THE DISTILLERY: European denouement

Business Spectator's Karen Maley deserves a pat on the back. For nigh on six months she has led analysis of the European debt panic in Australia, for much the time alone. Her doggedness is now vindicated. Today she reckons "predictions that the cascading PIIGS debt crisis will cause the eurozone to collapse are becoming more widespread. At this stage, however, a more plausible scenario is that eurozone will shrink in size, as the stronger eurozone countries seek to push the weaker countries out of the common currency. There is also huge disappointment that the European Central Bank is reluctant to try to prevent the financial crisis from escalating by buying up the government bonds of the PIIGS.”

Sadly, in the absence of a new quantitative easing program, this column sees no smooth way out of the crisis. Former IMF chief economist, Simon Johnson, sums up what's required and it isn't pretty.

It looks like we're rapidly approaching the end of our first stimulus-induced cyclical recovery within the larger debt-deflation structure. It lasted longer than this column thought likely but shorter than it hoped. If the dynamics of the unwind follow the path of the last cycle, here's what's coming: the European debt crisis will drive risk-aversion and reverse the reflation/risk trade out of commodities and emerging markets. Commodities will fall and the borrowed money that fed boom prices will flood back into its countries of origin – the US and Japan. The US dollar and yen will keep rising, choking off those countries' export recoveries. The upside for the US is that its bond yields will dive, driving down mortgage rates. In the early 2000s, this chain dynamic bounced the global economy upwards on a massive rise in US house prices and consumption. This time, however, it runs headlong into US housing overcapacity, the expiration of its housing-boost tax breaks, ongoing price falls and the wind-down of its inventory cycle. As equities break down, the wealth-effect US consumers have ridden for 14 months will reverse and consumption fall. Chinese exports to both Europe and the US fall simultaneously. Commodities take another down leg. 

Various stimuli can be applied to remedy this, not least being the European Central Bank ultimately capitulating on quantitative easing. It remains, however, our likely fate in the longer term to see this repeated over and again. If you haven't already, this column recommends buying gold, which has now clearly decoupled from the US dollar.

On more banal affairs, the resource super profit tax debate throws up more spin from both sides today. First, The Australian runs a piece by small business minister, Craig Emerson, who retells the story of how Ross Garnaut adopted his Phd thesis in the application of the petroleum resource rent tax (PRRT) in the early eighties. Emerson recounts how when the policy was announced "the oil industry went ape."

"I had proposed to allow oil exploration costs in one offshore area to be offset against profits from existing operations in other areas, mainly Bass Strait at that time," writes Emerson. "The industry rejected the idea. The government pressed ahead, introducing a petroleum resource rent tax at the rate of 40 per cent. That was 27 years ago. The PRRT has stood the test of time and is supported by industry for its stability... Under the PRRT, all project costs, including the extra costs of extracting the last amounts of oil from reservoirs, are taken into account, avoiding the waste of resources associated with royalties and the crude oil levy. Under the crude oil levy and royalties, the Bass Strait partners were planning to shut in several of the producing oil fields and not to develop further gas fields. ...Under the PRRT, there are still more than 20 years of oil production and 30 years of gas production remaining in Bass Strait."

This column will state the obvious, that Emerson is making a tacit comparison with the RSPT. So, is it sound? The first observation is that the RSPT is not a carbon copy. The risk-free rate for profits in the PRRT is the bond rate plus 5 per cent on development capital and up to 15 per cent on exploration capital. In the RSPT it's simply the bond rate, a big difference which Emerson does not mention. As John Durie of The Australian has argued, there are clearly offsets in other EBITDA benefits in the RSPT but are they sufficiently better than those in the PRRT to make up the 5 per cent and for Emerson's comparison to hold? John Young of Wilson HTM points out that under the PRRT companies can transfer exploration capital costs between projects whereas under the RSPT companies can also transfer development capital. However, he still concludes that under most projects the PRRT is likely to be more attractive. 

Second, Emerson's point that gas exploration and development has not been inhibited by the PRRT spins by omission. Yes, offshore gas has operated under the PRRT since its inception, but it has never applied to terrestrial projects, which is why is the Queensland LNG projects are facing a larger adjustment that Gorgon. The offshore projects have the option of switching to the tax if they wish. 

A second piece by Matthew Stevens of The Australian hints at where this debate should be, but doesn't quite get there. Using Fortescue Metals as an example, Stevens argues "the super-profits tax is supposed to hit revenue lines at the EBIDA level. That means it is to be assessed before accounting for some lines of business costs, the main one, evidently, being interest. The interest line is, generally, a product of capital investment. Certainly, that is the case for Fortescue. It is heavily indebted and is currently capitalising biannual payments due on a $US100 million ($110 million) subordinated note held by cornerstone investor Leucadia. The interest on those notes is 4 per cent of Fortescue's revenues from the Christmas Creek and Cloud Under projects. But Fortescue's other lending covenants constrain it from repaying any of the Leucadia interest until the others debts are repaid. That means the interest bill rolls forward and gets larger. But the super-profits tax will come out before interest payments, which means it is going to take Fortescue a whole lot longer to hit its return on capital targets.”

Fair enough, but how much longer? And what are those targets? Were they based on historic ROI measures or super-profit measures? 

The increasingly pressing need for the miners to put a clear case is demonstrated by Stevens' total whitewash of yesterday's mine and media hysteria. According to Stevens, "if the PM needs guidance on how to manage a backflip with dignity, Rio Tinto yesterday showed the way, moving promptly to clarify a headline in The Australian that asserted $11 billion of investment in Pilbara iron ore projects had been shelved. That headline was inspired, in part, by Rio iron ore boss Sam Walsh who on Wednesday said: 'We have got all our projects on hold while we try to understand the ramifications of a 40 per cent increase in taxes'." 

This column will observe that Rio was forced to clarify its statement by the ASX, which has all the dignity of a kid caught with his hand in the cookie jar. Moreover, Rio admitted that the plan has been on hold since the GFC, strongly suggesting the spin was premeditated.

Add to this the comment by Robert Guy of The Australian Financial Review's Chanticleer, that "global investors are agog at the folly of the proposed imposte on Australia's most globally competitive industry ... [it] won't be tolerated by investors who can put their money anywhere ... how much more value needs to be wiped from the Australian sharemarket before government realises the plan in its current form does threaten investment and job creation?" – No evidence, no quotes, and that old chestnut that correlation equals causation in the equity market correction.

This is ridiculous. There are dimensions of this plan that make this column, with its liberal views, uncomfortable. They will also discomfit many centrist Australians. Perhaps the most pressing of these is a tax structure that trades government guarantees for failed mines against an equity-like tax take. Stevens mentioned this in passing, and Michael Stuchbury's questions yesterday about the appropriateness of this resonated with this column. Though it will point out the deep hypocrisy of The Australian's commentators, given their universal support of the not dissimilar off-balance-sheet guarantee offered the banks. Anyway, the point is, mining needs unblinking and stern captains of industry calmly dispensing killer data to turn this debate. For an example of this, try former head of the Minerals Council David Buckingham on ABC this morning. 

The other commentary clusters today are around Telstra and NAB. Though they're more dirges than debates. Stephen Barthlomeusz and Alan Kohler of Business Spectator, Elizabeth Knight of The Sydney Morning Herald and Malcolm Maiden of The Age all observe that the McKinsey NBN report has the government going it alone with $26 billion on the line resulting in a return somewhere around the bond rate. Only Malcolm Maiden picks up on the irony that in conceding private capital will not engage on this return it is undermining its RSPT pitch. All observe also that for Telstra the witching hour is rapidly approaching. Alan Kohler goes further, offering the sensible suggestion that Telstra should take what's on offer.  

On NAB, Adele Ferguson of The Age continues to hammer Cameron Clyne for NAB's strategic "circle of failure" as it tries to overcome the failed acquisitions and left it behind its peers by making more acquisitions that only "paper over the cracks”.