Off On A Tangent

…and it’s too late to give out any decent (capital-preserving) market advice.  I’m truly sorry what advice I did give was probably too vaguely worded and too infrequent (and too optimistic, I think!).  Not that anyone really reads this blog, but I’d feel better had I done a better job writing here.

So, the markets are falling fast now.  There will be a bounce at some point - probably a sizable one.  But I see no way of knowing when that will be.  It would be extremely foolish to try and catch some profits on that future bounce.  Being wrong in your timing could be disastrous, as we are in a position now where the market can very easily react to some unexpected bad news with a 10% drop in a day (at which point the market is closed).

However, since there is every reason to expect fundamentals to erode further from here - housing prices will fall further, unemployment will rise more, credit will continue to tighten, debt is increasing faster now than ever, consumer spending will fall from here - then it does make sense to wait for the bounce to happen and then sell into it.  If you’re willing to take a short position that is (which doesn’t have to mean shorting a stock, it can mean buying an etf that tracks the inverse of a market index).  Wait for the bounce and then sell it.  It won’t matter a whole lot how you time that bounce, because the market will almost surely thereafter retreat below whatever temporary bottom the bounce starts at.

I believe we are in for a 2-4 year downturn and a grinding market bottom of up to 90% down from the highs is pretty likely.  Once unemployment begins to rise fast, all our debt is going to eat this economy alive, and the debt will be defaulted on person by person, household by household, corporation by corporation, municipality by municipality, and possibly even state by state.  That defaulting on debt will make matters worse each time, exacerbating the feedback effect.  The end result is a 90% downturn (and that’s the good outcome) or hyper-inflation, in which case the economy is just toast anyway and we’ll either be going to war or rebooting the financial system with a new currency and across-the-board debt forgiveness.

I’m having nightmares now about basic utilities being shut down due to lack of credit to pay employees and pay for commodiites (ie, natural gas, water, coal, uranium, etc).  If the credit markets fall apart and paychecks bounce, what keeps people going to work to provide the water, the natural gas, the electricity that comes to my house that is needed for life?  I’m guessing the answer will be a government mandate to go to work possibly enforced by the national guard (are they all back from Iraq yet?  Looks like we might need them).  But I’m having nightmares of keeping my family warm during a cold winter, of feeding them, of feeding my baby megan with formula.  I have some rice and beans stocked up that the rest of us can eat - I think I probably need more though.  I need to update my disaster supply list and get moving in buying some - it could become too late to do so within days.

This past week’s oil inventory report was quite strange. It reported an 8.8 million barrel decline in commercial crude oil inventories. That’s a huge drop, especially at this time of year. Inventories of both crude and gasoline are at or near the bottom of the 5-year average range. Just a month-and-a-half ago, gasoline supplies were far above the top of the average range. That’s what happens when the price of gas is so cheap compared to the price of a barrel of oil that refineries don’t work too hard to produce extra gas - there’s no profit in doing so.

But what made the report especially strange is that it included an “explanation” for the 8.8 mb drop in supply: that ships were delayed in offloading supplies in the gulf [of Mexico] ports. All the analysts are citing fog as the reason for the delays. However, there has been no fog in the region in the past week, so it’s a bit of a head-scratcher. On top of that, after the report came out, oil first shot up $3, but ended the day down over $4. I can’t quite figure that, but I suspect a lot of traders are trading on hope - hope that there really was plenty of oil imported and that it was just delayed and hope that therefore next week’s inventory report will show a monster build to make up for it. A build of over 10 million barrels or something like that. Trading on hope - not a good idea.

But more troubling:

Here are the last four weeks of crude oil imports into the Gulf Coast:

6.683 mbpd
6.130
5.173
4.996

(link)

The problem being Mexico and Venezuela primarily, but Nigeria also. This is the net exports problem, explained in the Export Land Model. Mexico’s production is falling off a cliff - 24% in the past year. Exacerbating the problem is that every country that produces oil also consumes oil. And each year most countries consume more than they did the previous year. So, a country like Mexico, where oil production is falling and internal consumption is rising, the remainder left over for oil exports (called “net exports”) becomes less and less at an accelerating rate. Mexico looks to cease being an oil exporter in the 2012-2014 time frame. Canada, often cited as a place where oil production is growing (and it is), is also experiencing declining net exports. Saudi Arabia, often cited as the one place left in the world with excess capacity, is also experiencing declining net exports. Saudi’s oil production ticked up slightly in Jan and Feb this year, but their exports have fallen year-over-year. The problem of declining exports began in 2004, but it may now be poised for a big jump in effect. At some point, it’s likely that exports will “fall off a cliff”, as they say. That point may be right now.

Certainly the problems in Nigeria aren’t helping matters with nearly the entire country’s production shut in by violence for a couple weeks, and even now they are still down a few hundred thousand barrels per day. But Mexico and Venezuela are the real problems right now:

The 2007 Annual Net Export Decline Rates for Mexico & Venezuela (EIA) are as follows, and the recent monthly data don’t look any better.

Mexico: -16%/year
Venezuela: -7.6%/year

(link)

To make matters worse, gasoline hasn’t gone high enough in price yet. Wholesale gas is at $3.40, which translates to about $4.05 in retail gas once it works its way through the system. But, at $3.40, refiners aren’t making much money with oil trading above $120. Therefore, their utilization rates have been very low this year, and in about 45 days, we’ve gone from very high gasoline stocks, to pretty low stocks. Traditionally, refinery utilization at this time of year would be 91-92% in order to keep up with summer demand. The highest it’s been so far is 87.9%. It needs to go higher, or there will be shortages of gas. If it goes higher, it will only be because the price of gas went high enough to warrant the increased costs of overtime, maintenance, etc that such high utilization rates entail. So therefore, if oil stays high, I think we’d see gas go over $4.50 by the end of summer. Possibly $5.

But, crude stocks are also low. This was not the case last year when gas stocks went dangerously low - then, crude stocks were pretty high. If we’re having a net-exports-falling-off-a-cliff problem right now, that’s going to throw all estimates out the window. It will take many weeks to find other exporters to replace Mexico and Venezuelan oil as they are relatively nearby countries. If we have to get more oil from Saudi Arabia than we do now, it will take a while for the extra tankers to get here. And we’ll have to outbid China and India for that oil. In the meantime, we’d probably have to make withdrawals of oil from the SPR (strategic petroleum reserve) to avoid shut-downs of refineries, pipelines, and gas shortages. All this would send the price of oil and gas into a pretty severe spike - maybe up to $180 in a matter of a week or two. Gasoline to $6-7.

And, even after the immediate crisis was over, oil would probably remain above $140 due to the need to outbid others for the oil we’d no longer be getting from Mexico and Venezuela - and there’s no end to the decline in net exports. Soon, these countries stop exporting, and then, they start wanting to import oil. I say “wanting”, because I don’t think Mexico will ever be able to afford to import a drop of oil. Mexican civil war of some sort is probably happening relatively soon (ie, within 10 years).

If it happens like this, we’ll end up with gas at $5+ at the end of summer and only headed upwards from there. The crisis of peak oil could be starting - may have started with this latest odd inventory report. We’ll know within 3 weeks either way, I think. If the things I describe above haven’t started happening by then, then it’s a false alarm.

Happy Hurricane Season!

Last year I talked about peak oil and I’m hoping some of the events of the past year
reminded you of some of the things I talked about.  Oil rose from about $50 at the
beginning of the year to $100 at the end of the year (oil was just a few cents shy of $100
in November, and crossed the $100 threshhold on the first trading day of 2008).
Previously, in 2005, the world was a bit shocked when Katrina caused oil to hit $78 a
barrel.  This year, no particular severe event happened to push oil up.  It was simply
supply and demand getting tighter and tighter, as well as the dollar falling in value.

That situation continues as this past week, oil hit $103 and the dollar continues to fall
sharply.  And even though the dollar is losing value, the stock market and the real estate
markets are also dropping in value - a sort of double-whammy on our wealth.
Additionally, we are seeing the beginning of a similar potential drop in the bond markets,
as lending becomes tighter and tighter and is perceived as riskier and riskier (otherwise
sometimes known as the “credit crunch”).  Despite the fed lowering short-term interest
rates, mortgage rates are starting to rise, and I expect them to continue to rise.

Mortgages around the country are going into foreclosure at record rates, and there are
signs that various other economic data are heading southward in a hurry.  Already, the
financial and retail sectors of the market have lost about 40-50% of their value, and will
in all likelihood continue to lose more.  Another 50% is not unlikely, I don’t think.

There are two basic reasons I think we will see a severe economic downturn, with the
dow going below 10,000 (currently at 12,266 and with a high around 14,100) and the
S&P 500 going below 1200 (currently at 1330 with a high around 1550).  Real estate,
nationwide, has lost around 10% of it’s value, with some areas being hit harder
(california, michigan, florida especially).  To get back to historical norms (as measured
by prices to income ratios), it will have to drop somewhere between 30%-50% in total
from it’s high.  A 20% total drop would leave a little more than 10 million homeowners
“upside-down” on their mortgages - ie, owing more  than their house is worth.  A 30%
drop would leave around 20 million homeowners upside down.

Upside-down homeowners tend to default on their loans, and this is what is happening.
Banks are losing money and it is a big reason why we’ll see a number of bank failures
this year.  Also, people struggling more and more with their mortgages stop buying
discretionary items.  Consumer spending being 70% of our economy, this can have a
severe impact.  The American public stopped saving money in 2005 and the savings
rate went negative.  We, as a whole, have piled up a large amount of personal debt, and
as lending becomes tighter, credit cards cancelled by banks, home equity lines of credit
cancelled by banks, a lot of people will no longer have the means to keep their current
lifestyles going.  For this reason, a fairly dramatic slowdown of the economy is in the
works.

But, it gets worse, because, as you may or may not have read or heard, there are some
“experts” suggesting gasoline will cost $4/gallon this summer.  I would like to take a
moment now just to say “I told you so!”  I’ve earned that much.

You may have also heard about the recent dramatic rises in food prices.  Wheat is going
throught the roof and our stocks of wheat grain have not been lower since the 1940’s.
We’ve been eating more wheat than we produce for 7 of the last 8 years.  Less than 4
years ago, wheat was $3-4 a bushel.  In the last couple weeks, it has gone over $20.
Other grains are rising similarly, if not quite as dramatically.  Two major reasons for this
increase is corn ethanol - the demand for food has increased because we are burning
more and more of it in our cars, and bad weather has hurt production, especially of
wheat in places like Australia.  The central breadbasket area of the US is having less
than ideal conditions right now, which is partly why wheat is booming in price most
recently.

The higher prices from these food items is still in the process of getting to the end
consumer, which means that while food prices have risen noticeably already, they are
set to continue to rise significantly throughout 2008.  Gas prices, currently around $3,
are still yet to rise to $4, but they almost certainly will unless oil drops in price
dramatically back to below $80 or so.  These additional expenses, when combined with
the difficulties of real estate and people losing access to credit, ARM mortgages
resetting to higher rates will make for a severe contraction of consumer spending, which
will tank the economy.  The markets are set to fall sharply when this becomes obvious.

So, what to do?  In the short term, I hope everyone is making moves to protect their
money and investments.  I think cash is a pretty good place to be for now.  I am mostly
short the market - there are ETF’s that allow one to invest in indexes on the short side,
meaning you make money when the averages fall and lose money when they rise.
ETF’s like SDS, SKF, SRS, for example (they are “ultrashorts” meaning they rise and fall
at twice the rate the actual markets do).  I am long on energy and agriculture, stocks like
APA and POT, which will rise if oil and food continue to rise.  They are pretty high right
now though, and I think they are likely to get hammered a bit with all the other stocks in
the next month or two.  Gold and silver are good investments at this moment too, though
I feel more confident in energy and food myself.

I would like to stress that short-term, there is every reason to fear a dramatic fall in the
markets, and protecting your money would be prudent.  If you really don’t like to be in
cash, then consider being neutral on the markets at least - ie have at least as much
money on the short side as on the long.  Bond markets may not be safe either as
corporate default rates are on the rise and long-term bond rates are rising (meaning the
price of the bonds is falling).  If the bond insurers Ambac and MBIA do not get bailed out
by the government, then there could be a real bloodbath.

I would also recommend storing some gas at home.  A little bit of stockpiling could go a
long way in the event of short-term (but severe) shortages.  It is perhaps not likely that
you’ll be unable to buy gas anytime you want it this year, but if there is a hurricane like
Katrina or some other event, it could happen, and a couple dozen gallons of gas at
home might be enough to get you through it.  In any case, it’s easy to do and can’t hurt.

For the longer term, I don’t have any really good suggestions, mostly because it would
require convincing you of a lot more than I’m attempting to in this letter.  Maybe you’ll
come around to my thinking about the crisis of peak oil a few years from now, but I don’t
think any of you do just yet.  We’ll get there :-)  I would like to point out one reality
though - if oil keeps going up, then eventually gas is going to cost $10/gal, air travel will
be out of reach for someone like myself, and I won’t be able to visit places like North
Carolina or Florida, not to mention Egypt and Chile.  I expect 5-10 years from now, we’re
all going to be forced to live a lot more locally (but me in particular, being of the most
limited in means), and we could get cut off from one another.

So, happy 2008 everyone! ;-)

A few days ago, Jaime was reaching for his new Rhyme game (from his Aunt Debbie) and threatening to dump the contents all over.   Vivi told him not to do that.  His response: “why not?”

I think it was the first time he ever used the word “why”, and upon hearing Vivi’s explanation of why he should not dump the game, his inevitable response was: “why not?”

Again, Vivi tried to explain why she didn’t want him to make a mess all over the floor and that he’d have to pick it all up if he dumped the game.  His response?  “WHY NOT?”

“BECAUSE MOMMY SAID SO!”

“Ok.”

Finally, a meeting of the minds on something they could agree.

The market is looking pretty ugly right now.  The S&P has fallen from its high around 1550 to 1325, which represents a 14.5% drop.  And while after every significant drop the MSM commentators all wonder anew if this represents a good buying opportunity into the market, another segment of market analysts keep pointing out that the average stock market drop during a recession is 30%.  Ie, we’re not halfway to average yet.  And few believe we are facing average difficulties currently.  Thus the many predictions of a 50% or more market fall.  One thing about a housing bubble burst is that it is a slow unwind.  Although we are just now entering the peak of ARM resets, increased rates of ARM mortgages resetting continues well past 2010, even reaching new peaks then that will equal current rates.  In other words, it is likely that the real estate business is going to be slumping for 3-5 years, probably resulting in house values dropping slowly but consistently that whole time.  House turnover being so much slower than stock turnover, it doesn’t just fall catastrophically and get it over with.  It lingers, and fools everyone into thinking “it must be over now”.

Unemployment has just begun ticking up, which will exacerbate the problems of debt defaults and foreclosures.  Which will worsen the economy, which will lead to more unemployment, etc.  And if you don’t think the economy can go into such a negative feedback loop for a protracted period of time, then you weren’t paying attention during the Great Depression.  It can happen again, and right now seems at least somewhat likely.  Right now, oil is at $90/barrel.  If it doesn’t fall back to $70 or less soon, then gas prices will be up to around $4/gal by May.  Why is that?  Because the “crack spreads” are very very low right now (ie, the difference between a refineries’ cost to buy oil vs what it makes when selling the gas).  It is low now during winter, when supposedly gasoline demand is “soft”.  Peak gas demand season comes in late spring around memorial day, and it stays high throughout the summer.  The refineries will raise their prices for the gas they produce, because their only other choice is to not produce the gas, which would result in shortages.  Why is this?  Because to keep up with demand in spring, refineries have to work full out, including overtime costs.  Those costs aren’t supported by the current crack spread.  Since shortages won’t be tolerated so easily, the only other choices are that oil comes down in price or gas goes up.

It is still possible that oil will fall in price.  Saudi Arabia and OPEC probably have some extra capacity and could bring some more oil to the market.  No ones for sure how much though, or for how long.  Currently, however, it doesn’t sound like they want to do so.  Assuming they don’t, oil is not going to come down in price, and in fact, is more likely to go up.  All the more so because the fed is cutting interest rates which is resulting in a falling dollar.  Now, gas at $4/gal is just another expense for the American consumer that he/she can’t afford.

Food prices are also going up radically.  Recently, corn and wheat have been increasing in price at the daily limit (the markets for these items are stopped for the day when they move a certain amount in one direction).  Some would tell you this is the result of higher oil prices, as oil is a component in the growing, harvesting, and transporting of food.  But that is not the whole story.  A bigger part of the story is that the world has been drawing down its grain supplies for 7 of the last 8 years, and are at their lowest levels in terms of Days-Of-Supply since the 70’s.  And, farmers are planting more corn at the expense of wheat and barley and other grains because of the demand for ethanol.  Which sort of makes it all about oil anyway, doesn’t it?  To make up for a lack of oil, we are burning our food in our cars, and it is rapidly increasing the price of our food.  And the price of gas is going up anyway.

So, I expect the markets to continue going south.  I expect the dollar to continue to fall, the price of gold and oil to continue to go up.  At some point the price of natural gas will follow suit and move from its current trading range of $6-9 to $12-18.  And then all of us who heat our homes with natural gas will know the pain of those currently heating their homes with oil.

My first day on the homefront has gone pretty smoothly so far, minus Vivi’s panic over being late for her first day of work over the issue of how to get the cadillac’s defroster working.  The cadillac, as a car for older people, seems like an utter failure, as it is full of tiny little buttons and knobs and levers all over the place that make no sense whatsoever.  It has simply the most user-UN-friendly interface I’ve ever seen in a car.  It will take some time for Vivi to get a handle on it, I’m sure.  Meanwhile, Jaime had a good day at school, and I had a pretty easy morning.  Just a few minutes late in bringing him in, but no bid deal, and then back, home to do some programming for work.  And finished off the near-term feature requests pretty easily.  When I picked Jaime up from school, he was in a happy mood, and it is a bright beautiful day, so I took him to the playground and we played in the sunshine for about 40 minutes.  What a day!  Staying at home like this feels like a complete scam and I could almost feel guilty that meanwhile Vivi is shut indoors in some windowless office park hell, but then I remember, this all was her choice.  So I’m just going to enjoy it.

Picked up some groceries for dinner tonight, got Jaime home, and he played with his choo-choos and watched the john deere tractor video for a bit before his nap.  Now he’s napping and I am doing some laundry, did the dishes and cleaned the kitchen a bit.  Things couldn’t be easier!  Well, except the house is a disorganized cluttered mess that I really want to whip into shape, but I see there’s a big difference between doing the stuff that is simple to do, and doing stuff that is a bit of a head-scratcher.  I mean, our biggest problem is that we have too much stuff for our small house, so where do you put all the stuff that is lying around?  I’m not sure - Vivi was surely better at creating space for things than I am, but I’m determined to figure it out.  Less clutter = more space = more relaxing living, I think.

On the market front, I see the stock market has raced nearly back up to it’s all-time highs.  Oil made some strong gains and is trying to hold onto them, and gold has held at $740 - wow.  That .5% rate cut has sent everything skyward.  I’m not changing my tune about things - it was never my belief that I was calling or could call a market top, it is simply that there is bad news that has come and that will continue to come, and the downside risk to this market, IMO, outweighs the upside.  I’d still get out now while you can.  I diversified my own commodity holdings to include oil, swedish and swiss currencies, agricultural products, and natural gas.  I thought I’d bought gold too, but I seem to be mistaken there - oh well.  Maybe if there’s a sell off in it, I’ll try to buy in.

Well, I can’t avoid my duties forever!