Notes on the Economy – 06/30/08

1. More politicians are waking up to reality – we need to drill for oil in the U.S.  Leaders who are supposed to worry about our future instead of being re-elected in 2 years should have figured this out years ago.  As usual, no leadership in Congress, heads in the sand until disaster strikes.  So here we are, domestic oil production down 20% since 1980, oil consumption higher, 60% imported, oil prices the highest in history.

Politicians who still oppose drilling (like Daschle) make this argument: drilling won’t help us today, it takes years to get new oil.  Duh!  And that has been the mantra for decades to get votes.  But how about thinking about our future??

The argument of opponents to new exploration is equivalent to not starting Microsoft because there is no immediate profit, or no need to start first grade because what’s the immediate payoff?  This is the mentality of people running our country and we are worse off because of it.  There is an election in a few months, be sure to make your views known.

2.  China has invested tens of billions of dollars in infrastructure and raw materials deals in Africa as they take steps to assure their supplies of needed oil and commodities in the coming years.  For the next decade, the pressure on commodity prices and supplies is likely to be strong, even if China and India growth slows.

In many countries that provide raw materials, governments own the producers.  As we know, governments don’t run businesses very well.  Oil output in Venezuela, for example, has declined since Chavez took control.

Governments in many of these countries are also unstable, and from time to time, they nationalize assets that were developed in partnership with other countries.  Russia and Venezuela are excellent examples.  Exxon sued Venezuela for assets confiscated and won in court.  I wonder if governments that are dictatorships will be as civilized when their assets are seized.  Let’s hope so.

3.  Today’s high oil price reflects market assessments of the balance of supply and demand in the future.  Demand has grown strongly as China and India joined the growth club.  More growth means more oil demand.

On the supply side, the picture is not so good.  Oil fields in the U.S. and the Middle East are old and the amount of oil that we can extract each year declines.  We are not finding new oil fast enough to replace declining output in the old fields.  This is made worse by government restrictions in the U.S. on locating new oil.  Most countries with oil are increasing their oil production with new discoveries, but U.S. oil production is down 20% since 1980.  If the U.S. developed its own oil assets, the price would fall since the market would know that supply was going to be larger in the future.

Then, the money we pay for oil would stay at home and not enrich the foreign suppliers of oil.  On the other hand, if we use up their oil first, then in future years, we’ll still have our oil and they will be short.  Interesting dilemma.

4.  Although large banks have been writing off the bad loans they made related to real estate and raising new capital, there is still more bad news to come.  Most of the problems are in Florida, California, Nevada and Arizona where a third of bank loans are tied to real estate and 90 percent of the increase in foreclosures exists.  This is true in Georgia and North Carolina as well.  A huge chunk of the bad loans made in these states were made by banks that do business nationwide, yes, those Wall Street Banks.  This means that they have less money to lend and this affects business everywhere, not just in the troubled states.

Foreclosures are definitely up, and these do cause losses for lenders.  But keep in mind that a huge number of these foreclosures are not putting families out on the street, they are speculative purchases where no family ever planned to move in.  The purchaser hoped to flip the home for a profit, but the flippers ran out of flippees.  It’s bad, but not as bad as the numbers suggest.

5.  The role of oil speculators has become very controversial, as many blame them for gas prices.  The amount of money devoted to commodities indices has risen from $20 billion in 2003 to over 250 billion today.

But let’s look at the fundamentals.  There are only a few buyers for oil, such as refiners and chemical companies.  You and I don’t want a load of oil delivered to our homes.  The real determinant of the price they will pay depends on the price they can charge for the things they make from oil, such as gas, plastics and chemicals.  If users of these items won’t pay higher prices, then producers won’t buy the oil at higher prices.  The popular term for this these days is “demand destruction”.  The higher the price, the lower the quantity taken.

So, as the oil tanker travels across the ocean, ownership of the oil it carries can change many times as speculators buy and sell it.  But in the end, the last speculator must sell to a real user of oil.  If a refiner can’t sell the gas at higher prices, it wont pay higher prices for the oil.  Thus, it’s not speculators driving up oil prices, it’s a shortage of oil relative to demand.  Markets work.  In the U.S. it is a shortage of low sulfur oil, the only type of oil our refineries can use and that’s the oil whose price is out of sight.

6.  Many investors think stocks provide protection from inflation.  However, the evidence suggests that this is not the case.  Surges in inflation are generally bad for equity prices.  One reason this occurs is that inflation generally leads to higher nominal interest rates and thus a reduced value of the expected profits that stocks promise.

But profits are the ultimate determinant of stock prices.  And the most important determinant of profits is labor costs, accounting for about two-thirds of business costs on average.  If these go up with inflation, profits are squeezed and share prices suffer.  If labor costs don’t rise with inflation, as seems to be the case these days, then inflation is not as harmful.

Another caveat, many companies make a significant share of their profits from foreign operations.  Exxon would be a good example, or Coke or drug companies.  Thus, inflation in the U.S. may not have as much of an impact on their profits as it used to.  And that, in part, depends on the value of the dollar as many companies like Caterpillar sell more when the dollar is weaker.  For investors, lots to keep track of.  Good luck!

7.  The issue of executive pay continues to trouble investors.  It looks like greed gone wild and it appears that Boards of Directors aren’t doing their job.  There is truth in this, although it doesn’t apply across the board.

But greed extends beyond pay.  The recent disclosure that the former heads of Fannie Mae got  sweetheart loans from Countrywide is an example.  Both of these CEOs made hundreds of millions of dollars on their jobs.  Yet they engaged in other activities such as getting special deals on huge mortgages from Countrywide, knowing that it was at best highly unethical and likely illegal.  [Countrywide provides about a quarter of the mortgages purchased by Fannie Mae, Bank of America about 5% perhaps explaining why B of A still wants to buy them.]

Both of these CEOs are crooks, plain and simple, looting shareholders’ earnings to fatten their bank accounts and leaving their respective companies in worse shape.  Problem is that punishments are still not severe enough to deter this behavior.  After fines and a wrist slap, they still have millions of our dollars.

8.  Economists have warned for years about the looming crisis in the public sector arising from the outrageous promises made to workers and retirees.  There isn’t enough money to pay for these promises.  The big three automakers are sinking under the weight of such promises.  Social Security and Medicare will do the same to the economy.

The town of Vallejo, California might provide a glimpse into the future.   Three-fourths of the city workers earn over $100,000, the city manager earns more than Vice President Cheney, police captains earn more than $300,000 (6 times what a school teacher earns).  Firefighters earn $170,000 a year on average.  These workers can retire at age 50 and get 90 percent of their pay.  There are only 120,000 residents to bear this cost.

Unable to meet these promises, the city has declared bankruptcy.  Now, scale that up to promises made for Social Security, Medicare, Medicaid and the like.  If workers can’t afford to pay these promises, they will have to be broken.

9.  Although immigration is critical to the growth and success of the American economy, it also presents some important challenges.  Having more people is not good if those additional people cannot be as productive as the current population.  Thus, education is a critical key to making sure that immigration is an asset for America, not a liability.

The latest census shows that 55 million Americans over the age of 5 don’t speak English at home, an increase of over 70% since 1990.  In some states like Georgia and North Carolina, non-English speaking homes have risen over 200% since 1990.  In California, over 40% are in non-English speaking homes, up over 50% since 1990.  Texas and New Mexico are similarly situated.

Having everyone speak and read the same language is a real plus for economic growth and job creation.  If I can’t understand you, I can’t hire you.  This is one problem faced by the European community.  There are as many languages as countries (27) so labor mobility between countries is restricted.  This is a real challenge to the education system as well.  Many of these people are or will become bi-lingual, an advantage in a globalized economy.  But many aren’t getting the education they need to compete in that economy.  And that will be a problem.

10.  The farm subsidy program sets floor prices below which, it is argued, farmers can’t stay in business making corn or milk.  If market prices fall below these floor prices, taxpayers make up the difference.

Since the last farm bill was passed, the prices of cotton, corn, wheat and soybeans are up 100 to 200 percent.  And no surprise, it looks like the new “floor” prices might be adjusted to this year’s record high prices!  So if corn prices were to fall from today’s record $6 a bushel to the pre-ethanol price of $3, you would give corn farmers $10 billion a year in subsidies.  So, farmers get rich whether corn prices fall or not. Sugar growers are now guaranteed $21 a pound compared to a world price of $12.  Candy companies are leaving the U.S. as a result.

President Bush’s proposal to limit these subsidies to small farmers making less than $200,000 was rejected.  Instead, the Democrats will pay your money to “farmers” (many don’t farm at all, just collect the subsidies and hire the farming out) making as much as 2.5 million, hardly a poor farmer.  The bulk of these subsidies go to rich farm owners including agricultural corporations.  Bottom line, the government is setting food prices, you either pay high prices at the store, or if prices fall, the government will lift the difference out of your wallet as you bend over to pick up a cheaper gallon of milk.