The World's Push for Power

The Daily Reckoning PRESENTS: The North American power grid is the largest in the world – and is in need of some major renovations. Chris Mayer explains that investment in the power grid will top $100 billion by 2015 – but that’s nothing compared to what other countries are going to spend…

THE WORLD’S PUSH FOR POWER

You remember the blackout of 2003?

It was the biggest blackout in North American history, affecting more than 10 million Canadians and 40 million Americans. The loss of power rippled through the whole Northeast region. Communications failed. Rail services shut down. Border protection systems failed. Thousands of businesses closed. There were some reports of looting. It even fouled up water supplies. Raw sewage poured into open rivers. Millions lived under a “boil water advisory.” Estimated financial losses totaled more than $6 billion.

Think we’ll see it happen again? I think we will. Over the past five years, we’ve had several significant blackouts. Those are portents and signs, reader. We’ll have more.

Why? Because America and Canada have neglected their power grids like gardeners who have allowed their flowerbeds to fill with weeds. The North American grid is the largest in the world. Much of it was built in the first half of the 20th century. Despite its age, from 1975-1998, investment in North America’s power grid declined every year.

That’s a 23-year stretch of declining investment in maintenance and upgrades. Things haven’t gotten much better over the last five years. Investment in our power grid has averaged about half of what it was in the prior two decades.

Now add to that an ever-growing number of users. The U.S. population just topped 300 million people. And consider the growing reliance our economy places on electricity. North American Electricity Reliability Council’s most recent report found that demand is growing three times as fast as supply. The capacity margin, or the ability of the system to meet the unexpected (e.g., extreme weather), is below the minimum target of 15% in most of the United States.

Put simply, the system is old and overworked. Yet we keep pushing it to the brink like never before. Mix that aging power grid together with increasing demand and what do you get? You get a bitter cocktail of repeated blackouts.

It took a lot of years to dig ourselves this ugly hole. It will take a lot of years, and a lot of money, to get out of it. The blackout of 2003 opened some eyes. Changes were soon made that would help kick off a spending boom the likes of which we have not seen in more than 30 years.

The bottom line for investors is this: Investment in the North American power grid should top $10 billion annually sometime over the next few years. In total, utilities expect to spend more than $100 billion by 2015 on the power grid.

I could tell you more about the fascinating history of the grid and how we got to this point. I could tell you about the most congested areas on the grid – just ripe for blackouts. I could run through the half-dozen or so biggest projects with estimated costs in the billions of dollars. Surely, these estimates will prove too low. That’s just the nature of this kind of work. You start with a $3 billion estimate and you end up spending $9 billion. There’s plenty of precedent for that.

But the spending boom on the world’s power grid is pretty simple in its outlines. You don’t need to know all the details to make money here, just as you don’t need to know how that white filling gets in a Twinkie to enjoy one.

In fact, I haven’t even gotten to the best part yet. The amount of money other countries will spend on their power infrastructure dwarfs North America!

Let’s start with India.

I recently finished reading a book titled India: An Investor’s Guide to the Next Economic Superpower by an analyst named Aaron Chaze. It’s a well-researched tome on India’s economic transformation. While Chaze is bullish, as you might expect, he’s downright giddy when it comes to infrastructure. “Thanks to decades of corruption and neglect that retarded infrastructure creation,” writes Chaze, “India now has the best potential for investment in infrastructure, not only in Asia, but in the world.”

A good slice of that potential is in power generation. As with North America, there’s been a widening gap between demand and supply. That gap has just exploded over the past decade. Unlike North America, India is building a lot of brand-new capacity.

Most Indian households – about 60% – still use traditional sources of energy, such as firewood. Increasing prosperity in India, though, is leading to rapid change. Chaze writes, “The explosion in demand once these households start wanting their share of energy is driving feverish additions to capacity.”

India plans to spend more than $180 billion to create the largest power grid in the world. Prime Minister Manmohan Singh says he wants all Indians to have access to electricity by 2012 – a mere five years from now.

India is not the whole story. Just a part of what’s shaping up to be a monsoon of spending on electrical infrastructure.

China, as you might imagine, also figures prominently in the story. Much of rural China still lacks basic electrification. China plans to spend over $140 billion through 2012 to bring electricity to all of its citizens. That’s hundreds of millions of new consumers. In urban areas too, demand should soar as households purchase more TVs, air conditioners, refrigerators and the like.

Outside of China and India, Russia is the next biggest market for spending on electrical infrastructure. Yes, Russia. (More on Russia later in this letter.) There is more than $90 billion on tap to modernize Russia’s old and strained power system.

Then there’s Europe. The story in each of these places is so similar it feels repetitive. Here’s a snippet from a recent Financial Times article: “Europe faces the growing threat of electricity shortages because growth in demand has outstripped investment in new power stations.” Sound familiar? In Europe, spending on electrical infrastructure comes in at around $40 billion by 2010.

These are the biggest markets spending the biggest dollars. And yet there are similar stories in many smaller markets in the Middle East, in Africa and in the emerging economies of Southeast Asia (such as Vietnam).

This is a mammoth trend, one that will take years to play out. For investors, the playbook is fairly straightforward. The companies that will build all this stuff should enjoy a strong bull market in their businesses over the next five years – at least.

Regards,

Chris Mayer
for The Daily Reckoning
January 4, 2007

P.S. At Capital & Crisis, we already hold several other companies that own, manage, build or feed the world’s infrastructure assets. In my latest report, I’ve got another one that sits squarely in the middle of the boom in power grid spending.

Editor’s Note: Chris Mayer is a veteran of the banking industry, specifically in the area of corporate lending. A financial writer since 1998, Mr. Mayer’s essays have appeared in a wide variety of publications, from the Mises.org Daily Article series to here in The Daily Reckoning. He is the editor of Mayer’s Special Situations and Capital and Crisis – formerly the Fleet Street Letter.

‘For every long there’s a short.’

That is one of the comforting myths of the present credit bubble.

Yes, there are more derivatives than there are people…but no, they are not supposed to pose a threat to the world economy. Why not? Because there is always someone on the other side of the trade, say the experts.

Every dollar lost by one trader in London is recovered by a trader, say, in New York or Berlin. The total amount of ‘money’ or ‘liquidity’ remains constant. One man’s loss is another man’s gain.

But is it true? Is liquidity like water? Does every drop lost to evaporation come back as rain? Is it like energy and matter, of which the world supply is constant, unchanging and irreducible?

There’s the problem, isn’t it? We know very well that the world’s supply of liquidity has recently grown at the fastest rate ever recorded. If it can increase, isn’t it obvious that it can decrease too? And when it does go down, who gains?

One of the remarkable features of this entire remarkable period is the disappearance of what is called ‘short’ interest – interest in selling. We mentioned yesterday that the people who are supposed to have shorts – hedge funds and young, female celebrities – have been forgetting to put them on. Life is so pleasant…so safe…they don’t think they need them anymore.

What was supposed to make hedge funds different from mutual funds or other collective investments was that they ‘hedged.’ They went short in order to protect themselves on the downside…thus trying to achieve decent returns even when the broad market went up. Time goes on and hedge fund managers – like hikers and husbands – lose track of where they are and how they got there.

Today, a ‘hedge fund’ is merely an unregulated pool of money in search of investors’ cash. This desire is driven, not by a love of investors, but a love of investors’ money. Warren Buffett describes hedge funds as a compensation plan disguised as an asset class. By that he means that hedge fund managers pay themselves so richly – typically, 2% of assets and 20% of profits – that is it unlikely there will be much left for investors. We have said so often ourselves.

But the burthen of today’s comments is not to curse the darkness of the hedge fund industry but to light a small candle…hold it up…and burn their fat derrieres!

We are only joking, of course. Instead, we hold up our flickering lamp in order to try to see who is on the other side of these massive bets…and what will happen to all this ‘liquidity’ when the bets go bad. We have faith, dear reader…faith in the eternal verities…including this: Every dollar created out of thin air eventually goes back from whence it came.

But let us return to our first question: if there is a buyer for every seller, how come the world’s supply of riches – cash, credit, liquidity – doesn’t remain constant? First, it is worth pointing out that as a credit bubble expands, short interest does not expand with it; instead it shrinks. Look at the hedge funds themselves. They dropped their shorts because, as prices rose, short-selling became unnecessary…and chances to do it became harder to find.

“We’re having a tremendous amount of trouble finding short ideas,” says Paul Mampilly, managing director of investment group Kinetics Advisers LLC. “We prefer to be more long than short.”

Who wants to short prices when they are going up? Only someone who is worried that they might go down. But the longer prices continue to go up, the less concerned about a reversal investors become. A hedge fund that actually hedges has a disadvantage in the marketplace; its short positions – though adding greatly to investors’ security – depress the performance numbers. The fund managers may not be geniuses, but they can do simple math. ‘Two and twenty’ works a lot better on $50 million at 20% growth than on $25 million at 10%.

The other thing that happens in a big, long expansion of liquidity is that as the interest in hedging goes down so does the price of it. Thus, there are fewer and fewer actual dollars on the short side. Yes, if the market goes down, a few short sellers will make a lot of money, but nowhere near as much as the bulls will lose when their asset prices collapse.

And often, there really is no one on the other side at all. If the price of Google shares falls to $50…hundreds of billions of dollars simply disappear into a black hole. Except for the short interest, everyone is worse off. The money has gone away…up to ‘money heaven,’ never to be seen again.

You can see even more clearly how this works in the residential property market. A man who has a house worth $500,000 thinks he has a lot more wealth than the same man when his house falls to only $250,000. He is out a quarter of a million dollars. And who was on the other side of the trade? Who made the money he lost? Where is the short interest in the residential housing market? It didn’t exist. When house prices fall almost everyone is worse off – except for new buyers. Owners feel poorer. Lenders make less money from new transactions…and old ones comes back to haunt them. Realtors make less. Builders make less. Appliance makers, toolmakers, furniture makers, Home Depot and other retailers – all make less; people are unwilling to put a lot of money into a house that is falling in price.

And imagine what happens if the dollar falls. The U.S. national debt is nearly $9 trillion and growing at $1.24 billion per day. Remember how Gerald Ford sounded the alarm back in ’74 when the national debt was a grand total $30 billion. Now, it grows by more than that amount every month!

Well, imagine that the dollar is suddenly worth only 50 cents. People who thought they had nearly $9 trillion in assets suddenly realize they have lost $4.5 trillion. Where did the money go? Who was on the other side? The lenders are out trillions…while the borrower – the U.S. government – has achieved debt relief of the same amount. But it never actually had that amount of money; that is, it never had the money to pay back the loans…and never would have. In effect, the trillions would just be ‘written off’ like a bad debt. This doesn’t mean people are necessarily worse off…but they definitely would have less cash and credit – less liquidity – than they had before. And other asset prices would collapse.

Of course, if the dollar were to fall in half…all of America’s dollar-based assets would be marked down 50% too. Farms, factories, labor, stocks, bonds, tools, cars – everything would be reduced in price. The whole country would be about $35 trillion dollars poorer, at least on paper. And where is the short interest? A few speculators betting against the dollar…but what else? Again, the world would not necessarily be a worse place. U.S. industries would be more competitive…foreigners would stream in to buy U.S. assets at fire-sale prices…and even the working man might finally get a real pay increase. But, there would less cash around…fewer dollars…much less liquidity to flush up asset prices.

No, dear reader, when a credit bubble implodes, it swallows up what people once mistook for wealth. All of a sudden, they have less money to spend, less money to lend, and less money to invest. Asset prices go down…consumer spending goes down…and an economic recession comes up. What they once took for granted they now take to court – hoping to collect 10 cents on the dollar, if they are lucky.

More news:

————–

Chuck Butler, reporting from the EverBank world currency trading desk in St. Louis…

“People are buying dollars because they believe the economy is stronger than previously thought, and that the Fed will continue to raise rates to combat inflation. Geez, Louise… I can only wish that’s the case!”

For the rest of this story, and for more market insights, see today’s issue of The Daily Pfennig

————–

And more views:

*** Speaking of residential property, the news reports tell us that it seems to be stabilizing.

Have we reached a bottom? Not according to Hugh Moore of Guerite Advisors, courtesy of our old friend John Mauldin:

“In the previous [seven] cycles since 1959, housing starts (seasonally adjusted) have fallen, on average 50.7% from peak to trough. Each time housing starts have fallen more than 25% from their most recent peak, a recession has followed (except during the ‘credit crunch’ of 1966-67 that ended in an economic contraction, but not an ‘official’ recession.)

“Housing starts have dropped 34% so far since their peak in January 2006. Just to get to the average drop we have another 20% or so drop in the starts to go.”

Meanwhile, the low end of the mortgage market is beginning to fracture. Sub-prime mortgage contracts total more than $300 billion. By definition, many of the borrowers are marginal. Many face higher expenses that they won’t be able to afford.

A friend writes from the Maryland suburbs:

“The whole housing boom with inflated values has now trickled down to me. Our new tax assessment for our property increased 45%!”

We remind readers, too, that much of that $1 trillion in mortgages whose monthly payments will increase this year are in the sub-prime category – where payers are least likely to be capable of sustaining higher costs.

Granted, this money doesn’t disappear. It goes to local governments and international financiers. Eventually, it could possibly come back to consumers in the form of higher wages. But a lot of homeowners will have gone broke long before that happens.

*** “Everything happens in sixes and sevens,” our grandmother used to say. We never understood what she meant by it. But now we find – thanks to Richard Russell – a study that tells us that the years ending in sixes and sevens always bring corrections – going all the way back to 1856.

And there it is…that immense bubble of cash, credit, and liquidity floating through a universe full of pins. What’s more, the gravity of this Jupiter is so intense it draws the pins towards it…like sharp edged asteroids attacking from every direction. Will it make it through another year without exploding?

We don’t know…but it will be fun to find out.

*** Our Christmas vacation is over. We are back at our desk in Paris… It is a new year. We have another chance…a fresh start…still 361 days ahead of us before we have to get another calendar. What will we do with it?

Stay tuned.