Tuesday, September 02, 2008


Oil is down more than $7 per barrel this morning! The economic cycle turn is finally moving forward rapidly. The best investments are now the "opposite" of commodity plays.

Think of this as the hard goods--soft goods switch or the Gold to Financial switch. Instead of buying the producers of oil and other commodities, investors should buy the users of oil and other commodities. Another word for users is consumers.

The one day decline of $7 per barrel will save consumers about 600 Million Dollars PER DAY. The PER DAY savings from $147 to $107 is 3.4 Billion Dollars. So far, price reductions that have already occurred, will produce annual savings to consumers of 1.2 TRILLION DOLLARS.

Where and on what will consumers spend 1.2 TRILLION DOLLARS ANNUALLY? One obvious place will be at Best Buy. With the change over to digital TV occurring in February, millions of people will buy new TV's. Millions who already bought digital TVs will buy the next generation as volume production pushes prices down. Consumers will actually commit to spending of several TRILLION DOLLARS when they finance durable goods purchases. Car owners who have felt locked into fuel guzzling vehicles will spend to update their rides. Buy retailers!

Other consumers include truckers, airlines, electronic goods producers and virtually any company that produces goods or transports them. And, let's not forget that money is a commodity. As the cost of oil falls, the cost of money falls. Banks, savings and loans, insurance companies and finance companies that deal in money have seen a reduction in their cost of goods.


Don't look back to say that oil hit $147 and it will go there again. It will eventually but nor for a long time. Look forward to appreciate the reasons that the price will continue to fall.

In the early 1970's, the US went through the economically painful process of accepting the fact that pollution had to be controlled and that substitutes had to be found for newly expensive oil. Pollution controls were put on cars and coal fired power plants and nuclear power plants were built. It took many years for the car technology to catch up and it took many years for the nuclear power plants to be built. Stocks suffered; economic growth suffered; demand for oil fell. The Dow peaked in 1968 and did return to the peak until 1983. The pain was acerbated by the failures of central bankers. Poor old Jimmy Carter contributed to and got caught in the worst of times. He was simply not prepared to handle hyper inflation. Ronald Reagan and Paul Volcker came along just at the right time to fix problems.

In today's market, it took hosting the Olympics to sufficiently embarrass the Chinese into committing to reduced pollution. Some folk believe that China will continue to grow at double digit rates for the next couple of decades. There are powerful reasons to believe that growth in China will moderate.

The move to reduce pollution is one major reason. China will make the switch to nuclear power faster than did the USA but it will still take years. Adding scrubbers to coal plants will cost billions; producing the public good of clean air but reducing growth in the short run.

The second major reason is that population control has finally "kicked-in". The one child per family policy was first instituted 29 years ago, but it took years to be fully implemented. From 2000 through 2,004 there were an average of 20 million additional 15 through 19 year old teenagers in China. The number is now running at 1 million per year. Even today, there is an average of 1.3 children per Chinese family, but the number continues to approach one. The population growth reduction will have consequences for many years to come.

In America we have seen the "demographic pig being digested by the python". Big motor, fast cars were the rage when our baby boomers were teens, during the 60's; big homes and second homes were the rage when our baby boomers reached their 50's. China was having a baby boom but that boom is over. There is naturally a close correlation in population growth and resource growth. The slowdown in population growth will lead to a slowdown in resource demands.

Efficiency and substitution effects will further erode the growth in demand. Japan continues to be a great example.

Japan has reduced its use of oil to the point that it exports oil products. Today, the TV "news" about falling oil is all about a miss by Gustave, but Gustave is only a short term story. The "double news" out of Japan is much bigger, even though you probably did not hear a word about it.

Yesterday, it was announced that Japan decreased its purchases of oil, again. The country like so many others continues to become more efficient and to find substitutes. (Japan is close to commercial production of uranium by farming ocean seaweed.) Secondly, Japan dramatically decreased its purchases from Kuwait and Saudi Arabia and dramatically increased its purchases from Iran. Iran announced that it has sold the last 7 million barrels of oil stored in VLCCs. Some of this oil was sold to Japan. At the same time, the Christian Science Monitor reported that the US and Iran are moving toward face to face talks.

The purchase of the Iranian oil in lieu of other oil is at the least a "good faith gesture". It implies another compromise between Iran and the rest of the world has taken place.

The $7 per barrel drop is not just about the potential for a deal with Iran. The actual key is that the majority attitude has changed. While China has finally made the attitude change of reducing pollution, even at the cost of slowing economic growth, most of the rest of the world is finally coming to the understanding that increased supplies are the answer, not subsidies for wind mills, ethanol or solar. In America, for example, the majority of Americans are now for drilling off our coasts, politicians are generally ready to vote for measures other than expensive and generally non productive subsides. We will know more about the change in congress next week and definitely by Oct.

The public, perhaps, is starting to understand that subsides will only make more Billions for people like T-Boone without solving the problem. Americans overwhelmingly support drilling. The left and T. Boone are pushing wind hard, with or without appreciating that it is bad for the environment. At the same time, innovations continue. The latest technology example is better batteries. Researchers claim that they can reduce the payback on Lithium Ion batteries in hybrid cars from 8 years to 2 years. Several companies have built or are building new battery factories. A123 is the pure play but companies such as Bosch and Samsung are building plants as well. Should the payback fall from 8 to 2 years, then I will join millions of others in the purchase of hybrid vehicles.

Iran is converting cars to clean burning natural gas (under the threat of a gasoline embargo) while huge new supplies of natural gas are being brought on line in the US. Genetically engineered single celled creatures hold great promise for dramatic increases in natural gas production.

The bottom line is that lower demand in the face of increased supplies will cause the price of oil to ultimately fall back to the marginal cost of production and the marginal cost of production will be lowered by new technology. The current price supports all kinds of substitution. Jordan is known to contain at least 40 billion barrels of shale oil, the forth largest supplies in the world. The US is number one with an estimated 2,000 billion barrels of shale oil and equivalents. In other words, the US still owns twice as much oil as all that has ever been used. The reason to mention Jordan is that a deal is in progress to start taping this oil, using existing technology. By Oct 1 or soon after, the congressional prohibition on tapping US shale will be gone. Shale is difficult and expensive but the marginal cost, using existing technology, is less than $70 per barrel. $70 oil is the equivalent of about $2 per gallon for gasoline.


The other talk on TV is about how oil is falling because of strength in dollar or that the dollar is strengthening because the price of oil is falling. This talk is a lot like saying that Michael Phelps won 8 gold medals because he has a strong right arm. It does not matter if he touched the wall with his left hand or his right, both arms arrived at about the same time.

England, Australia and Japan are just three of many countries standing at the economic brakes. These three have braked so hard as to be on the precipice of recession. The standing on the brakes reduces the demand for oil and it lowers the long term price of money.

Everyone seems to understand that when central bankers make money tight, the results are lower demand for money and thus less economic activity. It seems to be well understood that lower economic activity reduces the demand for oil. It is even well understood that higher short rates increase unemployment and decrease inflation rates. What is often missed is that higher short rates lead to lower long term interest rates. There is a tendency to make statements such as "interest rates are going up" while implying that an increase in short rates results in an increase in long term rates. The term interest rates should always refer to short rates because high short rates bring long rates down.

Big investors are interested in long term returns. Earning 5.48% on a one year Euro Swap is not generally attractive to the investor who is trying to average 15%. The primary reason to accept a 5.48% safe rate is in order to avoid the risk of potential loss. It is actually the long end of the yield curve that counts.

In the past year, the 30 year swap rate in the UK has fallen from 5.6% to 5.1%. The seller of the swap earned a bonus as the rates fell. His capital value jumped by about 10%. If you can make 5% in yield while enjoying a capital gain of 10%, that is much more attractive than holding short paper, even when short rates are higher than long rates.

While the 30 year swap in the UK has moved 50 basis points, the USA swap has moved only 30 basis points. Put another way, the 10-year US Bond now has a .7% yield advantage over the 10 year Guilt rate. The value of the US Dollar is soaring against the value of the Pound. Yes, since oil trades in dollars, the price of oil is going down while the dollar goes up, but both oil and the dollar are moving as a result of the pressure produced initially by high short rates. It is all a matter of timing.

The price of oil is moving down because the average short interest rate in the world is causing economic slowdown (the US lead the way with 19 months of high short rates before releasing). The rest of the world is close to releasing the brakes, but to return their currencies to par with the dollar will take several years of rate differentials.

Yesterday, the AU bankers reduced short rates by 1/4 of a percent. Short rates in Australia are still in the low 7's. This first move is tiny but it will be followed by others as economic conditions follow the expected path. By dragging their feet and keeping short rates relatively high, AU is enjoying lower inflation, lower long rates and a lower AU $. The lower long rates and lower $ is setting the situation for strong non inflationary growth. Check out the Libor 1 year spreads if you want to see how much tighter is the EU and the UK.


What a nice way to end this story. The US is already set up for strong non inflationary growth. Other nations are about to join us. When will England release? When will the Euro bankers release? The market says soon.

Over the past week or two, the strongest investment returns have been seen in mortgage companies, in England and in the USA. Of the 30 largest companies, in the world, most have suffered significant losses in recent times. Many of these large companies are oil companies, including the monsters of China and Brazil.

From 1980 to 2001 the price of gold fell. From 2001 to 2008, the price of gold rose. The USB:GOLD ratio hit .118 in early March 2008. The ratio only made it to .12 in June of 1984. Gold was extremely expensive in March of this year. The US and the world are set for strong, non inflationary growth.