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March 15, 2011 Eye on the Market: Japan, energy prices and the resiliency of developed economies
(see PDF for a version that is easier to read)

"Matter over Mind"
I wanted to share some thoughts on the situation in Japan, short term and long term. Regarding the nuclear plants, Spiegel Online is showing a simulation of radioactive drift of I-131 (radioiodine) from the Viennese Central Institute for Meteorology and Geodynamics (ZAMG). Their I-131 concentrations appear at the very low end of the range, but are estimated to be drifting both south and east. Other models, relying on the National Oceanographic and Atmospheric Administration, project that any radioactive plumes would head east and drift over water for a few days, such that the majority of the radioactive particles would gradually dissipate into the ocean. The International Atomic Energy Agency reported today that the level of radioactivity at the Daiichi plant has fallen sharply from a rate of 1,190 millirem per hour to 60 millirem per hour with a span of 6 hours.

The human and economic damage from the earthquake and tsunami are terrible, and the apparent release of some radioactive materials into the atmosphere compounds the significant sense of unease in global markets. Given its inherent risks, nuclear power has always been an exercise of Mind over Matter, in which human intellect seeks to harness the power of nuclear fission of radioactive materials. In Japan right now, the Matter has overtaken the Mind's ability to control it.

Here are some facts and background information that are important to know:

[1] In Chernobyl, the nuclear reaction was left to operate at 100% of capacity after a failure, relied on a graphite control rod design from 1942 which is not used any more, and did not house the reactor inside a containment vessel. In Fukushima, immediate steps were taken to bring the reaction under control. Sometime in between the earthquake and the tsunami (perhaps only 90 seconds after the earthquake), sensors automatically injected control rods filled with boron into the reactor vessel, immediately reducing the power of the nuclear reaction to roughly 3% of its original level. Furthermore, the Fukushima reactor vessels are housed inside concrete containment units.

[2] What remains is the challenge of bringing the residual 3% reaction under control. Given the power of nuclear energy, even at 3% of its original level, it needs to be cooled further. Japan appears to have suffered a considerable failure regarding back-up generators needed to both circulate cooling water through the containment units, and ventilate the buildings of hydrogen build-up. Where does the hydrogen come from? Vaporized water converts to very high volumes of steam, which at high temperatures can separate back into hydrogen and oxygen. Hydrogen is highly combustible, even at only 2% concentrations.

[3] The failure of the diesel generators, from our sources in the nuclear power industry, are primarily a result of the tsunami washing away their fuel storage tanks, rather than from flooding which disabled the generators themselves. At most US nuclear plants, diesel fuel storage tanks are either buried underground, or located within a structure designed to handle an earthquake or flood. In Japan this appears not to be the case; they were above ground, adjacent to the beach, and not well protected. It is amazing to think that inland US nuclear power plants are more flood-proof than their Japanese counterparts. With the failure of the electrical systems, hydrogen has not been venting, and appears to have resulted in the explosions at 3 buildings. In one building, an explosion/fire may have damaged the concrete containment unit, or the concrete "suppression chamber" which helps reduce pressure/heat from the reactor.

[4] The critical objective is to inject water inside the containment unit (which houses the reactor vessel). While exposure of uranium/plutonium rods to air inside the reactor vessel increases the risk that the rods melt, as long as the reactor vessel is not breached and sufficient water is available, the process can eventually be cooled. The next 72 hours are critical.

[5] As for nuclear power more broadly, my sense is that when the book is written, the failure of the Fukushima systems design will play as prominent a role as the earthquake and tsunami itself. There is no question that one of the 5 most powerful earthquakes on record (which forced the North American tectonic plate eastward by 66 feet), combined with 6-meter tsunami waves, creates a terrifying and formidable obstacle for energy facilities. But considering how well facilities whose backup power did not fail are doing, design flaws regarding fuel storage tanks (and perhaps very basic ones) are likely to be part of the aftermath. The chart shows how Japan's nuclear efficiency (measured by its capacity factor) is among the lowest in the world. This may be a partial indication of Japan's design, maintenance and engineering inadequacies compared to other countries, which use different models, electrical system redundancies and protocols.
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What now for Japan?

``What has so often excited wonder, is the great rapidity with which countries recover from a state of devastation, the disappearance in a short time, of all traces of mischief done by earthquakes, floods, hurricanes, and the ravages of war. An enemy lays waste a country by fire and sword, and destroys or carries away nearly all the moveable wealth existing in it: all the inhabitants are ruined, and yet in a few years after, everything is much as it was before."

John Stuart Mill, Principles of Political Economy, 1848

Japan is experiencing a terrible human and economic catastrophe. What is important to remember at a time like this is that developed countries tend to have powers of rehabilitation that are often underappreciated:

** Purdue's George Horwich wrote the definitive study of the 1995 Kobe earthquake (at the time Kobe was the world's 6th largest container port). Media reports said it could take the city a decade to recover. However, within 15 months, Kobe's manufacturing activity was at 98% of its pre-disaster trend; imports recovered in a year, exports were back at 85% capacity, and 79% of shops reopened. Horwich also reminds us that by 1950, Hiroshima was once again a bustling commercial metropolis.
** In "Economic development and the impacts of natural disasters" (2007), Hideki Toya from Nagoya University and Mark Skidmore from the University of Wisconsin examine the history of such events. What they found: countries with higher income, higher educational attainment, greater openness, more complete financial systems, better developed supply chains and decentralized governments experience fewer losses in the long run. That would be the case in Japan.
** In an Inter-American Development Bank publication entitled "Catastrophic Natural Disasters and Economic Growth", the authors found that natural disasters generally do not have a negative impact on long-run growth. The only 2 times that this occurred is when radical political revolutions followed the natural disasters themselves (Iran, Nicaragua).
** The charts below are other examples of economic rebirth after periods of widespread destruction and deprivation.

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Japan faces a lot of challenges, such as poor demographics, ongoing deflationary pressures and the worst debt dynamics in the world. However, as we wrote last August, Japan's domestic debt market is held 93% domestically, rather than relying on the kindness of strangers (like the U.S. or parts of Europe). Japan also has the ability to mobilize the investment accounts of nationalized banks and insurance companies (Yucho, Kampo), which have accumulated over 300 trillion yen of JGBs in the last decade. Certainly, Japan cannot afford for interest rates to rise. As we showed in the piece (1), Japan's ratio of interest expense to tax revenue would rise to over 50% of government revenues if rates rose by 2% across the board. It seems to us that should Japan run out of domestic savings to finance its debt, that it would be forced to monetize it by printing their way out.
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Japan and energy prices

Japan is the world's third largest oil importer, the largest importer of thermal coal, and the largest importer of liquid natural gas (2). One would think that with 6%-7% of the electrical grid permanently offline (3) and another 7% of the non-nuclear grid temporarily affected, that energy prices would be surging across the board. But there are 3 caveats contributing to lower crude oil prices:

** First, to replace lost electricity, Japan needs ~300 thousand barrels per day of oil equivalents (mostly for diesel generators). In the context of the global oil supplies and 3.5-5.0 mm bpd of spare capacity, this should be manageable, particularly since much of Japan's incremental energy imports will take the form of liquid natural gas
** Second, the decline in economic output associated with a disaster like this tends to depress energy demand
** Third, the Saudi Day of Rage passed without much incident, and Qaddafi has retaken most of the oil facilities. On our conference call today, Vali Nasr highlighted that this calm should not be interpreted as a broad sanction for the status quo. Saudi Arabia is still caught between what he described as 3 pincer movements of Shi'a populations (in Yemen, Bahrain and Saudi Arabia's own Eastern Province; see chart on last page) looking for some combination of wealth, political freedoms and religious autonomy. But for now, the stability of oil exports in the Gulf region looks secure. As we discussed on the conference call today, the history of supply interruptions based on weather or geopolitical events mostly points toward a recovery in exports once the immediate event has passed. Only in the case of the double-barreled 1979 Iranian Revolution followed by the war with Iraq, did we see a country experience a sudden and unrecoverable decline in oil exports.

In an October 2009 EoTM, we mentioned Desertec, a plan to construct EUR 400 bn worth of concentrated solar power stations in North Africa, transmitted to continental Europe by high voltage direct current lines. Munich Re, ABB, E.ON, Siemens and Deutsche Bank had signed on. Something tells me that this plan may run into some headwinds in the wake of March events in North Africa. In the long run, this is all part of the foundation for a more bullish outlook for natural gas, and may explain why December 2017 futures contracts had a large increase today, as shown below.

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Heading into March, the world was enjoying a global rebound in both manufacturing and service sector activity, courtesy of both a private sector rebound, and monetary policy around the globe that sets the real cost of money below zero. After the Middle East events, the European compromise (austerity for Ireland, Greece and Portugal in exchange for loans they can use to repay German and French banks) and the events in Japan, the global recovery has absorbed a serious blow. Monetary policy will likely be easier for longer, delaying the adjustment to a period of markets functioning on their own.

In portfolios, we maintain an approach more reliant than usual on public/private credit, long-short hedge funds and commodities as complements to publicly traded equities. As for Japan itself, we had generally been very underweight Japanese equities in client portfolios, for all the valuation and growth reasons mentioned above.

Michael Cembalest
Chief Investment Officer

Notes
[1] "Are JGBs the Short of a Lifetime?", Eye on the Market, August 23, 2010
[2] "Global markets awaken to the severity of the damage in Japan", J.P. Morgan Securities, Commodities Research, March 14, 2011
[3] Nuclear power is around 28% of Japan's electrical production, and the 11.3 GW of capacity shut down in Fukushima is around 23% of its nuclear capacity.

Reprinted with permission of Columbia University Gulf2000 Project (www.gulf2000.columbia.edu<http://www.gulf2000.columbia.edu>)
(only worth seeing in color)
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