Oil Is Not Well

John Mauldin | Thoughts from the Frontline
November 16, 2001

"Leningrad gets DAMNED cold in the winter, so bring it on, lay the price siege, and lets see who can outlast whom." For details see more below.

Lot's of news this week, especially in the oil patch. Kuwait tells us there is "no floor for oil prices." I smell a rat. Let's jump right in.

Global Recession

I noted with interest that the economists at the International Monetary Fund have finally noticed that we are in a global recession. "There is no real precedent for this situation, which makes forecasting based on previous experience look something like trying to read the tea leaves," said Horst Koehler, the IMF managing director.

He predicted a recovery for the second half of next year, but added, "We can't exclude the possibility of a worse scenario." In a huge understatement, the International Herald Tribune tells us the IMF's forecasts are frequently criticized for lagging behind private economists' estimates of future activity.

For instance, the IMF now says the U.S. economy will grow by only 0.7 percent next year - a sharp downward revision from the previous forecast of 2.2 percent. J.P.Morgan thinks we will grow by .2% next year, which is not exactly a prescription for a robust second half recovery.

What could make the cheer-leading economists think we might be in a global recession? Let's look at just the headlines which crossed my desk today.

"German profit outlook gets worse" and the article goes on to tell us just 17% plan to increase their capital expenditures while 36% plan to decrease them.

Taiwan is officially in a recession and is on course to report its first ever full-year economic contraction. Taiwan's economy shrunk during the third quarter, with gross domestic product (GDP) falling 4.21%, according to official figures. But there is hope, their chief industrial economist says. The US is prevailing in Afghanistan and that will help the Us economy recover and then they can sell more goods to us.

Singapore's economy contracted by 5.6% in the third quarter of this year as the wealthy city-state spiraled further into its worst-ever recession.

Japan is now in official recession, Europe is continuing to slide and South America is in trouble on numerous fronts.

These are typical headlines from around the world. I will stop, though we could go on for a page or two, but you get the picture. In fact, you got it far sooner that the chief economist at the IMF. Only you aren't getting several hundred thousand a year. Somewhere there is a big disconnect. It seems the bigger the organization and the larger the salary the longer it takes to discern reality. But rather than ponder upon that observation, let's move on to the US economy.

More Evidence of US Deflation

We find that Industrial Production has dropped 1.1% in October for the 13th month in a row, which I believe is now a record. The Consumer Price Index fell 0.3% last month, the first time in 15 years that prices have dropped twice in a four month period. The U.S. producer price index (PPI) fell by 1.6% in October, the largest 1-month decline on record (the series began in 1947).

Inventories in the US, while falling, are not falling as fast as sales. There are stories on steel prices falling. Nordstrom and other retailers are cutting prices. Chrysler (I still don't want to write DaimlerChrysler) lowered prices on 2002 models by almost 1% even as they offered O% financing. This is unheard of at the beginning of a model year. Even Pilgrim's Pride expects prices on chicken to dorp due to a surplus.

Will we slip into out-right deflation over the next year? The "experts" tell us no, since they contend housing and medical costs are going up, and oil won't drop much more. I am no expert, but I believe there is reason to think we could see prices soften in both oil and housing.

Oil Is Not Well

Several years ago, as I was contending in my writings that we would see deflation in the future, I would frequently get letters from readers telling me "No way, John! We are going to see inflation. Just look at the price of oil go up! We can't produce enough and prices are just going to keep on rising"

To that I politely said (in summary) the following: even with rising energy prices inflation is slowing down. But energy prices are very cyclical. Like those magnificent men in their flying machines, the go uppity-up-up and they go down-ditty-down-down.

Oil is a complicated commodity. It is subject to demand but it is also subject to manipulation. The price of oil rose as demand rose and OPEC cut back production. It is easy for OPEC to control production in times of rising demand. That is because if OPEC countries cut production back a little, their overall dollar income increases.

But in times of falling demand, as in the global recession we are now experiencing, cooperation is harder to come by. Countries, which need as much as they can get, simply cheat on their quotas.

Oil is not something you can pile up in the back yard. There is a finite amount of storage. Basically oil is a steady state or production and use. Think of it as a bathtub. The drain and the faucet are normally flowing at the same rate.

As oil storage builds up, demand falls. But the oil wells keep pumping, and the oil has to go somewhere. As inventories grow, the price drops. If the total oil production in the world is just 1 million barrels a day over what is used, it is not long before there is a glut of oil.

We used about 77 million barrels of oil in the world each day prior to September 11. Demand is down, but production is not. Inventories of heating oil, for example, are approaching all time seasonal highs. Greg Weldon tells me the futures prices of heating oil indicates that prices will be flat this season, at best. Good for the consumer. Bad for oil companies.

OPEC has been trying to get Russia, the other major producer, to commit to lower production. Russia apparently agreed, which sent oil prices rising. Then Russia announced their "cuts" would be a meaningless 30,000 barrels per day, and prices started dropping again. Once again I go to Weldon for the best quotes on the situation. The next few paragraphs are either direct quotes or summaries. Nowhere else on the news did I find this rather startling series of quotes.

First, Kuwaiti Oil Minister Adel al-Subiah tells the world "There will be hard times to come in the form of low prices. Then things will square up. If OPEC does not maintain prices, then there is every reason (for non-OPEC) to cooperate. It is an offer that is hard to refuse. The alternative is rather grave to everyone, including Russia."

Saudi Minister Ali al-Naimi chimes in "We will see who has resolve. If the price really drops, and stays down, you will see a lot of instability not only in the economy, but also in the stock of companies, and their ability to invest in future production."

Wow. Read that again. That is rather stark and very aggressive language. Basically, that is the Arabs telling Russia to get in line or they will let oil prices go to Hades. Says Weldon, "OPEC's agenda is CLEAR, as orated by Saudi Arabia: price Russian production out of the market. Hence the 'call' by Kuwait for $10 oil."

So, when faced with such clear determination, what does Russia say? "Russia's second largest producer, Yukos Oil Company, and CEO Mikhail Khodorkovsky, firing back like any respectable Russian Bear would, "OPEC's proposals are not acceptable for Russia. Prices will collapse, but our Arab colleagues won't be able to keep prices low for more than two years, because their economies are dependent on oil exports."

"In other words [says Greg]... circa 1943-44 war-words ... Leningrad gets DAMNED cold in the winter, so bring it on, lay the price siege, and lets see who can outlast whom."

In reply to a reporter quoting Khodorkovsky's comments, OPEC chief-talking-turban Ali Rodriguez said pointedly "We have no floor for prices". (Weldon)

Thanks Greg. Now let's see what this means. I called my good friend and Chairman of the Texas Railroad Commission, Michael Williams. The Commission oversees the oil industry in Texas. He tells me that many Texas producers have costs of $14 per barrel. Some Arab wells can bring up oil for as little as $3.

(As an aside, Williams was campaign treasurer for a little known losing Congressional candidate called George W. Bush in Midland, Texas back in the 70's. Williams is also one of five black statewide elected officials in the United States. Four are Republican. Think about it.)

Could oil go to $15? You bet it could. In an Afghanistan heartbeat. Who blinks first? OPEC? The Arabs? Russia?

The fact is that both the Arabs and Russia could come out winners in this contest. If you drive down costs, you also drive out a lot of high priced production. They simply have to shut the wells down. In many Texas and Us wells, the pressure is so low you may not be able to get them started again without considerable cost.

You also stop new production form coming on line. If you do not replace existing production, total production over time goes down. That means tighter supplies and higher prices.

If you are willing to slash prices for a year or so to get prices up to a potentially permanently higher plateau, you engage in a price war today. Especially if you think that over a decade you get more total dollars. If you are already oil-rich, you think in terms of decades.

The problem is not just one for my Texas oil patch friends. If you are Mexico or Venezuela lower oil prices are a huge blow to your economy, and very destabilizing socially.

While US consumers get lower prices for a short period, we end up being more dependent upon foreign oil at even higher prices at the end of the decade. And who will we be dependent upon? The Arab world or our new best friend Russia?

The above quotes look more like fighting words than overtures for cooperation. It may even be in the producer's long term interest to lower prices for a period of time to shake out all the weak hands.

Unless someone blinks, lower oil prices are in the cards. Book it, Dan-o.

Will Housing Prices Soften?

Unemployment rolls are at an 18 year high. The percentage of unemployed is going to 6% at least. Housing costs have risen at over 3% this year, and is a big part of the overall inflation rate. If housing costs and rentals begin to soften, then the annual inflation rate could go even lower.

The question is, which way housing prices?

I will admit to being mystified at the recent action in bonds. The market giveth and the market taketh away. The explanation is that bond traders are seeing signs of economic recovery in the future and think the Fed will not lower rates any more. Therefore, long rates have gone almost back up to where they were before the Treasury decided not to sell any more 30 year bonds.

This has got to be frustrating to Greenspan. That was their one surprise bullet. Many analysts, myself included, thought that would be a big help in getting long term rates down. Lower rates mean better a better housing market and stable prices. Prior to the lowering of rates, the housing market was showing signs of weakening.

David F. Seiders, the Chief Economist of the National Association of Home Builders tells us he expects 4th quarter housing starts to be down about 10% from the third quarter. He also expects next year to be flat or to show little or no effect from the recession. He makes this optimistic projection based upon lower mortgage rates.

If long rates do not drop, then the housing market is at risk. Prices could drop.

Thus, we are left with only medical costs as a sure lock to rise in price.

It is not altogether clear to me that price deflation could not get more serious than most analysts I read imagine.

Long-term this should be quite bullish for bonds. Short-term it means more volatility. Do I still believe that long term rates are going down? Yes, but not without the bond vigilantes fighting every step of the way. Bond traders are a much tougher breed than Taliban warriors, it seems.

Stock Market Cycles

I have just finished a remarkable book called Stock Cycles by Michael Alexander. You can get it at Amazon.com. I read a number of books each year, and only find a few that truly stimulate my thinking. Alexander gave me an "aha!" moment while reading his book.

Doing very original research, he has found a relationship between stock market cycles and several economic cycles. He shows us an intriguing new way to look at the economy and stocks.

Long time readers will remember that I keep talking about the research of Dr. Robert Shiller, who tells us that stock market indexes do not show any gains ten years after P/E ratios go above certain levels. Shiller postulates a few reasons, but the hard connection between why high P/E ratios mean lower stock prices in the future is not easily seen. If it was, P/E ratios would never rise.

Alexander goes further and shows us the dotted line which connects the economy and stock prices. Next week, for your Thanksgiving week-end reading, I am going to review this book at length.

The book is not light reading, and has a lot of statistics and calculus. Alexander is nothing if not rigorous. But it is worth the time and the $14.95.

Our New Best Friend

I was driving home last night, and tuned in the radio to hear the President of Russia, Alexander Putin, doing a talk radio show on NPR. To give the host his due, he was not serving up softball questions. Putin did a remarkable job talking about his country, his view of the world and his new friend George W. He did not dodge questions on Chechnya, his days in the KGB or Russian experience in Afghanistan.

I am old enough to remember pictures of a former president of Russia, Nikita Kruschev, taking his shoe and banging it on the desk at the United Nations. The then and now contrasts can hardly be more stark.

As an aside, my e-letter is often translated into Russian and disseminated in Russia over the internet. I communicate with Russian colleagues regularly. They are eager to find US partners for their businesses.

I also note that Russia is now a major exporter of oil and needs a stable market and we are a major importer of oil and need a stable supply. Interestingly, Putin and Bush seem to be in more agreement on most issues than we can get with our "ally" France . I am sure the connection between the two is just coincidence. Maybe my Russian business readers can shed some light on their take on our new relationship I can share with my readers.

It is a strange world.

Thanksgiving

I just got an Instant Message from Ed Artis of Knightsbridge. He is in Thailand on his way back to the US from Afghanistan. He will not be here long, as he will be raising more money to go back to buy tents and food. The need is great, and with winter approaching is getting greater.

As we sit down to our feasts this year, let us remember those around the world who are not as fortunate and ask ourselves what our role should be this Holiday Season in making the world a little more humane. To those of you who gave to Knightsbridge, I can only really the heartfelt thanks of the parents who children will live this winter thanks to you.

I will be posting a web site address so you can see what your funds did. I hope we can do more the next time as Ed goes back.

For those of you who wonder what I and my family look like, my daughter posted a /familyphotos.asppicture of us from last Christmas on my web site. The picture is about halfway down the page.

You can see a great deal of the reason why I am so thankful at this time of year.

Your grateful for all the Blessings of God analyst,

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