Wednesday, December 24, 2014

Peter Schiff On The Fed's Impact On Oil Prices

By: Peter Schiff 
Monday, December 22, 2014
In a normal economic times falling energy costs would be considered unadulterated good news. The facts are simple. No one buys a barrel of oil to display above the mantle. No one derives happiness from a lump of coal. Energy is simply a means to do or get the things that we want. We use it to stay warm, to move from Point A to Point B, to transport our goods, to cook our food, and to power our homes, factories, theaters, offices, and stadiums. If we could do all these things without energy, we would happily never drill a well or build a windmill. The lower the cost of energy, the cheaper and more abundant all the things we want become.

This is not economics, it is basic common sense. But these are not normal economic times, and the mathematics, at least for the United States, have become more complicated.

Most economists agree that the bright spot for the U.S. over the past few years has been the surge in energy production, which some have even called the "American Energy Revolution". The stunning improvements in drilling and recovery technologies has led to a dramatic 45% increase in U.S. energy production since 2007, according to the International Energy Agency (IEA). And while some suggest that the change was motivated by our lingering frustration over foreign energy dependence, it really comes down to dollars and cents. The dramatic increase in the price of oil over the last seven or eight years, completely changed the investment dynamics of the domestic industry and made profitable many types of formerly unappealing drilling sites, thereby increasing job creation in the industry. What's more, the jobs created by the boom were generally high paying and full time, thereby bucking the broader employment trend of low paying part time work. 

The big question that most investors and drillers should have been asking, but never really did, was why oil rocketed up from $20 a barrel in 2001 to more than $150 barrel in 2007, before stabilizing at around $100 a barrel for much of the past five years. Was oil five times more needed in 2012 than it was in 2002? See my commentary here for more on that subject.  

Despite the analysts' recent discovery of a largely mythical supply/demand imbalance, the numbers do not explain the rapid and dramatic decrease in price. Yes, supply is up, but so is demand. And these trends have been ongoing for quite some time, so why the sudden sell off now? Instead, I believe that oil prices over the last decade has been driven by the same monetary dynamics that pushed up the prices of other commodities, like gold, or of financial assets, such as stocks, bonds, and real estate. I believe that oil headed higher because the Fed was printing money, and everyone thought that the Fed would keep printing. But now we have reached a point where the majority of analysts believe that the era of easy money is coming to an end. And while I do not believe that we are about to turn that monetary page, my view is decidedly in the minority. Could it be a coincidence that oil started falling when the mass of analysts came to believe the Fed would finally tighten?

If I am wrong and the Fed actually begins a sustained increase in rates starting in 2015, oil prices may very well stay low for a long time. But apart from the fact that our broad economy can't tolerate higher interest rates, an extended drop in oil prices may create conditions that further force the Fed's hand to reverse course.

If prices stay low for very long, many of the domestic drilling projects that have been undertaken over the past few years could become unprofitable, and plans for further investment into the sector would be shelved. Evidence suggests that this is already happening. Reuters recently reported a drop of almost 40 percent in new well permits issued across the United States in November (this was before the major oil price drops seen in December).
This huge negative impact on the primary growth driver of U.S. economy may be enough in the short-run to overwhelm the other long-term benefits that cheap energy offers. If prices stabilize at current levels, then the era of triple digit oil may, in retrospect, be looked back on as just another imploded bubble. And like the other burst bubbles in tech stocks and real estate, its demise will make a major impact on the broader economy. But there is a crucial difference this time around.

When the dot-com companies flamed out in 2000, most of the losses were seen in the equity markets. Dot-coms either raised money either through venture capitalists or the stock markets. They rarely issued debt. The trillions of dollars of notional shareholder value wiped out by the Nasdaq crash had been largely paper wealth that had been created by the sharp run up in the prior two years. As a result, the damage was primarily contained to the investor class and to the relatively few number of highly paid tech workers and entrepreneurs that rode the boom up and then rode it down. In any event, the Fed was able to cushion the blow of the ensuing recession by dropping rates from 6% all the way down to 1%.

The real estate and credit crash of 2008 was a much different animal. Despite the benefits that lower home prices may have brought to many would be home-buyers who had been priced out of an overheated market, the losses generated by defaulting mortgages quickly pushed lending institutions into insolvency and threatened a complete collapse of the U.S. financial system. Unlike the dot-com crash, the bursting of the housing bubble posed an existential threat to the country. The construction workers, mortgage brokers, landscapers, real estate agents, and loan officers who were displaced by the bust represented a significant portion of the economy. To prevent the bubble from fully deflating, the Fed bought hundreds of billions of toxic sub-prime debt (that no one else would touch) and dropped interest rates from 5% all the way down to zero.

I believe, a bust in the oil industry will likely play out somewhere between these two prior episodes. As was the case with falling house prices, while low prices offer benefits to consumers, the credit and job losses related to unwinding the malinvestments, made by those who believed prices would not drop, can impose severe short-term problems that the Fed will be unwilling to tolerate. Of course, long-term it's always good when a bubble pops, it's just that politicians and bankers are never prepare to endure the short-term pain necessary for long-term gain when they do.

A good portion of the money used to finance the fracking boom was raised by relatively small drillers in the debt market from banks, institutional investors, pension funds, hedge funds, and high net worth wildcatters. Public involvement has been involved primarily in the high yield debt market where energy companies have issued hundreds of billions of "junk" bonds in recent years. In 2010, energy and materials companies made up just 18% of the US high-yield index but today they account for 29%.

But many of the financing projections that these bond investors assumed will fall apart if oil stays below $60. Although the junk bond market is nowhere near as large as the home mortgage market, widespread defaults from energy-related debt could cause a crisis, which could make wider ripples throughout the financial edifice. Bernstein estimates that sustained $50 oil could result in investment in the sector to fall by as much as 75%. According to the Department of Labor, oil and gas workers as a percentage of the total labor force has doubled over the past decade, and have accounted for a very large portion of the high-paying jobs created during the current "recovery." As a result a bust in the oil patch will result in a very big hit to American labor, causing ripple effects throughout the economy.

But we are far less able to deal with the fallout now of another burst bubble than we were in 1999 or 2007 (the years before the two prior crashes). I believe it will take much less of a shock to tip us into recession. But I don't even believe that a burst energy bubble is even our biggest worry. Much greater and more fragile bubbles likely exist in the stock, bond and real estate markets, which have also been inflated by the easiest monetary policy in history. More importantly at present the Fed lacks the firepower to fight a new recession that a bursting of any of these bubbles could create. Since interest rates are already at zero, it has no ability to aggressively cut rates now in the face of a weakening economy. All it can do is go back to the well of quantitative easing, which is exactly what I think they will do. 

Despite the widely held belief that 2015 will be the year in which a patient Fed finally begins to normalize rate policy, I believe the Fed has no possibility of withdrawing the stimulus to which it has addicted us. QE4 was always much more probable than anyone in government or on Wall Street cares to admit. A recession and a financial panic caused by sub $60 oil will significantly quicken the timetable by which the Fed cranks up the presses. When it does, oil could once again increase in price, along with all the other things we need on a daily basis. That should finally dispel any remaining illusions that the Fed could successfully land the metaphorical plane. More QE may minimize the damage in the short-term, but I believe it will keep us trapped in our current cocoon of endless stimulus, where we will slowly suffocate to death.

Tuesday, December 23, 2014

Robert Shiller Currently Writing Third Edition Of "Irrational Exuberance"

Robert Shiller's first edition of Irrational Exuberance was released in March of 2000, the exact month the NASDAQ peaked and then fell 80%. The book was focused on the irrational exuberance surrounding U.S. stocks at that time.

In the summer of 2005 the second edition of the book was released, which focused on U.S. residential housing. That summer marked the peak in price for many markets in the United States, which then collapsed in the years ahead.

In an interview he gave this week Shiller told that he is currently writing the third edition to his book. Here are his comments (for the full interview click here).

This is probably a question you're getting a lot lately: Are we in a period of irrational exuberance right now?
I'm actually working on the third edition of my book, "Irrational Exuberance." Anyway, it's a matter of degree—it's a matter of percentages. The market has been going up rapidly and there is some exuberance behind that, I suppose. But it's not something that is uniform. There is a story at any time, and the story has multiple dimensions.
One thing that our story now is starting to share in common with the year 2000, which was the peak of the market in real terms—the 2007 peak didn't make it back up to that level, so I think of 2000 as a major turning point—is at that time, people were very concerned that the market was overpriced. We have been seeing increased concerns that that would happen; that is a sign of a bubble. If you're buying and holding the market but think it's overpriced, that might be a sign of irrational exuberance.
What is irrational exuberance? I think it's often a sense that the market always goes up in the long run, and it's hard to predict when it might go down, but it will surely come back up. So one question I have been asking in surveys is, "Do you agree with the following statement: The stock market is the best investment for long-term holders who can just buy and hold through the ups and downs of the market." Our agreement with that is going up, but it's not as high as it was in 2000. We're not quite in a 2000-like irrational exuberance, but we're moving in that direction.

Monday, December 22, 2014

The Retirement Dilemma In The United States

Here is a recent snapshot of 401k balances in U.S. by age group:

These totals follow 33 years of rising bond prices and 5 spectacular years of stock market gains (most portfolios are concentrated within U.S. stock and bond funds).

I don't want to sound like an alarmist, but there are probably a lot of very worried people out there right? No one could reasonably expect  to support themselves for 20 years or more in retirement on $126,900 in 401k savings.

Remember when you enter retirement you must begin to sell your 401k in order to pay for your living expenses. When you sell you incur the income taxes you did not paying going into the program. 

Here is the bigger problem: What if a baby boomer is financially astute enough to understand the U.S. stock and bond markets are both close to the climax of historical bubbles with tremendous principle losses around the corner?

Here is the alternative return they could receive by exiting the markets and depositing $100,000 in a bank CD (cash). From a $5,240 return in 2006 they now receive $390 annually. Enough to pay their car payments for a month.

This is the dilemma facing retirees today, dubbed financial repression. Do you walk out on the plank to try and reach for yield, understanding that the board could snap at any moment? Or do you patiently sit in cash while inflation eats away at your life savings?

The Fed's QE program is a wealth transfer mechanism. About $400 billion every year that banks would have to pay out to American savers in interest is kept in their pockets with interest rates held at 0%.

Modern Central Banking Has Gone Beyond That

Two great quotes from Hussman's commentary this week:

“I cannot imagine any condition which would cause a ship to founder. I cannot conceive of any vital disaster happening to this vessel. Modern shipbuilding has gone beyond that.”

Edward Smith, Captain, RMS Titanic

“One reason that risk premiums may be low is precisely because the environment is less risky… The Fed has long focused on ensuring that banks hold adequate capital and that they carefully monitor and manage risks. As a consequence, banks are well-positioned to weather the financial turmoil.”

Janet Yellen, July-September 2007

Sunday, December 21, 2014

Why Great Business Owners Are Terrible Investors

I'm someone that spends an unhealthy amount of time focused on business and investing. I've discussed in the past that when I'm not directly working on a business activity or studying finance, I'm often thinking or daydreaming about it indirectly.

Something I've noticed throughout the years that has both fascinated and surprised me is that great business owners tend to be mediocre or poor investors and great investors tend to be mediocre or poor business owners. The relationship exists on somewhat of a sliding scale. I'll give you an example I have experienced personally.

Throughout 2013 and a good part of 2014 I worked with one of the largest commercial real estate finance companies in the United States. I spent my days pouring through and analyzing loans on large real estate projects.

In my office and other offices around the country I had the opportunity to interact with some of the most brilliant minds in commercial real estate finance. With their decades of experience they were able to show me things about a potential building, market, or investor that I could not initially see when I read through the documents.

A commercial building is a business that exists within an economic ecosystem. You can look at population growth, business activity and an endless amount of data that would impact supply and demand surrounding the building. This then directly impacts rent levels and vacancy, which determine both the building's value and ability to pay back the loan.

Here is where business met finance for those that don't love real estate: Part of making a loan involves setting a loan value that can still perform should interest rates rise in the future. For example, if you make a loan today at 4% interest, you want the building to have the ability to still generate enough income to pay the loan at 7% interest in the future (the loan will need to be refinanced, the owner could get into financial trouble, etc.).

I found my coworkers could create flawless models showing how this risk could be minimized, however, in conversations I had with them privately almost no one could provide me a financial explanation to why rates could or would rise in the future. They essentially did not pay attention, or did not understand, what would push rates in either direction moving forward.

Many of these people had been working in the commercial finance industry for decades leading up to the summer of 2008. Countless people I spoke with told me that they watched their portfolios disappear almost overnight following that summer as their company stock (which they loaded up heavily on during the boom years) was wiped away in an instant. No one told me they had a "bad feeling" about the market and decided to cash in some of their profits, and these are the people that were on the front lines of commercial real estate finance!

How could that be?

A different part of the human brain is used to make business decisions than the part used to make financial decisions. The business/rational/economic part of the brain is called the Neocortex, which is the part dedicated to maximizing utility. People strong in this area have the ability to build great businesses or determine value within a commercial building based on the surrounding economic supply and demand factors in the market.

Price, supply and demand are all very important within the Neocortex. Remember the black Friday videos released a few weeks ago where consumers were trampling each other and fighting to purchase TV's at Walmart? That is the Neocortex at work, the part of the brain that tells someone to buy something because the price is lower.

A second part of the brain called the Limbic System deals with the financial markets. It is emotion driven and it is what causes investors to engage in herding behavior. Investors want to own an asset more when prices rise and they want to own an asset less when prices fall. I could spend hours with countless charts showing this phenomenon in work, and long time readers have seen many of these examples over the years.

Investors in the financial markets naturally move in herds, they are emotion driven and logic goes almost completely out the window. This is not because they are unintelligent; it is just the way that humans are wired psychologically. Unless you spend a ridiculous amount of time studying market history (and strengthening your Limbic System), the natural tendency based on your everyday surroundings will be to enter this psychological herd.

The best example of this in nature is the murmuration of starlings. There can be no better visual of how investors exist within the financial world than the video below:

This is why great business people tend to be poor investors. If you spend a tremendous amount of time strengthening the Neocortex part of your brain (where supply and demand are important to business decisions), then it will most likely come at the expense of your Limbic System (in the financial markets supply and demand have an almost inverse corollary).

Consumers and businesses make rational decisions within a healthy economic ecosystem:

While in the stock market, for example, the exact opposite occurs. Higher prices lead to higher demand due to the natural herding psychology of humans surrounding financial decisions. Everyone wants to own stocks at the top, and no one wants them at the bottom.

I don't want to say this in a way that sounds mean (I certainly do not consider myself a highly intelligent person), but I have found entering a discussion with someone on finance even if (or especially if) it is someone who is an accomplished business person, is a complete waste of time (and borderline detrimental). I like to talk to great business people about business, and I try to focus conversations surrounding finance with people who have a profession that exists within that world (they are forced to strengthen their Limbic System daily). For this reason almost no one in my personal or business life knows that I am a financial nerd. I would rather talk to them about sports or catch up on their personal lives.

There are a few people out there I have spotted that can comfortably exist in both worlds. One of them is Mark Cuban, the owner of the Dallas Mavericks professional basketball team in the United States. He is a billionaire who has created countless profitable companies over the past 15 years. His Neocortex is extremely strong.

However, he also has the ability to shift gears and walk on to the CNBC studio (America's largest financial television network) and carry on a fluent conversation surrounding finance. In late 2012 he took all of his business debt and converted it from U.S. dollars to Japanese yen. The yen was trading at 77 at the time and has now fallen to 119, meaning he has paid off 35% of all his debt with a simple keystroke. Based on what he has told others, he has spent countless hours over the past 25 years strengthening both areas of his brain (he was not born with some sort of gift). He is a complete workaholic.

While my business and investment world still exists with far less zeros than Cuban's, the concepts are essentially the same. My goal is to continue to strengthen both portions of my brain daily to be better prepared for both the business and financial world as I move forward. I'll be here updating the Limbic System view of the world every step of the way!