No Sale: Liv-Ex Report on Low Interest Rates & Bordeaux’s Dismal New Normal

bigstock-no-sale-280I have sometimes made fun of my wine collector and investor friends, saying that they are engaged in what Thorstein Veblen might have called “Conspicuous Non-Consumption.” They buy some fine wines for the purpose of not enjoying them in the glass, or so it seems at times.

Owning the wines and visiting these great wines in their climate-climate-controlled secure storage lockers is pleasure enough. Drink them? Horror! Then they’d be gone! OK, I know it is more complicated than this, but  you get the idea of the joke.

Not For Sale

Now a fascinating report from liv-ex.com, the fine wine market trading platform and research center, suggests that non-drinking of great Bordeaux wines must be considered along with another phenomenon that would make even Veblen scratch his head: producers who make a business of not selling their wines. Or not selling very much of what they produce.

livex“Final Thoughts on Bordeaux 2015” is the title of a Liv-ex report that tries to make sense of the recently concluded Bordeaux en-primeur campaign. This year’s market for 2015 wines was unusually complicated, the report indicates. Vintage quality varied greatly by sub-region, for example. And while critics gave the wines high markets overall, they didn’t do so consistently, which is important since the speculative value of a 97 score (Suckling’s overall rating of the vintage) is very much greater than 94 points (Wine Spectator‘s evaluation).

Add to this exchange rate changes in the run up to the Brexit vote and you have a recipe for confusion. But all of this doesn’t really explain the fact that seller prices were well above what the market expected and so not much wine changed hands (at least compared with a few years ago). The opportunity to re-set the market, which the Liv-ex analysts had anticipated, was apparently wasted.

High Taxes, Low Interest Rates

This wasn’t a universal situation, the report makes clear. 2015 was the best vintage ever for some producers and the market accepted the higher prices. And some producers offered necessary discounts to move their stocks. But many raised prices and seemed content with meager sales and big retained stocks. Why?

The answer, according to Liv-ex, is complicated and begins with today’s historically low interest rates, which make the cost of carrying inventory low. Fine, but don’t they need to sell wine to pay costs? Yes, Liv-ex explains, but the margins on the grand vins are very high and so most costs can be covered quickly with an initial tranche of sales. Second- and third-wines provide additional cash flow.

France’s high tax rates are also mentioned — postponing revenue is also postponing taxation (possibly until a more business-friendly administration takes office).

A Different Economic Model?

But perhaps the biggest factor, which contributes to the “new normal” that Liv-ex sees, is a change in the economic structure of the business. Profits from making and selling wine are now less important than maintaining and advancing the capital value of the chateau itself. Selling wine at a lower but very profitable market price is old news. Raising price to enhance reputation and capital value is the new strategy.

The Liv-ex study notes that

“Priorities have shifted from making sales and generating cash flow to trying to maximise prices (of the grand vin in particular) and by extension the capital value of their properties. Indeed, …  the motivation to generate profits is dwarfed by that of keeping land values high. … Owners have achieved this by releasing smaller quantities onto the market and spreading their production across a second and sometimes a third label.  … Many commentators ascribe this trend to deep pockets. It is true that most top chateaux these days are owned by billionaires and insurance companies, but this has always been the case. The main motivation for the strategy is exceptionally low interest rates.”

The combination of the factors described here combined with similar incentives for the negoçiants results in prices generally above what consumers are willing to pay, the Liv-ex study concludes. The 2015 Bordeaux market was an improvement over 2014, but this is a “low bar,” the study says. “Moreover, for as long as the current environment — distorted by low interest rates — persists, there will continue to be a standoff … ” between supply and demand.

Hotelling’s Rule Alternative

The Liv-Ex researchers study Bordeaux closely, so their theory is probably correct, but as I read the report I couldn’t help thinking of one of the most famous microeconomics theories of the first half of the 20th Century: Hotelling’s Rule, named for Harold Hotelling. Hotelling was interested in the rate at which a firm exploits a finite resource that it owned, assuming the usual (for economic theory) perfectly competitive market environment.

To over-simply, the objective is to maximize the present value of the finite resource and so the short-run production decision depends on whether market price is expected to rise faster or slower than the rate of interest. If price is expected to rise faster than the rate of interest, it paid to hold back production for the future. If price is expected to rise more slowly than the rate of interest, then selling now and investing the returns makes more sense.

Under theoretical conditions, the equilibrium occurs when market price rises at an exponential compound interest rate.

A given vintage of a particular wine is indeed a finite resource to be sold today or sold tomorrow. Interest rates today are extremely low and so only very modest expected price increases are necessary to induce a winery to hold back stocks. At zero interest, prices need only remain steady to make stock-building a viable strategy.

The incentive to retain inventory is stronger than this, in fact, because the Bordeaux fine wine market is not perfectly competitive and restricting supply of a particular classified wine raises its current price. So in fact withholding stock may allow a wine firm to have its revenue “cake” today (scarcity premium for the wine that is sold) and eat it tomorrow, too (in the form of future sales of the retained inventory at prices above the low compound interest bar).

All else being equal, when market interest rates inevitably rise, this will shift the calculation towards current sales. But in the meantime, No Sale is the name of the game.

Logical Extreme: No Sale

I don’t think this application of Hotelling’s Rule is a better explanation than the Liv-Ex analysis or inconsistent with it, but it does open up a different way of thinking — looking at the situation in terms of the present value of the income stream.

It is possible to take this way of thinking too far, however, which is what New York Times columnist Frank Bruni hilariously did earlier this year when he wrote an “April Fools” column about college admissions. He announced that Stanford University had taken selective admissions to its logical extreme … and admitted zero percent of its applicants!

Because it was now totally unattainable, Bruni reported, Stanford was even more ardently desired than before and admission applications and strategic financial donations poured in. In Bruni’s fictional world, zero admission “sales” maximized Stanford’s reputation and revenue stream. Wow!

I wonder if that would work with wine? Whatever you do, don’t let the folks at Lafite, Latour and Margaux read Bruni’s column.

Good News & Bad News from Oz

Sometimes the good news is that the bad news could be much worse. At least that’s how it seemed to me when the wine economists met at UC Davis last week to discuss the continuing Australian wine crisis.

Kym Anderson, a leading expert, spoke about the problems in Oz at the symposium on “Outlook and Issues for the World Wine Market” and I thought his assessment of the “challenges” Australia faces was pretty grim.  Big oversupply. Falling grape prices. More and more quality grapes sold off at fire-sale prices in the bulk market (40% this year compared to 15% in the past).

The best selling white wine type in Australia isn’t from Australia any more — it’s Marlborough Sauvignon Blanc. Even the Australians are tired of “Brand Australia” Chardonnay!

Maybe, Baby

Professor Anderson looked for a light at the end of the tunnel and was able to point to some potential sources of relief. Maybe water reforms could be implemented. Maybe R&D to help the industry deal with climate change would produce results. Maybe the new export strategy to promote Australia’s regional diversity and wine families would catch on. Maybe the China market will open wider and drink up the surplus.

Since the bad news was so compellingly concrete and the hopeful notes so speculative, I took the overall forecast to be very dark indeed. Imagine my surprise, then, when I attended a talk by another Australian expert the next day who described  Anderson’s presentation as optimistic! When the good news is this bad, the bad news must be really bad.

Bad News, Bad News

Sure enough more bad news arrived shortly thereafter in the form of a Wine Spectator article, “Aussie Wine Company Faces Angry Creditor,” concerning the financial problems of The Grateful Palate group, which exports many hot brands to the U.S. market including the unlikely-named Luchador Shiraz shown here.

Trouble is brewing in Australia. The Grateful Palate’s Australian affiliates, which produce wine under labels such as Bitch Grenache, Evil Cabernet Sauvignon and Marquis Philips for American importer Dan Philips, are in receivership and face the danger of possible bankruptcy. Growers and other creditors for the South Australia-based affiliates of the company received notice on June 18. Many growers, already facing tough times, worry that they’ll never get paid for fruit they sold Philips.

Philips, the company’s founder and owner, confirmed that he is in negotiations with his top creditor, Dutch lender Rabobank, but declined further comment. The bank initiated the action to put Grateful Palate International Pty Ltd and several related Australian companies into receivership. The most prominent is R Wines, a partnership with winemaker Chris Ringland, but 3 Rings, a joint venture involving Philips, Ringland and grower David Hickinbotham, is also part of it.

This is bad news, of course, but bad news is no longer a surprise to those of us who are following the Australian wine scene. Perhaps it is really good news of a sort — an indication that the necessary industry shake out is gaining speed. Hard to tell good news from bad.

Darker or Brighter?

The same situation applies to the Foster’s de-merger situation. Foster’s, the Australian beer giant, bought into the wine business at the top of the market, paying an estimated $7 billion for an international portfolio of about 50 top brands including Penfolds, Wolf Blass and  Beringer. The investment may be worth as little as $1.5 billion in today’s market.

Foster’s beer business is an attractive target for global giants like SABMiller, but not with the wine portfolio attached. So Foster’s announced a de-merger to allow the beer group to move ahead independently of the wine group. What will happen to the wine business?  Who will buy these assets in today’s depressed environment?

When I posed this question to an Australian winemaker several weeks ago the answer came back quickly: China! Everyone in Australia is paranoid about the Chinese buying up our natural resources, and so we are convinced that they will buy up Foster’s wine business, too.

Interesting idea, I thought at the time. No multinational wine firm (Constellation Brands? Gallo?) would want to go bigger right now. But maybe a Chinese firm that wants to break into the global markets would take the bait. Might make sense. Maybe.

Bright Idea

Sure enough, the Bright Food Group. (Mission: “To build the company into a leading enterprises group in the national food industry, with famous brands, advanced technology, strong competitive power and deep influence in the world by the end of 2015.”)  recently signed a three-way memorandum of understanding with the New South Wales government and the China Development Bank to explore opportunities for the Bright Group to invest in the sugar, dairy and wine industries.

A Financial Times article reports that  the company is interested in “global top ten players in wine, sugar, food packaging, commodities and healthcare sectors.” Bright Food is currently studying both wine and beer assets in Australia, but has not decided to buy either yet according to the FT.

Many Australians no doubt consider the potential sale of yet another natural resource business to Chinese buyers bad news in terms of their economic sovereignty, but that bad news might actually be the best news they can expect given the sorry condition of the global wine market today.

Myth of the Level (Vineyard) Playing Field

Terrain matters, both in wine and in markets.  Many of the world’s best vineyards  cling to hillsides or follow natural contours (like the famous Pewsey Vale vineyard shown here).

While wine people seem to appreciate the challenges and opportunities that complicated terrain presents, economists are drawn (at least metaphorically) to tabletops. We think of the world in competitive terms and seek out “level playing fields” where our favorite theories are most applicable.

The Difference Between Vineyards and Soccer Fields

As a wine economist, I can appreciate the flat and the steep of the wine world and I have come to upon a particular irony.  Wine market reforms in the European Union are intended to create a level playing field and to encourage, induce and sometimes force winegrowers to compete. The days of big subsidies and routine “emergency” distillation are gone, or will be soon, we are told.

But wine markets are as complicated as the vineyard shown above and establishing a flat competitive arena is not a simple matter.  Wine markets are more like vineyards than we like to think.  Tariffs, quotas, subsidies and selling regulations can be brought into line, of course, but that is just the beginning. The uneven contours of the market run very deep.

Whither/Wither the Vines?

I was reminded of this by a recent post on the Tablas Creek Vineyard Blog titled “Whither inexpensive, artisanal California wine?” (Tablas Creek is a well regarded maker of Rhone-inspired wines in California’s Paso Robles area.)

The question that the article posed was whether it made economic sense for the winery to develop a new vineyard property to produce high quality reasonably priced wine (the $20 price point plus or minus a few bucks). The answer? Probably not, but with a rather thorough cost analysis provided so you can see how the various factors (land cost, debt service, planting cost, operating cost, even opportunity cost) factor in.

It’s a really good article for anyone who thinks that the decision to start of vineyard or a winery is an easy one.  (The sommelier  in the video above would do well to read it!)

At the end of the day, the single most important factor was the cost of the land. Even in a depressed market, land costs create a hurdle too high to overcome in Paso Robles.

(Note: I was also struck by planting and operative cost differences associated with dry farming the vines. Much lower cost, somewhat lower yields — worth serious consideration where feasible given the growing water shortage.)

Why are vineyard land prices so high that they make the vineyards themselves uneconomic?  Well, the land has many uses aside from the obvious one of growing wine grapes. Speculators might want to buy it to hold and resell, not operate for the long run. Lifestyle investors push up the price because they consider the amenity value of a vineyard home more than the economic value of its grape crop. These alternative demands can push the price above the level growers can afford.

Tilting the Playing Field

This distorts the playing field on which international wine markets operate. Land costs are a big factor for many expanding New World wineries because those costs are so recent that it is difficult to ignore them.

Land costs are often ignored for Old World producers, I am told — especially the thousands of small winegrowers who have owned their land for several generations. Ignoring the cost of capital allows them to sell for less, depressing prices (and therefore, ironically, the value of their land, too).  Poor economic choices in the Languedoc tilt the playing field against Paso Robles.

But the loudest cries I have heard in this regard are from Australia, not California, where vineyards that produce grapes for bulk wine find themselves more directly in competition with those economically untutored Languedoc vignerons. The low prices that result when French winegrowers ignore the cost of vineyard capital are not the only or even the biggest source of Australia’s current crisis, but they are certainly a contributing factor.

Time to Invest in Wine?

October. This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August, and February.” — Mark Twain, Pudd’nhead Wilson (1894)

I wonder what Mark Twain would say about speculating in wine in October, May or any other month? I expect he would be suspicious of the idea. Mark Twain was a great author but a lousy investor. His cautious attitude toward investment was based upon his own disastrous financial experiences.

I was reminded of this quote this morning when I opened the New York Times “Special Section on Wealth & Personal Finance.”  The cover features a half-page color image of an exploding cherry pie (or maybe it’s strawberry — what do you think?). I am not really sure what it means.

What Time Is It?

But the theme of the special section is pretty clear — time to consider alternative investments and investment strategies.  And on page 4 I found the article that got me thinking about Mr. Twain’s investment advice: Investing in Wine: Now May Be the Time by William L. Hamilton. It’s an interesting article — click on the link to read it.

The idea, of course, is that wine prices have been falling, so this is an opportunity to buy in at the market bottom.

“It’s a great time to buy wine, the best time in a decade,” said Charles Curtis, who is in charge of Christie’s North American wine department. “People we’ve never heard of are jumping into the market, taking advantage of the lull to get into collecting, now that they have access.”

I am naturally a bit suspicious of buying advice given by people with an interest in the sales.  They always seem to think that now is the time to buy.  Rising prices? Buy now because they can only go higher.  Falling prices? But now before they rise again.  Mr. Curtis may be right, and I’m sure his recommendation is honestly given, but he might be wrong, too.

Uncommon Times

These are uncommon economic times and market changes are unusually hard to predict, which makes investing even in fine wines feel a bit speculative. Alfred Marshall, the great Cambridge economist, argued that markets are generally as stable and predictable as an apple in a bow. Prices fall when there is a surplus until the excess supply is gone. Prices rise when there is a shortage until the shortage disappears.  The movement towards stable equilibrium is quite strong and predictable.

But wine markets today look a bit more unstable — more like that exploding pie now that I think of it.  Here’s another quote from the New York Times article.

Though falling prices kept many collectors from selling, reducing the amount of wine on the market, returning prices in the last four months have produced an uncomfortable volume of wine to sell, said Charles Curtis of Christie’s.

The first part of the sentence describes how a market responds to surplus  — falling price causes sellers to pull some goods out of the market.  The second part describes a market in shortage — the opposite condition — where rising price brings sellers into the market. This is not a combination of forces that you expect to see in the same paragraph much less the same sentence.

There are a number of supply-demand changes that could account for this (Econ 101 students — do your stuff), but one distinct possibility is what economists call over-shooting, which is a characteristic of some financial markets and especially foreign exchange markets and maybe now wine markets.  When over-shooting occurs, prices don’t drop smoothly to equilibrium like an apple in a bowl. Rather they over-shoot the equilibrium and then shoot back up. Back and forth, sometimes in increasingly unstable cycles. Market equilibrium and the “true market price” are hard to determine.

It is difficult to know where prices will go next in a market like this and the difference between “investing” and “speculating,” at least in the short run, is not completely clear. I don’t give investment advice (or rate wines, either, which makes this an unusual wine blog), but I’m not planning to rush into high end wine markets just yet. Too risky for me.

Investors vs Collectors

But then I’m not really a wine investor.  In my reading I find the terms wine investor and wine collector often used as synonyms, but I’m not sure they should be.  A wine collector buys what he or she wants to own (and, presumably, drink). It’s a personal thing. A wine investor should buy what other people will want to own, which might have nothing to do with personal taste.  I have known only a few real wine investors but lots of wine collectors who  justify at least some of their purchases as investments, but don’t manage them as they would a real investment.

In today’s market, however, both groups need to realize that there is a significant speculative element to their wine purchases and keep Mark Twain’s 115 year-old warning in mind!

Note:  Stephen Bachmann at Vinfolio posted an interesting reponse to this article. Click here to read it.

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