Financial Sense Newshour
The BIG Picture Transcription
October 15, 2005
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THERE IS NO PLAN "B"
JOHN: You know, Jim, I once had a friend of mine say to me when we were dealing with a political issue, “Oh, Great! the big green dragon is coming roaring over the top of the hill, and we're down at the bottom and the political parties are having a spitting-contest.”
And as we start in to the Big Picture today, there is no Plan "B". This really reminds me of that. I just read the article you have posted on the website here: There was no Plan B. And as I look at the facts and figures you compiled in there, my eyes were getting bigger and bigger as I realized there really is a giant green dragon coming over the top of the hill, belching fire at the US economy, but everyone else is still looking in the rear view mirror, down at the bottom of the hill. They don't have a clue of What's really coming down upon us now.
JIM: No. The main problem, John, is a lot of people are scratching their heads. Politicians are upset that energy prices are up. People are upset because They're paying $3 for gasoline. They’ve just been told their heating bills or natural gas bills could go up as much as 50%, and a lot of people are saying, “How did we get here!?”
If you go back historically, we had two decades of benign energy prices. Prices for energy were extremely cheap in the '80s. And as a result, gasoline became so cheap the automobile companies got rid of � Mercedes replaced its American line of cars with gas engines vs. diesel, as we had at the beginning of the '80s � the automakers came out with bigger muscle cars. We went from maybe the family station wagon and the fuel efficient car to these big SUVs that consume more gas. Because when energy was cheap, we could afford to do that.
But the important thing to realize is for 3 decades we have allowed our energy infrastructure to go into neglect: whether It's power plants, electrical grid system, its pipelines, exploration, refineries. Whatever it is you're looking at, we just did not invest in that sector. And in the meantime the American economy continued to grow, we added more people, the population base in this country grew, our economic base in this country grew, we added more technology. You know, look at the PCs now. They're ubiquitous; everybody has a PC in their home and that consumes more electricity. We went from 19�� television sets at the beginning of the '80s to everybody now has a big screen television and home surround system. That consumes more energy. We went to bigger homes. The homes became McMansions. Instead of a 2000-sq ft home, now the average has gone up to close to 3000 sq ft and we added more appliances.
So we're consuming more energy. In the meantime, we've allowed this infrastructure to go into neglect. And so that when you get a bottleneck � when you have a hurricane, when you have a mishap � you have trouble in Nigeria, which is a major exporter of energy to the United States, or trouble in Venezuela; or for the other matter � you have China and India now � and the new variable in the energy equation is China�s voracious need for energy. We didn’t have to consider Chinese demand for oil in the '80s. It simply wasn't a factor. It did not become a factor until the latter part of the '90s as the Chinese economy really went on a manufacturing [tear], building new factories and equipment which requires more consumption of energy. [3:56]
JOHN: Yeah, I notice a new political process. It's not really new, but It's becoming predominant now. I'm calling it offloading, which means we have crises that are brewing that have been developing for quite some time. No one deals with them and they wait for a momentary crisis to do the offloading. Say, for example, the fact that the stock market had gone flat in 1999, it really didn’t get dealt with until 2001 and they blamed it on 9/11. And here we see a blame on Katrina and Rita as being the cause and in reality all these were were catalyzing events that tripped an already deficient system.
Now, a question. Just like the Titanic, can we dodge the iceberg at this point?
JIM: It's too late. One of the lines I put in my article was � �the United States will find itself moving from one energy crisis to another in quick succession.� In the near future we will see oil and natural gas price spikes. we're going to see brownouts � they just had a brownout this week in Los Angeles � gas lines and eventual shortages. There is nothing, I repeat, nothing, we can do to prevent these crises from erupting. John, there is nothing that we can do. We can't go to China and say, �China, stop industrializing, stop consuming and adding additional demand.� And even if the world could go into recession, which would curb some of this demand, you can't build a refinery in 6 months. You can't build a power plant in 6 months. You can't expand the grid system, build a pipeline, go out and discover oil and get this done in 6 months. I mean, It's not like the common phrase, you can flip on a switch and bingo!
we've got all this excess energy [demand]. All of this stuff is going to take [supply], whether It's going to be expanding our energy infrastructure, coming up with alternative forms of fuel � whether It's going to be nuclear, wind, geothermal, biofuels, whatever, we're going to start doing to come up with alternatives � it is going to take time. In the meantime, non-OPEC production continues to go into decline, just as North Sea oil production peaked in 1999, we had Alaska peak in I believe 1988, and then this year Cantarell, which is Mexico�s largest oil field, that field will be peaking. So There's nothing we can do to stop or arrest this. And yes, we can start to conserve, you could start maybe turning off the lights, wearing sweaters, going back to the Jimmy Carter era. That may help a little bit in terms of curbing the demand growth, but the demand is going to grow and production is going to decline. So there is no easy answer to this. We can't dodge the bullet. Three decades of neglect have led us to where we are today. [6:53]
JOHN: Everybody is complaining at the pump right now. What are we looking at, as far as we can see oil and gas prices say within a year, and then within a time bracket, say about 2010? What could we be looking at?
JIM: There are a number of people forecasting out there. Dr. Michael Economides, who we had on the show � remember in the Summer of 2004, when oil was around 40-something a barrel, he was forecasting $65 oil �and people looked at him like he was a looney-tune. So of course we got up to $70 with Katrina. Professor Michael Economides believes We'll be seeing $100 oil prices by next Summer. And then in a speech to the Houston Petroleum Institute on September 15th, Matt Simmons is predicting We'll see $200 oil by the year 2010. And Matt is putting his money where his mouth is. He’ll bet anybody $5000 that he’ll be right with that $200 oil by the year 2010.
The other thing we have going into effect, beginning in January, refineries will have to reduce the sulphur content of gasoline from 90 parts per million (ppm) to roughly 30 � in regular gasoline � and then next June, when it comes to diesel fuel, They're going to reduce it from 500 ppm down to about 15. And Economides� group is projecting that this will not only create some shortages and inconveniences, but we could be looking at $5 diesel fuel by next Summer. And the problem is the capital investment That's going to have to be employed by the refineries to bring this into compliance. we're talking about refineries having to invest billions and billions of dollars to do this. This will not increase output. In other words, the billion dollars worth of investment will not enable these refineries to increase the amount of gasoline or diesel fuel that they can produce. This is just making the content of this diesel fuel.
The other factor that you have in the United States is we're going to have 50 different blends of gasoline. So we can't agree on one environmentally-friendly level of gasoline and one environmentally-friendly form of diesel fuel. Because if we could do that, then all refineries could produce the same kind of fuels so that, for example, if you have a bottleneck in the Gulf region because of the storms � having these 12 refineries shut down � perhaps refineries elsewhere � in California or other places in the country - could pick up the slack and ship the extra fuel to the areas that are experiencing a bottleneck. You can't do that because Chicago has different forms of gasoline, California has what we call the Flave [phon.] blend of gasoline; you have all these regional different environmental fuel standards, so we've got this gigantic maze of different qualifications for fuel standards. So we can't get anybody to agree on the same thing and this is grossly inefficient. So That's a problem.
The new mandates are going to be a problem because That's not going to increase production. You may have certain refineries saying, �Look, I don't want to spend the billions of dollars to do this, it just makes more sense to ship our diesel overseas.� And the other problem that we have right now is because of our lack of refinery capacity we cannot make all the gasoline that we need in this country and so we have to import it. We import a lot of gasoline from Venezuela. So you have foreign refiners that say, �You know what, I'm not going to make the billions of dollars of investments to meet your fuel standards when I can sell anything I have to Europe, or to Latin America, or to Asia, that don't require these standards. Why should I spend the extra billions of dollars to sell to you guys, when I get no return on my investment for doing so?�
JOHN: You can almost see a price control spike coming there between government and suppliers. Suppliers say, “Well, to heck with that! we're just taking the product offshore.” The government comes back and says, “You will sell.” But of course, that puts the business in a negative cash flow type situation if it can't even break even on that. This is a losing fight at that end -- the same as wage and price controls.
JIM: Well, you have several proposals that are working their way through Congress. Senate Minority Leader Harry Reid is endorsing energy price controls. He wants to see new gasoline tax increases, then he wants suspension of the new bankruptcy bill, and a revival of the oil windfall profits tax. These are the things Jimmy Carter did in the latter '70s, which exacerbated the energy crisis, by slowing oil exploration in the US, keeping oil prices higher than they had to be. So, It's like we've got a bonfire going and They're adding more explosive fuel to the bonfire to make it worse than what it already is. [11:49]
JOHN: Yeah, That's because of looking in the rearview mirror and not comprehending the situation. Politicians don't tend to catch on, Jim, until the crisis is well established, and then they are always make the wrong decision. let's look briefly I know we did this last week, but once again � how did we really get here? Because if people understand the factors that brought us to this point � just as a sort of itemized one, two, three, four then it helps with some perspective of where we're headed.
JIM: To begin with, we had a couple of things that happened. In 1970, US oil production peaked and as a result, beginning after 1970, the US found it necessary to import oil to meet its energy needs. So we ceased being energy independent as of 1970 in the United States. But fortunately, our decline in oil was arrested somewhat by a major discovery in the North slopes of Alaska, Prudhoe Bay, so that helped to arrest part of the decline. At the same time in the North Sea, one of the largest oil discoveries was made. So Britain was able to bring extra oil production on line. And so we had 2 new sources: one in the United States and one in Great Britain, which helped to kind of cover up what was happening globally with oil discoveries and oil production. But little by little, John, oil production in the United States began to decline. So when we had the energy crisis in 1973 in the US and then in 1979 with the Iranian Revolution, the United States was only importing somewhere between 20-25% of its oil and energy needs.
Then also we began to move in the '80s to natural gas. In other words, the appliances changed over to natural gas stoves, heating we began to move in that direction at the same time, which means we had to import natural gas from Canada because US production wasn't totally sufficient to meet all that demand. But by the time we got to the late '80s, oil production in Alaska peaked at around 2 million barrels/day, and by the time we got to 1999 North Sea oil production peaked. So, production in the United States began to decline decade by decade, and as a result we were losing our ability to control the price of oil.
The center of the oil business shifted from the United States over to OPEC; OPEC was now in the driver�s seat because they were the largest producers. And while all this new production came on line, as it did with the North Slope, the North Sea, and then Russian oil production after the mid 1990s � all this extra supply came on, and remember during the '80s, and '90s, new technology was coming onboard in the oil industry �it made it easier to find oil. But as Matt Simmons pointed out, what this new technology did is it enabled oil companies to stick a bigger straw in the ground and draw the oil out of a well at a faster pace, which was how production increased. Now we've reached the limits of that technology and we have not been replacing the oil that we consume each year since 1985.
So every year, we consume more oil and we're not replacing it and eventually that catches up with you. In the meantime, because of the low returns on energy, we had 325 refineries in the US and a lot of people think there was a conspiracy by the oil companies �they couldn't make any money, the rate of return on capital from a refinery was 5 � % - every single year you had environmental regulations that would go into place that would require you to make more capital investments. Capital investments that would not allow you to earn a higher rate of return on the products that you produced. And so we quit investing in the energy sector; the energy sector was allowed to contract; we lifted price controls and subsidies to the industry so a lot of these refineries were gotten rid of, and basically, with the decline in oil prices as production increased, there just wasn't a lot of incentives to go out and invest in a new refinery. So by the time we got to the end of the 1980s, refinery capacity had gone from almost 18 or 19 million barrels/day, down to about 15 million barrels. Now, in the 90s what happened is existing refineries over the next 15 years did make capital investments, and it really came towards the end of the 1990s. They were able to increase production at existing facilities by 28%, but we are still far below where we were in 1980 in terms of our ability to produce oil. In the meantime, demand for gasoline has increased by 45% since then: there are more people in the United States; there are more cars being driven on the road.
So, we've neglected on the supply-side to bring enough new structures, to modernize our refineries, build more pipelines, go to alternative fuels, explore for more forms of energy. All of that went by the wayside on the supply side; the only thing that happened is the industry consolidated because there were low profit margins, which is what happens in a bear market. And then on the other side, demand grew exponentially especially in the late 90s as the economies of India and China began to expand. [17:44]
JOHN: let's see if I can frame this into some perspective that makes people understand this. If we have to import 60% of our energy, we've lost control over some aspects of our economy, because we're now more and more dependent on What's going on out there. This also has strategic implications as well from a military perspective.
JIM: Well absolutely, because when you have to import something you don't have, you're at the mercy of the marketplace. In other words, if our energy imports were only 10-15%, we might be able to go to some programs like conservation � as we did in the '70s � which reduced demand. We went to the 55 mile per hour speed limit. American car manufacturers, as a result of competition from Germany and Japan, made more fuel-efficient cars so conservation could help us out of part of that mess. But today we're importing 60% of our energy needs, and that percentage is going to increase every single year as demand increases, and as production falls in the lower 48 states and Alaska. So, each year the United States will produce less oil and natural gas which means we will have to import more of our fuel from places that are what we consider very unstable right now: Venezuela; the Persian Gulf; and Nigeria. These are 3 of the largest exporters of energy to the United States. we've got political problems in Nigeria. we've got political problems all throughout the Persian Gulf and Middle East region and we have political problems in Venezuela.
And the other thing is, John, we now have larger customers that are in the marketplace. In other words, if the United States was the only game in town, then we, as a major consumer, might be able to exert influence on our suppliers, in the same way that Wal-Mart does to many of its suppliers. It can say, “look, we're the largest buyer of your product. This is what we're going to pay you.” Now, let's put the shoe on the other foot. you're a Middle Eastern producer. The United States can't go in and say, “Look, the price of oil today is $62 a barrel. we're not going to pay you $62. We want to pay you $40 and we think That's fair.” You know what They're going to do? They're going to say, “China will buy all the oil we can give them at $62 a barrel. India will buy all the oil we can give it, so will Europe.” And so, we're not the only game in town and in the next 10 years it is estimated that as China’s economy continues to industrialize and grow and the same with India China and India alone will surpass energy consumption in the United States. So, we can't just wave a wand and say, “Look, you do what we tell you or else.” we're just not the only player in the room anymore and there are very powerful interests outside the United States that would love to have all the oil produced.
If you take a look at China, Chinese foreign policy is now based on securing access to oil and energy. There's a great article in the current issue of Foreign Affairs, which I cite. It's all about Chinese foreign policy from military expansion to protect its trade routes, but They're moving into America�s backyard, moving into Canada, making and securing deals to develop Canada�s tar sands. They're moving into Venezuela to develop Venezuelan oil. They're moving into Latin America. They're moving into Australia � all parts of the world. And the other producers of raw materials are saying, “Hey! we like to have other customers. We don't like having one customer that tells us what to do.” So, on the supply side those producers of energy and raw materials now have various customers and can tell the United States, “You don't want to pay $62? Sorry!, We'll sell it to China or India.” [21:38]
JOHN: Of course, That's always the point historically, Jim, when the rules of fair market, gentlemanly play � so to speak � get abolished, and military actions step in too. Of course, as Frederick Bastiat once said, “when goods and services don't cross borders, That's when armies do.”
JIM: Referring to this article in Foreign Affairs, and this article is addressing this conflict over resources between the United States, and let's say China. And I'm just going to take a quote from this article, it says:
“While China struggles to manage its growing pains, the United States is the world's hegemon. It must somehow make room for the rising giant, otherwise war will become a serious possibility. According to the power transition theory, to maintain its dominance a hegemon will be tempted to declare war on its challengers while it still has a power advantage. Thu, easing the way for the United States and China, and other states, to find a new equilibrium will require careful management, especially of their mutual perceptions.” [Zweig, David and Jian, Bi, "China's Global Hunt for Energy," Foreign Affairs, September/October 2005.]
And they go on further to say, the next big test is if China decides to flex its economic muscle by expanding its military presence. While many nations are, for example, disposed to Chinese trade They're increasingly uncomfortable with China increasing its military power. Meanwhile, China believes for its own self-interest it must protect its trade routes. It is expanding its Navy giving it the flexibility of both offensive and defensive positioning. It's helping Pakistan build a new port and military base. It's upgrading its military airstrip in the South China Sea and its monitoring stations in Myanmar. It's also negotiating naval facilities in Bangladesh. Chinese military power is growing, and this is beginning to make not only Washington uncomfortable, but other countries as well. So, it almost reminds me, John, of the situation that we saw in the early 20th Century, when Britain saw with dismay the manufacturing prowess of Germany and also Germany�s arms race. So Britain began an arms race, which eventually, as we know, led to war. The same thing with the United States in the late '30s in Roosevelt’s Administration’s desire to check Japanese imperial ambitions. It cut off oil to Japan. As we know, that forced Japan to attack us at Pearl Harbor.
So we're entering what could be several tipping points out here that we have to bear in mind, because a lot of people say, “don't talk about these kind of things, let's just keep focused on the market.” Well, if we don't talk about these things that are underlying below the surface and they're bubbling and heating up then all of a sudden you wake up one day and all of a sudden an event happens like 9/11 or December 7th, or other events, and we go, “Wow! where did that one come from?” And it takes everybody and the markets by surprise. [24:45]
JOHN: OK, Jim, let's look at it this way. The big question I always ask is when we get done with all the theory there is a big “so what” at the bottom. How is this going to impact people? Say for example, that we were really confronted with a major oil crisis over a 7-month period bang, bang, bang, bang, bang � what would happen?
JIM: You know, It's interesting John, because we posted an article on our web this week, it was called Oil ShockWave: Oil Crisis Executive Simulation and I'd advise anyone listening to read it. And the things that you and I are talking about, people at the highest levels of government and industry are thinking about these very same things. And what happened was on June 23rd of this year, a group of nine former White House cabinet and senior National Security officials convened to participate in a simulated working group of a hypothetical White House cabinet. Their task was to advise an American President as the nation grapples with a 7-month oil crisis. As they enter the room, they are unaware of the circumstances or the nature of the oil crisis. They had several simulations of political crisis in Nigeria and a terrorist attack on Saudi Arabia’s oil facilities. And here's what they came to some conclusions and I’ll just read a couple of these:
“Oil is a fungible global commodity. A change in supply or demand anywhere will affect prices everywhere. In a tight supply-demand market the removal of only a small amount of oil can have a dramatic effect, for example, a 4% reduction in global shortfall of oil production would lead to a 177% increase in crude oil” this gets back to the kind of figures Matt Simmons was throwing out. At the time this panel met, on June 23rd, oil prices were at $58 and they said a 4% decline could raise oil prices to $161"
A price shock of that magnitude would send the US economy immediately into a recession. They also concluded military options offer little recourse in the event of a supply crisis, and the simulation that took place, Saudi Arabia’s largest oil facility was attacked by terrorists and taken off line. Also the US energy infrastructure at home and abroad was highly vulnerable to terrorist attacks. Political unrest in any of the key oil producers presents a greater threat than terrorism. Relying on Saudi Arabia as supplier of last resort is suspect given the Kingdom’s susceptibility to terrorist threats and political tensions. All of the supply-side and demand policy options take time to develop here it goes back to this thing that we're stressing here, you can't flip on a switch and their benefits could take a decade or more to mature. The time to act is now. [27:42]
JOHN: This brings us back to “stuck on stupid” doesn't it?
JIM: we're still talking about price controls. The refinery bill barely passed � 212 to 210 in the House, now one Democrat voted for the bill, and even Republicans broke rank on this bill � It's considered a dead issue by the time it hits the Senate. There's just not enough votes they think to pull it out. So we're not going to build refineries, and a lot of people say, �Jim, why build refineries if peak oil is down the road?� Well, we don't know when peak oil’s going to hit, number one. Number two, if we go to alternative fuels, whether It's Canadian tar sands, or shale oil, We'll still need some kind of refinery to process this into finished products, whether It's plastics, drugs, diesel, tar or gasoline. And the idea that you have 50% of your refinery capacity along the Gulf coast is just not a good idea, now that we're experiencing warmer temperatures due to the decadal cycles in the ocean and having your refinery capacity exposed to this. It just doesn't make a lot of sense. And we're still doing nothing to expand the grid system. we're still doing nothing, or virtually nothing, on the alternative fuel front. we're still doing nothing about building pipelines. In other words, if we're building natural gas plants, doesn't it make sense to build pipelines to get the gas to the gas plants? So once again, to quote the gentleman from New Orleans, we're still "stuck on stupid" here. [29:12]
JOHN: What do you think it is going to take to blow them off of this �stuck�?
JIM: I think next year when we get to $5 diesel fuel. I think as we get more power brown outs in Los Angeles, and elsewhere in the country; as the price of gasoline goes over $4. I think as people’s energy utility bills start to go up. Take a look at the CPI index, which was posted today � and I love this � we have never seen a jump like this. The CPI was up 1.2%, almost a 14% annual inflation rate, but the immediate response was, �Well, if you take out everything that went up, the core rate was OK.� Well, I hate to tell you, but most people [don't] live by the core rate.
JOHN: Yup, take out all the data that bothers us.
JIM: Yeah, and that way, That's denial. �Hey, as long as we're looking at the core rate, which is a highly jiggered number anyway with hedonics, then we really don't have inflation." It's amazing. There was an article in the Wall Street Journal, front page, talking about inflation starting to spike up all over the globe, whether It's bus fares in Germany � going up 4% - salt in China going up over 50%. I can't pick up the paper The Wall Street Journal and read each day some company is saying, �you know what, we're raising prices.� We can't live like this. [30:32]
JOHN: Jim, as we round down on this section of the Big Picture, we began by saying there really isn’t any Plan B and that we are condemned to enter this crisis. Loeffler�s rule of thumb says: never appoint the same people to get you out of a crisis that got you into it. Or in essence, if they didn’t see it coming, they won't know what to do when it gets here. And I notice you listed 3 basic reasons that we really do have this crisis as being: 1) failure to anticipate a problem before it arises; 2) failure to perceive the problem once it arrives; and 3) the tendency by society�s elites to perceive the wrong problem which distracts from the real problem at hand. And That's what I was talking about earlier �offloading the blame � and that just begins to confuse you because you notice in all the public debates, and the talkie channels, everybody's talking about the wrong thing.
JIM: And one reason why we're heading for a series of crises, like I said, you cannot flip the switch, bring on additional refinery capacity, bring on additional production, bring on alternative energies, expand the grid system, get rid of all the red tape, the rules and things like that. Our government does not function like this. And it is going to take a series of crises, one crisis followed by another. Just as we begin to bring the refineries � we've got 12 refineries along the Gulf coast that are still remaining off line, we've got close 90% of our oil production in the Gulf off line, we've got just under 70% of our natural gas production off line � just as we begin to bring all this stuff on line, we've still got growing demand, Chinese money supply is increasing. And at the same time as this gets fixed and we get every thing working ,which is March or April of next year, we begin the next hurricane season. And we still have to get through Winter. [32:30]
JOHN: Not only are we playing catch up, [but] we're almost playing behind the curve, really in reality now at this time.
JIM: Yeah, so unfortunately John, It's going to be just like the '70s, where we went from a $1.25 a barrel of oil to - by the end of the 70s � 40%. we've got inflation on the rise, interest rates on the rise, government spending and tax increases on the rise. I mean we're doing just about everything we could possibly do wrong and That's the way usually things happen, which will probably bring us to our next topic. [33:02]
HOOVERIZING THE ECONOMY
JOHN: Well, I have to say Jim, I thought that this next segment was really appropriately entitled for two different reasons. �Hooverizing the economy�, certainly because, first of all, in Great Britain, to �hoover�, is used as a verb to mean to vacuum. We don't do that in the US. I don't think the Australians or New Zealanders use that, but the British do. And the second thing is, remember what happened to the economy in 1929 when we had the stock market crash and Herbert Hoover�s Administration ran in there and grabbed every political and economic lever they could think of to try to recover the whole thing, and everything they did rolled us over? And That's what really caused the Great Depression. We rolled over and went down. The economy was already starting to recover until Hoover got his hands on it and that of course led to the election of Franklin Deleanor Roosevelt and the New Deal. we're looking at 3 factors here: number 1) raising taxes � and if you listen to any of the hearings this week on the President�s Commission on Tax Reform, the way They're talking become law there ain�t going to be no reform, Jim. All They're doing is tinkering around the edges. The second thing is rising interest rates and the third thing is this weekend on all the weekend talks, guess what they were talking about � �is inflation here?� - Well, give them enough time and they finally catch on.
JIM: Well, you know they begin with the obvious. If you are a consumer, you can't help but notice -- whether you're looking at medical premiums, your utility bills, what you're paying for gasoline, what it costs you each week for groceries, your kids� tuition bills, all the things � yeah, maybe you can buy a big-screen TV cheaper this year than last year, but you're not buying big-screen TVs every week � so the obvious issue is inflation is on the rise. It's on the rise globally. There was a great piece in the Wall Street Journal this week talking about how interest rates are on the rise globally. Central banks are going to be raising interest rates. It's widely expected. The European Central Bank will start raising next year along with the Bank of Japan. The Fed has made every indication as clear as they can speak more interest rate hikes are on the way, so we're probably going to get � barring a crisis, and I always have to throw that out, because some unexpected event could surface that would cause them to go on pause, but you know they didn’t go on pause with Katrina so it would have to be pretty major � but the first thing we're going to have is rising interest rates. They may take the Federal Funds Rate up to 4 � %, They're going to be raising interest rates in November, They're going to be raising interest rates in December, and the possibility that they could be raising interest rates in January, late January. So, taking the Federal Funds Rate, we've got rising interest rates, That's bad for the economy,because all these mortgages are going to have to be reset - these variable rate mortgages � you have home equity loans, they will begin being reset the month after the interest hikes go into effect. So, That's one thing That's being taken away from the economy: credit is going to be more expensive.
And the second thing is that They're talking about raising taxes. There were committees this week � and It's amazing, John, if they do nothing we're automatically going to get tax increases in 2008 with the expiration of the 15% tax rate on capital gains and dividends, and also by 2010 where you have the expiration of the low tax rates. In other words, we could go back to Clinton tax rates as high as 39.6%. The other thing That's happening that is capturing more and more Americans is this Alternative Minimum Tax. More middle class Americans are moving into this Alternative Minimum Tax, because they haven’t really indexed it for inflation. So, if you have tax deductions like state taxes, mortgage interest, or you have capital gains exclusions, it gets entered into another way we calculate tax, called the Alternative Minimum Tax. So if they do nothing, taxes are automatically going to go up each year with the Alternative Minimum Tax which will pull more middle class Americans into higher tax brackets, because the Alternative Minimum Tax is higher for many individuals.
I mean, some of the things that they are talking about: getting rid of favorable taxation on capital gains and dividends; raising the tax rates � They're talking about for example, reducing the mortgage exclusion to $300,000 instead of $1 million, or in other words, you can deduct interest on a home mortgage up to $1 million plus a home equity loan add another $100,000 on top of that. So if they reduce it to only $300,000, then you're talking about rising interest rates and getting rid of some tax deductions for real estate � talk about trying to collapse a real estate market; They're talking about a value-added tax, They're talking about raising income tax rates to higher rates; They're talking about expanding the wage base under which social security taxes are assessed. They're doing all kinds of things. And the negative thing about that is if you're a business or a company and you're thinking about for example making a business decision to build a new factory, or make an investment in a building, and They're talking about increasing the tax rates and getting rid of deductions. How can you plan in terms of your return of capital, if you make this investment?
One of the big uncertainties out there is taxes. Just the fact that politicians are talking about it is enough to scare everybody away and one of the things that we saw with the Great Depression is Hoover raised tax rates to 60%, and then Roosevelt came in and raised tax rates to 90%, which just about virtually killed the economy, and extended the Great Depression. And we all know that it took a major war to bring us out of the Depression because government did all the wrong things: they raised taxes; they interfered in the market place in all kinds of ways � with regulations, they even tried to control business, we got into this centrally planned economy and it literally turned what could have been a brief recession, and a brief market downturn into a 90% loss on the stock market, and what we know as the Great Depression, which gave us 25% unemployment. [39:58]
JOHN: What was amazing, last week as I was watching Neil Cavuto and guests on Fox News as I was flipping between the different channels, and one of the participants was saying, �look at all this deficit, we've really got to get the taxes back up here. we've got a war to fight. We have Katrina to bail out etc.� But you know the one thing in almost all of this conversation that I've been hearing, there is no talk whatsoever about slashing bloated, oversized government. Remember the Grace Commission � does anybody remember this commission, going back a decade and a half � when basically J Peter Grace and company said you could basically slash 50% of government, and we wouldn't notice any difference in the services to us. It is that bloated and that unaccountable. You don't hear any talk like that at all, Jim.
JIM: The amazing thing about all of this, too, John, is there was an op-ed piece in the Wall Street Journal this week by a prominent Democrat, in the Democratic Economic Committee. Ad he said, OK, he doesn't like the tax cuts, but he said if we're not going to cut taxes, let me just throw a couple of ideas out there. And he came up with about $140 billion spending cuts that could be made that nobody would ever notice. And the problem is one of the criticisms the Republicans always have of the Democrats, when the Democrats controlled Congress for 40 years is the Democrats were spendthrifts. Well, since 1994 the Republicans have controlled Congress and They're no better. They're spending. As we mentioned last week, the Republicans are spending like drunken sailors, and basically we are turning Washington DC � we ought to turn it into a hog farm because There's so much pork passed around � this Democrat was talking about, �do we really need a highway or bridge to nowhere in Alaska that we're going to spend $280 million to reward a Republican Congressman in Alaska.� Everybody is spending, and the Republicans have no fiscal discipline. They have no room to talk, to criticize their opposition in terms of being spendthrifts. Republicans are every bit as spendthrift as when the Democrats controlled Congress, and the words that Alan Greenspan spoke in Europe, he said �the US has lost control of its fiscal policy when Katrina hit�. There were some conservatives within the Republican party who said, �now wait a minute. We just passed a $286 billion pork barrel project for the highway spending bill. let's go back and reexamine some of this pork we're passing around, cut out a lot of this pork so we could use the difference to pay for Katrina.� And Tom Delay at that time said, �you know, There's just no place to cut.� There was absolutely no incentive within Congress to cut anywhere.
By the way, the tax cuts worked. Government revenues are the highest that They’ve ever been in this nation�s history. In 2004 the government took in nearly $1.9 trillion in revenues. The problem was they spent $2.3 trillion. So, we've had government spending, and this goes to � let's talk about Bush � the last year when Clinton was in office was 2000 and the government spent roughly $1.8 trillion. The first year 2001 Bush is in office and It's mainly Clinton�s policies were in effect at that time, spending increased by about 80 billion. Go to 2002, spending goes from 1.8 trillion to 2 trillion. In 2003 it almost goes to 2.16 trillion, and then spending goes to 2.3 trillion in 2004. And in this year I think It's going to be 2.5 trillion, if not more for fiscal year 2005. And then next year, 2006, it will go up even more.
So tax revenues went up. One of the things that we know is the government uses static accounting. And when you have rising interest rates, which are eventually going to harm the economy as the Fed keeps raising interest rates until something breaks, throw in tax increases on top of that, throw in regulations on top of that, and John, we've got a problem. [44:21]
JOHN: OK, but let's talk about inflation too. I was really surprised about a week ago, all of sudden, pop!, everybody wakes up, but again there is this offloading tendency to try to blame the hurricanes for that, when you and I know this was well-developing long before that.
JIM: The hurricanes are an easy scapegoat, as 9/11 became the scapegoat for the bear market and recession. Well, we really were OK � and the stock market was OK until 9/11 � then after that, you know, the accounting scandals came out, companies began to write-off all the goodwill for the frivolous investments they made at extreme overvalued levels in the late '90s. All of this stuff came out and they had a scapegoat, because it wasn't like, “OK, we were doing stupid things,” it was because 9/11 and that became the easy answer.
The easy answer now is not that we've been spending like drunken sailors � It's not that the money supply has been growing at above-average rates, that we have speculation, monetary growth we've never seen before � It's energy, Aha!, It's oil, It's the hurricanes. And so It's not really our policies. It's these extraneous events. And That's what you always have with inflation. You never have anyone willing to admit It's fiscal and monetary policies that create it. It's always trying to find something to blame it on. And It's not the Fed pumping money and credit into the economy. It's not reckless fiscal spending in Washington. It's Mother Nature with the hurricanes and It's greedy oil companies and OPEC that are causing this. And That's what you do � you try to offload the blame onto somebody else. [45:55]
JOHN: Yeah, but sooner or later, the offloading is going to have to come to a crashing halt. It's usually after the damage is done. Not just in raising interest rates, but the damage has to happen first and everyone goes, �Oh my Gosh.� And then usually some decisions are made that address the issue. But ahead of time, It's almost impossible to get anyone to do that, which lines up with what you were talking about much earlier and that is we can't dodge this bullet. It's not going to happen.
JIM: No. And all I can say is if this continues � the regulations, the infighting, the taxation which makes all of energy expensive because we're not putting Plan B into effect. The White House advisers that got together on June 23rd said, �We need to be putting this into effect, now!.� The longer that we delay this, number one, the prices will get much worse, and number 2, leaves us vulnerably exposed to any exogenous event that could occur, whether It's a terrorist attack or another natural disaster, and number 3, it puts us in a position where it leaves us few options and could likely lead to war. I mean, That's not a very optimistic outlook. So the longer we delay, the longer we get stuck on this stupid thing, the more likelihood that we will resolve this in conflict, and That's not a very promising outlook. [47:18]
STILL CHEAP AFTER ALL THESE YEARS
JOHN: Well, speaking of �so what� questions � so what � we are an investment type of program, so we ask �so what?� in that area. And the word on the street, Jim, if you wanna hot tip, oil�s gonna go back to $40 a barrel, They're saying, and oil stocks are overvalued, don't get into �em, and the whole market: energy is over, That's the word on the street.
JIM: As I ended this article, we've got to pull back, that we were looking for an energy. A lot of the hot money has exited the market, but if you watch the pundits on the programs, They're saying 3 things: we're heading back to $40 oil; number two, I'd stay away from energy stocks They're overvalued and overdone; and three, pretty much the commodity bull market is over.
And putting this in an investment perspective, 3 of the graphs that I am featuring in today's Storm Watch Update called There is No Plan B � at the very bottom � I ran P/E graphs on 3 oil companies, one was Exxon, the other was Chevron, and a natural gas producer Apache. If you look at these graphs P/E ratios were the highest at the end of 1999, at the end of the bull market when we were at 11,700 on the Dow. The P/E ratio in January 2000 was 36 on Exxon, and then we got the great downturn which began, the Dow peaked in January 2000, and then all the way down to the Summer of June 2002. In July of 2002, the stock price went down, the P/E went down along with it, then we had a spike in P/E ratios in 2002. And that was mainly due to a couple of reasons: number one, after the events of 9/11 and the recession of 2001, energy prices fell. We got down to about $20 oil. Profits for oil companies fell during that period of time, so that was a spike in P/E. But look from about 2003 when the price of energy began to go up, oil company profits, doubled, tripled, and even quadrupled. Even though the price of the oil stocks began to go up in 2004, the price did not go up as fast as earnings were doubling and tripling. So, if you look at the P/E graph, the low for P/Es was reached in May of this year, which was a P/E of around 12. Today, Exxon has a P/E of around 12 � and based on earnings for next year its estimated P/E is 11. So, P/E ratios have continued to go down while earnings have continued to go up.
So, a lot of people are saying energy stocks are over priced. I just don't buy that. And if we look historically, in other words, if Exxon were selling at 18 � It's average P/E ratio is around 18 � - or 19 times earnings, you might want to say, well, OK, you know this is a bit above the norm but Exxon is selling at close to the bottom range of its P/E ratio, historically. So we're far below its average P/E. It's the same thing whether you look at Chevron-Texaco. It's the same thing whether you look at Apache, Devon � I don't care where you look across the energy sector � prices for energy stocks are incredibly cheap and I don't know if any other sector of the market where you can get too � Chevron has a dividend yield of 3%, some of the other oil companies have dividend yields of 2 1/2. you've got royalty trusts that are paying dividends of 10-11%. And when we look at the S&P which is selling at close to 20 times earnings and you have oil stocks that are selling at over 11 times earnings, I don't know where these guys get that these stocks are overvalued. I mean, what do they want to see: to go back to a 7 P/E ratio? It's not going to happen. [51:32]
JOHN: Well, obviously, Jim, you don't think oil prices are going down to $40 again.
JIM: No, I think we're in that period � what I call the soft-shoulder period � September, October, we're in between seasons. In other words, we're in the Fall, the weather�s a little nicer and There's less demand for energy. The Summer driving season is over so you normally get a demand fall off during this time of the year. People aren't out on the beach. They aren't in their cars driving across country on vacation or in their motor homes. Also the weather�s a little nicer. Yu don't have to turn on the heat and so demand falls off. But then we've got Winter ahead of us. In other words, I think we're more likely for the next 12-18 months to see $100 oil than we will $40 oil.
And remember, John, when energy prices started to go up in 2003, when we hit $30 oil, the pundits were saying we're going to $20 oil. When we went from $30 oil to $40, they said it was going back to $30. When we went from $40 to $50, they said it was going back to $35. When we went from $50 to $60 to $70, they said it was going back to $40. In other words, this is a world that is in denial. we've had an inexorable rise in the price of energy that has gone on since 2003, production is in decline in the North Sea, the North slopes of Alaska, production will go in decline after this year in Mexico, Saudi Arabia has only roughly about a � million barrels per day spare capacity left. They're the only one with spare capacity. we're in no position, as Oil Shockwave points out, to withstand any under production of oil anywhere in the world. And if it happens anywhere in the world it affects everywhere in the world. [53:19]
JOHN: And by the same line of thinking, I take it, you're not going to buy into the concept of the bull market in energy and commodities have taken their run and are over as well.
JIM: Absolutely not. There's just no way you can have India, China, and Asia on the horizon where real manufacturing takes place. That's where the new plants are being built and that is becoming the manufacturing capital of the world, which makes that center of the world more energy intensive. And like it or not, we've got new players in the energy market and They're not going away. And no matter what happens, once you start building freeways, start adding cars, adding factories in China, you can't just turn the lights off in China and India, and say, �don't do that anymore, because we need the energy you guys are consuming, to maintain our lifestyle.� It just doesn't work that way, and like we said � even like Oil Shockwave said � the things that we need to be doing take decades to implement. This isn’t something you flip on the switch. There is no easy switch to flip on, so That's why I don't believe � not only with population increases, increased industrialization and the aging infrastructure of energy and commodities � this problem doesn't go away with wishful thinking. So, we're probably just entering the second stage of this bull market. So, this is probably a good entry point with the recent pull back in energy for somebody who if you've not been in this market you may want to consider. [54:43]
JOHN: As you describe it, Jim, the most interesting concept I have, we can actually find other sources but because we have delayed so long, we really have like a two-decade, maybe 3-decade long bottleneck where It's literally a crisis, and we're going to have to survive at that point to be able to evolve out of this.
JIM: Unfortunately, John, it takes crises to move politicians to act. Remember, politicians will take the least line of resistance. It's much easier to blame someone for something than it is to try to solve the problem. And That's where we're at right now. we're still playing the blame game and the stuck on stupid concept, and It's not until the electorate gets ticked off � when you see the lights go off you can't turn on the power, you begin to freeze, you have 40 to 50% increases in your utility bills, you wait in gas lines � That happens often enough, voters get ticked off. It's only until voters get ticked off that politicians begin to listen and say, �wait a minute, we better do something here.� [55:56]
JOHN: Especially if they get thrown out of office.
JIM: Yeah, That's the easiest way, that gets the message loud and clear to the new bums that they put in office. But you know, until they get focused on the right things, chances are we will make the wrong policy decisions. We will put price caps on energy. We will put windfall profits tax into effect. We will raise taxes. We'll raise interest rates. We will increase government interference in the economy. In other words, we will add all the wrong ingredients to the bonfire and make the fire grow. Unfortunately, that is the lesson of history. [56:32]
JOHN: Yeah, when you say that, That's not a sort of hopeless statement. That's a statement of reality. So anybody who’s planning their financial future can plan with all of that in mind.
JIM: So, when you take a look at history, That's what I'm saying, if you haven’t been in energy, raw materials, hard currency bonds of foreign governments, if you're not in gold and silver, as we mentioned in the Big Picture with Frank Barbera, these pull backs in commodities are very common. One of the reasons is the commodity markets are much smaller, so like for example in the gold markets it doesn't take much to have a withdrawal because the market is so small. So if you've got Danny Day Trader selling and panicking, jumping out of windows, along with fund managers you get this downturn, but you know, you've got to be smart: you use the downturns to build your positions. [57:29]
EMAILS
JOHN: Well, some of the blogs out there were saying with this whole global warming thing you've created your own storm � I don't think so, we've got a lot of positive emails � What we tried to do in last week's program was address some of the issues that people had written in response to the roundtable we did on global warming, and as we framed that thing ahead of time � and they weren’t listening � we said there is a controversy out there, and you are not hearing the other side of this controversy. It is not a small group of people. There's a substantial number of scientists. But all of that aside let's do a couple of emails and we need to summarize this thing and get on with life, alright.
The first one, Damon in Poomah [phon.], Louisiana says,
“That was the best one hour you've ever had the hour of global warming hoax, I sent the page to 20 people.”
Dave in Wellington, New Zealand,
“hello there, I'm a small time private investor in New Zealand. I have just recently tuned in to this website, It's an excellent place to get more informed, you're on my wavelength, and I'm on yours. What was interesting to hear the feedback on the climate change in the interview, that interview has shifted my perceptions towards climate change from the usual stance of the majority, to one of a more considered approach. In other words, offering a different viewpoint was very informative, and you guys were right: many people didn’t listen to the introduction on the subject. Cheers! I’ll keep listening.”
One of the ones that always drives me crazy for as long as I've been in radio, Jim, is the one where “I'm not going to listen anymore.” Now, Jim, all week long I listen to things and talk show hosts I don't agree with to see what They're saying, that always to me represents the epitome of immaturity.
Anyway, James in Whitby, Ontario, Canada says;
“Since getting so many of your negative letters I figured I would write to you guys with congratulations. I used to be a physics and chem major. I really love your work on the global warming hype. It stinks of mass controls techniques for someone to make money. Did you know the hole in the ozone will never go away, in fact It's impossible for them to go away except for one case, and if they did disappear We'd all be dead. People should appreciate your work as a means to step outside the box, and see if the different possible reality, That's the way to make money and be ahead of the crowd.”
I think you're going to talk about this, but we've been echoing the theme that environmentalism, in light of the crises that we outlined in the first part of the big picture has a real rude awakening coming if it is to survive. And this is not anti-environmentalist, it is sort of a gentle hint, How's that go?
JIM: Yeah, in terms of summarizing this because we're going to move on: first, there is a controversy, that controversy still exists in global warming. There isn’t mass agreement within the scientific community or the climatologists � the weather people. This debate was one-sided, so we brought another point of view. So that still exists. Number two, Kyoto is dead. Politicians from Tony Blair to others all around the globe are backing away, even while They're giving lip service. And number three, because of the coming economic crisis, environmentalism must adapt. If it doesn't, it does so to its own detriment. And that is not anti-environmentalism. It is just [that] the rents are too high. And when the economy starts to falter, take a look at what happens. This stuff gets thrown out the window. When you've got people freezing in the North East because or if they can't pay their bills or can't afford the gas, then all of a sudden the political debate changes enormously. And then I guess finally, John, out of all of this, the great disappointment for me was that there was no new information that they could point us to to say, �Aha! here's something, latch onto this, look into this, this is something we haven’t looked at.� It was mainly ranting and raving. And unfortunately when you rant and rave, it doesn't endear us to your point of view. So, enough said, we're moving on, What's next? [1:01:29]
JOHN: Alright, another email from Gordon in Leicester, England and he says,
“Hi Jim, I'm a regular listener to your excellent broadcast. I thought I would let you know that at last I'm in profit with the 2 silver bullion purchases I made, by almost 5%. The first was in September 2003, the second in February 2004. The reason that it has taken this long to get the right side of break even is that I had to pay a premium of 9% on my first purchase, and 8% on my second, as well as a 17.5% VAT, plus an annual storage charge on my holdings” [John] by the way, VAT came up as part of a proposal for the US here in the committee hearing “I'm also a paid up subscriber to Dave Morgan’s Silver Investor I've had to put up with a lot of ridicule over the last couple of years in standing by my decision to invest in silver bullion, but I am hopeful that some of the predictions I have heard will come true in the not so distant future.”
JIM: he's got to be pretty happy, because even on a day like today, where we've had a pull back in gold silver is holding strong. So silver may be taking the lead here in the bullion markets. [1:02:33]
JOHN: Brett writes from Fort Worth, Texas,
“Mr. Jim Puplava, I believe several months ago, Marc Faber discussed the behavior of gold during inflations and deflations in his GDB report, that was before I became a subscriber to his report, with the Fed apparently trying to cause deflation but perhaps bluffing, I'd like to know how you think gold would do in inflations and deflations. Is it consistent to be optimistic under both scenarios, and is the recent price rise explained entirely by inflationary expectations, of by a flight to safety mentality in advance of deflationary recession, for example?”
JIM: Well, let's take the big deflation in the US which was in the '30s. And gold did very well. Because what happens when you have deflation, you have credit defaults, you have contracting money supply, you have financial crises, banking crises, It's a move to a flight-to-safety. And even though the government confiscated gold in the US, you were able to go into gold stocks. After Roosevelt confiscated gold, he devalued the dollar by 40%, and the price of gold went from $20 to $35 � the biggest profiteer of that by the way was the government in the exchange stabilization fund. If you go back to inflation, whether you're talking about Germany in the 20s, or in the US in the late '60s, and '70s, gold did extremely well. It operates very well under both circumstances because it becomes real money. It becomes one safe haven in a time of trouble. You can get trouble in deflation or inflation, but I think the US is going to hyperinflate. Ultimately the first stage is we're heading into stagflation, and That's where we are now. The second stage and final stage will be hyperinflation, and gold will be soaring. I hate to predict where I think It's going to go because It's an investment that operates under fear, and under fear human emotions are much more dramatic, so who knows how high the price can go. [1:04:32]
JOHN: James is in Mableton, Georgia and says,
“I listen to your Financial Sense webcast where you talked about labor shortage in the energy sector. here's a real life example. There's a program called Primavera P3, which is used to plan large energy projects and maintenance. A P3 planner is usually paid $50/hr, on Monday the call went out for P3 planners - $100/hr, get your butt to Lake Charles, and Port Arthur and by Friday it went to $250/hr.”
JIM: I’ll tell you, if you're looking at a career over the next 10, 20 years, or maybe you're not happy where you're at right now, or maybe you've got laid off, or you're looking at job insecurity, going into geology and learning the oil, the alternative energy business, the mining business, they simply do not have enough personnel. Not only will you make a good wage, as this gentleman was referring to here, but you're going to have oil companies, mining companies scouring college campuses offering you inducements � not only high wages and benefits stock options. you've got a good future ahead of you. You know, it was amazing. I have a son who just graduated from college, came back from a 2-month tour of Europe and parts of Africa - he went to take a look at the pyramids and part of his tour group of students was a geologist. This geologist was talking to my son and telling him about the wages and the demand I mean he's a freelancer so he does a lot of freelance projects, earns a lot of money, and then takes off and travels around the globe; he loves it. And my son was saying, �you know, Dad, I always liked geology.� he's working in programming internet sites right now, and � we're just happy to have the kid have a job to be quite blunt � [John] There's the father speaking not the investor � as he came home and I'm like, �Dude It's time to get reality here.� But anyway, he was talking about it. Adam was intrigued by it. It is just one area in terms of people looking for a profession that is just going to be in high demand, high wages, high benefits, plus on top of that job security. Imagine being in a position where you can call your own tune to your employer; employers seeking you out, offering you higher wages, benefits, and being in a position where you're going to have pricing power for who you are and your job skills, for probably the next couple of decades.
JOHN: Mark is writing from Hong Kong,
“How can I invest in sugar and corn directly without buying futures? I'm new at the investing game, but I do believe these will be off and running over the next few years. Thanks for the reply.”
JIM: Probably without buying futures contracts you can take a look at companies that produce them, or probably look at something like a raw materials fund, or a mutual fund that invests in these things for you, for example, the Roger's Raw Material Fund basically buys futures contracts � they go long and they just roll them over � so outside of investing in the companies directly that produces the commodity then you can go into a commodity mutual fund.
JOHN: Well Jim we have blown our budget for the week. Great way to waste money isn’t it? Do a radio show. How's that? Anyway, what are we looking at in future weeks.
JIM: Boy, I’ll tell ya, we have some great guests coming up in the weeks ahead. My special guest next week will be Addison Wiggin, he's got a new book out called the Demise of the Dollar, on October 29th Tony Blankley, he's written a new book on the New York Times Bestseller List, The West�s Last Chance, talking about confronting fundamental Islam. Larry Williams, the famed commodity trader, has got a new book called Trade Stocks and Commodities with the Insiders. On November 5th, Raymond Learsy's got a new book called Over a Barrel, about how to solve this oil crisis, then Ike Iossif, we've Deborah Weir Timing the Market, and Eric Weiner What Goes Up, and in between then We'll be doing live broadcasts from the San Francisco Gold Show, the week after Thanksgiving. So, all kinds of great things coming up on the program. In the meantime, we have run out of time, as you mentioned John, on behalf of John Loeffler and myself We'd like to thank you for tuning into the Financial Sense Newshour.
