Oil, Terrorism & International Risk Management
By James J Puplava CFP, November 19, 2002
Headlines & Indicators
Let's start with headlines. U.S. chain store sales were flat or lower during the first weeks of November. Home Depot also reported that the company had its slowest quarterly growth in at least 12 years. Annual revenues this year will be less than forecasted. This news may not yet be a trend, but it does point out to an apparent slowdown. The government reported the U.S. trade deficit for September was the second highest on record, but it fell slightly to $38.03 billion. The trade deficit for the first nine months of this year is at a record $317.3 billion, an increase of 17.4% from $270.3 billion in 2001. China and Europe were the two regions with the largest trade surplus with the U.S. On top of a still deteriorating trade deficit, consumer prices rose 0.3% last month. Removing the items that went up the most, such as energy and food, the CPI still rose 0.2%.
On the political front, Venezuela is a sea of chaos. The government of Hugo Chavez is now embarking on a course of confrontation with its opposition. That confrontation could come as soon as November 19th according to Stratfor.com when opposition leaders take to the streets in a protest march. The country has seen violence escalate between civilians on both sides of the political spectrum. It appears that anarchy and social disorder are emerging everywhere in the country as the Venezuela's economy heads towards a depression similar to Argentina and possibly Brazil. The country's oil production is at risk with social anarchy. Venezuela exports a large amount of its oil to the U.S. A declining economy and declining oil revenues could set off a chain of defaults throughout the region where many of the major states in Latin America are clearly in dire economic straights. This would have enormous implications for the U.S. banking sector with many of the nation's largest banks having made large loans to governments in the region. Most recently Argentina defaulted another $1 billion in debt.
Oil & Terrorism in the Middle East
Venezuela's economic and political plight could impact the oil markets negatively at a time war is about to break out in the Middle East. The geopolitical risks that are emerging out of the Middle East make for a very uncomfortable situation in the world's energy markets. There are no major surpluses or room for error. Oil prices have recently begun to rise again as uncertainty reasserts itself. Of particular concern is the prospect for possible terrorist attacks against the world's oil infrastructure. This is new evidence that al-Qaeda may be changing its strategy in going after oil targets. The world's oil infrastructure is a target rich environment. The following targets are all under consideration:
- Oil and gas wells
- Pipelines and pumping stations
- Tank farms
- Underground storage sites
- Loading terminals and ports
- Offshore drilling and production facilities
If attacked, Iraq may choose to destroy its oil fields. During the Gulf War Iraq's army set fire to Kuwait's oil fields. It took almost a full year to extinguish the oil well fires, removing 2 million barrels of oil per day from production. Rebuilding the industry took another three years.
In addition to attacking facilities, the world's oil flows could become disrupted through bottling up or attacking oil flowing through the world's choke points in the following locations: Straits of Hormuz, Suez Canal, Bosporus Straits, and Malacca Straits (not shown).
There have been conflicts between states and terrorist actions in these regions that have been steadily increasing over the last five years. In 1995 there was a conflict between Yemen and Eritrea over control of the shipping lanes around the Greater Hanish Island.
Terrorists have several options at their disposal including Strait of Hormuz, Suez Canal, explosives, weapons of mass destruction, and chemical and biological weapons. In the words of Neal Adams, an oil industry firefighter, "Terrorism has no rules and, as such, can’tbe defined by a society based on rules." Neal Adam's new book, Terrorism & Oil. is a warning of the risks that now confront the oil industry , which is the lifeblood of western economies. It is a highly recommended read for financial professionals and most Americans who take cheap energy for granted. The book will be published shortly in December and is included in the FSO Current Reading list.
Looking at market internals, they show a breakdown in the retailing sector as the above charts of Wal-Mart and Home Depot indicate. The breakdown in this group may be signaling the coming retrenchment of spending by the consumer. Unless the Fed can resurrect a new bubble in the bond market that would generate another round of home equity refinancing, the consumer looks to be tapped out. The fed rate cut of half a point in November was designed to increase money velocity by making money less attractive to hold. For a fuller explanation of this concept please see Storm Watch Update Changing Preferences: The Velocity of Money & the Short Sellers Nightmare Part 1. The recent retail sales figures and concomitant reports coming from Wal-Mart and Home Depot may be early signs of this consumer retrenchment. The government reported that in September personal consumption declined by 0.6%, the first decline in since last December. The figure understates the drop in consumption when you add the fact that consumer credit expanded by $10 billion in September. Without additional lines of credit, consumption would have fallen much more than the reported drop of 0.6%.
Greenspan Speaks on International Risk Management
Elsewhere in the news Mr. Greenspan spoke before the Council on Foreign Relations today. The subject matter was "International Risk Management." I have included key highlights of the speech and my own comments in green.
International financial issues have so engaged us at the Federal Reserve over the past year. [Translation, crises from Enron, WorldCom, Argentina and Brazil, to now Venezuela.] The development of our paradigms for containing risk has emphasized dispersion of risks to those willing, and presumably able, to bear it. If risk is dispersed, shocks to the overall economic system will be better absorbed and less likely to create cascading failures that could threaten financial stability. [Alan, please review J.P. Morgan's derivative book. Risk has become concentrated in the hands of a few key players in the U.S. -- Morgan, Citigroup, and Bank America.]
The broad success of that paradigm seemed to be most evident in the United States over the past 2 1/2 years. Despite the draining impact of a loss of $8 trillion of stock market wealth, a sharp contraction in capital investment and, of course, the tragic events of September 11, 2001, our economy is still growing. Importantly, despite significant losses, no major U.S. financial institution has been driven to default. Similar observations pertain to too much of the rest of the world but to a somewhat lesser extent than to the United States. [$8 trillion in losses is viewed as a success. No mention of the housing bubble or mortgage bubble that replaced the stock market bubble. The fed, in Alan's view, is incapable of knowing when bubbles exist.] The wide-ranging development of markets in securitized bank loans, credit card receivables, and commercial and residential mortgages has been a major contributor to the dispersion of risk in recent decades both domestically and internationally. These markets have tailored the risks associated with such assets to the preferences of a broader spectrum of investors.
Especially important in the United States have been the flexibility and the size of the secondary mortgage market. Since early 2000, this market has facilitated the large debt-financed extraction of home equity that, in turn, has been so critical in supporting consumer outlays in the United States throughout the recent period of cyclical stress. This market's flexibility has been particularly enhanced by extensive use of interest rate swaps and options to hedge maturity mismatches and prepayment risk.
Financial derivatives, more generally, have grown at a phenomenal pace over the past fifteen years. Conceptual advances in pricing options and other complex financial products, along with improvements in computer and telecommunications technologies, have significantly lowered the costs of, and expanded the opportunities for, hedging risks that were not readily deflected in earlier decades. Moreover, the counterparty credit risk associated with the use of derivative instruments has been mitigated by legally enforceable netting and through the growing use of collateral agreements. These increasingly complex financial instruments have especially contributed, particularly over the past couple of stressful years, to the development of a far more flexible, efficient, and resilient financial system than existed just a quarter- century ago.
[The offloading of risk on to the financial markets is not discussed. The double-digit growth in derivatives, the concentration of that market in just a few hands, the expansion of the debt of GSEs is seen as "innovation," not as a risk.]
However, compared with decades past, banks now have significantly more capital with which to absorb shocks, and they employ improved systems for managing credit risk. In conjunction with this improvement, both as cause and effect, banks have more tools at their disposal with which to transfer credit risk and, in so doing, to disperse credit risk more broadly through the financial system. Some of these tools, such as loan syndications, loan sales, and pooled asset securitizations, are relatively straightforward and transparent. More recently, instruments that are more complex and less transparent--such as credit default swaps. collateralized debt obligations, and credit-Iinked notes--have been developed and their use has grown very rapidly in recent years. The result? Improved credit-risk management together with more and better risk-management tools appear to have significantly reduced loan concentrations in telecommunications and, indeed, other areas and the associated stress on banks and other financial institutions.
[Once again the offloading of credit risk through the financial system on to the portfolios of pension funds, insurance companies and in hedge funds is considered prudent. Tell that to Calpers which lost hundreds of millions in WorldCom and Enron.]
The market for credit derivatives has grown in prominence not only because of its ability to disperse risk but also because of the information it contributes to enhanced risk management by banks and other financial intermediaries. Credit default swaps, for example, are priced to reflect the probability of the net loss from the default of an ever-broadening array of borrowers, both financial and nonfinancial.
As the market for credit default swaps expands and deepens, the collective knowledge held by market participants is exactly reflected in the prices of these derivative instruments. They offer significant supplementary information about credit risk to a bank's loan officer, for example, who heretofore had to rely mainly on in-house credit analysis. To be sure, loan officers have always looked to the market prices of the stocks and bonds of a potential borrower for guidance, but none directly answered the key question for any prospective loan: What is the probable net loss in a given time frame? Credit default swaps, of course, do just that and presumably in the process embody all relevant market prices of the financial instruments issued by potential borrowers.
Price trends of default swaps have been particularly sensitive to concerns about corporate governance in recent months. The perceived risk of default of both financial and nonfinancial firms has risen markedly in the wake of company-threatening scandals, though levels remain moderate for most. [No mention of widening credit spreads or rising swap premiums. Next, the warning.] Derivatives, by construction, are highly leveraged, a condition that is both a large benefit and an Achilles' heel... More fundamentally, we should recognize that if we choose to enjoy the advantages of a system of leveraged financial intermediaries, the burden of managing risk in the financial system will not lie with the private sector alone. Leveraging always carries with it the remote possibility of a chain reaction, a cascading sequence of defaults that will culminate in financial implosion if it proceeds unchecked. Only a central bank, with its unlimited power to create money, can with a high probability thwart such a process before it becomes destructive. Hence, central banks have, of necessity, been drawn into becoming lenders of last resort. [Who ultimately pays for it?] If private financial institutions have to absorb all financial risk, then the degree to which they can leverage will be limited, the financial sector smaller, and its contribution to the economy more limited. On the other hand, if central banks effectively insulate private institutions from the largest potential losses, however incurred, increased laxity could threaten a major drain on taxpayers, excess creation of money by the central bank, or both. In the end, we would be faced with a severe misallocation of real capital. In practice, the policy choice of how much, if any, extreme market risk should be absorbed by government authorities is complex. Yet central bankers make this decision every day, either explicitly, or implicitly through inadvertence. Moreover, we can never know for sure whether the decisions we make are appropriate. The question is not whether our actions are seen to have been necessary in retrospect; the absence of a fire does not mean that we should not have paid for fire insurance. Rather, the question is whether, ex ante, the probability of a systemic collapse was sufficient to warrant intervention. Often, we cannot wait to see whether, in hindsight, the problem will be judged to have been an isolated event and largely benign. [Benign? I rest my case for systemic risk. What is needed here is a one-arm economist. Read the complete text yourself. Link]
All of the major averages fell for the second day as concerns mount that the consumer may be at the end of the line as more companies are reporting a slowdown in sales. The Bank of Tokyo-Mitsubishi reported that sales slid 1.2% at chain stores in the week ending November 16th.
Within the market natural gas stocks, drug, defense and consumer stocks rose; while retail and tech stocks took a drubbing. Volume came in at 1.32 billion on the NYSE and 1.62 billion on the NASDAQ. Losers beat out winners by 18-14 on the NYSE and by 19-14 on the NASDAQ. The VIX inched up by .25 to 31.36 and the VXN continues to fall dropping 2.57 to 45.52. The drop in the VIX and the VXN, declining volume, and a falling advance/decline line indicate the weakness in this current rally. You need to have strong breadth and volume in order to have a sustainable rally. Both have been conspicuously absent in this rally. The CBOE put/call ratio has also been falling showing growing complacency.
Outside the NASDAQ, the S&P 500 and the Dow have failed to surpass their November 6th and 7th highs. Even the NASDAQ has tried three times and failed to penetrate resistance at 1425. Momentum has been steadily declining, which is not a good sign. More so when you consider that a half point rate cut by the Fed and a Republican victory in the election has failed to generate much of a response in the markets. This is evident in the charts of the S&P 500 and the Dow. The NASDAQ may also be joining this trend with yesterday and today's breakdown. This time of the year is seasonally a strong period for the market. However, there remain no major catalysts to move stocks higher. What's next? Maybe the Fed will start buying stocks. Keep your eyes on the dollar, gold, the CRB and the bond market.
European stocks fell, led by Ericsson and Alcatel as Deutsche Bank advised investors to sell the telephone equipment makers. EMI Group and Groupe Vallourec dropped after cutting sales estimates. The Dow Jones Stoxx 50 Index dropped for the first day in four, shedding 0.4% to 2603.89. All eight major European markets were down during today's trading.
Japan's Topix stock index declined as Mizuho Holdings Inc. and UFJ Holdings Inc. plunged to record lows on concern the government will seize the nation's weakest lenders. The Topix closed at an 18-year low for the third day in four. The index's 5.2% drop this month, the world's worst in local-currency terms, has eroded the value of banks' shareholdings and made it more likely lenders will need a bailout after new rules for counting bad loans are outlined this month. The Topix lost 0.8% to 817.09.
Treasury bonds closed with slight gains, with long-dated issues attracting the most interest. The 10-year Treasury note was up 1/8 to yield 3.975%; while the 30-year government bond gained 5/32 to yield 4.855%.
© 2002 James Puplava