Storm Watch Update
AFTERSHOCKS AND ANOMALIES
by Jim Puplava
www.financialsense.com
September 28, 2001

The economic reports coming out this week have been discouraging for the economy and the financial markets. These numbers signify that even before the advent of the terrorist attacks, the American economy was in fact in recession or at least heading in that direction. The bad news mounted with Monday’s fall in the Leading Economic Indicators, Tuesday’s plunge in Consumer Confidence, Wednesday’s change in U.S. and global economic forecasts, Thursday’s rise in unemployment claims and drop in durable goods orders, and this Friday's drop in Consumer Sentiment. The only good news this week was the upward revision to 2^nd quarter GDP and a slight up-tick to Chicago's Purchasing Management Index. Overall, this week's numbers point to continued economic weakness. The conclusion to be drawn from these reports is this: despite tax rebates and interest rate cuts, the economy was heading for recession before September 11th.

Promises Pushed Back
What was obvious to CEO’s that run businesses was unclear or misunderstood by politicians, analysts, and the financial media. For most of the year, financial analysts and their counterparts on network television have been telling investors that this was simply an inventory correction. Once inventories were depleted, we would be back to normal again in bubbleland. After first quarter warnings, the story was changed to a second half recovery. Then, after second quarter disappointments, the recovery was moved to the fourth quarter. Now, just about anyone left with a shred of credibility admits that after what happened on 9-11, recession is inevitable. Recovery has now been pushed back to sometime next year. Even Fed Vice-Chairman Alice Rivlin on Thursday acknowledged that the economy has slowed down significantly. Today, officials are admitting what the average person already knows, a recession is upon us.

Washington Scrambles to Provide Stimulus
In the wake of the terrorist attacks, government officials and many on Wall Street now have an exit strategy from their untenable positions prior to the attacks. Politicians who wanted a watered-down tax package are scurrying to line up around new stimulus measures. Talk about new tax cuts and fiscal spending is everywhere. The President was given $40 billion for emergency aid to rebuild New York and beef up the military. The airlines are going to get $15 billion in financial aid and Congress is still not through. Another $50 billion in tax cuts and spending programs are being negotiated. Gone are the meaningless arguments on whether the surplus will be one number or another.

The Roots of Recession Are Too Deep
With most of Congress up for election next year, both sides are rushing in with proposals to stimulate the economy, bring it out of a deepening recession, and hopefully put it on the road to recovery before next year's election. But this is going to be no ordinary downturn. As amplified in my Storm Series, the economy's problems are systemic. The underlying problems stem from an unprecedented credit boom. There is too much debt in the economy. Record debt at the corporate and consumer levels argue against a quick rebound. What Washington and Wall Street hope is that rampant money creation will jump-start the economy and financial markets again. This is both naïve and unrealistic.

Corporate America Has Been In The Skids
It all began in the corporate sector with a collapse in profits, which then led to a collapse in capital spending. As companies slash their capital spending budgets, they are also cutting back on payroll. These actions reduce consumer spending as jobs are lost. Our economic malaise is going to take time to sort itself out. It won’t come easily, nor will it improve quickly. That is the optimistic case. Unfortunately, any additional mishap or unforeseen event could shift the economy into a tailspin. There are just too many variables and wild cards that have yet to be played.

   
Source: The Dismal Scientist, CBS MarketWatch

As the charts indicate, the economy has been rapidly descending since mid-year. Inventory liquidation is proceeding slowly. This is because sales are falling faster than inventories, so inventory-sales ratios are still climbing. The plethora of corporate earnings warnings will only exacerbate excess capacity problems. In light of collapsing profits, capital-spending will be reduced even further. For the last few years, this weakness in corporate profits has been masked by creative accounting. Today, companies have simply run out of new tricks. Last week reality set in on Wall Street. Over 3,390 earnings revisions have been made with about 85% of them downward. It is this dreadful profit news that is haunting the stock market. The recovery mantra so often spoken on The Street and Bubblevision is a call for more rate cuts and wishful hopes for consumers to keep going into debt to support current spending levels and bring us out of the abyss. Macro and micro economic facts are simply ignored. Experts hope to spin their way towards recovery.

Doublespeak
Almost as ridiculous as the financial soothsayers have been the calls by stock market giants like Goldman Sachs, Credit Suisse First Boston and Banc America Securities for investors to keep buying stocks. Even as they urged investors to keep on buying, their own firms were busy cutting and slashing sales and profit estimates for the S&P 500 companies. The financial and forecasting departments were cutting profit numbers based on a worsening economy as earnings estimates were being reduced. And yet at the same time, the cheerleaders in advertising and investor relations departments were singing the "buy mantra" to a new tempo. It was as if one hand didn’t know what the other hand was doing. Citing the Fed stock model as proof that stocks were undervalued, they made their pitch to investors. Buying stocks now became a matter of patriotic duty. The Fed model, which is based on interest rates and the earnings estimates of companies in the S&P 500, had two flaws. Interest rates could change and so could corporate profits. Even with this knowledge, those very same firms were, in fact, already reducing those profit numbers.

Not everyone joined the chorus of the cheerleading section. Charles Blood, market strategist with Brown Brothers Harriman, issued a mea culpa to the firm's investors. Blood said “Those of us who have been bullish for many months have a lot to apologize for after last week’s precipitous decline in stock prices.” At the same time, he still urged investors not to panic in face of the market downturn.

What's Going On With Oil?
Another notable event in this week’s market has been the steep drop in oil prices. Oil futures tumbled as much as 15% in trading in New York on Monday. It was the steepest decline since the Persian Gulf War. The explanation given for the sudden drop in price was growing concern that a worldwide recession would decrease demand for oil. It is as if the news of an approaching recession was something new, a sudden surprise, something not considered before. Events in the oil market this week stand as an anomaly to past crises of war and trouble in the Middle East. As the following table illustrates, Brent Crude oil prices have been trading suspiciously different than NYMEX oil since the beginning of September. There has been close to a $2 dollar difference between the two since the beginning of the month. Prior to the terrorist attack on September 11, the price difference between the two had risen by $2.40. On the day of the attack, the U.S. trading markets for oil closed. However, in late trading in Europe, the price of Brent crude rose. Throughout the remainder of the week, the price of oil rose steadily in world markets as shown in the table. Our markets opened briefly for a short period on Friday where the price of NYMEX oil rose to $25.78. The markets in Europe were behaving as they always do in a geo-political crisis. Oil prices went up.

When our markets reopened on Monday, September 17, prices fell slightly in the U.S. while Brent crude prices continued to rise in Europe. Not until later in that week did Brent prices decline. Even then, they were still above oil prices in the U.S., the center of the crisis. Then on Monday of this week both prices plunged in the sudden revelation that there might be a economic slowdown. As of today's close, both prices are in line with each other. Many explanations were given for this sudden plunge, most notably, the economy. Another story circulating around the dens of Wall Street is that certain hedge funds had been leveraged long in oil and were forced to sell, thereby driving down the price.

I Don't Buy The Spin
What was clear to me was that the markets were behaving strangely. The explanation that the oil markets were just now waking up to the fact of an economic slowdown strikes me as incredibly naïve. As this chart indicates, oil generally rises when a crisis erupts. Oil prices behaved predictably in Europe, but not in the U.S.. The idea, that the economy will get worse and therefore the demand for energy will decrease, sounds plausible until you examine the facts. Stockpiles of gasoline and heating oil remain sufficient, but are still in fact, low. If consumers stay calm and that sense of ease works its way through the distribution chain, the outcome for oil and gas prices will remain benign. However, there is no supply cushion to handle war and the disruption of supply or a severe winter as we had last year. As the graph of natural gas inventoried indicates, supplies are up over last year, but remain below historical levels.

What the numbers and these charts don’t show is oil held outside of OPEC. Non-OPEC oil production is down 100,000 barrels a day. Despite a near tripling in the price of crude and a tripling in the amount of drilling rigs put into production, we have been unable to build up significant supplies of oil and natural gas. This is because world oil production outside of the Middle East has peaked. We are now entering a period of declining output. That in itself would dictate higher oil and gas prices -- even without a conflict or war in the Persian Gulf region. This supply-side predicament is often lost in the analysis and debate over energy. It is as if there is an infinite supply of oil. There isn't. The vast majority of oil reserves are located in the Persian Gulf and Caspian Sea. These areas are outside our control. The problem with all of the analysis over oil is that it focuses mainly on price at the expense of ignoring fundamentals of the market. If we go after Iraq, and there is mounting evidence they were involved in the attack either through financing or providing intelligence, then the possibility exists that Iraqi oil could be taken off the market. This would remove 2.5 million barrels of production off the market. That supply cannot be replaced.

Storm Front on The Horizon?
OPEC is determined to bring prices back to existing levels before oil’s steep plunge at the beginning of this week. Already the cartel is hinting that it could cut production even before its next meeting in mid-November if prices don’t stage a comeback. Saudi Oil Minister Ali al-Naimi said Friday that OPEC would move swiftly to prop up prices by curbing output by more than 500,000 barrels a day. The cartel has already cut output by 1,000,000 barrels a day at the beginning of September. The problem with current prices is that additional cutbacks could come at a time when the U.S. military is ready to strike a blow at Iraq. Top off military conflict in the region with unusually cold weather in the U.S. and you will have the equivalent of The Perfect Storm in energy.

Is This Back to The Future?
All of what is transpiring here is very much reminiscent of the 1970’s. Once again you have an emerging and assertive OPEC. The cartel is now in the strongest position to control the price of oil since the first oil shock in 1973. OPEC holds the reins over the most important supply source of oil in the world. Even with global economic weakness, the cartel has held firm to their price band for crude oil prices. Despite this year's global economic slowdown and the more recent tragedy, OPEC has moved throughout the year to cutback production in order to prop up prices.

The other similarity to the early seventies is non-OPEC producers inability to generate excess supply despite higher prices and a tripling of investment. This is once again due to the decline curve in production as experienced by the supply of oil and gas in the West. The energy industry is short of personnel and investment opportunities that would enable the industry to increase production.

The final similarity is the prominent rise in global conflict. The era of peace has ended. The stability of the region ended a year ago last September with the breakout of violence between the PLO and the Israelis. Now, there is the global war against terrorism. Sudden terrorist attacks requiring military response will destabilize oil supply. This will create unpredictable supply shocks. The consequence of these supply shocks will make the economic recovery even that more elusive.  ~ JP

© 2001 James J. Puplava
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