the mid-1970s, and from then on could survive without subsidies. But competitive full-sized cars came even later. BMW made a fortune in the 1980s and 1990s in Japan because they could charge higher prices than in other global markets, suggesting that the Japanese producers weren't competitive in that segment until the 1990s, and (given branding) perhaps not even until 2006, when Toyota at last launched their "German-killer" Lexus marque inside Japan. While Japan removed formal trade barriers by 1971, Japan's domestic market was small. The preferred route for the Detroit Three was via acquisitions, not de novo "greenfield" plants or exports (which would have been compact cars from Europe, not large cars from the US).

Trade models don't show that subsidizing industries saves on foreign exchange, because (cf. expensive domestic transport above) it raises costs for exporters and for firms that face import competition. Japan's surge in exports to the US following the 2nd oil crisis was brief, as the market for subcompacts collapsed by the mid-1980s. But in the meantime the US formally subsidized direct foreign investment (via the VER, voluntary export restraint, imposed by the Reagan Administration in May 1981) and encouraged imports (a side effect of the strong dollar policy of the early 1980s, one of the channels through which high interest rates helped quell inflation).

So I don't think that "It would have been self-defeating not to support MITI's policy to nurture - and protect - Japan's infant auto industry." (citing Roger Schreffler, of Wards Automotive, arguing on the NBR Japan Forum about US policy towards Japan in the Cold War.) It would have made more sense in the 1950s to welcome imports, and particularly to welcome direct foreign investment. The industry would have been more efficient early on, to the benefit of the growth of the economy as a whole. Through 1967 Japan faced periodic balance-of-payments crises, including a trip to the IMF in 1961, but by 1969 foreign exchange reserves were robust for the first time in the post-WWII era, while 15 years of rapid growth had raised incomes and automotive sales – it was only in 1967 that passenger cars first outsold commercial vehicles. Policy was to open the industry up to trade – while a grad student some decades back I read through many contemporary Japanese sources, where the need increase competitiveness was touted year in and year out, even while agriculture was fenced off from such pressures. It didn't hurt that there were several large car producers, and several that failed – when everyone was lowering costs, it was improve or die. Toyota did the former better than anyone else, for regular cars, while Suzuki was the undisputed champ for minicars (in Japanese, "kei" cars or 軽自動車 / 轻汽车).

China's industry provides a case in point. The early industry began with a turnkey car factory built by Soviet engineers; it focused on trucks, but from 1955 made small numbers of cars so that the senior leadership could appear at public functions in a Chinese vehicle. A few joint ventures were allowed in the 1980s; that of VW in Shanghai did well, at one point accounting for 80% of all passenger cars made in China. The was also an Audi plant in Manchuria, which used an assembly line exported from a plant VW was closing in South Africa; that helped lay the groundwork for a black Audi becoming the vehicle of choice for Party officials. (There was also an engine JV of Mitsubishi Motors, which supplied truck plants throughout China.) Meanwhile protectionism allowed lots of inefficient assemblers to exist, at peak around 200 – in the 1950s Japan had 30 or so manufacturers, which wasn't all that different given the 12-fold disparity in population.

In Japan those small, inefficient producers were whittled down in numbers, some through M&A (Toyota of the firms that became Kanto Jidosha and Toyota Auto Body, Nissan of Prince, 3 different Mitsubishi companies into Mitsubishi Motors), some via exit. But it took a long while for others to attain scale, and in 1980 there were still 8 passenger car makers (Toyota, Nissan, Honda, Subaru, Mitsubishi, Isuzu, Mazda, Daihatsu – did I forget one?).

China took a different route, touched off by the entry of GM in 2001, and a wave of subsequent ventures by the top global motor vehicle manufacturers (ditto agricultural and construction equipment firms). Motor vehicle prices fell rapidly, and continue to fall 17 years later. Exports? – not so much, because the economy grew so fast that the leading firms (the various joint ventures GM and VW) had no excess capacity, and as long as that was true, margins on sales within China remained more attractive than those on exports, which have to cover the costs of shipping and tariffs (2.5% for the US, now 10%). And they've worked on their road network, at the regional and the national level – unlike Japan, congestion isn't for a lack of planning and effort.

So the bottom line is that import substitution industrialization was an utter and complete failure before 2001. Allowing global companies to dominate the industry has been a boon: high quality, lower cost "global" vehicles made with Chinese labor, and Chinese-made parts (every global supplier for which I've tracked down information, an ongoing research project, has a substantial presence in China). All of this now comes with increasing levels of local engineering, as local staff gain experience. So it's a tale of two China's, the worst of times under Japanese-style industrial policy, and the best of times when the market was opened.

There's a bit of irony: China's domestic market is slowing, so in an early 2017 book (Smitka and Warrian, $9.99 on Kindle) and in a January 2016 blog post, China's Auto Industry Meltdown, I predicted excess capacity and exports within a couple years. Indeed, GM and Honda make niche products in China that are too low in likely sales to justify production in NAFTA, and had begun exports. Those have ended, at least to the US. A few "local" firms that aren't doing well inside China do have excess capacity and exports – I rode in one such in Lima, Peru, but definitely a step up from a used car but a step down from the entry-level global products of Toyota (the Yaris) and Kia (the Rio). There's no sign that China will manage to build significant levels of exports (through 2017 they've run a trade deficit on automotive products), because the most competitive firms – Toyota, Nissan, VW, GM, Hyundai-Kia – have local production bases around the world. But China remains a labor-abundant, capital-scarce economy for which the auto industry is still a weak fit. I've heard though that China does OK on the international trade front without the auto industry.

But how about electric vehicles, one focus of the Bloomberg article. They estimate that between them the national and provincial / local governments have spent $59 billion between 2009 and 2017. If you pay consumers enough they will buy them – Tomasso Pardi of ENS-Paris Saclav and Director of the GERPISA auto industry research association, together with Deng Xiaoxiang, analyzed insurance data on EVs in China. (Why insurance data? – you can't use sales data due to the fraudulent registration of EVs by unscrupulous "manufacturers" to pocket subsidies.) They found that despite the equivalent of US $8,000 in direct subsidies from Beijing, in many provinces there were effectively zero sales. EVs sold only in cities that added their own cash subsidies – in Beijing, up to US$15,000 – and indirect subsidies (such as getting license plates immediately, while waiving the US$2500 license plate fee and the 10% sales tax). In Beijing, with a quota of 50,000 licenses, total sales of EVs were 58,000.

...from a selfish perspective, we should cheer China 2025 on...

Beijing's China 2025 policy may sound great, but it can't overcome the limitations of lithium electrochemistry that keep battery cell prices high. China does lead the global electric vehicle industry, not because they're better, but because they have spent more. I'm guardedly optimistic that it is possible to develop better batteries. However, until scientists find ways are found to get around the current limitations, mass-market BEVs remain years down the road. Even if it's Chinese labs that develop the core technologies, that won't give the Chinese industry an advantage – second movers in the rest of the world will be able to improve on their chemical engineering. (No, that would not be stealing – you can't patent basic science.)

So from a selfish perspective, we should cheer China on – let them be the ones to invest in creating global public goods. The more China 2025 money spent on battery R&D, the more likely improvements will come our way!

Monday, August 6, 2018

Quick thoughts on the stock market impact of the trade war

Mike Smitka, Economics, W&L

What are the market implications? Below are quick thoughts. I will refine this initial and very tentative analysis over the next month. Above all, I need to add detail on the investment implications.

There can be little doubt that we are moving to higher and higher tariffs against China; the must-be top-of-the-news mindset of President Trump makes it very hard for those on the other side to defuse things, much less back down. Trump may be riveted on the stock market, and think that swings in Chinese equity prices drive politicians there. He apparently has never heard that all politics are local, and that the Chinese leadership can scarce be seen to "cave in" to a foreign power. Will the war spread? That depends on whether the Administration lashes out in the face of a global trade deficit that is more likely to grow that to shrink. That's thanks to their own actions, the fiscal stimulus packaged passed by Congress earlier this year with Presidential support. Demand will increase, even if not by much, and that will require more (net) imports. After all, few Americans remain unemployed, so factories can't expand and we won't see much uptick in domestic output. Goods (and services) will have to come from somewhere, which means reduced exports and increased imports.

Complementing that demand-and-supply story are higher domestic interest rates. Thanks in part to a growing Federal deficit amidst a strong economy, Treasuries are more attractive to global investors, and to get those they have to buy dollars. The White House will talk of a Chinese currency war, but the dollar is stronger across the board – Canada, Europe and Japan, along with most of our other trading partners. This will offset some of the pocketbook impact of trade, keeping imports high, while the strong dollar and the higher cost of intermediate goods such as steel will hurt exporters. Again, this complements the above analysis of supply and demand. [Wonks will recognize that a net increase in Treasury purchases by non-residents must necessarily be matched by a net increase in the trade deficit.]

Myths abound. One is that tariffs will cut our deficit. A quick glance at the data should inject a dose of realism, but twitter and TV "sound bites" aren't a good way to highlight basic arithmetic. Numbers aren't the story-monger's strength. So ... to data: in the year through Q2 we collected under $45 billion in customs duties, and that's already up sharply this last quarter. With higher tax rates, the total might go to $100 billion, paid of course by US consumers. Why not more? – we import $3 trillion a year, so shouldn't revenue approach 25% of that, or $750 billion? No, because all sorts of things will continue to face no tariffs. Examples include most of the goods shipped to us from Canada and Mexico ($300+ billion each) and the $250+ billion we import in energy products. That drops the amount subject to taxes by almost $1 trillion. Of course higher taxes also induce shifting to avoid them. Trade is no exception. Again, we might, possibly, collect $50 billion in additional revenue. That offsets little of the $1 trillion-a-ear increase in the budget deficit from early 2018 tax cuts passed by Congress. [Wonks should look at the history of the US prior to 1914 and the imposition of a national income tax.]

Now the Administration is encouraging the belief that the Chinese will back down, and we can return to the good old days of a strong US. Unfortunately — unless Trump caves very soon — there will be a permanent impact, as the rest of the world evolves to take advantage of the absence of the US. A lesson in point is that several of our "temporary" retaliatory tariffs to the 1963 "[frozen] Chicken War" with Europe are still in place over 50 years later. In addition, China's biggest trading partner isn't the US, it's Europe. The world will evolve without us, to our detriment, and to China's advantage in its quest for global power.

Part of the reason the impact won't soon be reversed is that no one will want to waste time negotiating with the US. After all, a 3am tweet storm can undo everything. The President has been less than consistent, and doesn't engage in the sort of careful, briefing- and reading-intensive memo and staff work to see that he understands what negotiators can achieve, and they understand his priorities as they consider many hundreds of policy options. Plus we lack negotiators: the Administration has lots of unfilled positions at USTR, among other places. But above all the other side understands that the people across the table have no idea whether Trump will back them, and has little incentive to make a counter-offer that might be on the news an hour later and claimed as a "victory", as the new starting position.

    several takeaways

For investors, what matters are identifying stocks and bonds that will be differentially affected.

  1. With taxes on intermediate products (steel), avoid final goods producers (autos). However, that advice has to be muted because many such firms are global businesses that earn only a minority of their profits in the US. Be wary of "US" brands, as those may be hit by future anti-American campaigns in China, and not just what happens to their sales in the US. General Motors sells more vehicles in China than in the US, and is highly exposed to such risk. Anyway, if you can quickly spot individual intermediate goods producers (that is, still overlooked by the market), their profits may rise. And I suspect that in a market dominated by trends, many hard-goods firms are already underpriced.
  2. Amazon and Walmart may be hurt, as their sales depend on final goods—their customers aren't buying rolls of steel. The lower half of the income scale in the US are the ones who have benefitted the most from trade. Here's an example—I ask my students how big their closets are, and then point out that older houses (pre-WWII) in rural Virginia often have NO closets. Why? – clothing was too expensive for all but the wealthy to have more than a couple changes of clothing. With various trade deals, even the poor in the US can have 5 pairs of trousers and 20 shirts and lots of shoes, socks and underwear. Then there is consumer electronics, including cell phones. China runs labor-intensive "screwdriver" plants that import components from the US [and elsewhere] and export complete units back to the US. So the Chinese economy obtains relatively little of the value added. Unfortunately, tariffs are blind to such details, taxing the gross and not the net amount. Again, Walmart and Amazon sell a lot of those, and will be hurt. Can Apple lobby for an exemption? If I were China, I'd try to turn on the PR machine to make it hard for Trump to carve out highly visible exceptions...
  3. Extrapolate: I expect the pain will show up in places we don't initially expect.

Details on the trade front are still few: most tariff hikes are still at the "promised" stage and are not yet effective. Second, much trade is under long contracts, so historically it takes 18 months for measures to work there way across the Atlantic and Pacific. Yes, tariffs can (and will) affect goods while they're in transit, so the price impact will be felt more quickly than changes in quantity. But the impact will consist on small increases in the prices of a large number of goods. Consumers may not connect the dots between trade policy and why they're having such a hard time making ends meet. But that won't be hidden to mass-market retailers, whose sales will inevitably be hit.

Thursday, July 19, 2018

Tesla Bond, again

Mike Smitka

I posted an article on Seeking Alpha on Tesla's junk bond. It may be behind a fire wall. In any case, here's the key chart, updated subsequent to the SA post to include data back to November 1, 2017 (previously I'd only taken things back to December 1st, 2017).

There's only a very weak correlation between the stock price and difference in the bond yield (relative to a "B" bond index) prior to the March 27th downgrade of Tesla's straight bond (5.3% yield, 8/15/2025 maturity, semiannual coupon). There's a strong correlation after the downgrade, usefully exactly 1:1, that is Stock $1 ↑ <==> Yield differential 1 bp ↓.

Regression results:
Stock price ==> bond price relative to "B" bonds

March 28 - Jul 18: 1.01 (±0.01) t=10.77 observations=77
Nov 1 - March 26: 0.38 (±.11) t=3.43 observations=100

Friday, May 11, 2018

Tesla Bond Yield

Mike Smitka
Economics, W&L

Tesla has one straight bond, an 8-year bond at 5.3% with a semiannual coupon payment, maturing Aug 15, 2025. I have been putting trade data into a spreadsheet for several months, with the underlying goal of comparing that bond with "B" rated bonds. Does the Tesla bond track other low-rated bonds? The quick answer is "yes." That has two caveats: first, the bond is thinly traded, and I benchmark against one bond fund that provides only a daily closing price. Second, the differential moves around, with one obvious discontinuity: yields jumped when Moody's downgraded Tesla.

...bond traders trade the rating, not the company...

First, the graph below provides trade-by-trade yields and a trade-volume-weighted moving average (a lot of 1,000,000 counts more than one of 5,000). These data are only for sell-side prices, and don't differentiate between various markup strategies. There are days with a dozen or fewer trades, and only the occasional day with 30 or more. Crude, but I chose not to throw out observations or try to adjust for markups (I could see no pattern). I did look at buy-side data, but there are very few trades reported, so I kept them out of the mix.

What do we see? Back in early April the yield jumped to 8.5%, and over the past month has gradually rise back to 8.4%. However, that's in the context of rising interest rates. So comes the second chart, to which I added additional days on a sampled basis (every 25th screen of prices...). When Tesla first issued their bond, it traded at a 40bp premium to the ICE BofAML US High Yield B Effective Yield. That disappeared within a month, and thereafter (with noise) the Tesla bond traded at a 25bp premium to B-bonds. Then came the Moody's downgrade, and yields instantly jumped by 150bp relative to B-bonds. Yields then fell back for most of April, but are now back to the immediate post-downgrade level.

...I see noise, not trend...

My hunch is they'll stay at about where they unless (or if you're a bear, until) there's another downgrade. That's based on the assumption that those buying such bonds assemble a broad portfolio, particularly for ones with a low rating. In other words, bond traders trade the rating, not the company. Nothing in bond prices suggests that they read Tesla's financials closely. Yes, yields climbed almost 40bp after the earnings call – but in a noisy manner. Indeed, the most recent date (Thur 10 May 2018) shows yields dropping a bit. I will revisit in a month or so, but for now what I see over the last month is noise, not trend.



  1. I could not get excel to label the axis sensibly for trade data, which provide the hour and minute and not just the day. So the axis is trade by trade, rather than by date.
  2. Trades are detailed by the Financial Industry Regulatory Agency at Tesla bond yield.
  3. On some days there are as few as 3 recorded buy-side transactions. I don't report those data, but the yield differential tracks that of the sell side. While logically buyers pay more than sellers, fees get buried in prices and I cannot in general match a "buy" with a "sell." When I can, the price is typically identical, that is, fees aren't built into the reported price.
  4. I had been intending to track data longer, but post now in response to Bill Maurer on Seeking Alpha.

Friday, April 6, 2018

Licensing our technology to China? Shhh ... it's nicely profitable

Mike Smitka, Economics
Washington and Lee University
Bass II, RCS

As an observer and sometimes participant in industrial policy debates for 30+ years, few industries are "winner takes all." It's just not the way either technology or competition works. In addition, few technologies turn out to be national in significance. Lots of players, lots of niches, not many jobs. There's typically a long delay between invention and innovation, and initial commercialization seldom makes money. Most patents are never used.

Furthermore, producers can't capture all the benefits. Users have their place in the value chain, except for the odd discrete product they're the ones who integrate it into what final consumers purchase. If the technology lets final purchasers reorganize their businesses, they too capture benefits. As a result, the whole world benefits from advanced countries subsidizing new technology. The gain to any one country is much smaller. And it's a big world: no one country can dominate more than a few slices of the market, even when they are the size of the US or China.

So here's a devils advocate position: the more China subsidizes their push into new (for them) technologies, the better it is for us, the United States. Let China bear the costs, which are upfront, and let us reap the eventual benefits. For the MBA's out there, think net present value: it's negative.

...Don't kill the goose!...

Oh, and licensing is a fool's game, and it's not us who are being fooled. Licensing is only good for yesterday's technology, you can't license something that doesn't yet exist or has no obvious value. In the auto industry, the product cycle means that a MY2018 vehicle represents the technology of 2014-2015 – and the technology in a Honda CR-V is going to lag that in the Acura RDX. Remember, too, that licensing is only the first step. The Chinese "partner" has to then get that technology into production. That takes a good 3 years. Licensed technology is old technology.

And licensing only covers what the other party can see – that's the equivalent of Tesla's purchase of lots of robots. Yes, you've the hardware and the access to the patents. But that doesn't tell you how to make a factory full of them operate, or how to design products for which automation saves money. That's tacit knowledge, embodied in part in teams of engineers who are in turn embedded in a larger engineering operation and networked with counterparts at component suppliers and capital equipment vendors. If the Chinese want to get their factories to run and their products to work right, they have to hire teams of consulting engineers. So those licensing get fees up front, get ongoing training contracts, and are the gatekeepers for buying specialized equipment and materials and so on. All of these can be nicely profitable, while leaving the Chinese perpetually 5 years behind.

This will vary from industry to industry. But many of the companies being "ripped off" are in fact crying all the way to the bank. They just have to be careful not to boast about it lest they kill the goose that is laying the golden eggs. How long has Shanghai GM been up and running? – the Buick Sail project started around 1999, the vehicle launched in 2001. So after 20 years how have they fared? They're still in the drivers seat for their regular trips to the bank.

Yes, GM's local partner, SAIC, is in the back seat. Why? Parts is because technology isn't readily transferred. But remember where the car is headed: SAIC is also on the way to the bank. Being a passenger isn't so bad, since GM delivers profits like clockwork. Neither SAIC nor the numerous other "domestic" Chinese auto companies have managed to make regular money on their own. Entering the auto industry is hard. Better to license, and license, and license some more. Don't kill the goose!

Tuesday, January 30, 2018

The Trump Bump in Coal

Mike Smitka
Washington and Lee University

I've no idea what Pres. Trump will say in his SOTU address, but it is useful for me, living near coal country, to look at what's happened in my neck of the woods. (BTW, I do live in woods!) In particular, can any president return jobs to regions with long-standing employment challenges? We in the US have tools to address "cyclical" unemployment, and hence affect what goes on at the national level. "Structural" unemployment is a different matter. Regional problems are, well, regional, with different origins. If we really want to do something, we need thus to diagnose causes and tailor solutions, region by region. No single national policy will do the trick. But in a Federal system we're not set up to do this: regional policy butts up against our many states, and a region may be comprised of slices of geography lying in several different states. Overcoming this institutional barrier – creating cross-state cooperation – isn't something possible without a great deal of hands-on, and likely heavy-handed, leadership.

Coal is a case in point. There's "met coal" that gets converted into coke and is used in smelting steel from iron ore. Imports aside, we (and everyone else) have become really good at recycling steel. The biggest example there is the rise of minimills, which recycle scrap into useable product. But even "basic steel" uses a charge of scrap that goes into the basic oxygen caldron alongside iron from the smelter. There are imports as well. The bottom line is that steel is a declining source of demand.

Then there's "thermal" coal that goes into power plants. Here the challenge is that alternatives are attractive. When oil prices are high, coal production does OK – but it doesn't rise, despite our growing economy. Today however energy prices aren't high, and coal output reflects that. Tax benefits aren't going to change that. (Note: The more important alternative today is natural gas. I tried to put natural gas prices into the chart, but it made the graph unreadable. Nor did I try to address how much coal is from WV versus Colorado or other regions where mining is less costly.)

Is there anything that a US president could do about this? Probably not: our current president is not to blame. But whatever might be done to help supporters in West Virginia won't help those in Ohio. There's no generic solution. Retraining programs might help, but even if community colleges could develop programs offering "portable" skills, those who finish programs would need to leave the region to find a job, so it might be helpful to add a one-time relocation allowance to training programs. That won't save the affected communities. It would help build a better future for the children of miners, and for younger Americans in general.

Saturday, December 23, 2017

America First: Federal Debt

Mike Smitka / Dec 23, 2017
Edited from a post on his Econ 102 course web site

Food for thought. The new tax bill will add $1 trillion in additional debt over the next decade – I emphasize that because the US already is adding debt faster than the economy is growing. The same is true of Japan. (Europe varies, but the OECD provides data that should allow an estimate of the growth rate of aggregate Euro Zone debt. I've not looked at their web site.)

As I will discuss in class during the Winter 2018 term, debt can't grow faster than the economy forever. The analysis is straightforward, though I won't do the arithmetic here. The stock of debt affects dynamics: the higher the level of debt, the more that higher interest rates make matters worse. So we've been helped since 2010 by exceptionally low interest rates. That is changing, with the Fed likely to bump short-term rates from 1.25% to 2.25% or higher in 2018. I expect rates to continue moving higher in 2019, once the new tax cuts phase in. For better or (in this case) worse, the Republicans in Congress are not conservatives, they're radicals who give only lip service to fiscal responsibility. At some point taxes must increase – again, debt can't grow faster than the economy indefinitely, and the deficit dwarfs the actual budget so even draconian cuts won't do the trick. (See the bottom graph, which uses Congressional Budget Office "cyclically adjusted" deficit estimates.)

Who on the political horizon is equal to the unpopular but necessary task of raising taxes? Japan's case does not make me optimistic. The issue is worse there, because debt is much higher, and thanks to demographics the economy is growing more slowly. Fiscal conservatives at the Ministry of Finance and elsewhere began talking about this issue in earnest in the early 1980s. Over time the need to cut deficits became sufficiently accepted across the political spectrum to be turned into legislation. The resulting shohizei (消費税, national consumption tax) took effect in 1989 with a modest 3% rate, as part of a broader tax reform that lowered other rates. The first big boost, to 5%, took effect April 1, 1997. The magnitude and timing of the increase was ill-judged, and the hike's initial impact was amplified by "buy now" campaigns for big-ticket items. Car sales boomed through late March 1997. Sales then fell off the cliff – I was living in Japan and visited a car dealership towards the end of the March. It was empty, because the registration process meant any sale wouldn't be recorded until after April 1. The consequent recession was such that, while the ruling Liberal Democratic Party continued to talk of further rate increases, it took 17 years to implement the next hike. There was always a good reason – the 9/11 US terrorist attack of 2001, the Lehman Shock of 2008, the 3/11 Tohoku earthquake in 2011, and pending elections all seemed to conspire to overcome good intentions. Meanwhile, and as expected due the to the rise of expenditures to cope with the aging of the population and various short-term stimulus and reconstruction projects, deficits remained stubbornly high. And that's in a country where the political consensus has remained one that taxes are too low, not that they are too high.

Tuesday, November 7, 2017

Cars are a long-term payment scheme

“The bottom line is that most people do not buy a home but rather commit to a long-term payment scheme.”

Izabella Kaminska, FTAlphaville, November 7, 2017

And the good phrasing doesn't stop there: her line refers to a Convexity Maven (Harley Bassman) note "House of Cards."

The above lede on the Financial Time's Alphaville blog caught my eye. It applies equally to the auto industry. Over 70% of new car purchasers use some sort of finance, and trade those wheels in before the loan matures for another financed "ride". At a 7.6% interest rate (the base rate from a major OEM's web site), and with a 7-year loan, a "purchaser" will still owe half the face value of the loan at the 4 year point. With 17% depreciation per year, their trade-in will just equal their loan value in the 52nd month.

Even I took out a loan – a 0.9% financing deal was too good to refuse. However, I didn't do a long loan, only 4 years, and I put 50% down so that I'd never be upside down. As it turns out, though, interest rates have stayed really low, and my short-term savings hasn't been earning at best 0.1%. So I might just as well have dipped into savings and paid cash for the whole thing. In any case, the four year consolation prize of being free of car payments will soon be here.

The point at which someone trapped in a long-term car payment scheme breaks even will vary with the depreciation rate, interest rate and length of the loan. Here are sample calculations. Note that a shorter-maturity loan pays down much more principle in the first year, and so purchasers aren't underwater for long. The cost, of course, is a higher monthly payment. Here I assume (unrealistically) that the loan is for 100% of the car value as reflected in the resale market – no extended service plan rolled in, no downpayment. The number of permutations with the latter is unwieldy. So if the car is valued at $60,000, then with a $10,000 downpayment (or tradein plus incentives), an 84-month, 7.6% loan remains rightside-up throughout but provides $5000 equity only in the first year, before that $60K has depreciated much, and then again from the 55th month.

Car payment calculations, $50,000 loan
Upside down