Unwarranted Optimism

“The combined effect of Venezuelan and Iraqi disruptions has the potential to be the biggest shock in oil market history, even allowing for offsetting supply increases by other players.”

– Jim O’Neill, Goldman Sachs

Today’s oil market is tighter and more geopolitically threatened than ever…and the markets are incredibly complacent about it. Somehow, investors still believe that supply is ample, that a potential war with Iraq will be won as easily as in the first Gulf War or Afghanistan, that foreign oil companies will invest after it’s all over, and that Iraqi oil production will soar after the 101st Airborne sorts out Saddam Hussein.

But in fact, capacity utilization in global oil is almost as high as it has ever been. Crude oil supply is lower relative to consumption than at any time in recent decades. And in three of the six largest oil-producing countries, oil supplies are at risk due to geopolitical factors.

Iraq’s case is obvious. There is also ongoing political instability in Saudi Arabia, the world’s largest producer. Venezuela’s oil-dependent economy is staggering under the weight of a labor dispute, which has disrupted oil exports. In this context, a war in Iraq could tip the balance in favor of a sharply rising oil price, which in turn could be the nail in the coffin of a teetering global economy.

Oil Shock: “More Perfect Storm than Desert Storm”

The prospects of an oil shock are as high as they have been in decades. According to a recent report by Goldman Sachs, “More Perfect Storm than Desert Storm”, low global oil stocks and reduced exports from strike-torn Venezuela have boosted prices by more than 30% since late November. The Venezuelan ‘outage’ has cost 125 million barrels of production, already the fifth biggest supply shock in history, which the study cites as ‘almost entirely explains the current high level of prices’. If the strike continues for a further two months, and an Iraq war lasts a similar time, the cumulative outage will be 600 million barrels – far more than the 400 million taken off the market in the Arab-Israeli war.

Since the Goldman report was completed, the strike affecting the Venezuelan oil industry has begun to dissipate. But tightness in the global oil markets remains much as Goldman described. The Venezuelan government has sacked almost 10,000 striking workers, and its efforts to reactivate oil wells and refineries are achieving only limited success.

In addition to Venezuela’s problems, the increasingly tenuous position of the ruling House of Saud also weighs on the oil market. The ruling royal family of Saudi Arabia, which has enjoyed the lion’s share of oil wealth, is perceived as corrupt – and domestic discontent is high. Saudi oil production is at risk because social conflict over oil, such as has materialized in Venezuela, is possible…and also because a global Islamic extremist movement currently threatening terrorist action calls Saudi Arabia home.

The belief in an amply supplied crude market – whose current price just happens to be artificially propped up by a “war premium” – smacks of unwarranted optimism. Proponents see the impending war itself as the cause of the trouble…even though most stock markets peaked almost 3 years ago, well before Saddam became an issue. Many even seem to welcome the prospect of war’s outbreak, as they believe it would rid the markets of bearish uncertainty.

This is not to suggest that today’s market practitioners are all blood-thirsty warmongers. Instead, what appears to be “priced” into the markets is an image of conflict (largely inspired by the television images of Gulf War I or Afghanistan) that now bears almost no resemblance to the bloody, chaotic experience that has historically been war’s gory reality.

Oil Shock: A Less Comforting Precedent

Of course, if the first Gulf war conflict or the more recent Afghan experience has inspired such tremendous complacency, it becomes harder to argue that concerns over Iraq have been a major factor in discouraging investment. This paradox inspires us to sympathy with the view expressed by market commentator Richard Russell: that Iraq has become a “hook” inducing the public to hang on to its shares…despite the increasingly ominous political/economic backdrop and the catastrophic losses of individual investors over the past 3 years. The belief in an easy, relatively inexpensive war and the corresponding fear of missing a “war rally”, maintains Russell, are the factors preventing a major sell-off…not fears of a bloody, messy, economically disruptive conflict.

But the more one draws comparisons to the period preceding Gulf War I, the less comforting appears the precedent. Consider the political context today: As the U.S. contemplates a second Gulf war, it faces unprecedented terrorist threats, a fraying transatlantic alliance (including perhaps the biggest split in NATO’s 50 year history), and antagonistic relations with virtually the entire Islamic world. None of these conditions pertained in 1990/91. Nor is the economic backdrop remotely comparable: consumers in the U.S., Europe and Japan still have record levels of debt, accumulated long before any prospect of war with Iraq became a reality

The likelihood of a sharp price spike in oil being followed by a big decline (as was the case in 1991) is also much less likely this time around. Were the work stoppages in Venezuela conclusively ended, AND should all go well in the Iraqi conflict (i.e. no major supply disruptions occur), then much of the existing shortfall could be made up out of the world’s Strategic Petroleum Reserves. Iraqi oil production will probably stabilize for a year and then rise by perhaps 1.0 to 1.5 million barrels a day over a two-year period.

Oil Shock: No Iraqi Oil Flood

But over the longer term, it is unrealistic to expect huge amounts of additional Iraqi oil to come flooding onto the market. As a recent working paper co-sponsored by the Council on Foreign Relations and the James A. Baker III Institute for Public Policy maintains:

“Iraq’s oil industry is unlikely to be able to immediately deliver recovery in oil production and, depending on damage sustained during hostilities, may find its ability to export oil reduced. It is in dire straits with existing production levels declining at a rate of 100,000 bpd annually…Notwithstanding the value of Iraq’s vast oil reserves, there are severe limits on them both as a source of funding for post-conflict reconstruction efforts and as the key driver of future economic development. Put simply, we do not anticipate a bonanza.”

In short, there is no quick fix to the problem of high oil prices, even if an oil shock is avoided. A best-case scenario allows for stabilization and perhaps a modest decline in the price of crude, but an imminent return to sub-$20 oil, as was the case in 1991, appears unlikely. Venezuela adds to the severe problems of a market on the knife’s edge of a price explosion. To many, Iraq remains a relatively untouched jewel in the crown of the Middle East. But this ‘jewel’ could yet prove no better than a crown of thorns, if invasion plans do not adhere to the optimistic outcome now assumed by the markets.

Today’s markets view war as something akin to a machine. Armchair strategists squeeze out the human element in a clash between independent wills to a point where it is almost invisible…or at least, until something goes wrong. Only the most deluded optimist would expect certainty and good times to return to the markets once the first cruise missiles are launched.

Regards,

Marshall Auerback,
for the Daily Reckoning
February 24, 2003

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The Dow closed the year 1999 at 11,497. Since then, every year has been closed out at a lower number, with the Dow ending last week at 8018.

We are in the 4th year of a major bear market. But, on the whole, people are still fairly optimistic. In South Florida, the highways, restaurants, parking lots, movie theatres and bars all seem to be doing a good business. New apartment complexes are still going up. And out near the ocean…at least on the drive from Delray Beach to Palm Beach…people are still building mansions in the nouveau lumpen-millionaire style. It must be getting more and more expensive to show off – some of the new houses look more like gaudy hotels than single-family homes.

People are hoping that the great bear market will end this year. Stocks NEVER go down 4 years in a row, they say. But at nearly 30 times earnings, stocks are still far too expensive and must be expected to work their way lower, not higher, in the months ahead.

And here are the Daily Reckoning, we can’t help but think that there might be more going on than a regular bear market – even a major one. The structure of the whole world economy may be changing, we think.

Since the end of WWII, the world has counted on Americans to spend more and more money. The system seemed to work…the more Americans spent, the richer they felt.

But it was an illusion. Incomes rose modestly, while consumption increased immodestly. Taking advantage of the post-war stability, the credit industry found innovative ways to lure Americans into debt, so that the average homeowner owns less of his home today than he did in the 1950s…and owes a greater portion of his income to creditors. This trend cannot go on forever, for debtors cannot service an infinite amount of borrowing. And people cannot retire on debt; they need income, assets, and real cash to pay their bills. Eventually, the debtors stop paying…stop buying…and stop borrowing. And creditors shift their attention from the return ON their money to the return OF their money. They ask for higher rates of return to cover the risk…and the whole system implodes.

The major creditors are foreigners. At the margin, it is these poor saps in Asia and Europe whose savings allow Americans to mortgage their homes and buy land barges and billboard-size TVs. They’ve already begun to question the value of the dollar – and sold it off by more than 20% in the last 12 months. Americans hardly noticed. But this change may signal the end of one illusion and the beginning of another…

Stay tuned…as the End-of-the-world-as-we-have-known-it continues…including: The Destruction of the Dollar…Consumers Go Bust…Gold’s 10-year Bull Market…The Dow Falls Below 5,000…..and more!

Eric?

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Eric Fry, back in New York…

– Last Friday, your co-editor returned from a three-day junket to Miami to find a rejuvenated Mr. Market, brimming with youthful vitality. Like the plentiful Latin model- wannabes your co-editor observed dancing the night away in South Beach hot spots like “Bed” and “Pearl”, Mr. Market’s newfound energy seems to know no bounds.

– The stock market gained ground for a second straight week, continuing the trading rally anticipated in this column two weeks ago. The Dow Jones Industrial Average leapt 109 points to 8,018, while the Nasdaq bounded 3% higher to 1,349. The Nasdaq’s recent stealth rally has nudged the high-tech index into the black for 2003. The Nasdaq is now up about 1% for the year, compared with a 4% decline in the Dow.

– What was your co-editor doing in South Beach hot spots, you may be wondering?…Market research, dear reader, market research. Two days of exhaustive research produced the following conclusions: The bull market in boogie is still going strong, but tourism seems to be sliding into a bear market…

– However plentiful the model-wannabes may have been, the hotels, restaurants and bars did not seem to be nearly as crowded as they were last year. The über-rich are still in evidence, as they always are in South Beach, but the crowds of “merely rich” and “almost rich” were less abundant than in years passed. Many of the high-end restaurants that used to require reservations weeks in advance welcomed “walk-ins” this year.

– Business beckoned you co-editor to Miami (pleasure kept him there), as he was attending the invitation-only “Bears in Hibernation” conference, sponsored by Jim Chanos, the renowned shortseller. Jim’s renown stems largely from two extraordinarily prescient calls. He publicly identified both Enron and Tyco as terrible stocks, well before either of them collapsed.

– Jim invites about 25 professional investors to Miami every February, requiring the invitees to bring with them only two things: one short idea and one long idea. (In other words, a stock to sell and a stock to buy). The crowd that Jim invites consists mostly of professional short- sellers and folks, like your co-editor, who produce investment research for professional investors. (Your co- editor qualifies under the latter heading, in his role as editor of Apogee Research. Chanos is one of Apogee Research’s charter subscribers, and one of its biggest fans).

– Every year the ideas that emerge from the conference are truly superb, and this year was no exception. Unfortunately, all attendees are sworn to secrecy about the ideas that are presented. We are at liberty to mention last year’s ideas, however.

– Chanos, himself, has been on quite a roll with his annual short-sale ideas. Two years ago, he singled out Enron. Last year, he picked Tyco. The now-infamous Tyco has dropped about 50% since last year. The less infamous – but more profitable – idea that your co-editor recommended as a short-sale last year was Interpublic Group, which dropped 65% year over year.

– Speaking of short-selling, the recent Nasdaq advance has the feel of a “short-covering” rally. An explanation may be in order: Because tech stocks have been falling so reliably for so long, many professional investors have come to consider them “safe” shorts. Therefore, tech stocks are among the most heavily shorted stocks in the market right now. “There is some evidence to be found that professional investors perhaps aren’t geared for a cathartic rally,” Barron’s notes. “Sketchy polling data suggests hedge funds are more aggressively playing the short side of the market than they have recently.”

– These bearish investors have been lulled into the complacent expectation that tech stocks, because they remain demonstrably overvalued, will continue to fall. At some point, however, the swelling volume of short-selling creates a highly combustible kindling for an explosive rally.

– If/as/when Nasdaq stocks start to gain a little ground, all the folks who have sold them short will begin incurring losses. The higher the Nasdaq climbs, the greater the losses. As the pain of loss starts to become unbearable, some short-sellers will begin buying back the shares they’ve sold short, in order to cut their losses. Ironically, this panic buying helps to drive up share prices even more, thereby causing additional pain for the remaining short-sellers who have not yet covered their shorts. Soon they start buying as well and, before you know it, you’ve got a great big rally…Fasten your seat belts and get ready for lift-off…maybe.

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Back in Baltimore…

*** In South Florida, the cars are all shiny and new… but the people are old and broken down.

Maybe it is the weather that attracts them. Or maybe it is the youthful energy of the place. The 50-year-olds buy Harleys…and the 70-year-olds get convertibles. And all of them go about in T-shirts and shorts – as if they were teenagers.

*** “How much is this purse?” Maria asked a clerk at a shop on Worth Avenue in Palm Beach.

“Thirty nine fifty,” came the answer.

“Hmmm…that doesn’t sound bad,” said Maria’s father.

“Dad…it’s 3 THOUSAND…” Maria explained.

“Oh…”

*** What a marvelous world! People make a lot of money, and whole industries arise to help them get rid of it. A $39 handbag would work just as well…certainly, your editor couldn’t tell the difference. But that would take only $39 from the pocket of a rich person. At that rate, they’d never be able to get rid of their money.

A man with big money to squander can build a big house here in Palm Beach. A small house could be just as serviceable. But it would cost less to build and less to maintain.

And if he still has any money left…well, there’s always the stock market. *** Leaving Nicaragua for Baltimore…your editor left some of the world’s most beautiful natural scenery for beautiful scenery of an unnatural kind. Mount Vernon Square in Baltimore is covered with snow and never looked better. Maybe it was merely an accident of architectural history…but the 19th century buildings around the square are all handsome and elegant.