Taal selectie


The Bitcoin :
an accident
waiting to happen

Pascal Blackburne & Luc Synaeghel 2017-12-10

As 2017 wraps up, investors’ quest for return is becoming ever more desperate. The money flooding to private equity and venture capital funds is mind-boggling, as are the valuations at which some managers in these spaces are making transactions. Paying up to a hundred times sales for a recently-founded unprofitable company cannot in our view be called investing – rather it is a gamble. «But hey», even sophisticated investors are saying, forgetting prior discipline about double-digit portfolio internal return rates, «perhaps this one company will be the next Google?»

Trying to fathom such “irrational exuberance” brings us back, as always, to central banks. It is the extended period of ultra-low interest rates, combined with trillions of liquidity injections via quantitative easing programs, that have pushed investors into increasingly risky market segments.

Interestingly though, rather than reversing policy, central banks are preferring to try to contain the consequences of their actions. The European Central Bank (ECB) has for instance warned about stretched commercial real estate prices. Some national central banks in the ECB system are imposing credit limits on banks, and forcing them to hold more capital against their lending base.

We are also somewhat puzzled by the rhetoric of the various regulating bodies, requiring banks to provide ever more protection to savers and limiting possibilities for the latter to invest in many risky segments. Yet, what other options do savers have, beyond spending their money, when central bank policies effectively imply that cash held in savings accounts will lose value in real terms – and often in absolute terms too, given the various costs involved?

While central banks are no doubt afraid to rock markets – and the economy – by tightening monetary policy too abruptly, their slowness to act likely also stems from a form of political pressure. Governments across the globe can only be content with low interest rates, which make it far easier to finance public debt and ongoing budget deficits. Also, the banking system remains saddled with (insufficiently written-down) bad debts.

Historically, excessive money printing tends to result in a loss of trust in that money – and the emergence of new currencies. The bitcoin fever that we are experiencing today is not surprising in that regard: it is a currency designed precisely to avoid government intervention in private property. With limited supply and a growing use of the bitcoin network, the path for its value can only be upward. That is, until policymakers decide to destroy it. For not only do central banks eventually risk losing control of the monetary base, as the bitcoin network expands, but the government also has no oversight on the transactions – in some case illicit – that are being made anonymously and without trusted third party (bank or credit card company) intervention.

If neither central bank money printing, nor the present crypto-currency frenzy, manage to generate some inflation, then let us suggest that oil will do so. With OPEC and Russia having extended their production cuts throughout 2018, and US shale production less price-elastic than many believe, the supply-demand picture looks very positive for oil next year, particularly since inventories (measured in days of consumption) are now back to normal levels. A USD 80 price per barrel is not a far-fetched projection – with Middle-Eastern geopolitical tensions implying asymmetric upside.

Deciphering bitcoin mechanics


Source: Bloomberg

The technical details of the bitcoin design are exceedingly complex. That said, we believe it important to understand why it emerged, as well as its main characteristics. For these will also be the reasons for its eventual demise.

At its heart, the bitcoin is anarchistic: it was borne out of not trusting governments. Not only did its developers want a currency that was not issued and controlled by monetary authorities, but they designed it specifically to avoid third party intervention (commercial banks and credit cards being under governmental supervision).

A key characteristic of the bitcoin is its limited supply. For the first four years, starting in 2009, 2.4 million bitcoins could be “mined” each year. The per annum additional supply was then divided by two (to 1.2 million) for the next four-year period. And is to be halved again every four years – so as to reach a theoretical maximum supply of 21 million bitcoins. There are already close to 17 million bitcoins “mined”.

Each bitcoin consists in a string (or chain) of information, keeping track of every single transaction in which it was involved. As these chains become longer and longer, the computing power required to process a new transaction increases. This serves as a protection against dishonest participants, but also means that the system is inherently unfriendly to the environment. It is said that processing a single transaction now consumes about the same amount of electricity as a domestic washing machine over a full year.

The time taken to verify a transaction already takes several minutes – which is still fine for international transactions that would take days to be processed via the traditional banking system, but already lengthy for local peer-to-peer dealings. As such, the growth of the bitcoin network is crucially dependent on the so-called Moore’s law, which prophesizes a doubling of computing power every 18 months.

Finally, bitcoin usage is anonymous. Or, to be more precise, pseudonymous. This means that governments have no way of tracking down market participants that are using bitcoins to purchase – in some cases – illicit goods.

Putting all of this together, we conclude first that the value of the bitcoin has further upside, given the growing demand (of an increasingly speculative nature) and limited supply. But we also warn that the bitcoin network has internal flaws – notably the ever longer delays in verifying transactions – and a number of external “enemies”.

Central banks have no means to influence bitcoin issuance, even though they are legally the sole holders of the right to print money. They may well come to fear the inflationary consequences of this crypto-currency frenzy. Commercial banks run the risk of becoming obsolete, to the extent that this electronic peer-to-peer exchange system bypasses trusted third-party verification. And governments have much reason to clamp down on a market that is completely out of its control. We have no doubt that, at some point, policymakers will decide to shut it down – with a bang.

If all else fails to revive inflation, oil will

Late November, OPEC and Russia again extended their production cuts, through the end of 2018. This time round, though, they proved more adept at managing expectations. Russia’s dithering in the days preceding the meeting created some uncertainty as to whether the cuts would actually be prolonged – avoiding the “sell on the news” reaction that had occurred on prior occasions.

But capped OPEC and Russian production for the foreseeable future is only part of the strong fundamental oil story. Perhaps even more important on the supply-side are prospects for US shale production – considered the swing factor. Recent improvements in well productivity have been impressive, leading many analysts to extrapolate these trends into the future and predict continued fast shale output growth alongside the oil price recovery.

Academics as well as some on-the-ground industry experts are, however, questioning that assumption. They argue that it overestimates the role of technological progress in boosting shale well productivity. Equally important has been the prime location of the wells that have been drilled to date. With some 70% of Tier 1 acreage in the Bakken and Eagle Ford basins now exploited, future shale output will increasingly rely on wells located in Tier 2 or 3 (i.e. of lesser geologic quality) terrain. As per Mark G. Papa, CEO of Centennial Resource Development, Inc: «Completion technology improvements can’t cure bad rock».

The fact that shale company managements are increasingly focused on cash flow generation, and not necessarily increasing their investments as the oil price recovers, only adds to our conviction that US production growth will not keep up the pace it has exhibited during the last 12 months.

Demand on the other hand should remain buoyant for the foreseeable future, and OECD inventories will have fallen back to 5-year average levels sometime during the first quarter of 2018. Measured in “days of consumption” (which is arguably a better metric since it accounts for the growth in global oil demand over time), OECD inventories are actually already at their long-term average level of 30 days. During the course of 2018 they could fall to 28 days, which would near the lows posted in early 2014, when oil was trading above USD 100 per barrel.

All told, our positive fundamental thesis on oil is clearly playing out. As we look towards 2018, we are confident about the substantial upside potential for our holdings in that space. Shale companies’ valuations are far from stretched, and the share prices have some catch-up to do with respect to the oil price.

Also, with a sustained rise in the oil price will come a revival of inflation – if only due to base effects – which forms the very premise of our current overall portfolio positioning.

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