"Today's Daily Reckoning"
London, England
Thursday, August 7, 2008
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*** The two ways to play a correction...bargains, or traps for the unwary?
*** The Butch and Sundance of the financial markets...the clumsy, backwards-walking economy...
*** The whole world is slowing down...another farcical chapter in the history of the War on Terror...and more!
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The next big trend, dear reader...
It’s coming. Consumers – especially the baby boomers – are about to change their way of looking at things. And when Bernanke & Co. realize what is happening, they will greet the new trend like the citizens of Atlanta welcomed Sherman.
“War is hell,” said the yankee general, before burning the city down. So is a correction.
Yesterday’s news brought more details. The Dow rose 40 points. Oil remained where it was. Gold lost $3. And the dollar seems to be strengthening a little against the euro. You can now buy a euro for only $1.56.
“Retail sales stall,” is the word on the street, coming from Bloomberg . Of course, we already knew it. Restaurants are serving fewer meals. Malls are losing tenants. U.S. automakers are desperate to move their vehicles off the lots.
“Big three face bankruptcy fears,” is the headline from CNN/Money.
There are two ways to play a correction, as we mentioned yesterday. (Or forgot to mention?) You can look for bargains as investors sell off their losing positions. Or, you can take a vacation. Read War and Peace ...in Russian.
Here at The Daily Reckoning , we’ll take Option #2. We like doing nothing. It gives us time to think.
Many investors, on the other hand, are sure they are looking at the Opportunities of a Lifetime. They see Fannie and Freddie, for example, and remember when the stocks were trading over $60. “What a bargain they are now!” they say to themselves. Or look at Wall Street. J P Morgan, Lehman Brothers, Bear Stearns...they’re all selling at big discounts.
And don’t forget the nail bangers. The housebuilders were the first to get nailed. Their stocks got sold off; investors lost billions in just a few months. But take a look at the builders now – hey, maybe they’re coming back! ‘No guts, no glory!’ ‘Go for it!’
Yesterday, one of the biggest builders, DR Horton, reported a $400 million loss for the third quarter. While it is possible that we’ve seen the worst in the housing sector, it is also possible that the sector will never bounce back – at least, not in our lifetimes. Nor will Wall Street. The bargains, in other words, could turn out to be traps for the unwary.
How could that be? We’ll explain.
Over most of the last century, housing prices followed GDP growth and inflation. Nothing more. And it makes sense that they would. Housing is the number one consumer item. Consumers buy as much housing as they can afford – but not more. What happened in the 10 years – 1997-2007 – was an aberration, an unnatural freak caused by a rare conjunction of various absurdities. The dollar-based financial system...the collapse of the dotcoms...9/11...Asian export-mad economies...Alan Greenspan – all conspired to bring about a huge run-up in housing prices and consumer debt.
The two circumstances – like Butch Cassidy and the Sundance Kid – worked together. One kept his firearm on the bank manager, while the other cleaned out the vault. Consumers were able to borrow vast amounts, because their major collateral – their houses – was rising in value. And with the extra credit, they were able to buy more houses!
But the two desperadoes met their end, it is said, like Che Guevara, gunned down by the federales of Bolivia. And once they were dead, they were dead forever.
So too, our guess is that the bubble in housing and lending is over. If not forever, at least for a long time. Credit or interest rate cycles tend to last a long time – about as long as an investor’s career. High-grade yields reached a peak in 1920 and then retreated until after WWII. Then, they rose again...for the next 35 years. Since 1981, they’ve gone down...at least for 22 years...maybe longer. One generation is convinced that interest rates always go up. The next is sure they always go down. One thinks credit gets easier and easier. The next knows it will never be able to borrow another dime – and doesn’t want to. One generation forgets what the generation before it just learned. That’s the credit cycle.
But what did U.S. consumers learn during the last great credit cycle? What are they learning now?
One of the surest ways to make money in the last 10 years was to buy a house. The baby-boomers, especially, saw home ownership as equivalent to saving for retirement. Houses always went up in price; everyone knew that. If you had enough houses you didn’t need any money in the bank. A popular retirement planning technique was to buy a second house at the beach in your ’40s or ’50s. And then, when you were ready to retire, you could sell the main house.
But this is where the Next Big Trend comes in. The baby boomers are suddenly realizing that houses are not the same as savings. And they’re suddenly facing up to the idea of financing their retirements in a world of declining house prices...and rising costs.
“Home energy prices are expected to soar,” reports the New York Times .
What will they do? First, they will be forced to go back to saving. They won’t like it. But they will have no choice. They need money for their retirements. And the only way they can get it is by reducing their spending and saving more.
We know what you’re thinking, dear reader. You’re thinking – “it’s about time!” We’re thinking the same thing. Americans desperately need savings...capital...resources.
But we’re thinking something else too – that the U.S. economy of the last 20 years was built on excess consumer spending. Savings rates went from around 9% of GDP down to zero. Now, if they go in the opposite direction – and they must, in our opinion – the drop in consumer spending will cause the worst recession since the ’30s. We’re not just saying that to be provocative. We can add two and two. Subtract 9% from an economy that is growing at, maybe, 2%. Do that over a period of 10 years (the boomers don’t have to save just one year...they have to save every year). Of course, it isn’t quite that simple. When money is saved it doesn’t disappear. Some of it is re-invested in the real economy, leading to more jobs...more output...and growth. But it takes time to convert a consumer economy into a more balanced economy. And it takes time to pay off debts...and write-off mistakes. In the meantime, you have an economy walking backwards for a long time. And probably tripping over something along the way.
But wait. Will the Bernanke Fed allow it? Will the Obama administration permit a serious, multi-year recession? How will they try to prevent it? What will happen when they do?
Ah...we’re glad we don’t have time to answer those questions today. Stay tuned for tomorrow...
*** Japan says it is in recession. China says it is trying to avoid a slowdown, by loosening credit restrictions. The United States is probably already in a recession; its central bank is giving away money to try to get out of it. So is the U.S. government. Britain is falling into recession too; the IMF warned Britain not to cut rates to try to save itself. Europe must not be far behind...with the lowest consumer confidence numbers in memory.
The whole world is slowing down.
But commodity prices, while retreating, are still up for the year. Copper is 14% ahead of last year. Gold is up 5%. Aluminum is 23% more expensive.
Tanker rates are falling; tanker captains have been told to go more slowly to save fuel. And the oil producers are selling oil forward in order to lock in today’s prices. The industry seems to have little faith in today’s prices – even though oil has come down about 15% from the peak.
*** Another farcical chapter in the history of the War on Terror seemed to come to a close this week. It turned out that the ‘terrorist’ responsible for practically shutting down the U.S. postal system – closing mail rooms across the nation, and frightening old ladies to the point that they were afraid to open letters from their grandchildren – was most likely working for the U.S. government. Bruce Ivins cost the nation millions, maybe billions of dollars, when he sent the anthrax spores through the U.S. mail. But at least he had the good grace to save the country the few bucks it would have spent putting him on trial. After threatening to kill his co-workers and adversaries, he decided it was time to exit the stage.
*** Tomorrow too – more on the Zimbabwe with Oil, Venezuela...
Until tomorrow,
Bill Bonner
The Daily Reckoning
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The Daily Reckoning PRESENTS: The U.S. now finds itself backed into a foxhole when it comes to meeting its energy needs, and is dependent on foreign sources for 70% of its oil. For this reason, it behooves Americans to have a better understanding of the nature of the foreign sources. Marin Katusa, Casey Energy’s senior editor, explores...
THE WAR FOR OIL
by Marin Katusa
In the blustery winter of 1950, U.S. Major General Oliver Smith and his elite 1st Marine Division were surprise attacked by some 3,000 Chinese troops as the Americans attempted to take control of the mountainous eastern coast of North Korea. Suffering 1,500 casualties and over 4,000 wounded, Smith withdrew his force and delivered his now-famous quote: “Gentlemen, we are not retreating. We are merely attacking in another direction.” Smith then reassessed strategy, regrouped, and, with fresh supplies and ammunition, drove the Chinese off in one of the most heroic struggles in military history.
There’s a powerful lesson investors in today’s volatile market can take away from Major General Smith. Namely, that when the going gets tough and you feel backed into a corner, there is a way to come out on top. But, like Smith, you need to continually reassess your approach and have the conviction to go in a new direction.
Some might say the U.S. now finds itself backed into a foxhole when it comes to meeting its energy needs. Although we have the highest rates of energy consumption in the world, it’s no big news that our traditional sources of oil are either tapping out or have become “No Trespassing” zones, leaving us dependent on foreign sources for 70% of the oil needed to keep the lights on. It behooves us, then, to better understand the nature of the foreign sources. To do so, we are going to use an approach usually found in a military context, dividing the sources into Allies vs. Axis – an appropriate model given the current war being waged for global resources.
With Friends Like These...
To better understand the reliability of America’s oil imports it’s helpful to see who America’s faithful oil-suppliers are – and who they aren’t. The chart shows that 54% of U.S. crude imports come from countries we consider Allies willing to work with the United States (shown in black and grey). Some 31% of imports come from Axis countries (shown in shades of red) that have demonstrated hostility to America. Another 15% are from Saudi Arabia, a Wildcard we believe could go either way. It’s unsettling to note that almost half of U.S. imports come from countries that are either unfriendly or have the potential to be.
The Allies
“A faithful friend is a strong defense; And he that hath found him hath found a treasure.”
- Louisa May Alcott
First, let’s take a look at the good half. Although these oil exporters have been willing enough to work with America, they face their own internal challenges. For example, the U.S. has powerful competition for both Canadian and Mexican oil; and it’s from these countries’ inhabitants themselves. Canada already consumes 90% of the crude it produces, while Mexico consumes a growing 60% of its production. Further, both face challenges with their reserves. The only abundant reserves Canada has are the oil sands – expensive and difficult to extract. And Mexico, with its reserves dropping quickly, is likely to become a net importer of crude in about six years. Read that last sentence again, because right now Mexico is the third largest source of oil to the U.S...just after Saudi Arabia.
Shifting farther away from home, the stability of exports from Nigeria and Iraq is challenged by internal unrest. Nigeria is destabilized by ethnic battles, ongoing supply scares, kidnappings, sabotage, clashes with militants and election unrest. In addition, resource competitors, including China and India, are both making inroads in that country. Meanwhile, Iraq’s reliability is largely dependent on a long-term U.S. presence in the area, a presence that is in doubt.
And these are the good guys!
The Axis
“Keep your friends close, and your enemies closer.”
- Sun Tzu, 500 B.C, author of The Art of War
Now, let’s touch on the almost-50% of imports that come from considerably less reliable sources.
The stability of U.S. relationships with both Venezuela and Russia is questionable. Venezuela, under Hugo Chavez, has already reduced exports to the U.S. And Russia has shown dubious motives. Its recent tap-twisting with natural gas exports to the Europeans reinforces that it sees energy as a tool for gaining geopolitical power.
Angola, Algeria and Ecuador are very willing to sell oil to the US right now, because they need the money. But, they have also ramped up exports to other countries. Over time, they may pick and choose to whom they sell their increasingly precious commodity.
The Wild Card
Saudi Arabia – source of an impressive 15% of exports to the U.S. – is holding its dance card close to the chest. It either could supply the U.S. reliably over the next few decades, or, through its OPEC power, increase the price of crude even more. Despite the relatively stable relationship between the U.S. and the Saudi family, rising regional tensions, increased Islamic militarism and ongoing Israeli-Palestinian tensions could threaten exports. And, the U.S. presence in Iraq has implications for the stability of Saudi Arabia’s supplies, too. Should the U.S. pull out of Iraq, any implied chance of U.S. troops supporting Saudi Arabia, should push come to shove, disappears. (How likely would the U.S. be to send troops back to Vietnam?) This could leave the Saudis looking elsewhere for security guarantees – guarantees that would invariably be purchased with a realignment of oil sales to suit the new benefactors.
“...We’re Advancing in a New Direction”
With such vulnerability in our supplies, America’s quest for new oil is vital. The single most important conflict of this war will be replacing declining reserves. But for war profiteers – or investors – profiting big starts with betting on the right army. The unexpected victors of one early American military conflict come to mind as an example of the right type of regiment to back. Remember that famous 1775 battle of Lexington and Concord, the “shot heard round the world” that kicked off the Revolution and culminated in our freedom to pursue our way of life? It wasn’t the British Redcoats, trained to fight the old-fashioned way, lined up and advancing in unison, who won that one. They ended up scrambling for cover, tripping over their coattails as they hightailed it all the way back to Boston Harbor.
It was the Minutemen, the rebellious, nimble scrabblers, who knew the terrain, left business-as-usual behind and, sniper-like, came out on top. So it will be in the search for new oil today. This time, the major oil companies are wearing the red furry helmets and buttoned up uniforms and are ending up the casualties of war. That’s because the old world army, including players like ExxonMobil, Royal Dutch Shell, BP, Chevron, ConocoPhillips, must cost effectively replace their flagging oil reserves and maintain production or face a quick retreat...in their share prices. And these days, finding large new pools of oil that can be cost-effectively developed is no easy task. Plus, they’re facing stiff competition from China, Russia and others who are cashed up with plenty of fresh ammo – namely trillions of U.S. dollars thanks to the historic trade deficits of the last decade or so. These new, nationally-sponsored competitors, who aren’t constrained by prohibitions against handing over suitcases of cash to win concessions, are quickly signing long-term off-take agreements where price is hardly discussed in the negotiations. In the war for new oil, the business-as-usual army has little chance of advancing in the right direction.
So, if not “big oil”, where should an energy investor look to deploy their capital? We’ll place our bets on the Minutemen, or the small, more agile oil explorers targeting under-explored areas in the U.S., Canada, and more remote areas of the globe. Rather than being caught up in layers of bureaucracy, and hindered by the negative associations of big oil, these smaller companies can act swiftly and have grass-roots connections with local politicians to help push their projects forward. Plus, they can operate in areas that are less populated by environmental protest groups that can challenge progress.
Most importantly, when a small company makes a large discovery it can have a huge impact on its share price...where even a large discovery, by today’s standards, will barely move the dial on a multinational giant.
Investing in one of these companies early is one of the best ways to not only insulate yourself against the personal inconvenience of steadily increasing energy prices, but also to make you one of the few real winners in the war now being waged.
Regards,
Marin Katusa
for The Daily Reckoning
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