The Daily Reckoning U.S. EditionHome . Archives . Unsubscribe The Daily Reckoning | Monday, March 14, 2011 
The “Whys” of Epic Disaster Understanding “Black Swan” Events and Investing Accordingly
Reporting from Laguna Beach, California...
As the horrors of the Japanese tsunami push the horrors of the Libyan Revolt from the front page headlines, the rest of us struggle to figure out what it all means...
These horrors do not merely force us to consider whether oil will surge past $100 a barrel and/or whether the Dow will tumble below 12,000, they force us to examine the "whys" of inexplicable human suffering - to assign a cause and/or to extract a value...to the extent possible.
As the images of extreme - and seemingly random - human suffering illumine our TV screens, atheists and theists alike must decide where Divine providence ends and bad luck begins. No matter where you might place your data point on the continuum between providence and luck, your "explanation" will seem woefully inadequate.
If providence be the cause, why is Capitol Hill still above water? If bad luck be the cause, why are governments along the seismically active "Rim of Fire" investing in tsunami-warning buoys instead of rabbit's feet?
Although your editor, a Christian, believes in the "Hand of God," he also believes that the Hand of God sometimes looks an awful lot like bad luck. In other words, your editor is not smart enough - or righteous enough - to know what God is up to. He simply knows that lots of bad stuff happens for no apparent reason.
The Christian imperative is not to know the unknowable; it is to respond to "bad luck" compassionately. Let philosophers debate the teleological context of human suffering...and let God decide it.
A little over six years ago, when a massive tsunami inflicted epic suffering from Thailand to Sri Lanka, your editor wrote a column entitled, "Cosmic Dodgeball."
"In the span of a few terrifying minutes last Sunday morning," he wrote, "120,000 human beings perished beneath a fatal wall of water. That's more than double the number of American soldiers who died in a different sort of Asian cataclysm four decades earlier. But manmade disasters like the Vietnam War bear no resemblance whatsoever to natural disasters. Manmade disasters, despite their horrific consequences, seem almost tame and rational alongside the natural variety. In other words, the brutality of war is shocking, but not unexpected by those involved. The brutality of nature is alarming, precisely because it is so unexpected and so completely random.
"A soldier pinned down in a firefight on the beaches of Vietnam knows he may not see another sunrise," your editor continued. "But a tourist relaxing on the gentle sands of Patong Beach does not doubt he will watch that evening's sunset. Fate sometimes foils expectations and delivers utterly unimaginable outcomes.
"Whenever epic disasters occur, nature seems indifferent to both the laws of probability and to our human sense of fair play. Epic disasters just don't seem right, but they happen nonetheless. And whenever they do, it feels as though we humans are engaged in a kind of cosmic dodge ball - a 'game' in which the balls are invisible to the human eye until the moment they strike. The object of the game, of course, is to avoid getting hit. But as the balls are invisible, we are never really sure how we should be bobbing or weaving."
The game of investing sometimes feels just as random...and capricious.
Most investors trust the stock market to lap at their feet as soothingly as the waters of Patong Beach. They believe the stock market will be kind to them most of the time. That's what history shows, after all. Therefore, very few investors bother worrying about the financial tidal waves that could wash their capital out to sea. And even fewer investors prepare for these exogenous, "Black Swan" events.
Instead, most investors simply hide their complacency and/or lethargy behind the phrase, "No one can see disaster coming." But, in fact, that assertion is patently false. Scores of insightful investors saw disaster coming in 2008, well before the credit crisis rolled in and crashed atop the financial markets. A few of these insightful investors profited handsomely from the ensuing disaster, but most of them simply headed to higher ground before disaster struck.
Some of the very best investment strategies begin with mere survival - with mere capital preservation. When the ground beneath you begins shaking violently, it's best to head to higher ground...even if it means missing a day of work...or missing out on a stock market rally.
Middle Eastern tyrants are murdering - or preparing to murder - their own citizens; oil is topping $100 a barrel; Ben Bernanke is pursuing prosperity through dollar-debasement; one-trillion-dollar government deficits are the "new normal"; the Chinese economy has stopped producing trade surpluses...
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Looking at history, there are often major international economic declines after big natural disasters. The example I like is how the San Francisco earthquake of 1906 led to the bankruptcy of many insurance carriers and to an outflow of cash from London and New York money centers. This led directly to the Panic of 1907 - and eventually to the creation of the US Federal Reserve. So in a sense, you could say that a natural disaster produced an unnatural disaster.Byron King
Getting back to the present, the earthquake-induced drop in oil prices is just a short-term blip. Oil prices are on the way up because many nations are increasing not just demand, but oil stockpiles - due to uncertainty of supply from the Middle East.
In the Philippines, for example, the government recently required that refiners keep a 90-day oil supply, versus, the former 30-day supply. Other countries and large oil-using firms are doing similar things, in terms of building stockpiles.
So which news trumps the other news? Will generally rising oil demand keep pricing strong? Or will unexpected events continue to keep a lid on that oil demand, and thus hold down prices?
Bottom line is that this earthquake oil-selloff is likely a short-term phenomenon. There's strong upward momentum built into oil prices due to fundamental supply issues, not the least of which relate back to political unrest in the Middle East. We could see a quick rebound in oil price strength due to concerns over supply.
Looking further ahead, China only has enough oil in its strategic reserves to cover one month's consumption, according to Wang Qingyun, head of the State Bureau of Material Reserves. Mr. Wang says China is working towards building a 90-day reserve, but the energy bureaucrats are still working on selecting the storage locations and constructing facilities.
Oil availability and pricing is certainly a matter of growing concern for China, whose daily oil imports, as a fraction of total consumption, now exceed that of the US. China now imports about 63% of its daily oil consumption - double the percentage of ten years ago.
As China's consumption grows, the prospect of "permanently high" oil prices also grows. And that will mean investment dollars will continue pouring into the oil exploration industry.
For example, in the past five years we've seen (net) about 100 new jack-up and deep-water drill ships float away from the shipyards of the world. These vessels reflect over $40 billion of new capital expenditure. Then there's the multiplier effect of new-build vessels on the vendors, equipment builders, steel mills and all the way back to the iron mines.
Meanwhile, a hiring craze is on at Halliburton (NYSE:HAL), which has just announced that it will hire about 5,000 new geologists and engineers, worldwide. Heck, even I - your humble editor - routinely field calls from headhunters, seeking geological talent.
It all sounds like positive investment news for the oil industry. But there are other things to consider as well. What's the payback for all of this investment and hiring? Are we seeing an "energy return" for all the new capital outlay?
Let's compare some recent numbers. Between 1995 and 2004, the global oil industry spent $2.4 trillion on various capital expenditures. This $2.4 trillion helped increase crude oil production by 12.3 million barrels per day, to about 85 million barrels of output per day by 2005 (and hold that thought). This is just the raw, historical data set.
Coincidentally, between 2005 and 2010, the world oil industry spent another $2.4 trillion on capital expenditure. Yet for the same amount of money - $2.4 trillion - global crude oil production actually fell by about half of one percent.
What does this mean?
There are many implications, of course, but one key point is that the world's overall daily oil supply is not growing. For all the stories you see about "new" supply coming online from deep-water fields, from onshore discoveries, from enhanced oil recovery, from oil sands, from gas liquids out of tight gas deposits, etc., these are only replacing other oil supplies that are vanishing in the form of depletion.
It's fair to say that oil output is flat, worldwide, and prices are not really being set or moderated by efficiency, conservation or even by adding capacity.
No, the key control over oil prices in the past couple of years has been the recession. The recession has set the price of oil. And had it not been for the recession, the world might be consuming upwards of 93 million barrels of oil per day...and might be paying much higher prices than $100 a barrel.
Looking ahead, wherever things go with the world economy, we're in an environment that's supply-constrained. We're not going to find any "new" Saudi Arabias or Russias - although it's good to know the story of what's happening off shore Brazil.
Peak Oil is here, except right now we're experiencing it solely as an issue of affordability ($100-plus oil), versus lack of day-to-day supply.
Eventually - well, maybe - the world economy will begin to move out of recession. And maybe we'll even have a period of time without international crises (Middle East comes to mind) or large-scale natural disasters. Then we'll see what true supply constraint looks like - and prices will rocket upwards.
How does one deal with all of this? Well, begin by investing in companies that hold real assets in the form of oil and natural gas, as well as uranium and other resources of value - gold, silver, etc. That, and the energy-technology players of the oil service sector - the usual suspects of Schlumberger (NYSE:SLB), Baker Hughes (NYSE:BHI) and Halliburton.
Stay tuned and we'll figure it out together.
Regards,
Byron King,
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As we signed off on Friday, the Saudis were suppressing a 'Day of Rage' in Arabie... Gaddafi was mopping up the resistance in Libya... And an earthquake and tsunami left thousands dead in Japan.
But that didn't stop the stock market. The Dow rose 59 points.
Now it is Monday. And in all the excitement we kinda lost track... But we gots to know...
Is the Great Correction over?
We are coming up on the 4th anniversary. Countrywide - one of America's leading subprime lenders - went broke in 2007. That was when it began. After more than 6 decades of adding to its liabilities, America began to off-load debt.
And now we have to face a critically important question. Is the Great Correction over?
The New York Times tells us that the Great Correction has done its work. By defaulting on their mortgages and cutting spending, they've got their debt burden down to the lowest level in 6 years:Total US household debt, including mortgages and credit cards, fell for the second straight year in 2010 to $13.4 trillion, the Federal Reserve reported Thursday. That came to 116% of disposable income, down from a peak debt burden of 130% in 2007, and the lowest level since the fourth quarter of 2004.
The TIMES tells the story of one couple who have reduced their debts... (Notice to grammarians... Yes, it should be a couple "that has reduced its debts." But, what the heck? We've stopped wearing a tie to work. We haven't been to church in weeks. And now we're going to be a little loose with the language too.):
With the help of rising stock prices, the decrease in debts put average household net worth at $505,000 at the end of 2010, up 5.1% from 2009, though still well below a peak of $595,000 in the second quarter of 2007, before housing prices plunged.
Defaults on mortgages and credit cards played a large role in bringing down household debt, underscoring the extent of the financial distress still afflicting US families. Commercial banks wrote off $118 billion in mortgage, credit-card and other consumer debt in 2010, the Fed said. That's over half the total $208.8 billion drop in household debt, which also includes new mortgages and credit cards.
People are also fixing their finances the hard way, by boosting the portion of their income that they use to pay down debt. The personal savings rate averaged 5.8% in 2010, up from a low of 1.4% in 2005, and back to a level last seen in the early 1990s.
Even as US households reduce their debt, the country's overall obligations are rising, with weak tax revenues and efforts to stimulate the economy translating into large budget deficits. Total US nonfinancial debt rose 4.8% to $36.3 trillion, driven largely by a 20% increase in federal debt. Debts of nonfarm, nonfinancial companies rose 5.4% as companies took advantage of low interest rates, but much of that money went to boost their cash coffers, which grew to $1.9 trillion.Since late 2008, he and his wife have slashed their total debt from nearly $1 million to zero by walking away from the mortgages on four rental properties and paying off two others, all of which lost about half their value in the housing bust. He's no longer taking up to $4,000 from his monthly income to pay mortgage interest that the rental income didn't cover.
What a happy story. Here's a couple that improved its balance sheet by $1 million...simply by "walking away" from mortgages.
Instead, he and his wife are fulfilling their goal of building a new $350,000, four-bedroom home in the Dallas suburb of Lewisville, where they plan to retire. "It's a big relief," said Mr. Shah. "We went through some rough times, but now I'm comfortable and don't have to worry about my retirement."
And more thoughts...
Hey, wait a minute. Surely, those debits were someone else's credits. What happened to the million bucks?
Oh, don't play dumb, dear reader. You know how the system works. The mortgages were held by banks. The banks wrote off $118 billion last year. Other mortgages were included in packages known as derivatives. When they went bad, the banks sold them to the Fed, which included them on its list of "assets."
In 2007-2009 the banks faced losses that would have wiped many of them out - including the biggest. But what are the feds for if not to protect half-wits, incompetents and bankers? So, the bankers were allowed to dump their mistakes on the Fed...and the public. Zero interest rates then allowed them to restock their bonus pools while force-feeding debt onto the whole society.
You have to marvel at it. It is as though the debt just disappeared. Trillions' worth.
And now what? Private households may still be reducing their debt, but the financial sector - with the Fed behind it - is off to the races again. Corporations are going into the marketplace, borrowing money and distributing it to their owners.
The Financial Times:Economist Andrew Smithers points out that in the first 9 months of last year, non-financial corporations, listed and un-listed, paid out more to shareholders than they made in profits. In other words, they took advantage of record low interest rates to transfer money from lenders and bondholders to shareholders.
Yes, dear reader, the world may not be going back to the naive bubble of the '05-'07 years. No one would want it to. It's moving on - to a new bubble. Total bank loans are still below the level of 2009. But they're going up. "Cov-lite" loans - those with little protection for the lenders - are coming back. Even interest only loans are making a re-appearance.
Capital is changing hands...from the fools to the knaves. Private equity hotshots are borrowing money at low rates so they can pay themselves. The underlying business is weakened with debt; but nobody seems to care.
The other sector of the economy that is leveraging up in a big, big way is government. Here again, the money goes from the fools to the knaves. Government squanders the money in all the usual ways. But lenders still believe they will get it back. Our guess is that the lenders will be wrong. They are making a bad bet. They will not be repaid.
*** Oh those poor Japanese. It was not enough that they have had to endure a 21-year on-again, off-again slump. Nor that their economy, their country, and their race are all facing extinction. Now, they have Mother Nature washing them away too.
New Zealand was hit by a disastrous earthquake recently too. In response, its central bank lowered interest rates. Central banks are now called upon not merely to maintain full employment and level out the ups and downs of the business cycle. Now, they're called out like the National Guard.
Last week, the Kiwi central bank lowered its key lending rate from 3% to 2.5%.
But what will the Bank of Japan do? It already has a lending rate at zero - where it's been for the last 15 years. And yet, it is sure to need more cash and credit to rebuild infrastructure washed away by the tsunami.
Oh my... That's the problem with being "zero bound." There's nothing left. You can't give help when it is really needed.
Regards,
Bill Bonner
for The Daily Reckoning
Tuesday, 15 March 2011
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