Thursday, March 20, 2008


Yesterday, a reader wrote to say he does not see how the airlines can make a profit with fuel prices going out the roof. A few hours after I got his email, DAL announced yet another $10 fare increase and the price of a barrel of oil dropped another $2. This makes the 5th week in a row that airlines have increased fares. My guesstimate of the percentage increase is too loose to put in writing but I suspect the increases in the past 5 weeks has gone most of the way toward catching the fare increase up to the cost increase. BESIDES, THE PRICE OF OIL IS ON THE WAY DOWN!

You may believe me to be the boy who cried wolf in regard to the price of oil. As such, you may not believe that this latest sharp drop is the start of anything big. However, the data back me up.

From 2002 to 2008, the production of "liquids" as reported by the IEA has grown from 76 million barrels per day to 87.6 million barrels per day, a 15% increase. During that same time, usage in the OECD nations has not grown. The main sources of new demand have been India and China where total use grew from 6 to 10 million barrels per day. The most recent numbers from the USA show that implied fuel demand averaged 20.3 million barrels per day in the latest 4 weeks and that is 3.2% below the levels from a year ago.

Phil Flynn, the senior commodities trader at Alaron Trading said yesterday, "The commodity bubble is bursting". Yesterday, the price of gold fell $59 per ounce and it has since retreated another $12 per ounce in international trading. US gasoline stocks have jumped to 236 million barrels which is 35 million barrels higher than supplies at the same time of year in 2003 and 2004. Last year, supplies at this juncture were 224 million barrels.

The demand decline of 3.2% in the US implies that the commodity bubble is bursting and/or the economic slow down is here. Call it a recession if you like, only time will tell if it actually is a time of negative economic growth. Recession or not, people are finding ways to cut back on oil consumption and new production is coming on line. As mentioned in prior postings, Wikipedia estimates that new liquids production will exceed 7 million barrels per day in both 2008 and 2009. If demand falls in the US by 3% and supply increases 7% what do you think will happen to the market price?

Another reader says that he has read that OPEC is cutting back, not increasing production. First of all, he is wrong about OPEC cutting back and, second, he implies that OPEC is the biggest factor to consider. OPEC countries including Iran, Qatar and Angola are increasing production and huge new fields will come on line in Kuwait and in Saudi Arabia this year. The build out in Angola is happening. In the past year, Angola has increased production by 300,000 barrels per day. OPEC held stated production constant last month even though cutbacks are normal at the end of winter.

On the second point, while OPEC has increased production from 26.5 million barrels per day in 2002 to 32 million barrels per day in 2008, the rest of the world has gone from 47 million to 51 million barrels per day. These numbers do not reflect the massive developments in progress in Canada, Brazil or Kazakhstan. While it is true that the big fields in Brazil and Kazakhstan will not come on line for a few more years, there are other billion dollar projects closer to completion. Of the former Soviet Union countries, Azerbaijan is one of the ones currently bringing production on line. Over the past two years, Azerbaijan has increased production by 400,000 barrels per day. China and Russia also have various projects in various phases of development. The sharp growth in Russian production has leveled off but billions of investment will bear fruit soon. Non OPEC production is 160% of OPEC production.


Delta has taken the unusual step of increasing fares mid week, not once but twice. Yesterday, as soon as a couple more competitors finally matched DAL's previous mid week increase, DAL moved again. The bottom line is that international passengers are not likely to let a $10 or $100 ticket price increase prevent them from flying half way around the world. This morning, airline shares in China have moved "limit up". The fact is that international airlines are enjoying pricing power not seen since before the days of deregulation in 1978.


TV talking heads, in particular democratic politicians, are now consistently using the words "this recession". They say things like the FOMC had to act in order to prevent "this recession" from getting worse. This is the old, "say its true enough times and it will be true strategy". Many a democrat is elated over the prospects of recession as they believe a recession insures the election of a democratic president. If the democrats said "the housing recession" they would be correct, but, with commercial mortgage delinquency rates at record lows and with capital goods exports at record highs, are they sure we are in recession? With the world wide ratio of employed to unemployed at a new record level, is the world really suffering?

The massive drop in the gold price was to be expected by this point in the business cycle. Will all those, who screamed that the run up in gold was a forecast for high inflation to come, now call for a decline in inflation? Many will. Many will say that the decline in gold and oil means the recession is getting worse.

This morning, Lehman Brothers following the actions of JP Morgan last week, lowered its ratings on a number of airline stocks. Investors should remember that "sell side" research is even more unreliable than "buy side" research. Asking Lehman Brothers to estimate the value of a stock is like asking an auctioneer to estimate the value of a painting. The old saw is that the auctioneer will ask if you are buying or selling before giving his answer. I am a free market libertarian but I do not believe it should be legal for companies that make their living by trading stocks to issue "research reports" on those stocks.


The FOMC has held the fed funds rate at a significant premium to the t-bill rate for more than two years. The FOMC normally moves with the market. During Bernanke's entire term, he has held his foot on the economic brake. Even though the last cut was a massive 75 points out of 325 points, moving fed funds rate to 2.5% (a decline of 23%), the FOMC still did not catch up to the t-bill rate. As a result of the FOMC's tight policy, the 10 year treasury rate has fallen to near record lows. The 10 year bond traded at 3.3% yield yesterday. Since the yield on the 10 year is roughly equal to GDP plus inflation, we know that the actions of the FOMC are continuing to slow the economy, inflation or both. But we also know that the market is bigger than the FOMC and at some point those people who want or need to buy a home will realize that bargains are all around. Home prices in "non bubble" communities have fallen a little and financing costs have fallen a lot. The current fed funds rate is 47% below where it was 7 months ago!

Guess what else has recently fallen in value? The Euro! The pundits said the FOMC should not cut rates but should instead defend the dollar. The FOMC cut rates and the dollar held, it was the Euro that declined.


The long bond says inflation is dead. The price of gold says inflation is dead. Free trade and technology say inflation is dead. Women across America have been holding "gold parties". Women bring their old jewelry to a neighborhood party where it is weighed and sold. These women should get credit as rational investors. The price paid for melted jewelry has been higher than the EBay value of the whole pieces. Now that the decline has started, how low will gold go? Huge mutual funds hold mountains of gold that will be sold to the market if the public starts selling these funds. Gold and oil are joined at the hip. The spread between the two moves around a little but the two have about a 90% trading correlation.

The 30 year municipal bond rate was about 4.2% last year when the FF rate was at 5.25%. Yesterday the tax free rate was up to 5%. Why? Who wants to earn 5% tax free when quality stocks are on sale? Quality companies now pay dividends greater than the tax free rate on bonds.

With inflation dead and the cost of money low, the projected future income stream of a currently empty rent house is suddenly attractive relative to owning gold. The reason houses go up or down in value is the net present value of their income stream. If one buys a rent house at a rock bottom price, it may not even have to be rented to turn a profit when the market rebounds. An insured empty house is probably a better store of value than gold at this point. Rent the house even at a moderate rate and the rents are likely to cover the financing cost at today's rates.

While I admit that it was a long time ago when I first mentioned that consumers would use their windfall from lower oil prices to buy consumer goods, it is still going to happen. Keep in mind that this time the price of oil has gone so high that a significant decline will not force the collapse of alternative energy projects. As you may recall, Jimmie Carter promoted synfuel in the late 1970's but the technology made no sense once the price fell hard.


In the coming months, the FOMC will continue to play catch up because even the huge recent moves have been limited. The FOMC has added 200 billion here and there but the markets they are influencing are measured in trillions of dollars. To some extent, the "facilities" offered by the FOMC have been the equivalent of responding to a $200 request for grocery money with a $2 bill.

At some point, the market will take over from the FOMC. The huge decline in mortgage rates will result in the faster and faster absorption of excess houses.

DAL is leading the airlines in a game of fare catch up. DAL is in effect saying that it would rather lay off employees than to fly planes at an operating loss. This attitude puts enormous pressure on pilot unions to stop playing games. NWA pilots can come to terms or stay stuck at post bankruptcy pay grades. Assuming NWA pilots hold their ground, DAL and other airlines will ground planes and lay off workers as much as necessary to rationalize the business to the current economic climate. This environment will enhance the chances of a successful merger if a deal or deals can be worked out. As is most often the case, a great time to buy into an industries shares is when employees are being laid off. The willingness to layoff workers is a sign of willingness to make the tough decisions necessary to boost future profits.


GaveKal Research will appreciate two of the events of the past day. The USA indicated support for adding the former Soviet State of Georgia to NATO and Pepsi purchased a juice company in Russia. I include these events at the end of this post as a simple reminder that we live in a "new time". A time when the unemployed man in Siberia might find new work at Pepsi. The hard thing for Americans to appreciate is that the hiring of a Siberian worker is good for workers in the USA. It is true but I will not beat this dead horse any more. Instead, I invite you to take a look at the decline in metals over the past two days. The turn is here!


Anonymous said...

Great Article Courtney, Thanks for the mention! Phil flynn!