Friday, April 25, 2008


Thursday, the Euro plunged relative to the US Dollar. Friday, it fell some more. At the same time, there has been a major turn in the short end of the treasury market. The 2 year note has seen a huge jump in yields. With 7 Trillion Dollars sitting on the sidelines in the USA, there is the potential for a flood. Money could flow into the stock market, a hundred billion dollars a month, for the next 3 years in a row and still only get back to normal.


The Sunnis have agreed to rejoin the Iraqi government, al-Sadr is backing away from mischief, the IAEA is going back to Iran next week for additional talks and one of the Taliban tribes is making nice with the government of Pakistan. The US is once again showing off evidence that Iranian made weapons are showing up in Iraq. Over in Malaysia, Iran is being kicked out of a conference for violating UN sanctions. The other nations of Islam are cooperating to bring Iran into negotiations.


The average person does not believe it but the truth is that commodities prices go down over time. Over time, we learn to use cheap, cheap, cheap in the place of what is dear. We use plastic plumbing pipes instead of copper and our aluminum coke cans contain a tiny fraction of the amount of metal that was in our earlier steel cans. As regular readers know, my favorite example is that walls that were once made of solid wood are now made of very cheap material pressed between sheets of heavy paper. And speaking of paper, we now routinely read LCD screens as a substitute for paper. I wonder how many hundreds of thousands of pages I have read on the monitor I am viewing at this moment. The marginal cost of this "paper" is close to zero.

A commodity index posted by Paul Caslin shows that commodities prices dropped in real terms from 120 in 1862 to 20 by 1999. The rebound over the past 9 years is still noting but a bounce within the longer term down trend. Russia has decided to make a massive substitution for hydrocarbons. Russia has increased it planned nuclear power plants to 42 by 2020, up from 35 and with 7 already under construction.

Many other huge substitutions are underway. At the bequest of our Secretary of Defense, Robert Gates boys with joy sticks are being substituted for pilots in airplanes. Mr. Gates has lambasted the US Air Force for not moving to UAV's at a faster pace. He notes the pattern of doing things the old way. Unmanned aircraft can stay aloft for many hours per flight, there is no point at which pilot fatigue sets-in. If the "pilot's" shift is over, he turns his joy stick over to the guy in the next booth (perhaps located in Florida or in Oklahoma). No hazardous duty pay for this airman! Of course, the biggest savings is in human life. This is a great example of doing a job better while consuming fewer valuable resources. One question that will never be answered precisely is how many soldiers lives have been saved because the enemy is discouraged by the knowledge that he is being watched?


With the price of food and gasoline having spiked, the "news" media is going on and on. The price of rice has made the national headlines. Go back 100 years and the price of rice was a significant component of the average USA family budget. Today, it is at best a footnote. Today, the average family spends more on dance lessons in a week than they spend on rice in a year. At the same time, the prices of other goods are falling sharply. The following example is the price of a good that did not exist 5 years ago, one that you are not likely to use in the next few years but one that is likely to save your life or the life of a family member in the near future.

In 2003, the first sequencing of the human genome was completed at a cost of 300 million dollars. By last year, the cost had fallen to about 1 million dollars. By the end of this year, it is expected to cost less than $5,000. In the very near future, medical care will be tailored to each individuals genetic make-up. Google is supporting the building of a data base that will help scientist spot the potential for cancer and other diseases long before the diseases actually present themselves. How much would you pay to have your cancer cured before you got sick? Does $5,000 sound reasonable? How about $4,000? How about $3,000?

It is likely that the cost of "pre-treatment" will be only a tiny fraction of the current treatment costs. For example, in the case of breast cancer, the radical mastectomy may be replaced by the injection of a few stem cells.


On the other hand, it will take a lot of progress for man to create a cheap replacement for hydrocarbons that were "manufactured" in a long natural process. There has been an extreme amount of "news" coverage for Solar and Wind Energy. The facts are that from 2002 through 2006 the percentage of electricity made in the US from Solar Energy increased from .064 percent to .070 percent. During the same years, the amount produced from fossil fuels went from 83.894% to 85.307%. The increase in Wind power went from .105% to .258%.

The hype has damaged the US economy. Instead of drilling in ANWAR to tap what is known to be a huge reservoir of cheap fuel, we have spent billions and billions of dollars on inefficient schemes. Think about how much sense it makes to leave billions of dollars in the ground while spending billions on inefficient games. The state of California has passed a law to subsidize one million solar rooftops at a cost of 2.9 Billion Dollars. How Silly! Tons and tons of resources will be diverted into systems that are inefficient by more than half. Spend as much drilling of the coast of the USA and Trillions of dollars of fuel will be recovered. This is the equivalent of a major league coach starting a mediocre high school player. Why would anyone lose the game on purpose? Of course, we know the answer when it comes to a politician who wants to win the popular vote of a brain washed public.


The US Congress has passed CAFE standards that require cars to get 31.5 miles to the gallon by 2015. China requires 43 mpg by 2009! Europe and Japan require 48.9 by 2016. I do not believe these mandates are necessary but they show that conservation will dramatically cut the per person use of gasoline over the next several years. If the US car companies did not have such strong ties to congress, the switch to smaller vehicles would be even more dramatic. Do you thing the monster buses going through town with a few passengers make sense? Does it really make sense that one cannot invite his neighbor to share in the cost of gas to and from work, without exposing oneself to massive liability? Clearly the government regulations, paid for by the auto companies, deter the efficient cost of local travel.

On the production side, Canada just doubled its known reserves of natural gas. It is highly probable that recoverable reserves will double and double again now that new recovery technologies are being introduced to field after field. In the Bakken formation, estimates range as high as 500 billion barrels of oil, on the USA side! The US Government list these reserves at under 4 billion barrels. The difference is in the amount that are considered economically recoverable. As technological improvements march forward, and particularly if the price of oil stays high, a huge amount of these reserves will be moved to the recoverable category.

The current limit of reserves is a bit like the former "cap on the mile". No one could run a mile in less than 4 minutes and it was a common view that no one ever would. Roger Banister believed it could be done and he did it in 1954. Since then, John Walker has run a sub 4 minute mile 129 times. Steve Scott broke John's record and ran under 4 minutes 136 times. In Rome in 1998 Hicham El Guerrouj set the current record by running a mile in 3 minutes 43 seconds. A 40 year old Irishman has broken the 4 minute mile as have 4 high school students. The impossible is now relatively common.


The consolidation of DAL and NWA marks a major turn in the airline business. The consolidation is significant from several points of view. The most significant point is that antitrust immunity has already been granted to the Sky Team alliance that includes domestic and international airlines. The results will be significant new service for the public and price rationalization for the carriers. The number of seats sold at a loss is going to drop. The top ticket prices will not necessarily rise, the key is that the average ticket price will rise. The situation reminds me of what Dr. Janeway, Dean of the Bowman Gray School of Medicine told me when I went to work for him in 1975. He said that although the medical school was a non profit organization, it was like all businesses in the sense that it has to turn a profit in order to increase the services it can provide to the public. He said, if the school does not make a profit, people will die. The airline business must be allowed to make a fair profit.

Perhaps the way to explain the power of the consolidation is to note the difference in city pairs served. The new DAL will serve only 400 destinations but it will serve 6,000 city pairs. A striking example of a new city pair will be New York -- Tokyo! Northwest has the landing slot available in Tokyo and it once offered service from JFK. The service was pulled when Northwest could not consistently fill the planes. Northwest simply did not have enough routes into and out of JFK to justify the continuation to Tokyo. JKF is a DAL hub. The new combination will make the New York to Tokyo a highly profitable route. The reason is not a higher ticket price per seat but a higher load factor.

Right now, there is a big time squeeze on the 50 seat jet operators. The major carriers have a strategy in place that will ultimately make their "express service" operators just as profitable as the mainline routes. There are over 1,600 companies that operate 50 seat planes. You can expect to see a dramatic decline in the number of these carriers. It may sound like dirty pool but the fact is that one can often buy a ticket through a major and fly from podunk to hub to destination for less than the ticket price from hub to destination. The individual ticket from podunk to hub may be pretty cheap on the independent line, but any price paid is still an add-on to the total trip cost. For the passenger that only wants to fly from podunk to hub, the contract carrier will usually match the price.

It has taken the 30 years since deregulation for the majors to be in the position to beat the pricing offered by the discounters. Now that they can do it, they are being tough business operators (ruthless is a fair description). The consolidation of DAL - NWA will give the surviving carrier thousands of more opportunities to offer combined routes at prices less than the current price of separate flights. Drop the number of discounters from 1,600 to 600 and you can expect the majors to enjoy being able to rebuild solid businesses, including the purchase of modern fuel efficient aircraft.


The last time the dollar got close to current levels was in 1995. The US market will not likely have as big a bull market run as it had from 1995 to 2000, but it might! Last night on Kudlow and Company, Jim Awad suggested that the profits for 2008 could really be huge if the US economy recovers. He based his suggestion on the fact that the average report so far shows and increase in profits of 11% for non-financial companies. I agree with Jim, profits are rising during a time of zero GDP growth. Profits normally fall during recessions. It appears that there will be no recession in 2008. The numbers were too strong before the turn in the dollar!