Swimming in Oil

The Daily Reckoning – Weekend Edition
January 20-21, 2007
Gaithersburg, Maryland
by Chris Mayer


The big news this week seems to be the rather stunning and swift drop in the price of crude oil. It actually dipped below $50 a barrel on Thursday. That’s a long fall from $78.40 in July. Despite all warnings to the contrary, it seems we’re swimming in the stuff.

Well, I have no special insight into where the price of oil may go. But the way my brain works is that I tend to get bullish as more people turn bearish and I turn bearish as more people turn bullish.

Right now, there is a lot of fear that oil prices may not rebound. Many oil stocks sit well off their highs. It’s not just oil, either. There is a ripple effect to other energy sources, as well. All those investors who poured money into ethanol production suddenly have a touch of the chills. All those investors who dumped money into alternative energy stocks shiver a bit over their morning newspaper.

So does this mean oil will go back up?

I don’t know. Around here, we stitch our investment ideas from the ground up. Meaning things have to make sense on their own merits and not depend on my big-picture predictions, or anyone else’s, for that matter. Chiefly, we prefer lots of cheap assets that protect our investments. We like little or no debt — basically, a super-strong financial condition. And we like cash flow, in any case – the real stuff that you can pile in a bank account. The rest is, as they say, literature.

But I will say this: Many of the names coming up in my research today are energy names. That has not happened in a long while. What investors may be forgetting is that the oil business is still a good business, even at these lower prices for oil. Even at $40 oil, depending on the company we’re talking about, business could still be highly profitable.

The slide in the price of oil is not a solo act. The price of many other commodities also tumbled. The only area that seems to be holding up exceptionally well is the agricultural market. Namely, I’m thinking of corn.

As corn has risen to $3.66 a bushel – more than double the price a year ago – lots of farmers want to plant corn. Anecdotal evidence abounds. From The Wall Street Journal: “As corn prices rise, farmers are racing to cash in. Leon Corzine in Assumption, Ill., is planting 95% corn on his 3,000 acre farm, up from 50% in 2002.”

That means more trucks, tractors – and fertilizers.

Interesting to note, too, that this rise has come amid a bumper crop. The 2006 harvest was the third biggest on record. Demand is high, thanks to the demand for ethanol. You need lots of corn to make ethanol – not to mention water. Ethanol production also consumes a lot of energy – oil and natural gas. In fact, producing ethanol uses up more energy than ethanol itself provides.

With oil at $60 per barrel, maybe the whole ethanol thing is easier to stomach. It won’t be if oil gets to $40, especially if corn edges closer to $4 a bushel. By then, the farmers and ethanol producers will start getting their heads handed to them.

Corn, of course, is an important ingredient for lots of foodstuffs – cereals, syrups and more. It’s also the primary feedstock for raising chicken, beef and pork.

At some point, we’ll have too much corn. Interestingly, the price of oil may have more to do with that than the traditional demands from food producers.


Chris Mayer
for The Daily Reckoning

P.S. Selectively, I think there are still at least a few companies in the energy patch that are well capitalized, well managed and undervalued and that sit on increasingly scarce assets. Owning companies such as these are usually good bets in any industry or market.

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THIS WEEK in THE DAILY RECKONING: This week, Republican Congressman Ron Paul announced that he has formed an exploratory committee for a possible Presidential run. Read what Dr. Paul has to say about what the price of gold is telling the U.S. economy, below…

The Heart’s Dupe, Part II                                    01/19/07
by Bill Bonner

“Fads, fashions, cycles…booms and bubbles…public spectacles – all come and go. The disaster is that nobody takes it seriously anymore…because it doesn’t deserve to be taken seriously. But there is probably a deeper cycle at work. Bill Bonner explains…”

A Vote of “No Confidence”, Part I                         01/18/07
by Hon. Ron Paul of Texas

“This morning, we heard from our friends at the Charles Goyette show in Phoenix that Republican Congressman Ron Paul made his presidential intentions clear on today’s show. Even if he didn’t, we think it’s a darn good idea. See what Dr. Paul thinks the price of gold is telling the U.S. economy, below…”

Amusing Predictions                                                01/17/07
by Justice Litle

“Everyone is wondering what the falling price of crude means – and how long it will last. Today, Outstanding Investments’ Justice Litle gives us some perspective on this market. Read on…”

Economic Realities                                                 01/16/07
by Gary Shilling

“The question that’s on the tip of everyone’s tongue in January – what does the new year have in store for us? Well, our friend Gary Shilling sees twelve possible investment themes that could unfold in 2007. Read on…”

Another Nail in the Coffin                                     01/15/07
by The Mogambo Guru

“The Mogambo is attempting to stay calm…but when he looks at the housing market…and then back at the Fed…and then back at the housing market, not only is he getting whiplash, but some serious indigestion, too. Find out why below…”

FLOTSAM AND JETSAM: Libertarians have been exasperated by the Bush Administration’s supposedly laissez-faire policies that are anything but. Yet as enjoyable as it is to poke holes in the plans to “privatize” Social Security and so forth, there’s nothing quite so fun as economic commentary from a good old-fashioned leftist. In this respect, Robert Reich’s recent commentary on NPR didn’t disappoint. Robert Murphy explores…

Does Business Need Washington To Manage Wages?
by Robert P. Murphy

The former Labor Secretary under Clinton was discussing President Bush’s offer to go along with the Democrats’ plan for hiking the minimum wage $2.10 per hour, so long as it is accompanied by tax relief for small businesses. Reich would have none of this, claiming that the proposed hike in the minimum wage wouldn’t burden small businesses at all. To defend this paradoxical claim, Reich offered three main reasons.

Reich’s Reason #1: Businesses can pass the hike along to consumers.

In Reich’s words:

“[V]irtually all small businesses that pay the minimum wage compete in the local service economy. They’re retailers, contractors, providers of elder care and child care, local hospitals. They don’t compete internationally or even nationally. Their competitors are in the same city or town and all of them will be paying the same minimum-wage increase. So it’s likely that the increase will be passed on to consumers.”

Here Reich overlooks the fact that ultimately all businesses are competing for the consumers’ money. It is certainly true that a hike in labor expenses will be much more tolerable for a given operation, so long as all of its direct competitors are given a similar handicap.

If all the hardware retailers raise prices 5 cents per item, that won’t hurt any individual store’s revenue as much as would be the case if a single store unilaterally raised its prices. Even so, the industry’s revenue could still fall drastically, especially when foreign imports face no such burden.

Remember that the consumer can always choose to forgo a product or service altogether, or to produce it outside of the market. If the government hiked the minimum wage to, say, $50 per hour, this would annihilate the child care industry, as plenty of working parents would elect to stay home with the kids.

Reich is also simplistically ignoring the differential impact of the minimum wage hike on various small businesses. Some of them might be able to weather the blow fairly easily, by substituting out of labor and into more automation, or (as Reich suggests) by raising prices. But other small businesses enjoy no such luxuries, and will have to make hard choices should the Democrats’ plan go through.

Finally, I note with some irony that Reich conveniently fails to complete his train of thought. Let us suppose for the sake of argument that Reich is correct, and that Bush’s call for small business tax relief is unnecessary, since the increase will be passed along to consumers. Fine, fair enough. Even so, shouldn’t we then couple the minimum wage hike with tax relief for consumers? Perhaps Reich’s call for such cuts was edited out for reasons of space…

Reich’s Reason #2: The minimum wage increase wouldn’t be a minimum wage increase.

You may suspect that I’m misrepresenting Reich’s claim. See for yourself:

“Besides, it’s not really an increase anyway. The current minimum wage was enacted 10 years ago, and inflation since then has eroded its value so much that the new proposed minimum is more like an inflation adjustment than a real increase. Most small businesses charge prices that have risen with inflation. So it’s only fair that their employees’ wages should rise with inflation, too.”

Here Reich is quite openly conflating his notion of fairness with the entirely different condition of one number (namely, $7.25) being larger than another (namely, $5.15). He also adopts the typical political trick of using a moving baseline that biases the outcome in the direction he favors. This is how the government can “slash spending” and “gut programs” while federal outlays increase, or how “core inflation” isn’t so bad after we’ve filtered out the volatile components (i.e., the ones that increase a lot). Using this approach, I could argue that Robert Reich multiplied by Ludwig von Mises is a decent economist.

Naturally, the free market economist would point out that small businesses are currently operating in an environment where the minimum wage is $5.15 an hour, and their prices reflect the real (inflation adjusted) magnitude of this regulation. The burden is indeed lower than it was ten years ago, but that doesn’t mean businesses pocketed the annual gains with the steady creep of inflation. No, it meant that they could gradually hire more low skilled workers, and raise prices more slowly than otherwise would have been the case, because of the shrinking real minimum wage.

Now to “adjust” the regulation for inflation will simply force businesses to lay off some of those marginal workers and to restrict the quality of their products, not to mention hiking prices.

There is something even more fundamentally wrong with Reich’s statement. He seems to think that there was something magical about the minimum wage of $5.15 an hour when it was set in 1997, and that returning to that level of hardship on small businesses is only appropriate.

But what is the basis for this judgment? Suppose Vladimir Putin answered conspiracy theorists by pointing out that the mysterious murders of a few journalists was no real hardship for the profession, because the percentage of such killings had declined drastically since Stalin’s purges. Would Reich get behind that argument? If not, then so what if the Democrats’ proposed hike merely adjusts the minimum wage for inflation? That’s completely irrelevant to whether it would pose a hardship for small businesses (and also to whether it’s “fair”).

Reich’s Reason #3: The minimum wage increase would actually help small businesses.

Before letting Reich speak in his own words, let us review lest the reader become lost. First, Reich argued that the minimum wage hike wouldn’t hurt businesses because the damage would be passed on to another group. Then, Reich denied that the hike would be a hike. Now, in his third argument, Reich is claiming that the non-hike hike, the harm of which could be shunted to others, is actually not harmful. OK? Let us proceed:

“In fact, a minimum wage hike may actually help small businesses. Evidence from states that have already increased their own minimum wages suggests that a modest increase convinces more people to enter the labor market – people like retirees, spouses or teenagers who wouldn’t bother working at a lower minimum wage. For all these reasons, small businesses won’t be harmed by the proposed minimum wage increase and don’t need a tax cut.”

Isn’t that interesting? I bet there were a few small business owners who almost caused an accident while listening to NPR, so excited were they, to learn that higher pay attracted more workers.

Seriously, Reich’s argument here is so silly that he can’t possibly believe it. If a particular small business would benefit from the larger pool of applicants responding to higher promised wages, its owner doesn’t need encouragement from Robert Reich (or Nancy Pelosi) to offer such wages. After all, most employers currently pay more than the government mandated minimum.

What’s truly ironic is that this alleged benefit is reduced when the government forces every business to raise wages. For example, a business that currently pays $7.25 an hour (and yes, there really are such employers right now) can be far choosier with its employees than will be the case when all businesses pay at least that rate. But no worries: I’m sure such businesses will make up for the reduction in productivity by cutting product quality and raising prices.

It’s been fun to watch the Republicans get government off our backs and bring some conservatism to the federal budget. But if Robert Reich’s NPR commentary is any indication, we can look forward to some great yuks under the Democratic Congress, too.

Editor’s Note: Robert Murphy is the author of The Study Guide to Man, Economy, and State and the headmaster of the Mises Classroom.

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