the stern letter -- issue nos. 1-5 (aug 1 - sept 3 2012)

7/29/2019 The Stern Letter -- Issue Nos. 1-5 (Aug 1 - Sept 3 2012)

1/12

the stern letter Narrating the big picture for

investors, risk managers & policymakers.

Wednesday, August 1st, 2012

Issue No

1

Nexen + CNOOC = 0

Wow! The US regulators were all over the Nexen - CNOOC deal within femto-seconds.

Meanwhile, the Canadian Prime Minister would soon be dreaming of FIRA1days gone by. It

sure looks like someone in Washington knew it was coming. No surprise

therethe Obama administration is on top of the oil sands file.2 Notably, the

proto-demands of the US Committee on Foreign Investment in the United

States (yup, they have one of those) are entirely compatible with the ultimate

strategic rationale for CNOOC's investment, which is to continue building a real asset hedge

against high oil prices. Happily for China, the high fixed cost of oil sands extraction and

production delivers exceptional hedge leverage. Certainly, there's some cash-ridden US oil

company who3 would be only-too-chuffed to snap up Nexen's US assets.

In any case, the apportionment of the oil sands is central to

the economic and political partnership between Beijing and

Washington (more accurately, Barack Obama). As the FP's

redoubtable Terence Corcoran points out, China gets its

private property rights (irony!), while the US gains steady

access to Canadian oil. Of course, the US also maintains the

ber-option of imposing eminent domain, as required. In

pursuit of this policy and the upcoming election, I expect the

Obama administration to (more-or-less) sign-off on the

cross-border portion of Keystone XL by November. All of

which leaves Canadaand Albertaas the meat-in-the-

sandwich-du-jour.

1 Canada's Foreign Investment Review Agency (FIRA) was enacted by the Trudeau government in 1973 (whenthe oil price was ~$20/bbl) and effectively laid to rest in 1985 by Brian Mulroney (when the oil price was~$25/bbl).

2 President Obama has 'gone to the wall' more than once to prevent approval of Keystone XL.3 My wry bow to the Citizens United decision.

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So if you think that Nexen is the start of something big, welcome to my world. You can be sure

that the Canadian government is not going to like it. Cornered, in a word. Concerns about the

foreign ownership of Canada's black diamond birthright have now been stoked by this deal,

but it seems wildly unlikely that Canadian regulators will obstruct. But what about next time?

And the time after that? Expect fireworks. [More on CNOOC et al in the next issue.]

2) A Second Term for Barack Obama

Surely no world leader perhaps excepting Vladimir Putin, Benjamin Netanyahu, and

Stephen Harper want the Armageddonites back in the saddle. While Iraq's decade o' debacle

might have served China's interests at the time (a distant ten years ago), the prospect of

another Middle East war would threaten the economic and political stability of the world, notto mention members of The Politburo. If economics turns out to be The Decider in this

election, Chinese willingness to press capital and leverage into service to goose US economic

performance should not be doubted. It's all part of The Great Game.

So, I give Barack Obama 75% odds of winning. Assuming he's elected, I give him a 50% chance

of winning a landslide (55%+). So, if your wealth is positively correlated with share prices in

the oil and pharmaceutical sectors, I'd start cashing in. Barack Obama believes that oil

companies need to be taken down a notch or two. As to pharmaticals, the savings to fund the

Affordable Care Act must come from somewhere.

3) On The Topic of Cancer

The three-way combination of a) genetic engineering; b) nano-materials, -sensors and

-machines; and c) precision visualisation means that radically better cancer survival rates

(and patient experience) are perhaps five years out. Some may recall The War on Cancer

declared by Richard Nixon in 1971, and how that didn't work out. Well, cancer was killingmore than 75% of its victims then vs. fewer than 50% today. The most vulnerable

pharmaceutical company is Roche, which derives more than 50% of revenue from (mostly)

traditional cancer therapeutics. So even if you don't believe me in #2 above, Roche is likely

headed for troubled times.

-30-

August 1, 2012 2012 Philip Stern | All rights reserved. Page 2 of [email protected]


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the stern letter

Narrating the big picture forinvestors, risk managers & policymakers

Monday, August 6, 2012 | Issue No 2

1) More about CNOOC/Nexen

In North America's oil country, private property rights get the kind of respect not enjoyed by

government authority. Chinese policymakers have incorporated this social/legal observation

into their scenarios in energy and industrial planning.1 I anticipate that the northern length of

Keystone XL will be approved by November, thereby suiting the paramount interests of the

Obama administration.

2) A change of climate

In 2007, China became serious about climate change deliberately adding risk to

China's economic future.2 So it can be assumed that China's public and private oil companies

are prepared to invest the megabucks to bring their oil sands properties into line with EU

standards.

3) An early Merry Christmas

If Barack Obama 's national and international allies are on plan,

and Mitt Romney's cash-pumps are ready, expect a brilliant and

well-timed US economic statistics in second half of 2012. In other

word, there's more than one way to finance an election. With a

full percentage point ofmonthly GDP growth on offer for ~$15

billion of economic activity, the salient implication is that it won't

take much cash (especially when well-timed and well-levered) to

ensure Obama's re-election. a spate of big orders in favour of big

US firms (e.g., Bechtel, Boeing, GE) in the next months (with some revenue bookable

immediately).

1 According to my calculations, the Nexen deal will push China's cumulative oils sands investments since 2007beyond the US$100+ billion level.

2 Stunningly, only five years later, China is the world leader in solar power electricity production.




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4) The Eurozone is too big to fail

Do you remember the bookkeeping rule that for each dollar of debit, there's a dollar of

credit? That's the simple reason why a trial balance nets to zero; for accounting purposes, the

company is a closed system. Similarly, for each dollar borrowed in the world economy, there is

a party to whom a dollar is due. Worldwide foreign exchange reserves balances reflect this

principle, albeit with annoying technical complications.

Consider the net balances of reserves of the Eurozone and China. For reasons of paramount

geopolitical and economic importance, China cannot and will not accept the sky-darkening

wedge of black swan risks attendant to allowing the Eurozone and Euro to unravel. It is

troublingly easy to enumerate scenarios in which terrible economic consequences are

swamped by social and political impacts. Notably, China is not without natural allies in this

domain, among them Japan, Switzerland and the UAE.

Secondly, with equity market valuations evermore sensitive to marginal upticks and

downticks and their corresponding calculus measures (y/x, y/x, ...).

Thirdly, an official default of a country in the Eurozone will be viewed as a failure of the Euro

currency itself. The implications for other major currenciesthat they can failis a risk no

central banker can contemplate without horror.

5) IMO: De-fanging high frequency trading

If minimum price increments and/or scheduled regular micro-auctions (e.g., an auction each

second) are required to fix the problems arising from high frequency trading, so be it. The

Croesus-level incentives to cheat, reaching into too-big-to-fail levels, can't but drive Wall

Street rocket scientists to outwit any non-fascist regulatory regime. Structural fixes are

essential. The value-added (!) lost in consequence are regrettable but necessary for the greatergood. Market perfection is a straw god.Why demand of financial markets while we blithely

accept draconian imperfections in other markets and sectors?

August 6, 2012 2012 Philip Stern | 416.588.0000 Page 2 of [email protected]


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6) A spectre is haunting Quebec separatism

That the US would not act to prevent the political fracturing of its closest

neighbour seems to me beyond belief. The chance of such restraint died on

April 12, 1861 with the first shot at Fort Sumter. The US does won't accept a

next-door example for parochial Texans or Vermonters or Oregonians. You

can be sure that the most serious discussions have taken place between US

representatives and, among others, Parti Qubcois leader Pauline Marois.

On that basis, the risk of a declaration of separatism or even sovereignty-

association is lower than generally imagined.

7) Phil's Spidey Sense of the week ...

Do you get the Sense that Jean Charest, the Canada's the utterly bilingual, ber-centrist

premier of Quebec may be readying himself to be drafted by the Federal Liberals, whether he

wins or loses the Quebec election on Sept 4th?

-30-



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the stern letter



1) The Black Cloud

In public companies, governments, and financial institutions, the implementation of cloud-

based IT solutions will be gated by risk management committees. Incontrovertibly, the cloud

cannot deliver the security of a corporate firewall. There are subtleties, but senior executives

largely unversed in the dark arts of IT securitywill tend to opt for more tradi-

tional architectures, foregoing the cost and performance benefits of cloud-based

computing. Three observations:

i) Expect strong demand for computer hardware, especially storage systems, as

IT purchasing follow risk-averse business policies, while cloud service pro-

viders simultaneously build out their own infrastructure.

ii) Rich-media assets (e.g., TV programs, movies) don't generally require high security.

Since 90%+ of web traffic is rich media, demand for high-availability, cloud-based

storage will grow faster than demand for processing capacity.1;

iii) Application service providers that adopt the cloud as their platform will face clients

with rigid requirements for corporate firewall protection of their data. and associated

processing capacity.

2) SNC-Lavalin and climate change

Credible technologies and concepts exist that might mitigate

global warming.2 May the Good Lord protect us if, 50 years from

now, our grand-kids are (justly) appalled that we didn't pursue

mega-scale solutions other than suppressing/ diverting the

release of CO2 et al. Hence, I give 2:1 odds that, within 24

months, a group of industrial nations will announce a joint

feasibility study for such an initiative.SNC-Lavalin, take note.

1 To catch this wave, consider NetApp (NASDAQ: NTAP).





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7/12

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3) China & Europe #bestfriendsforever

A wide and deep alignment of European and Chinese interests is driving an extraordinary

degree of public and behind-closed-doorscooperation. Four observations:

i) Of the major powers, only Russia discomfits the others'

defence policymakers, and none more so than China's.

Chinese policymakers understand that Neo-Containment

requires a coherent bulwark on Russia's western flank.

ii) An official sovereign default by a Eurozone member could easily trigger a

multi-dimensional toppling of dominoes (e.g., the disbandment of the Eurozone, the

crippling of the Euro). A default would be tantamount to the default of the Euro cur-rency itself.3 Self-priming concerns about the validity of paper money itself would likely

erupt. It's difficult to see how the EU could hold together as these events took hold.

iii) Even the anticipation of such trouble would sharply undermine China's economic

momentum. While the power of internal dissent is sometimes over-estimated, China's

leaders have taken pains to repeatedly acknowledge that economic growth is the sine

qua non of their country's political and social stability.Ipso facto, China will continue

to use its FX reserves to backstop the Euro/Eurozone (e.g., by buying debt fromEurozone countries, by buying debt from the European Financial Stability Fund).4

Much of this help will not cost China a penny.

As the economic centre of the Eurozone, Germany has taken the lead, building a special

relationship with China. Angela Merkel has made more trips to Beijing than to Washington

since her election in 2005.5 Chinese policymakers also seek to transfer some of the

philosophy/ policy/ skills that enable Germany's astonishing economic success. The German

economy can only benefit. Invest in German companies like Allianz, Henkel, and SAP.

2 For example, adding phosphorus/iron/nitrogen to the oceans to hike carbon absorption.3 Imagine a situation in which Canadian Treasury/Bank of Canada refuses to bail-out PEI provincial treasury

in like circumstances.4 China holds $0.6+ trillion of Euro-denominated financial assets, up from less than $0.5 trillion in only 18

months. And that's only the visible portion.5 Passenger air traffic between Berlin/Frankfurt and Beijing/Shanghai has almost doubled in the last five

years, according to my rough calculations.


China

RussiaEurope
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4) A new vision for Turkey

Nevermind the Economist's recent namby-pamby (economist.com/node/21558279 ). Turkey's

policymakers are methodically implementing a new vision, one that places Turkey as the new

leader of the Muslim world, rather than their old role as a supplicant for EU membership.

Egypt's new leader knows this; expect a battle for this crown. Germany (yes, them again), via

its 3.5 million Turks, will benefit from Turkey's ascendance.

5) IMO: Mitt Romney just threw the election

As a pragmatist's pragmatist, Mitt Romney has game-played the November election, and his

choice of the Tea Party 's dearest budget designer indicates Romney's willingness to lose theelection if doing so enables him to protect his chances for political resurrection thereafter. As

a Harvard MBA, Romney will have drawn upperhaps only in his minda decision tree that

looked something like:

Placing responsibility for defeat at the feet of the apocalyptic wing of the Republican Party is

key. Romney is quite aware that his current chances are below 50%--and largely beyond his

control (at this point). It's Mitt Romney's nature to maximise his post-election credibility if he

loses. And the Tea Party's efflorescences have not made Romney's road any easier ...

-30-


Win: OMG!!!

Lose: Blame the Tea Party.

Win: OMG!!!

Lose: Blame Mitt & his wimpy compromise.

Win: OMG!!!

Blame Mitt and his band of pragmaticRepublicans.
http://economist.com/node/21558279http://economist.com/node/21558279


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the stern letter



Buying RIMM.

I give 50% odds that Dell will make an offer for RIM by Xmas.

(My WAG for the offer price is $12/share.) With Mr. Watsa 's

recent high-profile investment, RIM won't be raffling itself off

anytime soon, regardless of IBM's putative enthus-

iasms. I bet Mr. Watsa and Mr. Dell have spoken.

I can see no other company than Dell that could so

leverage its own brand, product ambitions and

unique marketing and distribution strengths

through such a transaction. RIM's brand, device/system/radio

expertise, carrier relationships, and network infrastructure can

help Dell in hiking its PE ratio and more. And Michael Dell is only too weary + leery of

Microsoft's tired promises of profitability & partnership, while knowing that he must resist the

cost-reducing delights to be found hanging from Google's tree of strategic generosity.

Sample potential acquirers

Assets Dell Samsung HTC Google Microsoft Amazon

Deviceengineering

Hardcore softwareengineering not a

Dell strength

Beenthere.

Donethat.

Motorola Nokia AMZN hasbetteroptions.

Proprietarynetwork

Supportsenterprise solutionselling; full mobile

strategy

Off-strategy.

Off-strategy.

We'reGoogle!

We'reMicrosoft!

We'reAmazon!

Brand Positioned forbusiness, big and

small

Happywith ours.

Happywith ours.

Motorola Falling intoeach other's

arms ...

Happywith ours.

Distribution Expansionopportunity: RIMis strong in Asia

We'reSamsung!

We'reHTC!

Off-strategy.

We'reMicrosoft!

We(re)inventeddistribution.






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10/12

the stern letter

China steps out

With China having quite visibly inserted itself into the Syrian situation, resolution cannot be

far. China would not have put its hard-won prestige to such a test without having nailed downan endgame.1 Hence, I expect a peaceful, face-saving climbdown by Iran, perhaps even

publicly backed by Chinese guarantees.2

To date, China has not cared to unsheathe its diplomatic and economic power to press change

in the affairs of Muslim countries (excluding its own Muslim minorities). As such, although

given little attention in the press, China's leadership is putting a lot on the line. In part, their

motivation is the re-election of Barack Obama, a straightforward objective of their foreign

policy. At risk for China if Obama loses: Implementation of understandings reached with theObama administration, very much including the geopolitical glide paths of Korea and Taiwan.

China is preparing for a larger role in reducing the risk of middle east war, particularly with

regard to Israel. Only for the US military-industrial sector is war still a profitable venture. And

commerce is king in Beijing.

North Korea controls its military. Not.

Especially not those missiles. The reason is simple geography: Pyongyang is closer to Beijing

(~800 kms.) than it is to Tokyo (~1,300 kms.). Too simple? Consider this: Were the Great

Sucessor to decide one day to rotate his Tokyo-

directed missile launchers ~175 degrees

clockwise, President Hu could be of no fixed

address in less than an hour. Would China's

leaders permit decades-long series of putative

nutcases to direct this drama? 3

1 Gives credence to observers (incl. me) who believe that theChinese leadership is genuine and serious about improvinghuman rights and extirpating corruption.

2 Illustrating the contrast between GWB-era anti-proliferationmethods and the low-impact Obama approach.

3 This is the same China that overran North Korea twiceseveral years after the USSR had exploded its first atomicbomb. It's also worth recalling that China has a long history of enforcing tributary status on bordering nations.

August 20, 2012 2012 Philip Stern | [email protected] Page 2 of 2
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Monday, September 3, 2012 | Issue No 5

A natural target

In my email last Monday evening, I pointed to Canada's efforts to diplomatically smother the

prestige of the Non-Aligned Movement (NAM) summit in Tehran, now just ended. In contrast

to the Canadian government's shrill effort to dissuade the UN Secretary-General

from attending1, Hillary Clinton chose uncharacteristically milquetoast language to

express "concern" about the location, while also noting that a solution to the

US-Iran impasse remained achievable.

Some background: The eleven OPEC are members of the Non-Aligned Movement

(NAM) whose members control 90%+ of world oil reserves2 outside of North America.3 As a

growing petro-power, Canada's economic interests are increasingly at odds with OPEC and

NAM. Moreover, as the only country worldwide to give Israel a free pass on its behaviour and

policies, Canada has become a diplomatic enemy for most NAM

countries, many of whom are actually powerfully aligned with

the US (e.g., Kuwait, Saudi Arabia, UAE). Crucially, Canada'sapproach runs counter to the Obama administration's Middle

East strategy, interfering with American efforts aimed at

Israeli -Palestinian peace.

Canada's government is beginning to feel the economic and

diplomatic blowbackafter all, Middle East peace is the US's top

military and foreign policy priority. Early signs of American

retaliation include: 1) The US's (unprecedented) voting

abstention when Canada sought to join the UN Security Council; 2) Obama's non-phone call to

Harper to discuss the Afghan surge operation; 3) The imposition of a $5.50 entry fee for

1 E.g., "... completely unacceptable.2 Includes the oil sands, constituting ~95% of Alberta's/Canada's reserves.3 Venezuela leads the world with ~20% of reserves, a fact often unappreciated in geopolitical calculations.

Venezuela's reserves are similar to Canada's in scale (which located deep underground but easier to process.)

September 3, 2012 2012 Philip Stern | 416.588.0000 Page 1 of [email protected]





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the stern letter -- issue nos. 1-5 (aug 1 - sept 3 2012)

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