Thursday, November 06, 2008

A Fast Train Over Runs the Station

Learning the details of the big turn being made in the markets is worse than watching sausage being made. The good news is that the sausage is ready and central bankers are scrambling the eggs. Breakfast is all but ready.

Today, the EU Central Bank lowered interest rates by 50 basis points, the EU Bankers are have turned on the stove. The Bank of England realized that it was behind and in a frantic catch-up move, it lowered short rates by 150 basis points, today! The yield curve in England is more positive than it has been for a very long time.

The first lesson new investors learn is not to fight the FED. In the current battle, the FED has been joined in battle by Central Bankers from around the world. In the USA, one has to go back to 1982 to find such massive percentage declines in interest rates. The data for the world is not as handy as we would like but a 150 basis point move against a 4% base is a rare event indeed.

Last week, we experienced the reflation trade "hook". I hope you did not get caught. Some readers have been inquiring about inflation plays such as CAT and Siemens. Those who are stuck on the idea that "oil prices are going right back up" were given support for a week. Yesterday, they were smacked on the fanny again. The best way to explain what happened is to use examples.

An index of Russian stocks, Russia being one of the countries that makes its money off the sale of natural resources, has fallen 62% in the last 52 weeks. This drop of 62% includes the 47% gain made last week! It does not include yesterday's 12% drop! Since it takes a 24% gain to make up for a 12% loss, it is silly to try to catch "falling knives".

For simplification let's put the above moves in terms of $1 invested in the Russian Index one year and one day ago. The value that dollar fell to 25 cents before bouncing 47% to 38 cents. Yesterday the value of that 38 cents fell to 33 cents. The one year and one day decline from $1 to 33 cents is a decline of 67%, up from the 51 week decline of 75%. The guys who bought solar energy 13 weeks ago have lost lost 61%. The solar reflation bounce of last week was 14%. The clean energy fund, PBW lost 60 percent in the past year which includes last weeks 14% bounce. (HT: to QVM Group).


Those who have been brainwashed into believing in the "end of oil" tend to fall into the "world is about to end" crowd. They believe that the current drop in oil prices is temporary and the world as we know it will die when more "oil wars" break out. This belief will cause them to miss one of the best stock market bull markets of all time.

A few days ago, I found the argument that seems to break through. These "peak oil -- global warming" people tend to be supportive of the new government CAFE standards. They believe it is the government that must force the people to save fuel. The imposition of laws requiring auto companies to sell high mileage fleets fits their view of the world that it is government that must "save the day".

The mandate, put on the books last year, is that US fleets, including light trucks, must get 35 miles to the gallon by 2020. Honda, for one, has said that making the targets all along the way is going to be a challenge. Obviously the market believes that Ford and GM will have great trouble in meeting the challenge. The mandated average increase in fuel efficiency per mile is triple the historic average of 1.1% annually!

The rules are complex (bureaucrats relish making rules that must be interpreted by bureaucrats). The new standards include both cars and light trucks but they give pickups a break with a sliding scale for the footprint of the vehicle. By the same token, the standards are automatically raised if the average size of vehicles goes down.

The most obvious "technology" available to help meet the standards is weight reduction. The easiest way to achieve weight reduction is to make smaller cars, but, due to lobbying by GM and Ford, small car fleets will be penalized by even tougher standards.

When I do a non scientific survey of my friends and neighbors, I find that many people think that tiny smart cars are a fluke. The public does not believe that a high percentage of cars will be of Honda FIT size or smaller any time soon. The average person surveyed is hardly aware that the CAFE standards were jacked up, last year, to go into effect in 2011.

The first move will be from the current 27.5 miles per gallon standard to about 29 in 2011. The curve slopes up sharply and the standard will reach 31.6 by 2015. While the different ways of measuring mileage and the combination of the light truck and car standards make comparisons difficult, the move from 27.5 to 35 represents a mandated decrease in fuel usage of 27%. The demand for oil is going down just as investments to produce more are "paying-off".

I doubt if many of my readers have even heard of the Grosmont Formation in Canada, but Shell Oil has spent 465 million dollars to lease a portion of this massive reserve. Oops, I should not have used the word reserve because the estimated 485 Billion Barrels of oil in this formation are not included in reserves because there has not been technology available to recover this oil. After years of testing new methods, Shell is making a bet, one that will reach trillions of dollars, that it can profitably produce oil from Grosmont.

Shell plans to "cook", cook is another word for refine, this thick slurry of oil in situ (where it sits). At 50 dollars per barrel Grosmont is worth 24 Trillion Dollars. When there is talk about spending 4 Billion Dollars to build one nuclear power plant, the citizens of many a community automatically start wondering if wind mills are not a better answer. Many folk simply do not want to understand that it cost double to build wind mills with the capacity to produce power equal to that of one nuclear power plant. They certainly do not want to know that wind mill runs only about 20% as much as nuclear power. Since the product of 2 times 5 is 10, a nuclear power plant is about 10 times more economical than a wind mill.

But what if 100 billion dollars worth of nuclear power would be enough to recover all 24 Trillion Dollars worth of oil from Grosmont? Those who say that we cannot drill our way out of the energy crisis should be told that we cannot make the wind blow.

The combination of higher fuel standards with abundant supplies of oil means that the price of oil is not "going right back up". The records we have of the past two thousand years consistently support the fact that wages rise faster than commodities over long periods of time. Commodities only "win" the price battle during relatively short cycles. The prices of commodities come down in the long run because we constantly learn how to do more with less. The process will never be smooth but mandates from the government only serves to make the process much more volatile.

If you want confirmation that car manufacturers plan to reduce vehicle weight, take a look at the price of nickel, a metal used in making steel. Scientist have learned to use nano technology to make carbon (graphite) panels that are stronger than steel but much lighter than aluminum. It has taken Boeing many years to design and produce aircraft in which aluminum panels and millions of stainless steel rivets are replaced with light weight graphite panels. The collapse in the price of nickel shows how the law of substitution has once again done its magic act.

The inflation adjusted cost of cars continues to fall. The drop in prices has been hidden by the addition of air conditioning, cruise control, power windows, GPS and much more, but the average person works fewer hours to buy a basic car than ever before. Gasoline priced in hours of work is not far from all time lows.

A fast Russian train, hauling oil, fertilizer, corn, grain, nickel, cars and much more was going so fast two weeks ago that it ran right past the midway station. The train engineer received warnings from central bankers to slow the train down. Last week, the engineer backed the train to the station but it left again yesterday. The load of oil has bounced around; at the midway station the oil had fallen from $147 to $60 before it bounced back to $70. The price is down $8 over the past two days and is currently around $62. If it falls no more, US consumers will save about 300 Billion Dollars per year on energy and much greater amounts on the sum of purchases of other commodities.

The election of Obama will have less effect on the price of oil than is commonly believed. Government subsidized ethanol plants are going bankrupt. Wind mill builders who collected 30 cents of the construction costs from the government are having trouble operating profitably. Shell is not going to leave its $465 Million in Canada just because Obama is president. Perhaps the investment was made in Canada in anticipation of higher taxes in America!

The public has been bombarded with the lie that we have been transferring 700 Billion Dollars of wealth to foreigners through the purchase of oil. The fact is that we got fair value for our 700 Billion Dollars (I guess you have noticed that I like to make the B's T's and D's capitals when I talk about Billions or Trillions of Dollars). What we have not been bombarded with is the amount of dollars consumers will be able to divert to other purposes as those 700 Billion Dollars fall to 200 Billion Dollars.

Think of the decline in prices the way a bond trader thinks. The lower the interest yield on a bond goes, the higher the climb in the value of the bond. The lower the price of oil, nickel and cars, the higher the value of ones income.

At some point, the fast trains carrying the price of commodities (including the massive reduction in the price of English money that hit today) will lose its momentum, stop and gradually turn around. A year or more after this train stops, consumers will reach their peak in real disposable income. While Obama will take a chunk of this disposable income, Milton Friedman taught us that even government spending will serve as an economic multiplier. The initial loss to the "government rake" will not reduce the number of times the "surviving dollars" will be multiplied.

Don't let tears cloud your vision. The relative value of real estate, airlines and shares of all sorts have reached levels well below historical averages. Prices can go lower but the odds that share prices will go up dramatically is greater and greater the longer your time horizon. The odds are great that the powerful decline of 150 basis points in England will be a ripple felt around the world. This ripple will help to slow the decline in commodities but it will not take away the gains already made.