Friday, February 22, 2008

Boone Pickens On Oil Prices & US Energy Policy

Yesterday morning on CNBC's Squawkbox program, T. Boone Pickens made some major waves.

First, in the course of opening comments and questions, the co-anchors pressed Pickens on his views for oil and other energy prices in the coming year. Noting that he had correctly predicted $100+/bbl oil, Boone gave a rough forecast of softening prices from now until mid-year, followed by higher prices after that. He said the same for natural gas.

The CNBC staff immediately asked if he was now short oil and natural gas. After a moment's thought, in which he obviously considered being coy, Boone said "yes" to each question.

Within moments, futures on both commodities were trading down. It was reported that the major newswires immediately published Boone's remarks on his pricing views and short positions.

But that's not what this post is about. Instead, it's about a topic related to this post of a few days ago.

Pickens remarked that he had lain awake in bed the night before thinking about the topic, it was so important. He reinforced that, saying it was bigger than being long or short oil, or making money in his fund by his prescient energy price calls.

What Boone Pickens worries about is the $500B per year that the US now pays foreign oil producers to import the precious commodity. Half a trillion dollars. That's how Boone put it.

More than $1B per day.

This morning on CNBC, AutoNation CEO Mike Jackson reiterated Boone's concerns, citing the need for higher oil and gasoline prices, if the US is ever to reverse this trend.

Boone went on to extol the benefits and practicality, feasibility, of wind power across the Midwest and Southwest US, and solar energy development in the latter region, mentioning Sweetwater, Texas by name as a model for economic redevelopment in concert with clean, domestically-produced energy.

Boone went on to cite, as I noted in that prior post, the continuing trend toward nationalization of oil reserves. He pointed out that Exxon pumps only 3% of the world's current 85B bbls pumped per day. He then cited a statistic that the US has 5% of the world's population, but consumes 25% of its oil production. That this "isn't fair."

Maybe, maybe not.

What Boone didn't note is that the US produces 25% of world GDP, using 25% of oil, but only 5% of population. Doesn't that make us a productivity wunderkind?

So here's my question: what if Boone, though well-intentioned, is wrong?

Could he be overlooking Ricardian economics?

How much do we export? Is our oil usage for our 300MM population, or our 25% of global GDP? on the latter basis, it seems actually fair.

Don't we effectively produce for export, as well? Can you actually align US oil consumption purely with domestic consumption, or is it, in a value-added-chain manner, an input into GDP, too? Don't our exports of intellectual property-based value-added goods and services represent a usage of imported oil? Just like we import aluminum, steel, titanium, diamonds, and a dozen other important, necessary commodities for manufacture of US-sourced goods?

I'm reminded of the pre-Ricardian economic comments of one of the men we honor on President's Day. It's the wrong one for today, unfortunately, it being the birthday of our country's first President, George Washington. But Abraham Lincoln is remembered, and occasionally quoted, a la Boone Pickens' remarks yesterday, for this quote, contained in remarks by former Fed Bank President Bob McTeer, in this piece,

"For example, Abraham Lincoln was a very good amateur economist, as I will show later. But he wasn't good enough to get international trade right. Here's what he is supposed to have said about tariffs: "I don't know much about the tariff, but I know this. If I buy a coat in England, I get the coat and England gets the money. If I buy a coat in America, I get the coat and America gets the money." "

That's how I remember the quote as well. And I was born in Illinois- does that count?

By extension, Pickens' and Lincoln's views become one of zero trade. Anything that sends our currency overseas, creating external liabilities, is to be shunned.

But where do you draw the line? Can Boone, or any of us, really know just how much of the $500B annually that we send overseas for oil is 'too much,' given that we use that energy, rather than other, assumedly less efficient domestic sources, to create value?

If we could stop buying foreign oil tomorrow, and, instead, use the $500B to buy onshore energy, would we accidentally reduce our resource productivity, make our exports more expensive, lower our domestic standard of living and, in the end, actually damage our long term economic prospects?

So long as we create value with the imported oil, and the dollars we pay for it are not being used with malicious intent toward us, what's the problem?

I think it's that second clause that is the issue. It was in the prior post, where I noted that the desire of other, oil reserve-owning nations to effectively withdraw from tradeable energy spot markets, makes the whole game different.

But it's not about trade balances, per se. It's about the motives of our putative trading partners, isn't it?

In effect, it's less about economics and productivity than it is about long term national security. And again, as I wrote in this post,

"Rather than global warming or clean air, I think the Journal piece reveals what's really going to drive new energy technologies in the West."

And that was the Saudi plans to consume more of their own oil, eventually changing the economics of many things- aluminum and other basic materials' production economics, oil pricing and supply.

That said, I think Boone is right to simply call attention to the outflow of half a trillion dollars annually for oil. But while he's at it, why don't we tote up the bill for various other commodities, in order to understand just how much we pay, and for what, in order to drive our current economy?

In the end, it's not about oil, is it? It's about creating dollar liabilities in the hands of those who don't wish to merely use them to trade, but, potentially, use them for purposes calculated to undermine our country's long term welfare.

And that's a different issue entirely.

Thursday, February 21, 2008

More On Bond Insurance

This morning's guests on CNBC provided some truly interesting and valuable insights on several topics.

One guest was T. Boone Pickens, opining on oil and natural gas prices, as well as longer term energy concerns. I'll be writing about his comments in my next post.

The other guest was one who I have seen once or twice before on Squawkbox- Doug Dachille. Mr. Dachille, from his title and the name of his firm, seems to be head of a not-large investment management firm. As I searched my prior posts, I found this post, dated exactly two weeks ago, in which Dachille's prior appearance (with Jim Cramer) is described.

I was, for the most part, impressed by Dachille. His grasp of macroeconomics left something to be desired, but his logic and comments on fixed income issues were refreshing and provocative.

This morning's appearance was no different, in terms of the quality and value of Dachille's remarks.

His focus was on the very hot topic of what is to become of AMBAC, MBIA, FGIC and other so-called financial instrument insurers.

The discussion began with remarks about noted short-seller William Ackman's proposed 'good insurer/bad insurer' plan, as well as NY State AG Dinallo's similar idea, both of which have put pressure on the insurers to do something prior to a rating agency re-evaluation of their credit ratings next week.

Dachille did an admirable job of cutting the Gordian knot surrounding the business of these bond insurers.

In essence, Dachille argued that their business is superfluous. Period. That their existence is now the result of some hoary old legislation or internal investment rules by various pension or government funds regarding the minimum rating which a security must have to be held in their portfolio.

Dachille noted that the insurers cost approximately 10-15bp for their function. In comparison, according to Dachille, fixed income managers are paid roughly 35bp.

Both fees are not necessary, according to Dachille, because only one 'due diligence' need be performed. If the insurers are truly taking the risk, via insurance, then at least a commensurate amount of fee should be removed from the managers, because their work is made easier, and risk removed for their customers.

Dachille questioned why an insurer whose financial resources are obviously inadequate to serve their obligations, whose stock price has fallen so much in the past year, and whose ratings are about to be changed to a level below many of their customers, should have any material affect on, or benefit to, a bond issuance?

Santelli agreed wholeheartedly. Both engaged in a brief dialogue suggesting that the bond insurers no longer serve an economic purpose, because they confer a sort of average risk rating, by virtue of their coverage, when buyers should really do their homework to more accurately price individually-issued municipal securities for risk.

Thus, Dachille's overall view is that there isn't really a crisis because these firms don't really add economic value now anyway.

Granted, he admits that banks holding suspect, effectively under- or soon-to-be-uninsured CDOs, will have to take further writedowns. On this note, he observed the parallel between the insurers' "crisis" and the super-SIV plans last fall.

Those plans, he noted, came to naught as banks began to just write down their losses. He feels the same should occur now, because, one way or another, the holders of these insured, but ineffectually so, instruments, will have to realize their lower values eventually.

I found much sense and value in Dachille's observations and recommendation. After years of a charade, the missteps by the bond insurers into non-municipal waters have accidentally exposed the lack of true economic utility of even their core business.

Wednesday, February 20, 2008

Changing Oil Industry Dynamics

Today's Wall Street Journal carried an article in the 'breakingviews' column about ExxonMobil's inability to replace its oil reserves at historically high rates. According to the piece, the replacement rate, per Exxon's calculation, was 101% in 2007. Its 5-year average rate of replacement has allegedly fallen, according to Oppenheimer, from 121% to 112%.

The source of this trend, of course, has been the recent, increasing nationalization of oil reserve ownership and control. Where non-state-owned oil companies such as Exxon, Chevron, BP, and others used to bid on and purchase the right to develop and own oil from fields, in exchange for royalties paid to the country in which the oil resided, China, India and Russia have begun to effectively remove their oil reserves from the world's markets.

With each passing year, it seems that the amount of tradeable, shippable oil is becoming a smaller proportion of the oil pumped globally.

What does this portend for ExxonMobil, Rex Tillerson, and the private, non-state, publicly-held oil companies?

I thought about this while running errands this morning, and came to some tentative conclusions. After discussing them with my business partner over a working lunch, I feel they have been sustained.

Here's what I think the near-term and long-term reprecussions of the nationalized oil policies may be.

First, recall the 1974 Arab oil embargo. By withholding supply from the market, the near term effect was to hamper and, in some cases, cripple American automotive energy usage. But the longer term result was the halving of the amount of oil required to produce a dollar of US GDP two decades hence. Parenthetically, the price of oil eventually fell, too, to just $30/bbl only a few years ago.

As I wrote here a few months ago, Julian Simon noted years ago that the constant-dollar price of most commodities remains fairly stable over time, due to the process by which a rise in price causes new supplies to appear. Or substitutes to be developed, causing demand for the commodity to ebb, and, again, prices to fall.

Back to the present, what would the probably results be, near- and longer-term?

First, I think that oil firms such as ExxonMobil will have a tough time in the near-term. As I wrote here, in December of last year, if you need a commodity that you don't own, and the owners of the bulk of the commodity use it for their own purposes, you have a problem. I wrote,

"As I told my daughter, I think cars of the future will use other fuel sources than petroleum, because of the long term consequences of the world's major oil supplier electing to consume its own commodity for rather uneconomic purposes.

And, by the way, when the Saudis burn oil to make electricity, they are doing the equivalent of a Dutch tulip 'investor' buying a bulb in order to destroy it, and make his own worth that much more. The more oil the Saudis foolishly waste, the more valuable their remaining below-ground reserves.

In a world like this, American innovators have historically stepped in with creative solutions. In fact, this situation is virtually identical to our invention of synthetic rubber (the Buna process) before WWII, when the Japanese seized the Southeast Asian natural rubber plantations.

More than any other single driver of a change in how we fuel US autos, trains, planes and ships, this looming demand increase by the Saudis for their own commodity will, I think, cause a radical change in fuel technologies in this country over the next twenty years.

Rather than governmental standards, I told my daughter, you can usually count on some creative, hungry American inventor to develop a technological solution to the problem of ever more scarce and expensive gasoline to power our cars.

Imagine, a decade from now, Dupont, GM and ExxonMobil collaborating to power, build and fuel new technology cars. Or perhaps not Dupont, but some venture-capital funded new fuel technology startup. With the assurance of the production of the fuel, GM will build vehicles using it, and ExxonMobil will use its existing fuel distribution system, if relevant, to provide the new fuel's ubiquitous availability."

The larger global impact would almost certainly be similar, as in 1974. When oil becomes less available because China, India and Russia effectively bought nationalized reserves at implied high prices- north of $70/bbl- you might expect global oil markets to begin to disappear. Alternatives would be sought.

For example, in the US, if automotive energy needs were able to be supplied by improved batteries, then our former need for petroleum-refined gasoline for vehicles could be transitioned to coal-based electrical power to (re)charge those batteries.

In time, it's even possible that world production of various downstream products using non-petroleum energy sources could undercut the more costly products made using high-priced petroleum.

In the longer term, I think it's quite possible that the value of the petroleum reserves bought at such high prices by countries such as China and India would become a burden. Demand for the scarce commodity would fall, as alternative fuel sources were developed and commercialized. Eventually, the oil-owning nations might want to return to some market-oriented system, only to find that the new clearing price for their commodity was much lower than that at which they took the supplies private.

In effect, if a substantial proportion of world oil supplies are removed from the market, for internal consumption, the remainder of the world will have no choice to, where possible, behave similarly, and, then, where there are shortfalls, develop alternative energy sources.

Over time, then, total demand for the energy commodity would fall, and its implied price would, as well. Any country having built inventories of oil at high prices would have to absorb the loss in some fashion, if only in the national balance sheet value of oil reserves.

Like any other commodity supply disruption, that of oil may cause pain for industry players and consumers in the short term. ExxonMobil may become more of a refiner and distributor of what petroleum products are available to it for the foreseeable future. However, where market forces are allowed to function, substitutes will arise, demand for oil will wane, and it's effective market price will eventually fall.

I think Julian Simon's theory would still obtain in this scenario. Whether the ExxonMobils of the world could hold out that long is another matter.

Tuesday, February 19, 2008

Paul Ingrassia On The Source of Progress on Automotive Fuel Efficiency

Today's Wall Street Journal features an excellent editorial on the historic sources of progress on automotive fuel efficiency. Written by former Dow Jones senior executive, Pulitzer Prize-winner and my former squash partner, Paul Ingrassia, it's entitled, "Detroit's (Long) Quest for Fuel Efficiency."

Paul Ingrassia knows cars and the auto industry. Probably better than any other American observer around. He was the WSJ bureau chief in Detroit, which provided him the opportunity to write his prize-winning book years ago. He's well-connected to various former and current senior industry executives. When you talk with Paul, cars and the auto industry are never very far from his mind, or your discussion.

In his piece, Paul provides a rare, valuable examination of the progress that America's, and the world's automakers have made on this front over the past sixty years. Coming, as it does, amidst a Presidential campaign which includes calls for 'energy independence' and 'higher fuel economy standards,' this piece provides great value.

He's organized his thoughts to offer three "lessons" about automotive fuel efficiency:

1. Incremental progress shouldn't be dismissed.

2. Market forces, not government regulation, provide the most effective impetus for higher gas mileage.

3. New technology will require new infrastructure, presenting a chicken-or-egg problem.

All three points have tremendous bearing on the current 'debate,' if you can still call it that, in the business and popular media regarding energy usage by automobiles.

Specifically, Paul cites the 1959 GM Corvair as having made significant advances in fuel economy for its time. By contrast, he notes that GM's electric EVI failed miserably thirty years later.

Among current incremental technologies, Paul describes the current European diesel as having great potential to improve fuel economy incrementally, without the need for a radical technological innovation.

His second lesson is perhaps the most politically astute one. That is, it addresses the aspect of this issue that generates the most heat, but least light, if you will, in current political debate.

As various Presidential candidates excoriate Detroit for its failure to build more fuel-efficient cars, they turn to Congressional CAFE legislation, as if this will really matter. Holman Jenkins, Paul's former colleague at the Journal, wrote similarly in a piece on which I wrote this post late last year.

Paul's meticulous retelling of the SUV story puts the lie to any belief that CAFE standards actually affect real consumer behavior. Gasoline prices and actual vehicle gas mileage do, but the standards do not.

Along with Jenkins, Paul notes that, when consumers want high fuel-efficiency cars, Detroit will build them. When they don't, Detroit will still have to meet consumer demand, but CAFE standards will become another constraint that doesn't actually accomplish anything except providing politicians with a false sense of having 'done something' about this issue.

Finally, Paul provides a detailed explanation of how one GM executive, then-president Ed Cole, simply introduced catalytic converters into the GM product line in 1975, forcing the oil refiners and gasoline retailers to provide unleaded gasoline, which is necessary for cars with these air-cleaning devices.

Paul notes that Cole showed more decisiveness and leadership more than thirty years ago then any current figure, public or corporate, seems to be capable of doing to move forward on this issue.

If anything, Paul's recitation of history, and the forces at work today, are cause for me to remain leery of expecting Ford or GM, or even Chyrsler/Cerberus to realize significant value-added, profit, and consistently superior market returns for their shareholders from their responses to the fuel efficiency dilemma.

Monday, February 18, 2008

Last Week's S&P500 Performance

We seem to be in a period of weeks of indeterminate financial markets behavior.

For the evolving month of February, the S&P is down, with roughly a -2.2% return. That's including last week's +1.4% return, and the prior week's -4.6% return.

Looking at my newly-devised monthly standard deviation measure of daily S&P500 Index returns, it's hard to get excited about last week's return. That is because it falls within the confidence interval of 68% that such a return could occur, plus or minus, in one day for the S&P.

The daily returns last week were: +0.59%, +0.73%, +1.36%, -1.34%, and +0.08%.

Tuesday's rise was attributed to Warren Buffett's self-serving offer to reinsure municipal instruments. Wednesday's gain was allegedly due to positive corporate earnings reports and some positive sales data. This, by the way, amidst what more pundits, and a few economists, including former Fed chairman Greenspan have decided is, or is about to be a recession.

Thursday's large drop occurred as Treasury Secretary Paulson, Fed Chairman Bernanke and SEC Chairman Cox all testified before Congress. Given the typically-hostile attitude of the Democratic-chaired committee to the Republican administration officials, it's not all that surprising that the subsequent testimony roiled markets.

Some felt that Bernanke left the door open to a further rate cut of 1/4% point at the next Fed meeting.

Finally, on Friday, despite poor manufacturing data and a low Michigan Index of Consumer Confidence, as well as reported investor concerns about inflation, the index managed a small gain.

Confused about investors' reactions to various 'news' items? You're not alone. At least I'm with you.

So, as we head into the last half of this month, the S&P is so volatile that there is a good chance it will either slice most of the negative return, or add another -1.4% to it, on any given day. In any two day period, the index could turn positive, or more than double its negative return for the month.

After reviewing this past week's sample of putative causes and effects on the index's daily performance, it gives one pause to have any sense of which way it will finish this month.

It's so tentative that my partner and I are actually watching daily S&P performances, in order to keep up with the latest moves in this very unstable market. Until one of the major indicators which we monitor either confirms its current position, or moves significantly in another direction, we are unlikely to take any new positions in equities or options.

It's simply too difficult to discern a longer-term market direction for the next few months at this time.