Analyzing oil companies - The economics of the energy, commodity and materials business, and valuation traps

One school of thought is that investing in commodity-processing/resource-owning companies, such as oil majors like XOM, RDS, BP and CVX, and pulp and paper companies like Votorantim Celulose e Papel (NYSE ADR: VCP), is a good way to preserve wealth during periods of elevated inflation. The underlying hypothesis is that the price of commodities will rise in line with the general price level, allowing them to grow their profits in line with inflation.

However as with all investments, it is crucial not to overpay for a stream of earnings or you will end up with negative real returns. We'll look at one way of analyzing and valuing a commodity-processor/resource-owning company's earnings quality. We'll also see why in some cases we are better off buying commodities directly.

The economics of Commodity producing businesses

- they are price takers

Because their products are seen as commodities, customers have no particular reason to pay significantly more for a product from one company over another. In many cases, it is also relatively easy for customers to switch suppliers. This means that commodity sellers are price takers who cannot sell their product for more than the market-clearing price. The implication is that:

1. The strongest company is the one with the lowest cost of production and cash reserves. One of the worst things that can happen to a commodity company is if the market price for the commodity drops below its cost of production, making it lose money every day it stays in business. (While hedging can ameliorate this, it is only a short term solution) So well-funded companies with the lowest cost of production will have the most sustainable competitive position; if prices drop, the lowest cost company will be able to run with the lowest losses until all other competitors go broke and withdraw capacity from the market, allowing prices to rise to a profitable level.
   
   
2. They are vulnerable to price-irrational competitors. A competitor that decides to sell product below cost could drive the company out of business. This is a particular risk in "essential commodity industries, as governments may run loss-making state-owned competitors for political reasons. This is also a risk if the industry requires large amounts of fixed capital to operate, because ailing competitors may resort to flooding the market with product just to cover some part of their fixed costs (ie. manufacture as much as possible, as long as variable production costs are covered).

Durability of competitive position

- Factors affecting Earnings stream quality

Because they are price takers with an undifferentiated product, they have a durable earnings stream only when (a) the environment minimizes chances of prices falling below their operating costs, and (b) in the event that occurs, they are the best positioned to weather the down period until prices recover.

Industry reports and published financial statements can give you an indication of which companies are the most competitive, and have low production costs. The leading companies typically achieve their competitive position by (1) having economies of scale, (2) acquiring commodity reserves with lowest costs of production, and (3) applying operational efficiency and technology to minimize production and overhead costs. Unless there are disruptive events, it is likely that the leading companies will retain their competitive positions over the short term. However, the long-term durability of their earnings stream depends on 2 principal factors:

(1) The probability of price-irrational competitors emerging (such as government funded competitors). This depends on:

1. the geo-political environment: For commodities that are considered strategic assets, there is always the possibility that interventionist governments may setup state-funded not-for-profit competitiors. States with resource reserves are especially good candidates for this. The probability of this happening is balanced by the existance of trade barriers and trade agreements which can prevent dumping of commodities into foreign markets.
   
   
2. the cost structure of existing competitors. Competitors that are heavily in-debt and/or have high overheads may flood the market with product, just to cover some part of their fixed overhead costs/debt servicing. They can price product below true (fixed+variable) costs over the short run, just to meet cash flow needs.

(2) the probability that an upstart competitor can achieve lower costs of production. This depends on:

1. The components of the cost of production. For example, the bulk of the cost of steel production lies in the cost of energy needed to run furnaces. So a competitor could achieve lower costs of production if it managed to find a cheaper source of power, for example by erecting a new dam for cheap hydroelectric power. You would need to analyze the probability of this happening to estimate the earnings quality of a commodity company. Likewise a pulp and paper company's costs could predominatly be in forestry costs, so a competitor who could open up cheap forestry landbanks (because of climate change or changes in government rules) could gain a competitive edge.
   
   
2. Commodity re-cyclablity. Recyclable commodities like gold present the possiblity of a recycler finding a way (through technology, or finding an untapped source or cheap recycled gold) to produce re-cycled commodity at a lower price than extracting it out of the ground. For example in the gold market, it is conceivable that gold prices can fall below the cost of production of even the lowest cost miner, because there is a huge supply of gold which is already in the hands of consumers. Because gold is indestructible, there is always the possiblity that existing consumers may flood the market with their gold, and depress the market price of gold below it cost of extraction from the ground.
   
   
3. Probability of changes in the company's competitive sphere. The "competitive sphere" is the range of competitors who can serve the customers that the company is serving, and it varies according to the nature of the commodity. For example, a perishable commodity like fresh milk has a local competitive sphere (as long as customers aren't open to ESL milk or UHT milk which can be supplied from thousands of miles away e.g. by Fonterra in New Zealand). Competitive spheres can change with technology. For example, natural gas used to be a local product which could only be transported along a pipeline to nearby consumers. However, with technology advances and the build up of LNG processing facilities worldwide, natural gas can now be converted into LNG and shipped anywhere across the world, making its competitive sphere a global one. The lowest cost producer in a particular region might find itself displaced from the lowest cost position when compared with producers across the globe.
   
   
4. The Company's ability to keep acquiring lowest cost reserves. Resource owning companies constantly need to find new resource reserves to replenish reserves depleted by production. Otherwise the company will be operating in run-off mode, and will cease operations once its existing resource reserves are depleted. If the company is unable to find reserves with low extraction costs, or a competitor finds a motherlode of easy to extract reserves, then its future competitive position and earnings quality will deteriorate.
   

Valuing commodity/resource companies

- buying commodities, instead of resource companies, may be a lower risk way for investors to preserve wealth

To a long term owner looking at a company as an income producing asset, the valuation of any company is based on the present value of the expected stream of earnings which the owners can take out of the company. (We exclude earnings which need to be retained in the company, since they are needed to keep the goose alive to continue laying its golden eggs)

To arrive at a risk-weighted estimate for the future earnings stream, we need to combine all of the following:

1. the earnings that will flow from its current commodity reserves
   
   
2. the risks to those earnings, arising from changes to its competitive position (costs relative to its competitors) and the likelihood of non-economic competitors
   
   
3. the ability of the company to continue adding to its resource reserves without changing its costs of production relative to its competitors

In the short run the company's earnings will likely grow in line with inflation (assuming it also drives commodity price rises), because the company's costs of production (reserve extraction costs and reserve acquisition costs) are based on yesterday's prices while revenue is based on today's inflated commodity prices.

However over the long run, the ability of resource companies to grow earnings in line with inflation is not a sure thing. In fact, their earnings behavior over the long term is likely to be no different from the average of a basket of companies across industries. Why? Because (a) as inflation sets in, their cost of acquiring reserves and the costs of extraction will also likely go up, and (b) like all companies, they face competitive risks to their earnings. And as we have seen, as commodity producers they can face more earnings risks than non-commodity producers.

So if you are looking to preserve the value of your wealth during inflationary periods, you may be better off investing directly in commodities, if you hold the view that commodity prices will rise in line with inflation. (which is the same premise in the "invest in resource companies" hypothesis)

Valuation traps and mistakes

- particular to commodity/resource companies

One mistake is to value a company by extrapolating its future earning stream from its recent earnings history. Commodity prices tend to be cyclical in nature, because of the oscillating boom-bust feedback loop that develops; increasing production causes prices to drop, which causes production capacity to be withdrawn, which causes prices to go up, and so on. These cycles can span many years, so you need to look at the 10-year earnings history (or longer) to get a feel for the company's earning power.

For resource-owning companies, this approach also ignores the fact that the company's reserves are not infinite and will run out at some point. Management will continue acquiring new resource reserves to keep the company viable as a going concern, and the new reserves' cost of production will determine the company's earnings quality down the road. For example, an oil company with low-cost reserves may have a high quality earnings stream today. But if it cannot replenish its reserves with equally low cost resources, it will gradually slip into a weaker competitive position and become more vulnerable to losses in future. This should reduce the valuation placed on the company.

Another valuation mistake is to take the enterprise value of a commodity company as = the amount of commodity reserves they have, multipled by the prevailing commodity price. (i.e. valuing the company in run-off mode, where the company will cease operations once its existing reserves are depleted). The problem with this approach is that it assumes that it is possible to extract and sell the entire reserves all at once. In practice annual production capacity is limited, so if you want to value the company as a run-off company, you need to base your value calculation on the NPV of each year's production, until all reserves are depleted. (It is not uncommon for resource companies to have only 10-20 years of resource reserves if production rates are maintained.) You may be surprised that the NPV value expressed as a PE ratio can be in the low single digits.

The mechanics of buying stocks

Most of us receive regular statements from our stockbrokers telling us what stocks we own. But what happens if your broker goes bankrupt; will you lose all your shares? For legal and practical reasons, few people have physical stock certificates today. So how do you prove that you own your stocks if your broker goes bust, or makes a mistake?

Here's what actually happens when a stock trades, and how you can protect yourself from losing your stocks:

How the ownership of a stock changes during a trade

When you buy stocks, you're actually triggering off a long chain of activity in the financial system. But your broker is probably the only party that you deal with. Here's what happens:

(click on the image to expand it)

1. When you instruct your broker to buy a stock, your broker will go out to look for people who are willing the sell the stock you want. This could be someone else who has told the broker that he wants to sell that stock; in which case the broker would simply "transfer" the stock to you at the agreed price. More likely, the broker would have to get in touch with other brokers to find the stocks you want. This can be through a stock exchange such as the NYSE, where all trades and their clearing prices are made known to the public. Or, it could be through a network of brokers who have come together to trade. Such networks are known as Alternative Trading Systems. In general, the SEC regulates where public listed stocks may be traded, with the objective of minimizing fraud and creating a fair market for all parties. Once a willing buyer and seller are found, they are matched and the trade takes place. So far, the actual stocks haven't been transferred to you yet. Rather, you just have a confirmation that the buy trade was carried out.

2. The next thing that happens is the settlement process. This is where the stocks you bought actually get "delivered" to you. In the past, all stocks were held in certificate form. If you owned 100 shares of Company X, you would have a stock certificate which said just that. This was an extremely important piece of paper, because it was like cash in the sense that if you lost it, you lost your stocks. The stock broker would literally get the stock certificate from the seller (or the seller's broker) and hand the certificates to you in exchange for a cash payment. Some people would keep their stock certificates in a bank vault, others would keep them with a custodian in a custodial account, and yet others would leave them with the broker so that they could be easily sold later on.

The paperless settlment process today
- Stocks are often held in the broker's accounts

However today, most countries operate a paperless stocks system, in which no paper certificates are transferred between sellers and buyers. Instead, ownership of a stock is recorded in the books of various parties in the financial system. When you buy a stock, there is no paper certificate that gets transferred to you. Rather, a book entry (or many book entries) is made to say that the stocks have been transferred from the seller's account to yours.

At the heart of the system is a depository institution (for example, the Depository Trust and Clearing Corporation (DTCC) in the United States, or the CDP in Singapore). All brokers open an account with the depository institution and "deposit their stocks" there. After a trade, the buying and selling brokers will notify the depository that the ownership of the stock that was traded should be changed. The depository institution will then updates its books to move the ownership of the stocks have from the selling broker to the buying broker. It also manages the transfer of payments between brokers, and minimizes counterparty risk through various guarantees and insurance schemes.

The depository institution may notify the company (whose stock was traded) about the change in ownership of stock. All listed companies keep track of their stock holders in a "register of stockholders". It lists all the people who own the company's stock, and allows the company to know who to send dividends to, and who to notify in the event there are corporate actions which require a shareholder vote. In many cases, the company will outsource the work of maintaining the shareholder register to a stock transfer agent, such as Computerserve. (The transfer agent can do other things too, like manage dividend distributions, issue share certificates, and more. Stock transfer agents are also known as share registrars in some countries)

In practice, depository institutions and the settlement system is different from country to country. For example, the DTCC can also act as a custodian. Likewise, many brokers also offer custodial services, especially for foreign shares which you purchase through them. They may in turn, use other custodians (through sub-custodial accounts) and brokers in other countries to carry out your foreign trades. The way the DTC in the United States works is described here:http://www.dtcc.com/downloads/about/Following%20a%20Trade.pdf)

You'll notice that so far, the stocks aren't registered in the name of the person buying the stock. Instead, the stocks are usually held in the name of the broker. This is known as holding your stocks "in street name", because for all appearances to the rest of the world, it is your broker who owns the stocks. It is only in your broker's books that an entry is made to say that the stocks belong to you, to make you the "beneficial owner". Many people do this, because it makes it easier to get the broker to sell the stock later on.

So do you legally own the shares?
- No, but the law does offer some protection against broker misbehavior

Strictly speaking, you are the legal owner in the eyes of the company (that you invested in) only if you have registered your stock with a company's stock transfer agent and appear on the company's shareholder register. Otherwise, the securities technically belong to the brokerage firm or the custodian bank. So in general, it is important to use reputable and financially sound brokerage firms and custodians. Simply going for the cheapest broker isn't necessarily the wisest course of action.

Nonetheless, the Securities Investor Protection Act of 1970 does offer some protection to investors in the United States. It empowers the Securities Investor Protection Corporation to offer compensation to investors in the event a brokerage company fails. However, it is not a general insurance fund like what the FDIC does for savings accounts. Notably, it does not compensate investors if there is investment fraud or if your broker simply makes a mistake in executing your trade.

How to get yourself registered as the legal owner
- and protect yourself from broker failure

However, you can always ask for the stocks to be registered in your name in the company's register of stockholders. If you ask, most publically listed companies will explain to you how you can contact their stock transfer agent and get your stocks transferred from your broker's name to your name. The benefit of this is that you won't have to worry that you'll lose your stocks if your broker goes bust, or if some massive fraud is taking place at your broker's office. The downside is that it becomes much harder to sell your stock. To sell your stock, you'll need to tell the stock transfer agent to transfer ownership of the stock to your broker, then ask your broker to sell the stocks for you. Brokers often charge extra for this service, because of the hassle of deregistering them from your name on the stockholder register.

Some buyers, especially large institutional player like mutual fund managers, will ask their brokers to transfer ownership of the stocks to custodian banks, like State Street, instead of registering the stocks directly in their name with the stock transfer agent. They do this to use the services which the custodian banks provide, such as portfolio management and reporting. The separation of duties between trading (the broker) and holding inventory (the custodian bank) also reduces the chances of fraudulent activity. For example, with this separation of duties, it would be difficult for a broker to take money from the buyer without actually buying the securities it was supposed to buy.

Bottom Line: How to protect your right of ownership

The bottom line is, if you are investing a significant sum of money, go with an established and reputable brokerage. That way the probability of the broker failing to make good on its mistakes (or the possibility of fraud) should be lower.

If you intend to hold your stock for a long time, then consider having it registered with the company's stock transfer agent. That way, you will be officially recognized as being an owner of the company. 

[ You might wonder how depository institutions, custodians, and brokers identify the thousands of stocks that are traded. Wouldn't there be confusion especially since many companies trade on different exchanges? Fortunately, the industry has standardized on the use of a unique CUSIP/ISIN number for each security. This makes it possible to clearly identify a particular security.]

Nationalization risks for Investors (in Utilities, Banking, Insurance, Communications etc)

Industries like utilities, banking, insurance, telecommunications, and public transportation are crucial to the functioning of modern society. Because they are so critical, many countries nationalize these industries explicitly or impose private ownership restrictions, to ensure that these essential services won't be held hostage to private interests. Services that are monopolistic in nature, such as electricity distribution, are also regulated to prevent their shareholders from extracting undue economic rent on society.

In free-market oriented countries like the United States, these industries are in privately owned but subject to regulation to ensure they continue operating smoothly. In some states for example, electric utilities are regulated so that their shareholders can earn a fixed return on capital, while ensuring that the companies invest the capital needed for maintenance equipment. Usually, this arrangement works well, and shareholders have a safe predictable investment. However it is important to realize that it is not a risk-free investment.

Risk #1 : Eminent Domain intervention that suppresses your earnings stream

These investments run the risk of of "eminent-domain type intervention", where the state changes the "rules of the game for shareholders" in order to serve society's needs. Because of the immense importance of these services to society (and hence the political establishment), any service failure could bring about an overnight change in the regulatory framework and economic ecosystem which sustains your earnings stream. This is irrespective of whether the failure is the fault of the company or because of faulty regulation.

A sudden deterioration in affordability of an essential service can also trigger an eminent-domain type intervention. For example, a sudden rise in fuel prices in a country which relies of public bus services can lead to government mandated price controls, to keep the cost bus fares within the reach of the Average Joe. Likewise, rate-setting-councils could deny regulated electricity distribution companies rate increases during economic downturns. Sometimes political populism comes into play, and a government could force foreign owners of strategic businesses to sell their stakes at fire-sale prices.

Example 1: the Insurance industry after Hurricane Andrew in Florida in 1992

You might be thinking that this sort of thing doesn't happen in a bastion of capitalism like the United States, but you'd be wrong. Consider what happened before and after Hurricane Andrew in Florida in 1992. Prior to the hurricane, there was systemic underpricing of insurance premium as insurers were lulled into a false sense of security. After the hurricane, insurance companies sustained huge losses and tried to reduce the number of customers and/or reduce the amount of coverage they were providing. While this behavior is unfortunate for the homeowners, the insurance industry does tend to behave in this cyclical way. By their nature, natural calamities do not occur in a steady stream. Instead they tend to happen in bursts, probably approximating a power law statistical distribution. This leads short-sighted insurers who experience periods of calm to under price their premiums. Being a commodity product, this tend to force even prudent insurers to match the under priced premiums in order to retain market share. Then when disaster strikes, the weaker insurers fold, and the stronger ones raise their premiums to compensate for the earlier period of underpricing.

The state regulators however, decided that this was politically unacceptable, and wrote legislation that (a) limited the number of policy cancellations to 5% across the state, (b) restricted the size of premium increases the companies could impose, and (c) created the Florida Residential Property and Casualty Joint Underwriting Association to provide residential property insurance coverage. This intervention in pricing and the creation of a state sponsored competitor likely decimated the private sector insurers' profitability in Florida. The regulatory regime did not prevent underpricing during the "upswing" of the insurance business cycle because it benefited Florida residents, but it intervened the moment the insurance industry moved into its overpricing "downswing" phase of its business cycle.

Example 2: the Banking industry during the Financial Crisis of 2008-2009

A more recent example is the financial crisis that started in 2008. During the real-estate bubble prior to 2008, many banks and financial institutions made loans to people who couldn't afford the loans. When property prices were rising, these borrowers could simply refinance their loans based on the increasing paper value of their property, thus never having to actually pay down their loans. They simply enjoyed the initial teaser rates, then refinanced before the real loan payments started kicking in. When property prices started dropping, they defaulted on their loans because they couldn't refinance the loan, and were never actually able to pay the true installment amounts. (It wasn't just a matter of the banks underpricing the loans - some of these loans shouldn't have been made in the first place because there was no way the borrower was able to finance it from his income.)

Banks who made these reckless loans ran into trouble; their borrowers couldn't pay back the loans and they repossed homes. However they couldn't sell the repossessed homes at anywhere close to the outstanding loan amounts. Companies like Countrywide Financial and well-known banks like Washington Mutual became insolvent as they breached capital adequacy ratios (as their diminishing assets became less than the regulatory minimum required to support their liabilities).

Unfortunately, it wasn't just the banks who made reckless loans who were affected. Many of the reckless loans they made were also sold to investors and other banks as mortage backed securities (or collateralized debt obligations, whic are groups of mortage backed securities which have been sliced up and repackaged).

Banks who bought these securities also ran into trouble as the loans underlying these securities started getting into trouble. Some of the securities were so complicated that many investors and banks couldn't figure out how much their securities were worth, and the markets stopped trading them. They became known as "troubled assets" as people generally felt that they were worth far less than what the banks claimed they were worth on their balance sheets. In effect, the quality of banks balance sheets were now under suspicion. This fear and uncertainty further exacerbating the pull back in lending as investors refused to lend money to banks or to buy debt securities.

Impact to the real economy:

This cutback in the amount of loans extended made it hard for businesses to finance trade, inventory and working capital needs. The climate of fear about the true value of debt and asset-backed securities also made it difficult for companies to issue corporate bonds and short term commercial paper to finance working capital needs. (Investors simply stopped buying bonds, and refused to put money into money market funds which invested in short term commercial paper)

Economically, the bad lending decisions resulted in a misallocation of resources as people built houses and assets which society didn't really need and people couldn't really pay for. The subsequent fear and pull back in lending then threatened to cripple healthy companies who relied on credit, as many companies do, for day to day operations. This effectively put the economy in cardiac arrest, as credit, the oxygen carrying blood of economic activity, ceased to flow. Companies began to reduce their production and overall economic activity declined.

The decline in home prices also made people feel less wealthy. Combined with rising unemployment caused by the drop in economic activity, people reduced their consumption and lowered their standard of living. This further exacerbated the economic contraction, as people consumed less goods and services than what the global economy was geared to produce.

Government intervention to support the economy:

The government then intervened on two fronts: on the fiscal front, the government started spending through a series of stimulus packages, to kick-start economic activity. On the monetary front, the government started propping up banks and credit instruments in order to open up the flow of credit to healthy businesses. This monetary intervention had various side effects on the good banks, and their shareholders:

1. TARP forced equity investments. Through the TARP program, the government forced a wide swathe of banks to take the government on as an investor, by issuing preferred shares to the government that came with a 5% dividend payment. This allowed all banks to "raise capital", whether or not they needed it. The result was that:
   
   - prudent banks, who didn't need the capital, got saddled with high cost equity capital. This lowered their operating profits and reduced their ability to pay dividends to ordinary shareholders.
   
   - unsound banks continued operating and continue competing with the prudent banks.
   
   The prudent banks should have been able to grab market share during as their weaker competitors floundered, by being able to raise funds at a lower cost and taking on loans which the weak banks didn't have the funds to. Instead the TARP program allowed weaker banks to carry on operating, and negated the competitive advantage that prudent banks would otherwise have had.
   
   
2. Low cost loans through the TAF program. The Federal Reserve started making extremely low cost loans (below the discount rate) to banks in exchange for almost any type of collateral. The wide range of collateral accepted essentially opened up the loan facility to all banks, irrespective of the quality of their assets. This allowed weak banks to fund their daily operations, and kept them alive and able to continue competing with the stronger banks. (It is likely that this program didn't increase the amount of loans made, since it merely monetized a bank's illiquid assets. It does nothing to fundamentally improve a bank's capital adequacy ratio.)
   
   
3. Implicit government support for bank bondholders. When a bank got into trouble, it appeared that the government would keep the bank afloat by injecting funds and wiping out shareholders, while keeping bondholders untouched. This meant that troubled banks and financial companies could likely have issued bonds and raised funds at lower rates than healthy banks, whose bondholders didn't have that implict government support (at least for the moment). The result was that troubled companies and banks had access to cheaper funds than prudent, healthy banks.
   
   
4. Commerical paper guarantees through the FDIC's TLGP. The FDIC started its Temporary Liquidity Guarantee Program, which guaranteed the interest and principal repayment on all commercial paper issued by eligible depository institutions and financial companies. As a result, almost all banks and finance companies were suddenly able to issue commercial paper at the same low rates, since they were all effectively backed by the U.S. government. Prudent banks lost their lower cost funding competitive advantage.

Impact on shareholders:

The government intervention effectively eliminated a significant cost advantage that prudent, healthy banks enjoyed. Unless they have found a way to attract customers on factors other than price (not easy in a commodity-like business like banking) they are potentially going to lose market share if the government subsidyof troubled banks drags on. (I'm not saying the state subsidy is wrong - considering the dire stituation we are in, there is a real need to stimulate overall credit and lending to keep the economy working)

It was also possible that governments may have cajoled stronger banks to take over weaker banks in order to stabilize the banking system. For example, there is a possibility that the UK government encouraged Lloyds TSB to take over HBOS in order to prevent HBOS from collapsing. While this helped to stabilize the UK banking system, it saddled Lloyds TSB with HBOS' loan book which was of dubious credit quality. Lloyds TSB, which had one of the best banking franchises in the UK, is now in danger of needing to raise lots of additional funds (likely by issuing shares to the government) in order to manage the losses from HBOS. The merger has been bad for Lloyds shareholders.

The Lesson for Investors:

Always consider the probability of Eminent Domain intervention

So if you are considering investing in a company in one of these critical industries, then it is essential that you factor in the probability of such "eminent domain" type government intervention occurring:

1. You need to consider the probability of events which can cause your essential service to become unaffordable; for example, massive unemployment, or a spike in raw material prices.
   
   
2. You also need to consider the probability of systemic industry failure which would lead to the government changing the rules overnight.
   
   
3. If you are a passive investor, then you'll also need to consider the probability of the company management messing up, since you don't exercise discretionary control over management.
   
   
4. You need to analyze the political framework in the regulatory domain, to see how susceptible the political environment is to popular public pressure.
   

Risk #2 : Badly designed regulation that creates hidden dangers to the viability of your business

You've also got to check if the regulatory framework is well designed; some regulatory frameworks simply aren't designed well. (This is not a knock on the regulators - it's not easy to design a framework to balance the needs of society and the needs of private investors)

A good example is the California Electricity Crisis in 2000-2001, when several electric utilities went bankrupt and almost caused major disruptions to California's electricity supply. This was caused by faulty regulation which (1) imposed price controls on electric utilities who owned the distribution to retail customers, which reduced their incentive to invest in power generation, whilst (2) requiring them to purchase electricity on the spot market from electricity generation companies when their own generation was insufficient. Because wholesale electricity from generators was traded, and because electricity is not storable, it led to probable speculation (and possible manipulation) by energy traders and generators which caused the wholesale price of electricity to rise beyond the price at which the electricity distribution utilities were able to charge their customers. As a result the distribution companies went bankrupt, and the state government had to intervene to buy electricity on the spot market for the electricity distribution companies.

While there is no foolproof way of analyzing regulatory frameworks for such dangers, there are some general rules-of-thumb which you can use:

1. Any regulation that imposes any form of price ceiling is dangerous.
   
   
2. A regulatory regime that allows for a return on capital is better; but watch how this allowed return is calculated. For example, a return based on a WACC calculation might use the prevailing share price to calculate the cost of capital. This could dramatically reduce the allowed earnings if the share price drops over the years. This reduced earnings would in turn further lower the share price (unless the market is willing to pay a higher PE), leading to a downward spiral.
   
   
3. Any industry practice or regulatory regime requiring a "take or pay" arrangement warrants careful study. These are common in arrangements between companies using oil and gas pipelines. Typically, pipeline or downstream companies who receive gas from a pipeline are required to enter into a "take-or-pay" arrangement with the pipeline owner or the gas producer that is pumping gas into the pipeline. This to give the gas producer predictable demand, so that it can build the infrastructure to produce the gas. But this places a risk on the downsteam company.
   

Industries that may be subject to regulation in future

Based on the current political climate and zeitgeist, I think there is a possibility that a couple of presently unregulated industries may be regulated in the not too distant future:

1. Food industry. Possible regulation to discourage the consumption of food deemed to be unhealthy. For example, a tax on foods containing sugar would affect candy, soft drink and snack food manufacturers.

2. Tobacco industry. Possible regulation to further discourage the consumption of tobacco products.

Analyzing a Bank - business quality, credit discipline and resilience to losses

If you intend to invest in banks, you'll need to get a feel for how good a bank will be as in investment. I'm going to describe one way you can get a feel for a bank's business strength and its credit quality, and by proxy, whether the bank's management is making good lending decisions. This is especially important in light of the recent reckless lending behavior of some banks, which has already caused a number of "big banks" (like Washington Mutual) to fail.


Assessing the strength of a Bank's business
and investment merits

The value of a bank as an investment is not based on its credit quality alone, though it is an important factor. For example, a bank could be making excellent lending decisions, but be continually losing customers because of lousy service or because of irrational competitors who underprice their loans. Under-pricing to gain market share is a dangerous trap that businesses with long-tail risks and short-term management can fall into. A holistic picture of a bank's value can only come from looking at:

1. the factors and quality of managerial judgment, seen through:
   (a) the bank's propensity to loosen its standards and make bad credit decisions, and
   (b) the bank's willing to prepare for tough times - banking is an inherently cyclical business that tracks underlying economic cycles and cycles of excessive credit and credit shortages caused by competitive behavior - high earnings cause competitors to flood the market with cheap credit, until the credit becomes too cheap to handle normal default rates/or default rates go up, which then causes credit to dry up. The dynamic is similar to what happens in the insurance industry, and also similar to the boom-bust cycles in commodity prices.
   
   
2. competitive position: the bank's ability to cling on to its customers / attract more customers, in the face of rabid and sometimes irrational competition.
   
   
3. macro economics: whether the economic footprint underlying the bank's customers is a deep, broad and self-sustaining one (banks are creatures that depend on the underlying economy).

The latter two are qualitative assessments you need to make. The bank's public financial statements aren't likely to give you enough information to make a proper assessment. A bank's public financial statements can only help you judge a bank's credit discipline, and by proxy, the quality of its managers' judgments. Specifically, you'd have to look at the bank's balance sheet and its accompanying notes for clues on how a bank's loans have performed during the year.

Nonetheless, you should be aware this this is not a perfect indicator of a bank's current management discipline, because:

1. bad loans tend to default only after a year or two. So a bank could have really loosened its credit quality over the last 12 months, and you probably wouldn't see any indication of this in the balance sheet.
   
   
2. a low default rate doesn't mean anything if the economy is doing well and asset prices are rising. In such times, you'll probably see all banks experiencing low loan losses as the rising tide lifts all banks. This is particularly true in a credit bubble, when a borrower who is having difficulty paying off a loan can usually refinance it with another bank - this merry go round will make it look like the loan has never defaulted.
   
   Examining a bank's balance sheet during an economic downturn tends to be more useful, because we we can compare a bank's loan performance against its competitors. As loans start to default during a downturn, and borrowers have no way refinance their loans, you will be able to see which bank has been reckless and which has been prudent in its lending decisions. As they say, it's only "when the tide goes out that you can see who's been swimming naked".

Understanding the Loan Accounts,
in order to assess credit quality

The loan amounts that are shown in the balance sheet refer to (a) the outstanding principal and (b) the accrued interest that the bank's customers have yet to pay off. The accrued interest refers to the interest which the bank has "earned" or "charged" the customer up to the current date. For example, if this is the 5th year of a 10 year loan, then the amount of accrued interest reflected in the balance sheet would only include interest charged up to the 5th year and not yet paid. It would not include the interest yet to be charged for years 6 to 10, since the bank hasn't actually earned the interest. The interest is only earned if the bank continues holding the loan the next year; and there is a possibility the borrower may just repay the whole loan next year.

Loans generally start out as "Current loans". This means that the borrower is paying the installments regularly, and the bank has no reason to believe that this will stop. In the loan books, such loans are treated as current and accruing interest - the bank assumes that it is continuing to earn interest on the loan and hence add this interest, as it is accured, to the loan books. Such loans are carried on the loan books and are a part of the total loan amount shown on the balance sheet.

If a borrower fails to pay an installment within 30 days of when it is due, then the loan becomes classified as a "delinquent loan, 30-89 days past due, still accruing interest". If the borrower still fails to pay the late installment after 90 days, then the loan becomes classified as a "delinquent loan, 90 days or more past due, still accruing interest". The bank generally believes that it won't incur losses on these loans because either (a) the borrower will resume payment on the loan soon, or (b) the bank can seize the underlying collateral (e.g. the house is collateral for a mortgage) and sell it at a price higher than the outstanding balance of the loan. Such loans are still carried on the loan books, and are a part of the total loan amount shown on the balance sheet.

If at any time, the bank believes that the delinquent loan will not be recovered in full, then the loan becomes a "non performing loan, not accruing interest", also known as a "non performing asset". The bank believes that it will incur losses on the loan because (a) the borrow cannot continue paying the installments, for example because he/she is bankrupt, and (b) the market value of the underlying collateral is less than the outstanding balance of the loan. The bank also assumes that it isn't earning any interest on-top-of the principal, since the loan has effectively "stopped working". Even if interest is collected, it will be written off against the principal. Such loans are still carried on the loan books, and are a part of the total loan amount shown on the balance sheet, even though it is likely some part of the value will be lost in future.

During the year, if the bank believes that the borrower won't be able to repay a loan (Delinquent Loans or Non-performing), then the bank will begin proceedings to recover from the loan by seizing and selling the collateral for the loan (e.g. seizing a house and selling it). When it does this, the bank may incur a loss if the sale price of the collateral is less than the amount of the loan that is shown on the bank's loan books. For example, if the outstanding principal and accrued interest on a mortgage is $100,000, but the bank only managed to sell the house at $80,000, it would incur a loss of $20,000. Such losses are charged to the "loan loss reserves"/"credit loss reserves", so that they can be written off the books.

• As an accounting matter, these net charge-offs do not impact the current year's income statement; they only reduce the bank's loan loss reserves. The income statement was affected in previous years when the bank "added/built-up" its loan loss reserves. The reserves are in a sense, off the balance sheet (strictly speaking they are shown in the assets side. You will see it in the "total loans - loan reserves = net loans" item. However, they are conceptually off the balance sheet). When the bank builds up its "off-balance sheet" loan reserves, on the balance sheet what happens is that the net loan amount drops on the asssets side, and the shareholder's equity drops on the equity/liabilities side.
  
  
• The Credit Loss Reserves (Allowance for Loan losses) are reduced by "Net Charge-offs", and increased when the bank makes additional "Provisions for credit losses" (which hit the income statement).

Ways to Assess a bank's credit quality,
and management's credit discipline

There are 2 ways you can observe the banks credit quality, and by proxy, its management's credit discipline:

1. Point in time snapshot: One way to see the bank's credit judgment is to see the non-performing loans as a percentage of the total loans made by the bank. This gives you a snapshot of the credit quality of the loan book at a point in time.
   
   
2. Over the year: It is also important to review the net-charge-offs made over the year, as a percentage of the average loan balance during the year. This shows you the total amount of loan losses charged off during the year, as opposed to a snapshot of the state of the loans currently on the books.

While these are useful indicators, it is also important to look at these numbers with reference to (a) the loan mix, and (b) the overall interest rates charged for the loans. For example, a bank specializing in high-interest loans to low-credit-score borrowers would naturally see a higher rate of loan losses. But this is ok if the bank is able to charge interest rates high enough so that over the large base of customers, the loan losses are more than made up for by the higher net interest income. Just like in insurance, it is ok to take on higher risk business as long as you can price for it. Generally speaking, the most risky to the least risky (in terms of net charge-offs expected) loans are:

1. Credit card and Unsecured loans - these are unsecured loans, and experience higher rates of default. However among credit cards, it appears that affinity branded cards (e.g. alumni, associations etc) tend to have slightly lower loss rates.
   
   
2. 2nd Lien Secured Loans (Home equity and 2nd lien mortgages). In these loans, the bank only has 2nd claim to the underlying collateral, because the 1st right of claim goes to someone else (the holder of the 1st lien).
   
   
3. 1st-Lien Secured Loans (Residential Mortgages, Commercial Real Estate Loans, Lease financing). For such loans, the bank has the right to seize the collateral and sell it, if the borrower fails to make payments on the loan.
   
   

What we're look at is past credit experience,
it's no guarantee of future management behavior

The bank's credit experience gives you an idea of what the bank's management has been doing in the past. However, it says nothing about the bank's credit decisions over the past 12 months, because bad lending decisions often don't show up immediately:

1. The bank may have written a set of bad loans with a low teaser interest rate which only resets after 1-2 years. Credit losses will spike only when the resets hit.
   
   
2. The bank may have written a recent set of loans with higher Loan-To-Value ratios than in the past. So even if the bank continues lending to the same type of credit worthy borrowers, the amount of charge-offs will increase even if the proporation of people who default remains the same. Each individual default will on average, result in more losses to the bank because the loan outstanding is very close to the initial valuation of the collateral. A smaller drop in collateral price will result in losses to the bank.
   
   
3. The bank may have failed to increase its LTV guidelines in the face of a bubble in collateral prices. Simply maintaining a 80% LTV ratio may be insufficient if you are in a housing bubble and you expect housing prices to drop by 30%.
   
   
4. And in general, loans usually don't default until 12-24 months have passed (unless a really really bad lending decision was made and the borrower can't even service his/her first installment)

In other words, the numbers in the accounts give you a clue as to the bank's past practices, but you need to make a qualitative judgment as to whether the bank's management has changed its behavior in the recent past.

Another indicator of management judgment: a Bank's Resilience to Losses
Is the bank conservatively managed?

Generally, you'd want a bank to be managed conservatively, so that it can weather economic downturns and financial crises. The bank's balance sheet should be robust enough to withstand the booms and busts of free market capitalism. So how much losses can a bank take before it goes bankrupt? And how should the balance sheet be managed to weather such storms?

Banks must always have more assets than liabilities, otherwise they wouldn't be able to pay depositors and bondholders/creditors back their money. So conceptually, the maximum amount of money a bank can lose and still remain solvent is equal to the amount in shareholder's equity. Anything more and the bank would be insolvent (bankrupt).

In practice, regulators impose minimum capital adequacy requirements on banks. For example, a country's regulator may require banks to have a minimum equity to asset ratio (leverage ratio) of 4%. Many countries impose capital requirements on banks based on Basel 2 guidelines. For example, in the U.S., banks are required to have a Tier 1 capital ratio of at least 4%, and a Tier1 capital + Tier 2 capital ratio of at least 8%.

The very most a bank can tolerate in losses in one year is a combination of (1) that year's net income and (2) an amount of equity that would not cause the bank to breach its capital adequacy requirements. Banks can incur losses in many ways, such as:

1. Through credit losses when borrowers default, and the underlying collateral cannot be sold at a price to cover the outstanding loan amount.
   
   
2. Through losses in the value of securities it holds as assets. Banks typically invest some of their cash into treasury bills, bonds and other securities. If the securities default or experience a permanent loss in value and the bank is unable to hold them to maturity, then the bank will incur losses. (Note that some securities that are on a bank's books may not be marked to market. Accounting rules allow some securities, known as Level 2 and 3 assets, to be booked at a value determined by the bank's valuation models. Assets carried at mark-to-market values are classified as Level 1 assets)
   
   
3. When business costs rise too fast, for example because of unexpected litigation, a failure to control expenses, pension costs, and so on.
   
   
4. By failing to manage their asset and liability interest rate and forex sensitivity. For example, during the Asian financial crisis when several Asian currencies experienced sudden devaluation, some banks ran into trouble because they had liabilities in foreign currencies.

One way of seeing when a bank is in danger of becoming insolvent from bad lending decisions is to make an assessment of what a probable credit loss rate would be, then see if the bank can withstand that.

Credit Risk Modeling: (Stress testing)
how bad can credit losses get?

It really depends. For example:

• In the 1997 Asian Financial Crisis, some banks in Singapore had up to 7% of their total loans become non-performing (in some countries, up to 25% of total loans were non-performing). Even up to 2001, Indonesia's banks NPLs were estimated at 48% of total loans.
  
  
• In 1976 (the aftermath of the 1974-75 recession) in the US, up to 5.3% of loans (according to the New York Times) were problem loans.
  
  
• In 2005, 8.6% of China's loans were reported to be NPLs (according to Xinhua)

So a large part of estimating NPLs is based on an analysis of the strength and resilience of the underlying economy. This is a macro-economic assessment that you need to make. The long term health of a bank is greatly dependent on the strength of the economy that underlies it.

If you have a view of the underlying economy, then you can make an educated estimate for the credit losses a bank might sustain. For example, if we assume:

• The bank has an average outstanding loan to value ratio of 80% (e.g. mortgaged houses are valued at $100 in the market, and the borrower's outstanding loan is $80). In other words, the bank won't suffer any losses even if the borrower defaults, unless the selling price of the property (or other collateral such as machinery) drops more than 20% i.e. to below $80.
  
  
• Collateral (or housing) prices will drop by 35%. We can make this estimate based on a back-of-envelope analysis of the Case Shiller index (Composite-10 CSXR overall price index). If we assume it will drop back to year 2000 levels, then it will drop 35% from Oct 2008 levels. (October 2008 index value=169.78, Dec 2000 value = 113.56). This means that houses drop from $100 to $65.

Scenario 1: Now, if we assume that all customers will default the moment their house re-sale prices drop below their outstanding loan value (entirely possible if the house was purchased as an "investment", and not for living in), then all customers would default and the bank would have to seize and sell the underlying (mortgaged) property. The bank is owed $80 for each loan, but is only able to sell the house for $65. This implies the bank will suffer a loss of $15 on each loan. In other words, credit losses will be ($15/$80) = 18.75% of the total loan value.

This scenario assumes that all loans that are in negative equity will default. However, this usually isn't the case if the bank has only lent to people who borrowed to buy the house to live in. People who buy their houses to live in tend to continue paying off their loans as long as they are employed and have the means to. This is in part because of the need for a place to stay, a desire to keep a good credit rating, and because of a psychological escalation of commitment to the house. If they default on their loan and give up the house, they will lose the $20 they paid for the house. (From their point of view, even if they buy a new house for $65, they will have paid in total $20+$65=$85 for this new house, excluding interest costs. i.e. they will only save $15)

Scenario 2: If the bank has been lending to people who will only default when they are unable to continue paying because of unemployment, then the bank's losses will be lower. (A similar principle applies for commercial and other loans, even though our example is based on residential mortgages). Let's assume a worst case scenario of 20% unemployment, which we roughly take to mean that that 20% of borrowers will default. Of these customers who default, the bank will, after seizing and selling the houses, lose 18.75% of the loan value because of the lower market prices of the houses. This translates into an overall loan loss of 3.75% of the total loan book.

Summary

This in a nutshell, is how you can approach the task of assessing a bank as a investment. Much of any analysis will involve qualitative factors, as I have described here. Be careful not to ascribe too much importance to the quantitative results of your analysis, without the looking at the qualitative factors that form the backdrop of your analysis.

The current dour sentiment for banks in general ignore the fact that there are a number of good quality banks in the industry. Of course this is a relative statement, no bank will be viable if the entire economic or financial system collapses. But barring such a systemic event, you will be able to find some banks which will weather this storm reasonably well.

Earnings managment and Creative accounting - How pension accounting can be used to boost short-term profits (Investors beware!)

If you are planning to invest in a company with a defined benefit retirement plan, then you'll want to have a close look at the company's pension accounting. Why? Because (1) companies can use pension accounting to smooth out earnings, or even report headline profits when the underlying operations are running at a loss, and (2) companies can report short-term profits even if they have vastly underfunded pension plans, plans which will eventually lower future profits as pension eligible employees retire and the company has to top-up the pension accounts to pay them.

What makes this particularly insidious is that this can be done without violating any accounting rules or principles. How is this done?

It stems from a basic feature of accrual accounting: the need to make estimates and assumptions. Accrual accounting generally requires management to make assumptions, for example, the depreciation period of assets, and actuarial assumptions in their pension accounts. Unfortunately, making "aggresive" (i.e. unrealistic) assumptions in their pension accounting can greatly distort the picture of the company's financial health.

This is because pensions are liabilities that are incurred many years in the future, and affected by many variables which are hard to predict. For example, overestimating the discount factor in accrued pension benefits by just 1% can cause millions of dollars of liabilities to disappear from the pension accounts. The good news is that much of this can be detected by the astute investor, as long as you understand the mechanics of pension accounting.

The heart of the matter: Pension Fund's Assets vs the company's Pension Obligations (off balance sheet item)

At the heart of a defined benefit pension scheme is the pension fund, which is usually made up of assets such as equities, bonds and treasury securities. For the pension plan to work, the plan assets must be sufficient to pay the pensions expected by its employees. These pension plan assets are usually not recorded on the balance sheet, because they are held in a separate legal trust from the company itself, as an off-balance-sheet pension fund.

To know if a pension fund has enough assets to meet the needs of its (present and future) pensioners, we need to know how much money is the company obligated to pay out to its retired employees. This is known as the company's pension benefit obligation. Determining a company's benefit obligation can be complicated. By its nature, the future pension obligations depends on how long its employees live, how much salary they will earn when they retire (if the pension payments are pegged to their last drawn salaries), and how many of its present employees will stay on with the company till they are eligible for pensions. As you can imagine, determining the future pension obligations is an actuarial process - the plan administrator needs to make guesstimates about all these variables, much like the way insurers make guesstimates about how long people will live.

The administrator will also need to guesstimate when the cash needs to be paid out: how much will be paid out next year, how much for the year after that, and so on. For a pension plan to work, the administrator must set aside some money today for the future payouts each year. The amount company needs to set aside is not simply the sum of all expected benefit payouts, because money that you set aside today will earn interest (or it can be invested for capital gains and dividends) until it needs to be used to pay retirees. Because of this interest (or investment gains), the amount of money you need to set aside today is lower. To determine the amount the plan needs to set aside today, the administrator will discount all the future payouts by a discount rate to arrive at the net present value of pension obligations. Under accounting rules, the administrator is free to choose the discount rate that he/she wishes to apply, but as a principle it should be close to the risk-free interest rate or a conservative growth rate of an investment. This net present value of benefit obligations is the figure that is reported in the company's financial statements.

For a pension plan to be viable, two things must happen: (1) its current plan assets must be equal to (or more than) the net present value of its benefit obligations. This means that the money it sets aside today will be enough, after growing with interest or investment returns, to pay out benefits to pensioners when they are due to pensioners. (2) the calculation of the present value of its benefit obligations must be correct. This means that its actuarial assumptions must be accurate, and its plan assets must grow at the rate greater than or equal to the discount rate used in calculating the present value of benefit obligations.

Both the "present value of benefit obligations", and the "fair value of plan assets" are found in the notes of a company's financial statements. (Because these plan assets are legally separate from the company, they are not consolidated on the balance sheet). If a plan's assets are greater than the net present value of benefit obligations, then the plan is considered to be well funded. If the plan's assets are less than the PV of benefit obligations, then the plan is considered to be underfunded.

In either case, the "overfunding" or "underfunding" is calculated as the difference between the value of two accounts on the balance sheet: "prepaid pension costs" on the assets side, and "accrued benefit liability" on the liabilities side. If prepaid pension costs exceeds accrued benefit liability, then the excess amount is the the overfunding. If accrued benefit liability exceeds prepaid pension costs, then the excess amount is the undefunding. This difference between the two accounts is recorded in Shareholder's equity under "accumulated comprehensive income". (Comprehensive income reflect gains and losses e.g. from forex movements, that are recorded directly to shareholder's equity without going through the profit and loss accounts)

(Note 1: the net shortfall in funding may be less than the total shortfall reflected in the comprehensive income account, if it is shown. This is usually because of accounting adjustments and reclassifications.)

(Note 2: you won't be able to tell the net pension shortfall just by looking at the Net Accumulated Comprehensive Income in Shareholder's equity, because this is usually the net amount which includes other factors affecting comprehensive income, such as cumulative forex gains. The financial statement notes usually don't break out the balance of each compoacnent of the Net Accumulated Comprehensive Income in the Shareholder's equity)

How future (long-term) profits can be hit

There are two types of suprises that pension plans can spring on future profits:

1. Obvious danger: If a plan is underfunded, then it means that you can expect the company to need to inject cash into the pension fund sometime in future.
   
   
2. Hidden-lurking danger: If the discount rate used in calculating the PV of benefits is too high, then it is likely that the "present value of benefit obligations" is under estimating the amount of money that needs to be set aside today to meet the future obligations. If this happens, the balance sheet may not indicate an obvious underfunding even though the pension plan is actually in trouble. (The balance sheet amounts are based on the unrealistic discount rate assumption made by management.)

So what you see in the "fair value of plan assets", and the "present value of benefit obligations" accounts, and the discount rate used, will tell you if the company's future reported earnings are going to be hit by costs of funding pensions. These costs aren't seen in current earnings because of the nature of accrual accounting: such shortfalls are only recognized in the income statement (as a "net benefit expense") against earnings when the benefits, and its accompanying sufficient-or-insufficient assets, accrue to the employee as each year passes and his/her pension benefit increases because of the additional year of service. It is only at that point in time that the funding shortfall is moved from "shareholder equity:comprehensive income" to "shareholder equity:retained earnings".

How current (short-term) earnings can be manipulated

Each year, the income statement recognizes the additional pension benefits that accrue to employees for the extra year they have worked (service cost and interest cost), and the increase in plan assets from interest and investment growth. It also recognizes actuarial gains and losses (these are amortized over many years), which come about when actuarial assumptions have to be changed (for example, because employees are promoted faster than expected and become entitled to more benefits). The net difference between the increases in assets and increases in benefit obligations is the "net benefit cost". This is what the company needs to contribute to the pension fund for the year, and it affects the earnings for the year.

Unfortunately the way increases in plan assets are accounted for makes the "net benefit cost" susceptible to manipulation by companies who are trying to boost their headline earnings. Under current accounting guidelines, the increase in pension plan assets that is recognized in the "net benefit cost" each year is not the actual return on the plan's assets. Rather, the plan's assets are assumed to have grown by some fixed amount each year. This amount is the "expected return on plan assets" and is an assumption made by the company. Ideally, this rate would be close to the discount rate used in calculating the "present value of pension benefit obligations", so that the pension expenses recognized would be in tune with the overall pension plan's funded status. However, if a company wants to goose up its profits in the short term, it can simply increase the "expected return on plan assets" and reduce the "net benefit cost" for the year. This has the effect of increasing the company's earnings for the year.

However this earnings boost can only be maintained for the short term, because if the actual return on plan assets is less than the "expected return on plan assets", the the shortfall is booked to the balance sheet shareholder's equity under "comprehensive income". Once this shortfall exceeds some percentage (for example 10%) of the total plan benefit obligations, then any excess shortfalls in the "comprehensive income" account must be amortized to each future year's income statement through the "net benefit cost" under an entry called "gains and losses" or "amortization of actuarial gains and losses".

Useful links:
SFAS 158 (including SFAS87 - Employers' Accounting for Pensions)
SFAS 35 - Accounting and Reporting by Defined Benefit Pension Plans