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Today's Commentary: 05.25.04
The Weight of Oil
Billie wears all of her Iberian heritage with carefully applied make-up and a pouty intensity. When she sat down the other day, pulling her chair up to my desk, I didn't have to ask what was on her mind. Her husband wants to sell her full sized SUV, she told me. "He filled it up the other day", she said, "and he thinks it costs too much to keep. I love that truck!"
Affordable gas is believed to be an American entitlement, which makes it hard for people like Billie to understand what has happened at the pumps. The seventy five dollar price tag to refuel her Suburban was the final straw. Her question I believe was when the price would come down. I've got bad news for Billie. She should sell the SUV.
A good deal of us remember the gasoline shortages of 1970's but for those that don't, skyrocketing prices with news of diminishing supplies had many American held hostage in long lines waiting to fill our tanks. It's amazing how quickly we forget.
The bottom line: the oil business is generally a bad business to be in. As countries attempt to grow and expand, creating sustainable economic expansion, they must pay for the price for the oil that fuels that growth. Unfortunately, that price can be quite high.
Much of the confusion about high prices lies in the terminology. There is a huge difference between reserves and resources. If a country can prove it has reserves, or an oil company is drilling a mature field and is able to make believable predictions about how much oil is available, banks will lend money based on those numbers. On the flip side though, they will not loan money on the belief that a resource exists. That resource might be a huge, as-yet-untapped field of oil, but the money lenders do not care. Reserves have worth; resources do not.
Good oil exploration can identify where the oil is but it doesn't become a reserve until the ability to extract it, and the engineer's belief that it can be done, are confirmed. While the world may seem to be floating on a huge bed of oil as a resource, much of it may not be feasible or cost efficient to bring to the surface to refine - now or in the future.
It is widely believed, even with the miscalculated reserves that Iraq could one day offer, world-wide production will have reached its zenith in about eight to ten years. Since the seventies, the world's appetite for oil and the products of subsequent refinement have increased 50% while the supply has remained the same. China and India have recognized the need for fuel in their economic expansions but their increased need was not really factored into the equation until recently.
But what about the US strategic reserves that have been steadily increasing under the current administration? Forget they exist. That oil would have little if any effect on the price at the pumps. The oil in those reserves has been paid for by the issuance of debt, and worse, has been purchased at Tiffany prices. The Saudis believe that stability is a cost just shy of $30 per barrel. No more.
The problem it seems is production and perception. There is a false perception that oil will last long enough to allow for an adequate replacement to be developed. While great strides have been made in replacing oil in many products, dependency on the fuel remains not only strong but reflects a demand that outpaces that supply with no real sign of abatement.
In 1956, M. King Hubbert looked at oil production as a finite resource observing that unrestrained extraction will rise along a bellshaped curve. He drew the conclusion that oil production would peak when about half the resource is gone. Once an oil well has given up 50% of its capacity, production begins to taper-off rather quickly. With little in the way of new discoveries being made, it is possible that any increase in capacity will shorten the life of a well significantly.
No one has been able to pump every barrel from a hole in the ground. It just becomes too technologically expensive forcing companies to abandon them. With the known cumulative amount (the total we have extracted so far) and the estimated reserve amount (what we assume will be viable fields of production though estimation), the hope that what has yet to be discovered and exploited can not be counted as a future reserve. Many of those fields will never prove worthwhile to tap.
Two things are worth noting. Oil reserve estimates are closely tied to actual dollars in order to determine value. These numbers however can lack transparency, not to mention accuracy when used to determine the commodity they represent. When the Saudi's suggest opening their taps and allowing the flow of an additional 1 million plus barrels a day, the gesture is merely symbolic. Every oil tanker is running at full capacity now, plying the worlds oceans to find refineries to process their precious cargo.
Gasoline, the coveted lifeblood of the American economy, amounts to only 48% of the refined crude. The rush to build new processing plants, another subtle hint offered by the Saudis recently on aljazeera.com, is not coming either. The time involved in getting a refinery off the drawing board and running at full capacity is over four years.
There is some hope that newer methods of extraction can be used to get older fields to continue to produce in some capacity which, while costly, would at least sate the world's growing appetite a little longer. There is also some speculation that the restraint imposed by the OPEC nations will allow oil production to continue beyond previous estimates.
Either way, that price at the pump is getting close to where it should be. While the economy will grind to slothful pace of 2% growth over the next several years as a result of this long overdue energy cost (or tax if you will), the amount of usage will continue as long as the whole world follows our example - which has been to complain loudly about the high cost and borrow to pay for it. Just like Billie's husband who was staggered by the high cost to fill his wife's tank, the world will reach into its collective pocket and paid for it with a credit card.
At Arm's Length:
05.27.04
Reshaping the Mortgage Markets
So much has been speculated about the predicted rise in short term interest rates and their long term effect on the housing market, it is difficult to make sense of what is really happening.
Over the last ten years, the long term interest rates for thirty year mortgages have averaged 7.3%. Fears are rising among those who hesitated or are coming late to the game that the historic low rates we have just witnessed are never coming back. Those fears are well founded as most economist expect rates to reach some sort of historic average in the near future. The lowest rate available in the '90s was just shy of 6.9%.
The major difference between then and now is the effect of adjustable rate mortgages. Where they once had little effect on the housing market, these types of loans now comprise a full third of the outstanding home debt. These homeowners could be facing some difficult times ahead as the belief that low rates continuing for the near future dissipate in tandem with the low overnight rate. (It is important to note that the short term interest rate that the Federal Reserve Bank sets has little effect on mortgage rates.)
Alan Greenspan, the nation's top banker voiced his concern earlier this year about the effect of this type of debt, especially on those who have borrowed on slim margins. A slim margin exists when the amount of money borrowed is dangerously close to the amount of available cash the homeowner has available to cover any increases in mortgage payments. Owners of Adjustable Rate Mortgages (ARMs) will face rising monthly payments as a result of higher rates. This could increase the amount of defaults the mortgage industry will experience, which have already risen at an alarming rate.
This could be good news for those that have waited. While some people cash out their equity, take profits, and move on; others will find housing prices falling somewhat offsetting and small increase in interest rates. Also adding to this offset is the predicted rise in job security and the wage increases that often follow.
But those using ARMs will take a good deal of the housing debt into bankruptcy court. Significant increases in personal bankruptcy filings, a lagging and often ignored economic indicator, has begun to play a role in the lives of a good deal of homeowners who borrowed cheap and spent extravagantly.
The Blue Money Report
Financial Commentary covering a wide range of topics concerning money, investing, and how it effects the average investor and their financial health.
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