glad I asked, how about some Don Coxe...
Don Coxe
Vancouver, BC
Merry Christmas?
Charts: Heating Oil, Natural Gas
Thank you all for tuning in to the call, which comes to you from Chicago. The charts that we faxed out were heating oil and natural gas and the question that we asked was “Merry Christmas?” We are not trying to open the Christmas shopping season early; we are trying to get you thinking about the question as to whether what’s been happening to heating oil and natural gas, and natural gas in particular will turn out to be the big stories coming out of Katrina.
I want to talk about what I see as the longer-term impact of Katrina as shown particularly in these commodities. And then we’ve got other things we’ve got to talk about. There’s so much going on, in particular we’ve got this epochal Japanese election on Sunday.
Let’s talk about the eleven dollars and thirty cent natural gas. Because this is so far above what people had been using as their numbers. And you gotta realize that most utilities who supply gas to consumers have cost pass-through. And you also gotta realize that for the large percentage – something north of 10% - of US homes who are heated with electricity, the utilities that they buy their electricity from these days have cost pass-through.
Just over half of US electricity comes from coal, but that in the case of the coal-fired generators, most of them are subject to some kind of rules from the EPA in the last fifteen years that they’re peaking operations - which is when demand surges in response to special conditions such as weather - that they they’re peaking must be done with natural gas-fired generators. That was one of the big things that benefited General Electric during the 1990’s was all of these gas-fired generators which were sold to all utilities, the coal and nuclear facilities, as peaking capacity. And then as utilities were building new plants, what you had was an emphasis on natgas.
So something north of fifty-one percent of US homes are heated with natgas and what we’re looking at here is a different kind of supply-side shock. Which is, that as winter comes, what you’re going to see is that, depending on the degree days, so we’re really at the mercy of the weather on this, what you could see is a huge hit to consumers discretionary budgets.
Up until now, everybody’s talked about the cost of gasoline. But if you put in heating oil, between heating oil on the one hand, which is tied pretty directly to oil, except as part of this crack spread which has widened out so dramatically since Katrina. And then if you put in natural gas and then you assume that the electrical utilities also will have pass-through if there’s a big boost in natural gas cost, we’re looking at something where for the northern tier at least, in the United States, what you’re going to have here is the potential for a big hit to consumer budgets.
To me, this is part of a much bigger story and one of the reasons why I’ve been so interested in the elections in Japan and Germany. Because I’ve been worried that…since 1996, you can say that the global economy has existed and grown primarily on the apparently insatiableness of American consumers to go deeper into debt to finance their lifestyle.
So out of that came such arrangements as the Japanese and Chinese arrangement – what I call The Great Symbiosis – to maintain their currency parities and their parities relative to the Dollar which has meant over a trillion dollars of Treasury purchases and kept the US yields low. Other than the ones set by the Fed.
But what this also did was it provided manufacturers around the world, a base for their operations and particularly in the Euro zone, it meant that for Germany – the number 3 economy - that although consumer spending and capex in Germany fell after the huge surge when Eastern German came in, that was made up to a considerable degree by the US consumer.
So, in order to make a longer range bullish forecast for the global economy and in particular for the commodities groups as to what will happen to commodities pricing through the rest of the decade, one of the things that I’ve sort of felt that I needed for this was some signs of life in the second and third biggest economies in the world.
Ideally, then, if the US consumer finally did get tapped out, then what we’d have in growth in consumer spending and capex in Japan and Germany. And that plus the fact that the emerging markets would be generally doing pretty well would be enough to sustain global economic growth. And that would be enough to sustain higher commodity prices for all the reasons we’ve talked about in the last four years…supply and demand.
The news that we’ve gotten on these two elections, in the case of Japan, the confirmation has been that Koizumi is still holding to his lead and it’s really impossible to overstate the importance of this election. As we’ve been telling you, this will be the first election since MacArthur left, where it’s being fought on real principles and where the candidate is stressing reform as the basis of the program instead of vague things or new bridges or new handouts or whatever.
The crux of this is the three trillion dollar Postal Services that that’s been a gigantic piggy-bank for Japanese municipalities and government at all levels including of course the national government. And what it’s done has meant that consumers have diverted savings into what they saw as the safety of the Postal System. Because they knew their banking system was in trouble. And the banking system then – faced with the fact that they had to pay higher rates – got into all sorts of bad practices, gradually, through the Seventies and the Eighties leading to the triple waterfall collapse of Japan.
Well, we’ve got confirmation in the last few weeks for the first time of an uptick in bank lending in Japan. And it depends how you calculate this but it looks like something like eight years of falling loans. And the idea that there’s actually an uptick there and they’ve taken down their bad loans dramatically, their balance sheets mean something, what we’ve got then is that, that plus the fact that real estate prices have finally stopped falling in Japan – we’ve had fourteen years of falling prices…now you may say “This is too early to make that call.”
Yes, it would be if the election result turned negative, because these straws in the wind wouldn’t be confirmed. But if Koizumi wins decisively on Sunday, then he will re-introduce the postal bill. And he’ll have other bits of legislation coming forward, because he’s made it clear that this is all about reform.
Now this is soooo important because we’ll be able to take Japan off the triple waterfall crash list. And that means it will be the shortest triple waterfall crash on record, only fifteen and a half years. It also means that it takes off, of the inverse correlation list, an asset class and says it goes into the loser class, relatively, which is US large-cap stocks.
Because for global managers with three quarters of US equities being Japanese and US, then as long as Japan was in a seemingly never-ending crash, it automatically diverted money into the US market. So it takes away that incentive. So this is big stuff. Something more is at stake here and it’s received very little publicity but I regard this as a Page Sixteen story in the Japanese election.
When Mr. Koizumi announced that he would not visit the Soldiers Shrine, the Yakisuni shrine, and he said this in the election, it was clear to me that this was in response to pressure from Beijing, that he used the election campaign, that was so highly personalized as a vehicle to say “Yes, Japan does recognize Chinese resentment about atrocities and we are not going to turn our back on them and we are not going to let the Chinese-Japanese relationship get torn apart by rage about what happened between 1933 and 1939.”
Now of course, when he did this during the election campaign, he was attacked by the militaristic right including people like Shintoishi Hara and people like that. So this was a ____ play. Because it’s one thing saying he’s not going to visit the shrine, but right in the middle of the election campaign to say he’s not going to do it…what he’s saying to the voters is “We have to admit, tacitly or otherwise, to what Japan did back in the Thirties and Forties and that it is important to us to have a long-term growth relationship with China. That’s the key to our growth.” All of that was the sub-text of what he did. And in Asia where they understand how signals are given this way, this was a momentous development.
Now it’s momentous also because the Chinese-Japanese currency parity arrangement which supports the Dollar, is crucial to the global financial system. In my view, that’s more important than anything that happens in Basel, more important than Federal Reserve policy. And so I really thought it was fabulously important that he said this during the election campaign, thereby reversing his policies. Because he had said flatly that this is an internal Japanese matter, it’s up to me to decide, I’m going to visit the shrine.
By reversing that, in the campaign, not waiting until it was over, what he’s done is given a signal to Beijing and I regard that as very reassuring for the economic outlook of the world going forward should he be re-elected resoundingly. Because he then will have had a vote of support from the voters where part of what was included in this was his choosing to admit some of the horrors of the Japanese past.
So you can see why I’m very keen about this election.
The German election, which when we talked last week was looking good, that we were going to have at least a tepidly reformist government in, headed by Angela Merkel, the news there is bad. They had a debate there in Germany and the polls show instead of a big lead for the CDU/CSU alliance, it’s narrowed in and they’re now talking about a grand coalition between the CDU/CSU and the Socialists. That condition did apply during the mid to late Sixties. It was broken when Willy Brandt chose to back out of the coalition and precipitate an election against the advice of a lot of cautious people in his own Socialist party.
He won that election and that set Germany on the road to center-left government. That was the first center-left government in Europe in a major economy. And that was one of the foundation stones of the European recovery thereafter. That they showed that the Socialists could be in fact an alternative government. This time around though, if we had a grand coalition, this would be a commitment to torpor and stasis going forward. In other words it would be a very bad outcome.
What changed the situation was that once again, just as Schroeder last time managed to win the election by playing the anti-US card on Iraq, he’d done it again, because he kept bringing up the fact that he kept Germany out of Iraq whereas Angela Merkel had supported the US in Iraq. And that was enough, apparently, to do it. Plus the fact that Angela Merkel is not a great TV performer, whereas Schroeder is a very practiced performer.
So, have to say that, yeah, it’s more important for the future of the world the Japanese election outcome but this is a big disappointment and it does suggest that hope for progress in the Euro zone has to be muted. Because Berlusconi in Italy is in very serious trouble, even the Bank of Italy is in serious trouble because of Fazio’s involvement in backing an Italian bank in a takeover situation. In other words, when you look at the big economies then you get over to France and although that’s the most vibrant of the big economies what you have there is a virtually impossible political situation at the top as between Chirac, Villepen and ___, so it was Germany that we needed to see that was going to be on the road to reform and as things stand now, a week Sunday, we’re not going to get that kind of outcome. Well, we take what we can get.
In the face of all this, what we do have is evidence that the energy costs are finally starting to bite in to economic forecasts. This morning the Wall Street Journal economic consensus scaled back their collective estimate of GDP growth in response to Katrina.
Let me say this about Katrina and high energy prices. It’s as if you had a lawsuit in which a fellow, a drunk driver was shown to have had one drink in a bar. And the bartender and the bar are sued because this fellow proceeded to kill people in a car accident thereafter, when it was established thereafter that he had had six drinks before he came into the bar.
And the bar’s defense would be “Well look, we didn’t see that he was drunk and we gave him that one drink. This guy was obviously right at the edge of collapse beforehand but we failed to notice that. He covered it up and so it’s unfair to blame us for the crash.” To say that Katrina is the kind of supply side shock that has caused high energy prices is just a way, I think, of letting Wall Street’s oil analysts off the hook for their years of dreadful forecasting.
And now what we see, paradoxically, is a new consensus has emerged of high oil prices. And high energy prices generally.
We held up publication of the Basic Points which would have come out at the first of this week. We held it up for two reasons, to see how the Katrina unfolded. As you know this is not my kind of story because it’s a Page One story and I’m uncomfortable trying to evaluate a Page One story because people who are watching television during the day when I’m doing other things are actually getting much better coverage of the story than I’m getting from the print media.
What we’ve done is we held up publication until next week, which will also allow us to give coverage of the Japanese election outcome.
But from what has unfolded to date, in Katrina and the energy prices, what’s clear is that it’s exposed the fragility of not just US refining capacity but it turns out to be US and European refining capacity. Didn’t know that before. I thought we had lots of excess refining capacity in Europe and it turns out that we don’t and I guess it’s the same sort of problem that governments have kept mandating new improvements for air pollution of refiners and that more and more marginal refiners have just given up the ghost rather than refurbishing them to meet the government’s clean air rules.
See, the way it works, both in the US and Europe, is that the government comes in with new clean air rules and when any refineries are shut down for any rehabilitation, that’s the point at which in order to re-open that they have to equip the refineries for the new rules. And these become more and more onerous and so what we’ve had is a sustained shrinkage of refineries. Now some of them get bought by bigger companies and small companies, conspicuously Valero, become big companies by buying up refineries as they become available. But we’re still stuck with this statistic that in the US there hasn’t been a new refinery built since ’76.
So, in Europe, where the rules have been more complex, what we find now is that they don’t have excess refining capacity either. Now as you know in recent weeks what we’ve been suggesting is the emphasis should be for energy parts of your portfolio, it should be on the pure play refiners. The move in Valero and Tesoro has really been spectacular. What it shows though, is that this is not just a short-term blip now. What we can say is that we’ll have oil and natural gas production back up in the Gulf within a few months at the most. But the problems of refinery capacity aren’t going to go away so soon. And indeed, with the continuing onrush of new clean air legislation from governments almost everywhere, what we’ve got is still a problem that it’s expensive to do your readjustments and you don’t expand your output by one barrel a day. It just allows you to play. And in the US it allows you to produce designer gasolines, somewhere between sixteen and twenty-one designer gasolines.
So, my conclusion from this is that our emphasis of moving away from emphasis in the United States on oil producers to gas producers and particularly then, moving out from the E&P part of it, continues. And of course the oil service companies because one thing about this is we’ve got…it will…eleven dollar natural gas is going to stimulate a huge amount of natgas drilling in the US and in Canada.
Doesn’t change our view that the number one choice in energy investing remains the Alberta oil sands stocks. They’ve done very well, not much of a move during all this back and filling related to Katrina, but we’re getting closer and closer to the day when the SEC hands down its decision about accounting for oil sands properties in Big Oil reserve life indices. And that may turn out to be the biggest energy story of the year, much bigger than Katrina.
My view still is that you should assume that the SEC is going to find in favor of the oil companies on this and what that will do is trigger a land rush buying by Big Oil of Alberta oil sands properties.
This week, a company based here in Vancouver that I’m very familiar with, Teck Cominco, announced a participation in an oil sands project. This is with a small company, UTS, and Petro-Canada. But the price that they paid for this, compared to what prices have been paid earlier this year shows that already Alberta oil sands properties are being big up sharply by strategic buyers. And when the SEC rule is announced, what I think is, it takes the gloves off. There’s going to be, I think, pretty formidable competition in bidding for these companies.
So, from the standpoint of Canadian retail investors, I simply say, don’t let this be like it was with deep gas, that these companies are bought out by companies for their reserve life indices problems cheaply.
Finally, the question of what’s happening in the bond market, we have a continuation of this pattern that even thought the news seems to be bond-unfriendly, namely that inflation numbers are popping up in terms of costs that are being passed through, what we still have is the Ten-Year note trading at 4.11. I’m really convinced the key there is the synthetic liquidity and I devoted a good section of the forthcoming Basic Points to explaining in greater detail how that process works.
Bank of Canada raised its rate this week by another quarter of a point and once again, the bank made it clear it’s the capacity utilization situation in Canada. A few years ago, David Dodge, the Governor was at a luncheon in Chicago and the question of how you set central bank policy came up and everybody else at the table except me was a prominent academic economist and they were citing various views and one of them said “Well, capacity utilization is something that Ben Bernanke thinks is important.” And the Governor just slammed his fist on the table and said “That’s it! That is the key. If you use that then you can set central bank policy and that’s the best way to see where inflationary pressures could develop.”
Now he’s never made any secret of that in his public appearances, too. He is not the Delphic oracular central bank governor like Alan Greenspan. And it’s clear that in Canada, what you’ve got is a different situation than in the US. Yes, in the US the Fed is in catch-up mode raising rates, but that’s because of vast monetary expansion whereas in Canada the monetary expansion was not as great. In each country I get asked “Well, what about the housing bubble in this?”
I’m looking out on the Port of Vancouver where vast amounts of construction are going on. It’s quite clear that this is a situation reminiscent of one that occurred just over a decade ago. Whether it will end as badly, I don’t know. But what is clear that what will stop it is not a huge pop in interest rates. Because we are going to have enough synthetic liquidity out there that we’re not going to have the kind of 1994 situation where central banks tightening together produce a collapse in the mortgage-backed market, leading to all sorts of problems elsewhere.
So, wrapping it up then, I think that the Katrina story is to a large degree now a story of human tragedy and a story of real problems in the political situation in the United States. It’s a bad news story for Bush and there’s going to be a lot of blame pointing. But as far as it being a true supply-side shock, the answer is no. What it does show is the US has no extra capacity in natural gas and no extra capacity in refining. Those problems will take a long time to work out.
Thanks for tuning in. We’ll talk to you next week and the call will be mid-week, because after that I’m going off for a business trip to Europe. So we’ll be able to update the Japanese election story at that time along with the other features. So we’ll talk to you once more before I leave for Europe, thanks for tuning in.
