In the Aftermath, Part I

In part one of this two-part essay, Justice Litle looks at an existing problem – energy infrastructure – made worse by Hurricanes Katrina and Rita.

There is a common saying among strategic planners: "Hope for the best, prepare for the worst." In Katrina, we have seen the worst, or close to it – and not just in terms of physical destruction.

The stories range from heart-rending to gruesome. The level of human suffering was staggering, with thousands of Americans subjected to conditions resembling a third-world combat zone. And the idea of a great city washed away is almost too big, too alien, to fathom.

In the deluge of news and commentary following Katrina’s wake, Bloomberg columnist Joe Mysak offers particular insight:

"This is a story being told on the ground right now, in hundreds of stories detailing human misery, particularly of the poor. But you know what? All those little stories don’t give you the big picture any more than the obsessive, agonizing stories of individual casualties in Iraq tell you about what’s really going on over there. Individual human tragedies offer insights into the human condition, not into what’s going to happen next."

This is not meant to trivialize the scope or seriousness of suffering, but to put it in context. The bigger picture cannot be distilled into sound bites, and will take time to reveal itself. As long-term investors – not to mention participants in the global economy – we have a vested interest in trying to make sense of what the aftermath will bring.

There is open debate as to the long-term effects Katrina will have. The most optimistic argue with a straight face that natural disasters have a "net positive effect" on corporate profits. This may be true in certain past cases, but not when an energy crisis is embedded in the mix.

The real viewpoint distinctions were made before the storm took shape. Observers and commentators can be placed in two groups: those who believed we were already in a dangerous place pre-Katrina and those who thought things were fine before the hurricane struck. For those in the concerned camp, the greatest natural disaster in American history has sped things along, moving the world closer to an inevitable endgame that was already on its way.

Hurricane Katrina and Energy Infrastructure: Hitting the Snooze Button

There are three areas in which Katrina has created urgency by magnifying an existing issue: energy infrastructure, consumer spending and building inflationary pressures. Today, we will look at energy infrastructure, and at the other two issues in the second part of this essay, to come next week.

"Americans have taken cheap energy for granted for years…Now it’s coming home to roost."

– Robin West, PFC Energy Chairman

When it comes to rebuilding and upgrading the nation’s energy infrastructure, America has been hitting the snooze button for too long. The devastation in the Gulf Coast is a painful wake-up call. Prices have eased somewhat with the release of emergency reserves from the IEA and SPR, but the long-term horizon is still unclear. For quite a while, we have had the luxury of postponing action; now we are forced to take emergency measures in the face of a catastrophe.

America’s energy infrastructure is cracked and strained, patched together with duct tape, outdated in some areas and pushed to the breaking point in others. Power grids are in dire need of upgrade and replacement; fuel distribution networks are inadequate and subject to disruption; desperately needed refineries and liquid natural gas terminals have fallen victim to excessive environmental regulation, stifling government procedure and, worst of all, a nearly impenetrable wall of NIMBY/ BANANA style politics (Not In My Back Yard; Build Absolutely Nothing Anywhere Near Anybody).

The problem can be described on one level as "out of sight, out of mind." Basic necessities are often taken for granted. In normal times, none of us thinks too much about the electricity that runs our homes, the water that pours from our faucets or the gasoline that fuels our cars. When the flow is disrupted, however, we notice very quickly.

Hurricane Katrina and Energy Infrastructure: Benign Neglect

The same benign neglect applies to the hidden web of energy infrastructure that makes modern life possible. As long as things are working, we don’t pay much attention. If the system is being put under increasing strain, we don’t notice – until something goes wrong. But the old cliché, "If it ain’t broke, don’t fix it" is very bad advice in this area. The farther infrastructure lags behind growth, the more disruptive it is when the creaking framework breaks down. The fewer fail-safes in place, the greater the likelihood of a small disruption causing big problems. And that is where we are now: Stomach-lurching volatility in fuel prices is the result of small demand shifts at the margin, thanks to a "lack of slack" in the system.

The climate for capacity increase and capital investment has been stymied by one of the biggest flaws in the political process: an overwhelming bias toward short-term time horizons. There is little political incentive to address long-term problems hidden from the public eye. On the other hand, there is usually strong incentive to seize on the popular "quick fix" whose long-run effects are hidden or postponed. Furthermore, those who benefit from sound policies are typically the unorganized silent majority, whereas anti-energy special interests (think NIMBY) are organized and vocal. Last but not least, the pool of political dollars is always finite – so issues without immediate political resonance are ignored. The system works against common sense. Promises are made without analysis, favors are doled out without foresight and the eventual mess is left to be cleaned up on someone else’s watch.

This logjam of neglect and aggressive special interests requires a jarring shock to be broken through. That shock is now upon us. Daniel Yergin of Cambridge Energy Research Associates makes an argument for why Katrina’s aftermath has created an "integrated energy disaster":

"What makes it an integrated crisis is that the entire energy supply system in the region has been disabled, and that the parts all depend upon each other for recovery. If the next weeks reveal that the losses are as large as some fear, this would constitute one of the biggest energy shocks since the 1970s, perhaps even the biggest. Unlike the crises of the ’70s or the Persian Gulf crisis of 1990-91, this does not involve just crude oil: It includes natural gas, refineries and electricity."

Hurricane Katrina and Energy Infrastructure: A Bit Less Pessimistic

Fortunately, as of this writing, the assessment of the situation is a little less pessimistic (though there are still plenty of unknowns). It looks like damaged ports and refineries may be brought back on line faster than feared, and worst-case scenarios may yet be avoided. The most intractable problem may be rebuilding communities to which the tens of thousands of displaced oil workers can return. Wage costs will no doubt have to rise sharply in efforts to convince them back. Regardless of details, we have learned a powerful lesson here; wake-up calls don’t come much stronger. Hopefully, the point has been driven home strongly enough to dislodge the special interest groups who fail to see the gravity of the situation. Yergin expands on what needs to be done:

"This more expansive concept of energy security requires broader coordination between government and the private sector; more emphasis on redundancy, alternatives, distributed energy and backup systems; planning and prepositioning of vital supplies ("strategic transformer reserves" for electric substations); and methods that can quickly be applied to promote swift market adjustment. As with the August 2003 blackout, this crisis underlines the need for modernization and new investment in the energy infrastructure that supports our $12.4 trillion economy."

All these elements were critical pre-Katrina, and circumstances would have demanded implementation sooner or later. But now that public awareness is high – and the dangers of complacency are thrown into stark relief – the timetable will be accelerated. There is a lot of work to do, and no avoiding it. In the event of a recession, energy prices may fall as global demand slows. But even then, energy security would be critical as ever, as businesses and consumers would show more sensitivity to price shocks in the midst of a downturn.

A wave of rebuilding is coming, and it will encompass more than what was destroyed. There will be expansions, upgrades, new technology and new safeguards put in place. The Gulf of Mexico will be rebuilt to Category 5 standards. Legislation pressing for new refineries and new LNG terminals will finally gain the upper hand. New avenues will be explored. Uncle Sam will be whipping out the checkbook, big time. The situation demands it.

Regards,

Justice Litle
for The Daily Reckoning

October 05, 2005

P.S. In the second part of this essay, I’ll look at the effect that this hurricane season has had on consumer spending and increased inflationary pressures.

Justice Litle is an editor of Outstanding Investments. He has worked with soybean farmers, cattle ranchers, energy consultants, currency hedgers, scrap metal dealers and everything in between, including multiple hedge funds. Mr. Litle also acted as head trader for a private equity partnership, and made contributions to Trend Following: How Great Traders Make Millions in Up or Down Markets, a popular trading book by Mike Covel (FT/Prentice Hall).

We’re still wearing the boots we bought in Argentina. We think they give us a certain dash…a romantic air of gigolo from the pampas. Most likely, here in London, they merely look ridiculous. But they are helping us to focus: Why are some places so expensive, and others so cheap? Why do people prefer the expensive places over cheap ones? Which are the better places for your money…the places where people are rich and decadent? Or those that are cheap and growing? Why would people want to live in a cold, rainy city where you can’t find a parking place and a glass of wine cost $8, when they could live in a warm, sunny place at 1/10th the cost and park anywhere they like?

In America, household earnings declined last year. But the average household nevertheless spent more money and went further into debt. It got poorer, in other words. We do not have equivalent figures for England, but we imagine they are similar.

In India, China, and Argentina, on the other hand, real earnings rose. The Financial Times tells us that wages in India are rising faster than anywhere in the world – up 7.3% in real terms last year. In China, wages rose at a 4.8% annual rate.

Every empire needs a competitive advantage; an edge that allows it to become the Alpha Nation.

The Anglo-Saxon empire’s advantage was its ability to make things. In the 18th century, the Industrial Revolution began in England and then, almost at the same time, took root in New England. For nearly 200 years, English and American factories could turn out more and better products than anywhere else on the planet. GDP, wages, productivity, and real wealth raced ahead the rest of the world. London and New York became two of the most sophisticated, and expensive cities on earth.

Germany industrialized later, but went about it with typical Teuton energy. By the end of the 19th century, she was growing faster than Britain, and her output actually surpassed the United Kingdom in 1910. Then, in 1914, Germany challenged the world’s leading empire, Britain, militarily. America came to Britain’s aid with massive amounts of money and war supplies. In World War II, the Anglo-Saxon empire was challenged, once more by the Germans, who had not given up, and by a new latecomer to industrialization, Japan.

And again, the balance of power was titled, not by the superior fighting skills of American soldiers (who lacked the experience and toughness of the Huns) nor by the superior quality of their arms (the American tanks, for example, could never match those of Germany or the Soviet Union), but by America’s ability to produce more tanks, guns, ships and ammunition than all the other combatants combined.

And one other thing: America had cheap Texas oil. Neither Germany nor Japan ever had decent access petroleum.

How things have changed! Texas oil fields peaked out in the 1970s. Coincidentally, so did America’s competitiveness in factory output. The balance of trade turned negative in the 1970s, and by the time Alan Greenspan arrived at the Fed in 1987, the rest of the world owned more U.S. assets than Americans owned overseas. England’s North Sea oil production has peaked out, too. Now, the Anglo-Saxon empire has lost its edge. It has no money, no oil, and few competitive factories. But it still has its rich imperial cities – like Samarkand and Baghdad, waiting for the Mongol invasion.

As the 20th century progressed, another thing happened: American capitalism passed out of the hands of serious capitalists and into the hands of managers, caretakers, manipulators and middlemen. In effect, it has been collectivized…owned by millions of small shareholders, and directed by employee functionaries. Now, more than half of all stocks in the United States are owned by a group of 100 large money managers. And how many corporations do capitalists themselves run? Warren Buffett holds a light, but firm, hand on his enterprises. Bill Gates is unquestionably at the helm of Microsoft. But most large companies have fallen into the grip of professional CEOs, often celebrity managers who write popular books, pay themselves absurdly grand salaries, and drive their businesses into the ground.

A real capitalist can take a long-term view of things. He usually has enough money of his own already. His goal is to build a good business that can endure. He can build a factory, knowing that the return on investment may not come for many years. He is usually indifferent to quarterly profit reports. In fact, he may be willing to invest vast sums for a return far in the future, or hedge against the risk of loss by withdrawing from lines of business that are currently very profitable, things that few professional CEOs or money managers would tolerate.

Still, ask the people in the business class lounge and you’ll find they want to be just like Lee Iacocco or Jack Welch; they want to live in New York or London

More news from our friends at The Rude Awakening…

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Eric Fry, reporting from Wall Street:

"For the past couple of months, investors have been frantically chasing after oil stocks – the shiniest and tastiest prey in the stock market. But the feeding frenzy has reached a dangerous stage. Oil stocks are no longer easy prey; they are barbed lures."

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Bill Bonner, back in London with more views, opinions, and miscellany…

*** Ooh la la…"Slowing is seen in housing prices, " says the New York Times. Elsewhere, from CNN, comes news that "Manhattan Luxury Apartments Take a Hit."

First the old world…then the new. Prices in London have been slipping for months. Now they are softening in New York.

Bonds, too, are sinking…gently, so far. But lower bond prices mean higher mortgage rates. And higher mortgage rates put pressure on real estate prices.

*** Harper’s Weekly reports that George W. Bush’s new Supreme Court nominee once said the president was "brilliant." We know nothing of the woman, but we already have doubts: Either her honesty or her judgment must be defective.

We are not saying that there is anything wrong with G.W. Bush. The liberal press is hammering the poor man for his "mistakes" in Iraq and Louisiana. Now, he’s sure to take a beating for nominating a crony to the Supreme Court rather than a proven judge. They will say he has made another "mistake."

We once spent three long and tedious years at Georgetown Law School. What we learned from the experience was that a good judge is one who agrees with you persuasively. A bad judge is one who comes to the wrong conclusion – that is, one who thinks you are wrong. Franklin Roosevelt tried to pack the court with stooges who would do what he wanted; is it any surprise that G.W. Bush does the same thing?

*** In today’s paper is the story of a bidding war for an ordinary-looking house in a seaside town in North Cornwall. The house next door sold in the 1960s for about 7,000 pounds. Yesterday, The Scotsman reports that the neighboring row house brought 2.2 million pounds (about $3 million) at auction.

Also in The Scotsman is the story of how, "Jack Vettriano, Scotland’s most successful artist, painted some of his most famous pictures." Vettriano’s painting, The Singing Butler, sold for almost $1.5 million in April 2004, "breaking all records for a Scottish painting." How did he paint it? He copied it, "from a 16.99 pound book of photographs, with only minor changes to clothing."