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Today's Market WrapUp |
The Perfect Storm
The Halloween storm of October 1991 was caused by a rare event seldom seen by meteorologists. Three storms, an artic cold front, a nor’easter, and a hurricane met out at sea to from one giant perfect storm. We now have the same potential in the energy markets. A strike in Venezuela, a possible war in Iraq, and a cold winter in the Midwest and Northeast could form together and give the US its next energy crisis.
As this WrapUp was being written, crude oil prices jumped $1.40 in the futures markets to $31.70 a barrel with heating oil jumping $3.65 to $89.60. The problem with oil is that the world oil markets could withstand a disruption of one large source of oil but not two. We currently have one large source of disruption with the workers strike in Venezuela. The next possible disruption could come because of war with Iraq. ABC did a report last week that stated it is widely believed Saddam Hussein has mined his energy infrastructure and would blow it up if attacked by American and British forces.
The outcome of war is never predictable, especially with a war in the Middle East where oil is a key commodity. If a supply disruption resulted because of war with Iraq, the world oil markets would skyrocket. You already have one supply disruption in Venezuela. If Iraqi oil flow was disrupted as result of war or if Saddam damaged his own oil infrastructure as a result of war, there would not be enough spare capacity to make up these disruptions. As the table below shows, most of the world’s spare oil capacity is located in the Middle East and within OPEC.
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Region |
Production Capacity |
Estimated Production |
Unused Capacity |
| Persian Gulf OPEC | 24.1 | 19.6 | 4.5 |
| Non-Persian OPEC | 10.3 | 9.3 | 1.0 |
| Total OPEC | 34.4 | 28.9 | 5.5 |
| Non-OPEC OECD | 20.2 | 20.0 | 0.2 |
| Former Soviet Union | 7.4 | 7.4 | 0.0 |
| Mexico | 3.7 | 3.3 | 0.4 |
| Other Non-OECD | 14.6 | 14.4 | 0.2 |
| Total Non-OECD | 25.7 | 25.0 | 0.6 |
| Total Non-OPEC | 45.9 | 45.0 | 0.8 |
| Total World Source EIA | 80.2 | 73.9 | 6.3 |
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Source: EIA |
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As the above table illustrates, the only real spare capacity in energy lies within OPEC and mainly in the Middle East. What replaces oil if two major oil suppliers, Iraq and Venezuela, are taken out of production? Is it alternative fuels such as natural gas? The answer to that question is there is no alternative fuel now to replace oil, not even natural gas. The world and especially the United States have become too dependent on imported hydro carbons. Therefore, any disruption because of war or strikes will most certainly send the price of energy soaring, acting as an additional burden to weak economies around the globe.
The situation in energy without war or strikes is only going to get worse throughout this decade. The current unfolding crisis will be the second energy crisis of the new decade. As the world population increases, demand for energy will rise along with it. World population is expected to grow from just above 6 billion to 8 billion in the next two decades. In the last decade, we added over 700 million people. We have added as many people to the world base in the last two decades as existed in 1890. More people means more energy use. While western energy analysts look mainly at western energy growth, they ignore the explosive growth in energy use occurring in the rest of the developing world. Despite the much-hallowed cry for energy conservation, there are very few things that can be conserved that could help us avoid another energy crisis. Warm sweaters, more efficient cars and refrigerators, and solar panels on rooftops will not solve the problem. In the meantime, the world will be woefully dependent on imported Middle Eastern oil and subject to all of the vagaries of its geopolitics.
The problem is not just one of environmental constraints, which keep us from solving the problem. Added to the problems of environmental extremism, which dominate much of the energy debate, there is also government interference in the market place with my own state of California as prime example. The other issues, which have not been addressed, are the assumptions made by government, academic and industry beliefs that supply is abundant and that prices will steadily fall. It is unfortunate that these misconceptions are widely held, because they bring us to another crisis in a very fragile energy world of growing demand and shrinking supply of cheap energy supply and alternatives.
The Bear is Coming After California
This brings me back to my own state of California, which I believe is about to face another energy shock. California is a high consumer of all forms of energy—oil, natural gas and electricity. The state has a very high demand for all forms of energy with very low domestic energy supply that keeps getting shorter thanks to environmental restrictions. Although heavily dependent on outside imported energy, California is embarked on an environmental crusade at a time when it is the nation’s number one and two consumer of all forms of energy. It is number one in the consumption of gasoline and residual fuel oil. It holds the number two position in consumption of natural gas, aviation fuel and distillate fuels. We are the country’s fourth largest oil producer with nine of the nation’s largest oilfields. The state has done very little to increase supply, while demand keeps rising. Consequently, California must import over 50 percent of its oil needs and 84 percent of all of its natural gas needs. While demand keeps rising and the state keeps building new gas plants (not enough to meet energy demand), it has done very little to build a natural gas infrastructure to supply these new power plants. This includes expanding the state’s grid system.
Unfortunately for California, the state’s problems will only get worse. In addition to having a major energy problem, it also has massive budget deficits. Now that the state’s governor has won reelection, the true position of California’s budget problems have been revealed. Starting with a $10 billion budget surplus when he took office, Governor Davis reported last week that the state now faces a budget deficit of $34.8 billion. The budget deficit is the result of declining capital gains tax revenues and a 35 percent increase in state spending by the Davis administration. Experts warned the governor that the capital gains tax revenues were not permanent. He had been warned by budget analysts not to spend money since the revenue increase from California’s tech industry would not be permanent. The governor ignored the warnings and now faces both a budget crisis and an energy crisis. Ironically, the architect of California’s failed electricity plan, former lawmaker Steve Peace, has now been appointed by the governor to solve the budget crisis. The Peace plan for deregulation forced utilities to sell their power plants, it fixed the price of energy, prevented the utilities from locking in long-term contracts for energy, and did very little to increase supply and expand infrastructure. Many of the state’s budget woes can be traced back to the Governor and Peace’s deregulation plan. I can just imagine what awaits the state with these two now tackling the budget deficit.
State residents have been warned that more tax increases are on the way. Residents of the People’s Republic of California will be stuck with a larger, more expensive bureaucracy, fewer services and higher taxes to pay for all of it. At a time the state will be facing its next energy crisis, there will be no money left to build, expand and increase its energy infrastructure and supply of energy.
As California Goes... So Goes The Nation
Why this is important is that many of the problems facing California will also face many other states of the nation. California’s economy is between the fifth and sixth largest economy in the world. With experts predicting strong economic growth next year and a recovery in the market, it is hard to visualize that happening judging by what I see here in the golden state. You can’t build prosperity on regulation, taxation, and debt, of which the state has plenty of all three.
Greenspan Talks About Monetary Policy
One final issue I wanted to cover before taking time off for the holidays is the Greenspan speech last week. Many others have analyzed this speech, but here are my two cents. The first thing that struck me about this speech is the admission by the Fed chief of the failure of monetary policy. By his own admission, he stated that under the gold standard, prices in 1929 weren’t much different than they were in 1800. After 1929, prices doubled. Then in the next forty years, they quintupled. In his own words, “…a fiat currency is subject to excess.” He then goes on to defend a prudent monetary policy as being able to contain inflation. I don’t know if I would call prices doubling and then quintupling as prudent and containing inflation. When my father first came to this country, it was possible to support a family on the wages of one spouse. Today for most American families the husband’s wages pay the bills and the wife’s salary goes to paying the taxes. I would hardly call that success. Taxes and inflation are now a burden that most families face. Unfortunately, that burden is paid for by taking on even more debt. Greenspan warns that if deflation were to take root, the mounting debt levels in this country “would convert the otherwise relatively manageable level of nominal debt held by households and businesses into a corrosive rising level of real debt and real debt service costs.” Both inflation and deflation “are in the long run monetary phenomenon.” He fails to mention the inflation that is taking place in the stock market, bond market, mortgage market, real estate, and consumption.
The stock market has only begun to deflate; while the bond, mortgage, consumption, and real estate markets are the next bubbles to deflate. The next issue he addresses is the problem of nominal wages. If wages don’t adjust downward to match the downward spiral in prices, then “nominal wages being restrained from falling could increase as price inflation moves toward or below zero. In these circumstances, the effective clearing of labor markets would be inhibited, with the consequence being higher rates of labor employment.” It is already happening. Current polices pursued by government and labor to keep real wages high in relation to falling prices will lead to higher unemployment rates. This is what occurred during the Great Depression. We seem to be following Santayana’s dictum that those who don’t study history are doomed to repeat it.
Greenspan then goes on to reiterate Fed options if short-term-interest rates head to zero. He points out how between 1942 and 1951 the Fed pegged long-term Treasury’s at 2-1/2 percent. After discussing asset bubbles, he goes on to say that they are difficult to detect even though it is the Fed who is responsible for creating them. The Fed Chairman says that even if they could be detected, trying to stop them would only create bigger problems. He warns that, “In fact, history indicates that bubbles tend to deflate not gradually [NASDAQ] and linearly but suddenly, unpredictably, [ten-sigma] and often violently.” He then goes on to say that “… the Fed is powerless to contain them because of adverse consequences. The degree of monetary tightening that would be required to contain or offset a bubble of any substantial dimension appears to be so great as to risk unacceptable amounts of collateral damage to the wider economy.” Instead, the Fed has chosen to create additional, if not multiple, bubbles in their place. The mortgage, consumption, and real estate and bond market bubbles have now replaced the stock market bubble, which has not yet to fully deflated. One would have to wonder how the Fed would answer when the bond market, mortgage, consumption, and real estate bubbles begin to unwind.
Perhaps the most telling statement in Mr. Greenspan’s speech is the most frightening when you consider this Grand Experiment the Fed has embarked on. “Weaving a monetary policy path through the thickets of bubbles and deflations and their possible aftermath is not something with which modern central bankers have much experience.” In other words, we don’t know what we are doing.
The rest of the speech warns of possible danger of the tremendous mortgage debt of homeowners relative to their income. He dismisses this danger because of the rapid rise in housing prices and the degree of low interest rates. What happens, however, if housing prices collapse or interest rates rise? I bring this up only because the same arguments were made during the tech bubble regarding margin debt and excessive prices for tech stocks. Since the bubble burst, $8 trillion in stock market value has been lost. Compare this loss to what might have been avoided had monetary policy been prudent, to use the Fed chairman’s words. Instead of allowing the bubble to inflate and then follow it by additional bubbles, would we not have been better off by an ounce of prevention?
As to the eventual outcome I would like to quote Frederick Hayek from his “Monetary Theory and the Trade Cycle, “ … Far from following a deflationary policy, Central banks, particularly in the United States, have been making earlier and far more, far-reaching efforts than ever been undertaken before to combat the depression by a policy of credit expansion-with the result that the depression has lasted longer and has become more severe than any preceding one.… But instead of furthering the inevitable liquidation of the malinvestments brought about by the boom during the last three years, (late 1920’s) all conceivable means have been used to prevent the readjustment from taking place; and one of these means, which has been repeatedly tried though without success, from the earliest to the most recent stages of depression, has been the deliberate policy of credit expansion… To combat the depression by a forced credit expansion is to attempt to cure the evil by the very means which brought it about; because we are suffering from a misdirection of production, we want to create further misdirection – a procedure which can only lead to much more severe crisis as soon as the credit expansion comes to an end.” To that end is where Greenspan’s Fed is leading us. Please take note of this credit expansion graph... it tells the story.
When you hear all of the talk about next year’s second half recovery and stock market rebound, remember it will be the fourth year that this forecast has been made. Just look at the possibility of war and higher energy prices, mounting debt levels, and rising bankruptcies. In my opinion the markets have some very serious discounting to do next year.
Watch List for The Holidays and First of the Year
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Watch energy prices, Venezuela & Iraq
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Watch the Christmas retail sales reports, actual numbers year-over- year and not estimates, which will be beat or exceeded.
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Watch for a build up in inventory. If the merchandise isn’t moving, inventory levels should rise or remain high.
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Watch job layoffs. If they keep increasing, it means business conditions remain weak and so will capital expenditures.
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Watch profit warnings. It takes profits to drive capital spending. No profits -- no capital-spending boom.
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Watch the dollar, the price of gold and the CRB Index (which just hit another new high today to close at 238.26.
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Finally, watch for U. S. Preparations for war.
Today's Market
Today's Casino action was a mixed picture. Technology stocks rallied; while blue chips faded. The S & P 500 and the NASDAQ rose; while the Dow Industrials, Transports, and Utilities all fell. Within the markets, the price of crude oil hit a record high for the year; while gold prices advanced with a strong showing at the end of the session. Investors and Wall Street are hoping for a Santa Claus rally. Economic reports out today showed that consumption is still rising at 0.5 percent. Income only rose 0.3 percent which means consumers are still borrowing money to live and pay their bills each month. Retailers fell on news that this Christmas season is turning out to be weaker than expected. Financial stocks led by Citigroup fell as many banks increase their loss reserves for loan defaults and lawsuits over conflicts of interest. Citigroup set aside $1.5 billion to cover the cost of settlement with the government and future contingencies from investor led lawsuits.
In other markets the dollar fell 0.1 percent, gold and commodity prices, especially crude oil and heating oil rose, and the CRB hits another record for the year. Oil rose over fears of war with Iraq and the strike in Venezuela which is now entering its 22nd day.
Volume was low because of the holiday-shortened week. It now appears, despite any year-end rally, that the major averages are headed for their third straight year of double-digit losses. The S&P 500 is down over 22% this year -- something we haven't seen since 1974. Winners and losers were abut even on the NYSE. The VIX fell 2.14 to 29.33 and the VXN dropped 2.62 to 45.89.
Overseas Markets
European stocks rose amid speculation profits at oil companies such as BP Plc and Royal Dutch Petroleum Co. will benefit from a 15-month high in crude prices. British Airways Plc and other airlines fell on concern that fuel prices will increase, crimping earnings growth. The Dow Jones Stoxx 50 Index added 0.7 percent to 2473.57, with oil stocks accounting for about three-quarters of the advance.
South Korea's Kospi index dropped to a one-month low, led by Korea Electric Power Corp., Korean Air Co. and other companies that import oil, after crude prices surged. The Kospi lost 2.6 percent to 691.38, the lowest since Nov. 21. Hong Kong's Hang Seng Index dropped 0.6 percent.
And Finally...
This is my last WrapUp for the year. I won't return to my keyboard until January 6th. We do plan on continually adding content to our site throughout the vacation period. We have several editorials to post. All of our resource pages will also be updated. Soon we will post our 2002 favorites. Be sure to visit the Expert Archive during these next two weeks as we will only keep our top 10 of the year.
One of the advantages of living here in southern California is that it is one of the few places in the world that you can go sailing on Christmas and New Years with a sweater or light windbreaker. I intend to catch up on my sailing which has been greatly neglected these last few months. There is nothing like a stiff winter breeze, a sunlit sky and plenty of fresh salty air to invigorate the mind.
I would like to thank you, our friends of Financial Sense, for helping our website grow almost 800% this year. For all of you, we are truly thankful. I hope the New Year finds you prosperous and healthy. Remember, one of my favorite sayings, "One man's winter is another man's summer," when it comes to investing. Make a New Years resolution to study market cycles and in particular, "Things." It is time to be out of paper and into "Things," because that is where the new bull resides.