Leap of Faith

By Jerry Slusiewicz | June 23, 2008 | 5:11 PM | 1 Comment

 

The stock market is under extreme pressure as we test the lows of the year.  The economy is suffering with falling home prices set to continue at least into next year, rising unemployment, rising inflation, and plummeting consumer confidence.  Not to mention record oil and food prices.  The financial sector is leading the way down, which can never be considered good.

They say money makes the world go round. I believe that.  Therefore it is not comforting to know that the firms that make the money go around - don't have enough of it and are in dire need to raise more capital, some $65 billion more, on top of the already raised $160 billion.  So how far along are we in this financial crisis?  Simple math would say if the problem only becomes $225 billion then we are over 70% through the problem.  The only problem with that statement is the word "only". 

Last week regional banks started announcing increased write offs due to loan losses.  Regional banks, unlike their money center bank brethren, can provide insight into how well the average American is doing - not very well apparently.  Fed -Ex is considered a company that would reflect the state of the business community.  It also gave a grim outlook not only for the rest of 2008, but 2009 as well.  The troubles for the financial sector could get worse as more negative issues develop for consumers.

I firmly believe that much of our problems stem from two simple truths.  First there is too much easy access to the oil markets that is allowing speculators to dramatically run up the current price of oil.  The Nymex reports that speculative traders' interest in oil, accounts for about 70% of all trading in West Texas Intermediate crude on the Nymex, compared with only 37% in 2000.  This is a little like the internet market in late 1999.  Technology companies were trading a price to earnings ratios in the high triple digits, to levels of infinity, for those companies that had no positive earnings, based on 10 year forecasted projections of future earnings.

Today is not much different with global oil demand.  We did not wake up today with current daily global oil use being that much greater than it was 12 months ago when oil was $63 per barrel.  The world consumes approximately 80 million barrels of oil a day.  World demand for oil is projected to increase 37% over today's levels by 2030, according to the US-based Energy Information Administration's annual report.  China has seen oil consumption double in less than 10 years, and they still only account for less than 9% of daily global oil consumption.  So if they double again in say five years, that translates to less than a 10% increase in demand.  Yet prices have more than doubled in the last year.

Peak oil theorist say the problem is that we are running out of oil.  That theory has been around since 1956.  There is no concrete evidence that global production has peaked.  However since then new technologies have been developed to convert usable oil from heavy crude, tar sands, and oil shale - none of which are counted as oil reserves.  Taken together, these alternative resources in just the Western Hemisphere, equal approximately the identified reserves of conventional crude oil found in the Middle East.  While the conversion to usable oil, from these sources is more costly to produce than conventional oil, it is still estimated to be substantially cheaper than today's $138 per barrel oil.

One final note on oil, 75% of oil consumption is used for transportation.  The technology exists today, with no new inventions whatsoever, to more than double fuel mileage.  Also increased use of nuclear power, electricity, and natural gas for heating, together with better auto fuel efficiency, could effectively reduce consumption of oil by over 30% globally even as emerging market demand increases. 

My point is today's excessive price for oil is caused by speculators trading in the oil markets.  If higher margins were in place to enter trades, speculation would decline and oil prices would fall back below $100 per barrel very quickly.

The second big problem for our economy today is the ever rising cost of food.  It is estimated that U.S. consumers paid $15 billion more for food, in 2007, than they did in 2005 because of the increased demand for crops grown for fuel. Food prices really started to spike after a broad energy law was signed by President Bush in December of 2007, which required a major increase in "corn-based" ethanol to reduce U.S. dependence on imported oil. Ethanol can be produced from many sources, but this law required that it come just from corn.  Critics question whether it makes sense to devote about a third of the U.S. corn crop to fuel, when world grain stocks are at a 30-year lows and prices at historic highs.  Wheat and soybean prices have basically doubled, and livestock production costs have shot up as farmers increased corn production in the past year.

While ethanol can play a role in reducing U.S. dependence on imported oil, the country will use about one-third of its corn crop for ethanol by 2012, and only provide enough for only about 5 percent of our nation's gasoline need.  The new law favors corn ethanol by subsidizing it while imposing a tax on ethanol from sugar cane.  It would make more sense for the United States to grow food and let countries like Brazil use their land to produce sugar cane which is much more efficient than corn ethanol.  Instead the United States slaps a 54-cent-a-gallon tariff on imports of ethanol made from sugar cane, which packs more of an energy punch than corn-based ethanol and is cheaper to produce.

If you want to take some of the pressure off this market, the obvious thing to do is lower that tariff and let some Brazilian ethanol come in.  Corn ethanol generates less than two units of energy for every unit of energy used to produce it, while the energy ratio for sugar cane is more than 8 to 1. With lower production costs, more energy output, and cheaper land prices in the tropical countries where it is grown, sugar cane is a more efficient source.

Food prices are rising twice as fast as inflation, placing significant pressure on American families who are already suffering from economic uncertainty.  A repeal of the ethanol bill is warranted and will help stem the rising tide of inflation.

The monetary cycle is in the right spot; the stimulus checks are a positive for the fiscal cycle; the public has given up on the stock market, as evidenced by money market fund assets increasing by $500 billion in the first quarter despite skimpy yields.  But it is a leap of faith to believe that a slowdown in demand from a slow growth US economy is enough to right the ship.  A couple of minor strokes of the pen to increase margin requirements for oil future speculators, and a repeal of the corn ethanol bill, would go a long way to helping the economy and stock market move in the right direction.

It will be interesting to see What the Fed does. I look forward to your input later this week. Jim Submitted by Jim Slagle on Mon, 2008/06/23 - 8:05pm » reply |