What's Driving Oil Prices?

If the Hormuz Strait hasn't been closed yet, then we must be looking at an Iranian conflict to justify current market prices, at which point high U.S. gasoline prices will be the least of our worries. However, just checking some recent reports from the Energy Information Administration still suggests that there are few fundamental economic reasons for crude oil prices being where they are today.

The first thing EIA notes is the unusually large spread between WTI and Brent, with West Texas Intermediate currently priced at around $106 per barrel, verus Brent at $125.  It turns out that there are technical reasons for this spread.  The Buzzard Field in the North Sea has been having technical production problems for the past ten months, according to EIA, and though its production is small, its output is a key part of the Forties crude blend, which is key to driving the quote for Brent. 

U.S. 50 State liquid fuels production for Jan-Feb 2012 compared to the same period in the prior year, is up 7.3%, driven as the papers remind us, by the tight oil boom, and in response to some technical issues of scheduled maintenance at Canadian tar sands facilities in February. 

Now, looking at U.S. 50 State consumption of liquid fuels for the same two month period, it is 18.3 million barrels per day (mbd) compared to 19.0 mbd in the same period a year-ago, a decline of 3.7%.  Chinese consumption, according to the preliminary February numbers is up 4.2%, while world consumption, according to the EIA figures is up only 1%. 

We don't know if there are technical factors affecting the uptick in Chinese consumption, but the overall profile of world demand doesn't support sustained uptrends in crude prices.  In fact, at the beginning of February, WTI was about $5 a barrel cheaper, but this was the beginning of the drumbeats about Iran closing the Strait of Hormuz.

In Western economies, particularly in the U.S. there is a dominant trend of energy efficiency as measured by energy consumption to GDP.  There's no reason to believe that this won't continue. There is an argument that the level of swing, or excess capacity, in world oil output is at a historical low, but as a factor in driving prices upward, it shouldn't be a big determinant when global demand is soft overall.

German Economist Homburg on Euro Bailout

Der Spiegel has a refreshing and enlightening interview with Stefan Homburg, Director of the Institute of Public Finance at Leibniz University in Hanover.  Here are a few bullet points from Homburg's interview:

• "The government bailout initiatives create misdirected incentives that continuously exacerbate the problems on the financial markets.
• The alleged risk of contagion is a myth that doesn't stand up to closer scrutiny. If you share my conviction that all this talk of Greece being too big to fail is simply nonsense, then there is no reason for bailouts
• Last year, if we had adhered to the Lisbon Treaty, which prohibits assistance payments, Greece would have restructured its debt, just as Uruguay, Argentina, Russia and other countries have done over the past 15 years...
•  ...they (banks and hedge funds) take governments for a ride with this nonsense that a default would have devastating consequences. In a zero-sum game, there are not only losers, like us taxpayers, but also winners (the hedge funds)
• I myself have invested a considerable sum in Greek bonds. They will mature in one year's time and, if all goes well, produce a 25 percent return on investment. I sleep very soundly at night because I believe in the boundless stupidity of the German government. They will pay up."

The EU's long run prognosis is not good in our opinion, and Homburg's interview provides another take why the future is not sustainable for the union. 

Chancellor Merkel In a Lose-Lose Position

                Johannes Eisele/Agence France-Presse - Getty Images

The New York Times this morning carried a front page puff piece about the "friendship" between German Chancellor Angela Merkel and IMF Managing Director Christine Largarde.  It is full of references to synchronized swimming , and to  high end Fragonard French candles being given  as gifts to Merkel as symbols of "hope." Constrasts are drawn to  the differences between the analytical physicist Merkel and the smooth talking lawyer Lagarde, who was an intern on the U.S. Capitol Hill.  Well, as you can see from the picture, Chancellor Merkel has probably realized that she has been hoodwinked into a lose-lose position by an IMF Managing Director who couldn't have been appointed to that position without German support.

What's the big deal?  France is in the throes of Presidential elections, and there isn't any doubt that the timing of Lagarde's very public volte-face about European policies handling the EU crisis is intended to help incumbent President Sarkozy and to hamstring German influence on future multinational political decisions.  In financial crises past, the IMF has uniformly taken the position of "tough love" and taking the bitter medicine of austerity.  Now, the IMF is all about growth and stimulus, putting Chancellor Merkel's position about profligate EU members having to put their houses in order first, in danger of seeming backward looking and intransigent.

If Chancellor Merkel sticks to her guns, which would be absolutely appropriate, she opens the doors to her own internal opposition and to resentment against austerity morphing into a broader, anti-German sentiment.  If she were to throw in the towel and throw her support to the a gigantic bailout fund under the control of the IMF and Eurocrats then the future of the German economy would be be impaired and her own political career finished. 
Recent U.S. trade statistics show a dramatic drop in exports to Germany, reflecting the already marked slowdown in German economic growth, which makes Chancellor Merkel's position even more difficult.  Let's hope that German politicians of all parties can rally around the broader European and German self-interest, which is not served by the burgeoning bailout funds. 

EU Intransigence May Turn Airbus into Airbust

From today's Wall Street Journal:

"BRUSSELS—China's ambassador to the European Union said it "makes sense" for Chinese airlines to shun Europe's Airbus planes in favor of competing American models from Boeing Co. in response to the EU's new levies on aviation greenhouse emissions.


Wu Hailong's comments are among the first by a senior Chinese official linking Beijing's displeasure with the EU's emissions trading system, or ETS, to jetliner sales by the Airbus unit of European Aeronautic Defence & Space Co.

EADS chief executive Louis Gallois on Thursday said that the Chinese government is withholding final approval on contracts for 45 Airbus jetliners with a catalog value of $12 billion because of ETS.

Mr. Wu said that when the EU includes a Chinese airline in the ETS, "it makes sense for them to go to Boeing."

Under the EU program, any airline operating at an EU airport must hold special credits to offset its carbon dioxide emissions since the start of this year. Airlines have said their inclusion in the ETS, which already covered many EU industries, will cost them billions of dollars annually.

Airbus warned last spring of the risk of foreign backlash against the EU plan, as China and others had threatened action if their airlines were forced to comply.

Governments outside the EU, including China, the U.S., Russia and India, have accused the 27-country bloc of exerting extraterritorial authority by levying fees on emissions that occur outside EU airspace."


The final arrogance of the EU is their unilateral imposition of these wacky standards without any consultation, as the Chinese have rightly pointed out.

If international flights aren't allowed to even fly over European airspace, this will be much more disruptive to global economies than any realistic possibilities attached to the Strait of Hormuz blockade.  Someone is going to have to blink on this one, and let's hope that the Eurocrats come to their senses, but it's not guaranteed. 

Brussels Won't Be Capital of Europe

As the European debt crisis lumbers along, if it wasn't obvious before it is now: ceding national sovereignty to fiscal integration and political union in Europe will be a nightmare.  Bureaucrats in Brussels, we are told in the New York Times, can impose austerity on poor Greek citizens, but they can't make their own travel arrangements, must fly business class, and have to take private jets in order to visit with Russian officials. 

The CEO of Ryanair, a no-frills European airline, says, "The European Union spends most of its time either suing me, torturing me (a bit much, but he's a CEO), criticizing me or condemning me for lowering the cost of air travel all over Europe."  Efficiency can't stand in the way of comfort and ease for the Eurocrats in Brussels.

Even more outlandish was the requirement that international airlines flying over European airspace buy carbon offset credits for polluting once national, but now European airspace.  The Chinese government has rightly said that they will not play along with this ridiculous ploy to generate revenue for the failing Euro cap and trade system.  Their claims were rejected, but today the Chinese government has declared that one of their large orders for the Airbus 380 is being placed on hold because of EU intransigence over the carbon credit issue.  Can rationality prevail in Brussels?

The Greek government is seeing the effects of the Brussels-imposed austerity, and Spain and Portugal will have to wonder when the cudgels will be wielded on their sovereign economic policies by the Eurocrats.  A European customs union makes sense, a currency union makes a bit less sense, but political union is a non-starter.

Brian Clough and Bill Belichick on the Financial Crisis

Years ago, while scrimmaging during a soccer coaching clinic for one of my first licenses, I heard the English coach scream, "Most goals come from two men trying to do one man's job!"  He had just witnessed a play where my team had unfortunately been scored upon. I was a culprit, as I was in a bad position when the ball was fired into the goal.  I didn't really understand what he meant, but his passion was evident in many ways, including the large vein standing out, throbbing in his neck. 

Some time after that, I was reading an interview with  Brian Clough, the legendary English coach who was the only manager to lift the old First Division trophy with two different clubs, Derby County and Nottingham Forest. It became evident to me that the origin of what I had heard in my clinic was from Clough's philosophy.  Over many years of playing and coaching to today, I now know and understand that he was right! 

Fast forward to the recent Super Bowl, and Bill Belichick's famous rant, "Just Do Your Job!"  Believe it or not, this is basically  the same insight Brian Clough had.  I recall a Giant running play when Amed Bradshaw ran off right tackle and was stuffed at the line by the nose tackle and his partner, both doing their jobs.  The running back bounced out, looking to go right, and the Patriot linebacker was lining up the tackle, as Bradshaw continued to drift, looking for an option. On the outside, the contain man, whose job it was simply to ensure that Bradshaw didn't turn the corner, instead chose to bite and tried to make a tackle for a loss.  That was NOT his job.

Instead, Bradshaw used a stiff arm, ran over the DB and burst outside.  Because of one man not doing his job, the linebacker was now out of position and had to chase, not down the line, but from behind. Down field, Bradshaw was able to get blocks from receivers who wound up in great positions to block the surprised corners. Two men tried to do the linebacker's job: make the tackle at or behind the line. The second man didn't do his job, which was to contain, but he looked for a moment of glory and caused a collective failure. Sounds simple, but it's not a simple insight, by any means. Cloughie was a smart guy, as is Belichick!

Whenever I've run my Finance departments, I've always emphasized keeping it simple and just doing your job to the best of your ability, asking for help if it's needed. If you've hired good people, trained them well, and they buy into the concept and the team comes together with mutual accountability, it's a good recipe for success.

How does this relate to the financial crisis?  Simple: nobody did their jobs during the crisis. If Belichick had been  in Henry Paulson's place, he would have pulled up his hoodie and gone apoplectic.  I'm going to quickly use two of the most egregious bad actors in the subprime mortgage lending business as examples.  I've attached links to some useful documents for readers who want to go through some of the gory details.

By year-end 2006, New Century Financial was the third largest originator of residential subprime mortgages in the nation, originating $52 billion in that year alone. On February 7, 2007, New Century announced restatements of results for the first three quarters of 2006, due to errors in accounting for the effects of mortgage repurchase obligations from securitizations which were unraveling. On April 2,2007, New Century filed for bankruptcy protection with $26 billion in assets.  The most informative document on New Century is the hard hitting report of the Special Master Michael J. Missal, done for the Delaware Bankruptcy Court.

From its humble beginnings as a REIT, IndyMac Bank became the 9th largest originator of residential mortgage loans nationwide, hitting a peak annual origination volume of $90 billion in 2006.  From 2001-2006, indexing 2001=100, by 2006 IndyMac's stock index value was 222 compared to 158 for the Russell 1000 Financial Services Index.  Executive compensation, indexed to EPS and ROE skyrocketed based on the value of option awards and performance bonuses. The stock price collapsed less than one year later, and by the spring of 2008, IndyMac was shown to be a house of cards. The best reading on this case is the report of the Inspector General of the FDIC. 

Who didn't do their jobs at New Century and at IndyMac?

• Executive management and the board of directors allowed a toxic "tone at the top" to flourish which celebrated outlaw production of mortgages by uncontrolled brokers, who overrode IT, internal audit and underwriting controls with impunity.
• SOX 404 certifications and auditor reviews of internal controls clearly failed with no weaknesses uncovered until 2007. 
• Audit committees replete with CPA's and financial experts signed off on implausible financial results. The 2006 loan loss provision for IndyMac was $20 million, the same absolute amount as in 2003: originations in 2006 were $90 billion compared to $23 billion in 2003!  And, since 2004 management and the board had clear indications of deteriorating performance in the securitization trusts and in originations.
• External auditors never challenged any of the reporting practices, including the use of gains on sales, which often accounted for a significant proportion of reported earnings, which drove management compensation.  Mark-to-market accounting may or may not have been a major culprit in the total crisis, but it was clearly misapplied across the subprime industry's worst actors.
• Internal audit and underwriting processes failed because although their monthly work clearly showed the problems, they could not establish a direct communication to the audit committee, and so were squelched by the loan production groups who reigned supreme.
• SEC counsel and corporate counsel failed to require adequate disclosures of risk, current financial condition and forward looking statements.
• Federal regulators, particularly the Office of Thrift Supervision, failed in their routine, periodic audits of IndyMac Bank.  This failure caused material loss to the FDIC and was clearly called out in the report of the Inspector General of the FDIC.  The OTS was folded into the OCC as a result. 
• Equity analysts, credit analysts and credit rating agencies all failed to do their jobs to help investors.  Instead, they served as cheerleaders, driving their own revenue models.  

 We clearly don't need another regulatory nightmare like Dodd-Frank on top of what was already in place.  Any or all of these mechanisms above should have served to surface the strategic, business and financial risks of subprime lending and the mechanisms in place should have forced adequate disclosure and proper valuation of revenue, reserves, income and balance sheet items.  Listen up!  Do your job!

Are Cell Phone Carriers Stopping A Race to the Bottom?

ATT announced today that it was effectively eliminating unlimited data plans for its customers, and it said that it would allow customers to use a set amount of data services per month before adding penalties.  More downloads at the highest speeds will now hit a limit, generate a text warning, and then slow data download  speeds and generate higher user fees. It remains to be seen if other carriers will seek to obfuscate the issue to take share, but we applaud ATT for trying to introduce some rationality into the pricing of mobile data services.  Ultimately, the current situation is the interest of Apple and its devices, but not in the long-run interest of the carriers or of the broad consumer user base. 

In the investment research literature, behavioral economists and others have identified all kinds of irrational behavior by individual investors, leading to patterns of buying high and selling low, for example. Corporations are not supposed to behave this way.

Sprint and others started a race to the bottom by giving away phones and unlimited data plans.  Sprint further made a huge bet on iPhones and will be limited to operating on life support as a result. Carriers were subsequently forced into a network upgrade arms race and a pursuit of buying spectrum at ridiculous prices.

Water and power utilities have long ago proven the economic value of tiered pricing, with higher prices for those users who force the utility to build for peak loads which are excessively above average demand levels.  Perhaps rationality is coming to the cell phone carriers.  Let's hope so.