Friday, June 20, 2008

The Chicken or the Egg: Strong Dollar or Weak Oil: High Investment or High Return

Markets put things in the right order. Market mavens often put things upside down, backwards or both.

Which comes first, a strong dollar or weak oil prices? My favorite market TV show is Kudlow and Company. Larry Kudlow does a good job of applying economic principles to money and politics. Larry is a smart man but he sometimes joins the crowd in getting things backward. In recent weeks, he has been on a "strong dollar kick". He has wanted the Secretary of the Treasury, the FOMC chairman and the President to "talk up the dollar" and to thus bring the price of oil down.

The dollar will strengthen if the US adopts the right policies. All the talk in the world will not rescue the dollar. To his credit, Kudlow has more recently pushed "drill, drill, drill" for US oil reserves. The US dollar will strengthen when oil prices come down, not the other way around.

Oil prices are acting like a tax. High oil prices are depressing economic growth. To offset this tax, the FOMC has lowered short term interest rates. In the short run, the FOMC has been caught in a negative feedback loop; every time the FOMC lowered rates, the price of oil went higher which meant that even lower rates were needed to offset the tax. Now that the forces of supply are weighing hard on the price of oil, the tax is going to go away. Lower taxes will mean stronger growth and stronger growth will lead to both a stronger dollar and ultimately higher interest rates.

Even here, the TV talking heads often get the chicken before the egg when they suggest that it is higher interest rates that lead to a stronger dollar. Keeping in mind that inflation is the result of excessive money, the answer to what interest rate policies do depends on ones time frame. An increase in short rates will actually cause long rates to come down after given time to work. It is a stronger economy that pushes up the dollar but it is a strong economy that pushes up the demand for oil. When capacity is restrained, a stronger economy is not possible without a spike in oil prices; once capacity or economic efficiency has been increased, the economy can grow without putting the same amount of pressure on oil prices. In the short run, a decline in oil prices is a lowering of perceived inflation, but will this lead to lower interest rates? Brian Wesbury is one Chief Economist who believes lower oil will lead to higher rates. We must remember that interest rates are composed of two parts; growth and inflation. The good news is that the growth component of interest rates is about to increase relative to the inflation component! High growth and profit by US businesses should cause a flood of investment into the US (especially if the McCain - Rangle corporate tax rate cut comes through).

The Chicken or The Egg: Inflation or the "news"?

As I have mentioned many times, inflation is a lagging indicator. Inflation actually goes up in the short run as a result of a slow down in the economy. The example I have used is the airline business. In a slower economy, airlines cut back on capacity which allows them to raise the price. The result is a lot of very negative talk near the end of an economic slowdown when the slowdown is suddenly accompanied by reports of extra high inflation. It should be no surprise that the "news" about inflation is even more of a lagging indicator. High inflation hits but the financial figures do not show up until a month or two later and the "news media" is like a flock of chickens that eventually discovers the source of food. The chickens do the most squawking when they see the food arriving and after the food is gone, they are relatively quiet while eating. Right now there is a lot of squawking about inflation but the worst is already over.

The Iraqi Oil Law or Increased Iraqi Oil Production?

Iraq has struggle to reach an oil law agreement. The Kurds want to control the northern supplies, the Shiites want to control the southern supplies and the Sunni's don't want to be caught in the middle without revenues. The Maliki coalition must have the support of some Kurds and some Sunni to function. Isn't democracy grand? We all hate having to deal with the dumb lumbering giant called democracy but it is far better to battle at the voting box than with knives, bullets and bombs.

Since the government has not been able to pass a nationwide oil revenue sharing law, the decision has been made to bring on new production first. Exxon, Shell, Total, BP and Chevron are in final negotiations to provide technical assistance to increase production over the next two years. It is anticipated that 4 to 500,000 barrels of daily new production will be online by year end. This new production will give the people hope, revenue, and confidence. The democratic government will be strengthened. The opponents to an oil sharing law will be tempted by the presence of an increasing flow of revenues that need to be split.

The Oil Law or the Security Agreement?

The Iraqi foreign minister says that the July 31 deadline for a security agreement between Iraq and the USA will be met. The agreement will cover: 1) the number of troops and bases, 2) the lack of commitment to defend Iraq (this agreement cannot include the promise to defend Iraq against outside forces or it would become a treaty subject to the disapproval of congress), 3) the immunity of US troops from Iraqi courts, and 4) the power of US troops to arrest and hold Iraqi citizens.

Secretary Rice has made it clear that US security negotiators are not involved in the negotiations between the oil companies and Iraq. Several of these oil companies had major investments in Iraq some 36 years ago. The plan is for them to be paid a portion of the oil they produce. Back in the early days of Texas, the common split was for the oil producers to get one barrel out of every eight, a 12.5% share. Based on the history of nations which have nationalized fields, the one out of eight is a very good deal. Mexico, for example, kicked out the major oil companies years ago and is now close to having to import oil. To solve this problem, Mexico is considering allowing these "pros" to produce the oil, in exchange for a share. I am sure the split for very expensive deep water oil is much higher than one of eight. The telling story is that the estimated reserves in Iraq have been increased by about 200 billion barrels because these major producers have the know how.

The details of the SOFA (Status of Forces Agreement) are best left to the "pros" as well. What is going to be interesting is the agreed upon troop levels. We might see a major withdrawal if the two parties agree that 140,000 US troops are not needed, now that Iraqi forces are functioning well. The proper sequence here is victory and then withdrawal not withdrawal and defeat.

The Democrats Have Done It Again

A deal was just made between Bush and the democrats. Additional war funding of $162 billion was just passed. Triangulation politics required the dems to get this issue out of the way well before the elections. Pelosi was once again caught in a no win position. Democrats cannot admit the war is going well nor can they vote to withdraw. Using the football analogy, it would be silly to quit the game with the ball sitting on the 1 yard line, first and goal.

Nancy had to swallow twice. She swallowed the $162 billion in funding and she swallowed her pay-go rules again. You may recall that the democrats took the house in 2006 by promising to end the war and to not borrow any new money. They said they would practice "pay-go". The irony is that they added other bells and whistles without funding these items either. The extended unemployment benefits added is one of the typical democratic response to an economic slowdown. This is not a which is first, the chicken or the egg question. In this case, the democrats decided it is better to kill the chicken, eat it this summer, and not worry about the coming shortage of eggs this winter. Once again, the policy is to pay someone not to work, rather than to give a tax break to someone who is willing to work more.

The other addition to the bill was to increase GI college benefits from $40,000 to $90,000. As one whose college tuition was paid for by the GI bill, I certainly support GI benefits. I drew $242 per month from Uncle Sam for 4 years after Vietnam. Hanging $90,000 in front of a five year vet is a very different proposition. Our all volunteer army requires different strategies. The left should not try to bribe a professional soldier to leave the service. We need the best and the brightest to receive the best military education available.

One of my favorite movie scenes is that of Mel Gibson playing William Wallace in Braveheart. When Wallace was being tortured to death, he used his last breath to scream "Freedom". Some years after his death, at the Fields of Bannockburn, Scotland won its independence. Throughout the centuries, many people have died in defense of freedom. Wars should be avoided if possible but they should be fought to win. After voting to enter the war, it is the responsibility of the congress to fund the troops.

Natural Gas Prices Up or Gasoline Prices Down?

The great run up in the price of oil has not been accompanied by the price of natural gas. Based on the BTU value, either natural gas is very cheap or oil is very dear. Now that Qatar is shipping billions of cubic meters of LNG, its seems more likely that the price of oil will move toward the price of gas.

Over the longer term, the environmentalist must appreciate the chicken or the egg power question. Many environmentalist hope to replace gasoline engines with electric engines. The Plug-in hybrid is the rage but it is being charged by coal fired power plants. Hundreds of thousands of people die each year as a direct result of coal mining and coal power. We have trillions of metric feet of clean burning gas available. The north slope of Alaska can fill our needs for many years.

McCain has caught up with the 123 Agreement reached between the USA and Russia. McCain proposes that 45 nuclear power plants be built in the USA between now and 2030. He proposes that the permitting process be reduced to 2.5 years or better. You cannot replace gasoline cars with electric cars unless you have the electricity to spare. You do not help the environment by converting from oil burning cars to electric cars fueled by standard coal burning power plants. The reason a tax on carbon with offsetting payroll or income tax breaks is better than a cap and trade tax is because the carbon tax is applied to all sources of carbon prorata. The market then determines which fuel is used after taking the carbon costs into account. The correct sequence is to get the permitting of the nuclear power plants underway so that improved batteries can be charged 7 or 8 years from now.

Sanctions or Bombs?

The lefties have posted, all over the Internet, their belief that Bush is preparing to bomb Iran. Bush could have started with that strategy in 2002, but he didn't. He has followed strategic military advice and taken out the easy targets that surrounded Iran. He has gotten the world to mobilize around sanctions as a method of avoiding war.

Condoleezza Rice is every where, she's every where. She just made her 20th visit to Jerusalem. She just spoke at a Heritage Foundation Meeting where she talked about Pakistan, China, India, Iran and North Korea. She just met with Ban Ki-Moon and encouraged him to "get involved" with the Shebaa Farms negotiations. She is prepared to let many others share the credit for achieving peace agreements. She is on the way to China to visit earthquake victims and she will visit South Korea afterward. She has pressed the UN to act on Zimbabwe violence. She is keeping a high profile. Once again, she has presented the Iranians with the powerful argument that the US does not make permanent enemies but we do make permanent friends. We prefer no sanctions and no bombs but sanctions are our choice between the two.

Prime Minister Brown, Energy Secretary Bodman, Vice-President Xi Jinpiing and many others will parley with the Saudis this weekend. The Iranian oil minister will be present when the leaders at this conference make it clear that there is going to be increased supply and reduced demand until the price comes down. It should become clear to Iran that Iran's oil is not necessary to the rest of the world.

China just made a substantial contribution to this effort, more so than the announcement of 200,000 more barrels of production from the Saudis. The Chinese just raised the domestic price of oil by 18%. This is probably the first of several moves to take the price to the market price. Can you imagine the shock. What if you lived off of $4,000 per year and suddenly saw the price of gasoline jump 18%? Would you drive less or eat less?

Peak Oil or Peak Gasoline Demand?

Many environmentalist believe we are near "peak oil", the maximum level of production before world wide production declines set-in. Dan Yergen says we might be at Peak Demand, the point at which we find substitutes for gasoline. If Russia, China and the USA each build 45 nuclear power plants, plug-in hybrids might be well on the way to replacing the internal combustion engine.

It is believed that the latest bombing in Iran was placed by Shiites to kill Shiites with blame pointing at Sunnis. The purpose was to restarte the secular war between Sunnis and Shiites. The start of WWI was an assassination. Ahmadinejhad claims to have thwarted an assassination attempt by leaving Baghdad earlier than scheduled. Desperate measures for desperate times.

If Iran and the US Congress will get out of the way, private enterprise will find the energy we need at the lowest cost possible. Yesterday, a democrat proposed that the US Government take over the US refining business. The government just had to privatize the senate food service due to massive losses. If the government cannot run a restaurant, how can we expect it to run a very tough and complicated business. How would you like to take the chemistry classes required to be an oil refinery engineer? How would you like to be in charge of a plant where volatile liquids are heated to high temperatures in order to separate them into more volatile liquids?

Dumb and Dumber!

Over the past several weeks, McCain and Obama seem to have been playing a game to see who is dumb and who is dumber. While their success at gaining their parties nomination for president shows political skill, neither has demonstrated an understanding of basic economic laws, until recently.

Last week, Obama said, "Globalization and technology and automation all weaken the position of workers". Can you picture the daily life of a factory worker 100 years ago and compare that image to today's reality? Obama must have smoked a little weed with his leftist friends.

McCain is famous for his support for campaign finance reform. Obama has announced that he will forgo the $83 million dollar government grant (and the restrictions tied to it) and raise as much as he can to run his campaign. So far, he has raised $262 million dollars. If the result would not be so tragic, it would be sweet revenge for McCain to lose this election as a result of his attempts to have government rules and regulations replace the free market of words and ideas.


You would think that McCain, a war hero, would relish the last word of William Wallace. To McCain's credit, he is listening to the advice of others. His anti drill attitude was wrong but it has been replaced. Doris Kerns Goodwin, who wrote a biography of Abe Lincoln, likes to note that Lincoln was willing to say that times have changed and so have I. When McCain voted to not drill in ANWR, the price of gasoline was $1.63 per gallon. Obama would vote today not to drill in ANWR or on the OCS. McCain has changed his position on the OCS and is studying his position on ANWR. Sometimes, we have to put the chicken first and at other times we must understand that without eggs there will be no more chickens.

As conservation steps take hold, the money not spent on oil will be spent on something else. BUY, BUY, BUY! Something else!