Friday, June 06, 2008


Lots of questions and answers are being given in regard to the run up in the price of oil and the stock market slump on Friday. A question infrequently asked is why did everything but the price of oil and gold go down? (Of course, the "other side" of a number of trades were up, the dollar-euro cross being a prime example.)

A lot of things happened in the past couple of days and many of them were related to other important things.

The US Senate voted 48 to 36 to proceed with discussions on Cap and Trade legislation. Six Senators, who were absent, said they would have voted yes if they had been there. Not enough. It requires 60 votes in the Senate to break a filibuster. After the vote, a democratic spokesperson enjoyed making the announcement that a bipartisan majority voted to fix Global Warming but that republicans blocked the vote. The spokesman went on to say that the next president would Shepard this legislation through congress.

This mornings job loss information was "too hot". This is one of those upside down stories. The average person heard about the 49,000 lost jobs and the jump in the unemployment rate from 5% to 5.5% and assume this was "bad news". The reality was it was "news too good". The consensus expectation for job loss was 60,000. The big jump in the unemployment rate was a surge in the willingness of people to work. Thus the normal pattern at the "end of a recession" is progressing. In the 80's and early 90's, I routinely presented an investment talk titled "Recession: Crisis or Opportunity". One of the charts I presented was of the unemployment rate. I noted that the US stock market is primed for a big move up as soon as the unemployment rate jumps 1.2 points above the previous bottom. Early last year, the unemployment rate was 4.3% and it hit 5.5% last month.

It so happens that the move announced today is the biggest move since the mid cycle bottom in November of 1986 and it just barely surpasses the mid cycle bottom in 1995. In each of these cases the market was ready to soar. Of course, the head fake is to have a big down day when the news hits. Of concern is the fact that the market upturn in 2002 was delayed. The move up in unemployment rate occurred months before the market finally moved.

After Thursday's meeting of Ehud Olmert, the headlines suggested that Olmert won little in his talks with Bush. Today, an Israeli member of the Olmert administration said that Mahmoud Ahmadinijhad "would disappear before Israel does". The official went on to say that "If Iran continues with its program for developing nuclear weapons, we will attack it. The sanctions are ineffective".

It is known that oil tankers continue to sit idle off the coast of Iran. These tankers hold 12 days of production from Iran's two "heavy oil fields". I have found no information on what is happening now that these tankers are full. It seems safe to assume that at least this "half" of Iranian production is shut down. If it is, the most severe of the sanctions have only be in effect for about a month.

The statements of Jean-Claude Trichet, the head of the ECB, were touted on CNBC as the cause of the big jump in oil. The talking heads stick by the common upside down belief that higher rates in Europe lead to a higher Euro currency, a weaker dollar and stronger oil prices. These are all true but only in the short run. Higher inflation rates are also the very short term effect of higher interest rates. Speculators have once again jumped all over the long oil -- short dollar trade after hearing the words of Trichet. Given a little time, the higher rates will slow the European economy, lower the demand for oil, weaken the currency and ultimately weaken the inflation rate.

The congress has been busy blaming speculators for high oil prices while continuing to resist allowing drilling in the USA. It is possible that the negotiations with Iran and Syria are purposely being timed such as to force congress to vote on drilling in the USA before the deal is announced. This may be giving the Bush administration far too much credit but the fact of the matter is that the pressure on congress to do something to boost US production is growing.

The market will find the way to get the energy demanded by the market. The entire worlds air supply is dirtier today because environmentalist have been successful in blocking the construction of nuclear power plants. The entire worlds air supply is dirtier today because environmentalist have been successful in blocking the drilling of rich natural gas reserves off our coasts. The environmentalist had less success in blocking the construction of coal fired power plants. The irony is that these plants have produced many times the pollution that would have been produced by the nuclear and natural gas power.

The worm has turned. The people of South Dakota have voted to build a new refinery and the national, state and local government support the construction. The environmentalist have sued but the odds of construction are good. Will the congress vote to allow other oil development in the USA?


Bill Lienbach, a Merrill Lynch stock broker as far back as the early 1960's, like to compare the recent action to carrying a bucket of water. He said the water can splash from side to side to no effect if it does not spill out. In just a few days, a lot of excitement was caused when the price of oil fell from $135 to $122 and then rose back again. You sometimes get a lot of splashing in the short run that means nothing in the long run.

A couple of days ago, I mentioned Express Jet as one of the smaller airlines on the edge of bankruptcy. Yesterday, Express Jet signed a new 7 year contract with Continental. Express Jet had to cut their margins to the bone but they also won a path to survival. The firm will fly to and from Continental hubs on just the right schedule to connect passengers with long haul flights but it is free to make similar deals with other major carriers.

The majors have been using the above method to compete toe to toe with low cost carriers. Passengers get the best deal through these contract carriers. The low cost business model is being hammered by the majors. One irony here is that low cost carriers are more effected by high fuel costs than are major airlines. The seat miles per gallon of fuel on large jets can be 30% higher than on a smaller plane. Of course, the key to high seat-miles per gallon for the majors is to fly full planes. The planned cutbacks to capacity will help them do just that.

Today, the former Chairman of Continental, Bethune, said there will be more airline bankruptcies. He is right but he did not say that major airlines will go out. Just a few days ago, UAUA and LCC were considered the most probable of the majors. Since then, UAUA announced that it will close its low cost carrier, TED, and that it will reduce other capacity and costs. Again, it is the small, local and low cost airlines that are in trouble. The majors must cut back capacity, reduce cost and raise fares to survive. They will do all three. Each time capacity cuts are made, the ability to raise fares is increased. It is very normal for air fares to be very high during the second half of the business cycle. Businesses will pay the price. Profits will soar.


The perceived risk of an attack on Iran went up. The bold talk of war between Iran and Israel is not easy to discount. One sometimes gets the feeling that Amadenijhad would like to goad Israel into an attack and one sometime gets the feeling that Olmert would love to attack Iran. Olmert is in a pickle similar to the trouble Bill Clinton had. When Bill was close to impeachment, he blew up a factory in Northern Africa. It has been reported that the factory produced aspirins. It may have been a chemical weapons plant. Whatever the case, Olmert could in a fight for his political life push for violent action. It is frequently asserted that Bush and Chaney desire to attack Iran. Today, the response of the market was consistent with an increase in the possibility for war.

My belief is that war with Iran will be avoided because of the world is united. It sounds denigrating to the Chinese to say it but who is not surprised for a $16 billion gas deal between China and Iran to be on hold while the Chinese wait for a negotiated settlement. Should progress be made toward a settlement, the $10 plus jump in the price of oil could be reversed in an hour. The fact is that the fear of war did not cause the final demand for oil to go up but down!