China's Problem was Made in China - Not Imported

I am a sucker for a really good China story (I like the General Tao's chicken at Panda Express, too). There is a good piece on China HERE. The chicken, unfortunately, I cannot help you with.

Happy Thanksgiving.

Why Volatility is Here to Stay

The world is a dangerous place these days. Market participants in the stock market, the energy markets, or in agricultural commodities have seen it all - from all time high prices to crashes – in the last year. And inter- and intra-day volatility is increasing – as I mentioned in my previous post, The Vomit Comet.

Volatility makes life difficult to manage. It materially impacts the bottom lines and business plans of households and executive suites alike. I previously quoted Charles Dow in this blog by writing, “The one thing pertaining to all markets is that they will change.” I am going to break that rule in this posting, and put forward an argument as to why volatility is here to stay.

With world supply and world demand in relative equilibrium in the short run, the variables that most drive price are future demand and future supply of oil – since the world needs a lot of it and it is relatively difficult to know with certainty how much we have. (The International Energy Agency actually did a bottom up study of the productivity curves of major known fields in their World Energy Outlook. A summary of this analysis is available here.)

So assuming that the future supply/demand balance is the important metric for calculating oil price, allow me to stagger you with some really big numbers. Let’s talk population. In 1975, world population was estimated at 4.0 billion people. By 2010, world population is expected to be 6.8 billion. This staggering change is causing all sorts of problems for those economists who try to estimate consumption activity. The United Nations predicts there will be 8 billion people in the world by 2030. And the IEA says that in 2030 the world will use 125 million barrels of oil per day. Implicit in that consumption figure is a worldwide growth rate of about 1.8%. If the annual growth rate is inhibited by worldwide recession and instead is 1.6% over this timeframe, the estimate would be 3 million barrels off per day. If the industry builds infrastructure to meet the 125 million barrel forecast, prices will be depressed and bankruptcies will ensure as exploration and production companies will not be able to pay the debt service on their asset loans.

Let’s bring macroeconomics into perspective with an example almost everyone can get their hands around. My wife and I like hosting parties, and we have learned several lessons after hosing parties over the last few years. First, it always seems easier to have enough of everything when there are fewer guests. Second, it is difficult to predict how much of any particular party treat we will need. A few years ago, during the Atkins diet rage, we might have had leftovers from one bag of chips after a party of 30. But at that same party, we might have run out of mixed nuts. As our guest’s tastes have adjusted, we have had to adjust too – for fear of facing the wrath of party goers that have been inappropriately supplied with snacks.

The move from $147 to $48 in crude was based on the realization of decreasing worldwide consumption. And this major price shift affects production plans and capital projects throughout the world. The tremors associated a predicting future behaviors on a growing, crowded earth have just begun.

Merrill Lynch Economic Outlook Comments

On Deflation:

We are on the verge of entering the eye of the hurricane. The big story is that the savings rate appears to be rising from 1.3% now to over 3% by year-end, and is probably on its way to north of 5% by the end of 2009. How anyone can be talking about inflation as a “near-term” threat (please don’t talk to us about the long-run when we’ll be joining Keynes in the afterlife) at a time when the savings rate and the unemployment rate are going up in tandem? We can’t think of a more deflationary aggregate demand backdrop.

See the entire analysis here.

Commodity Volatilty Impacts Farming

The old adage is that "Farmers Hold Out for More, but Settle For Less" when marketing their crop. Today the New York Times has a piece on the remarkable market volatility impacting wheat farmers. Here is a quote:

The Kinders still have about 40 percent of their wheat, stored on the farm and in commercial grain facilities. “Farmers are terrible marketers,” said Jimmy Wayne Kinder, 50. “We fall in love with our crop.”

It was the same misguided optimism that caused homeowners to think their houses would always keep increasing at a 20 percent annual clip. Farmers across the country fell prey to it.

David Kanable at the Oregon Farm Center, a mill near Madison, Wis., was paying $7.25 a bushel for corn in June. “We never had a farmer lock in at that price. They wanted $8,” Mr. Kanable said. On Thursday, the mill was paying $3.17 a bushel.

"It's Not a Tumor!"

Infectious Greed blog reports:

"while watching the Charlie Rose interview with the automotive industry's David Cole, something occurred to us: the United States has become the world's leading authority on creating inoperable, metastasized industrial tumors. Not only this, but the creation of, maintenance of and discussion surrounding these tumors has become so integrated in the economic fabric and incentives system of the United States, that it doesn't even occur to participants that their behavior is part of a highly developed, multi-generationally optimized, metastasized tumor growth system."

Wow...I never thought of it that way. (But he's got a point.)
Sent from my Verizon Wireless BlackBerry

Jim Cramer on the MLP Asset Class

What you really need to worry about are dangerous members of a third kind of MLP: the gathering and processing MLPs that are unsafe. In general these companies collect the natural gas that comes out of a well, dehydrate it, treat it, make it worthy of long-distance pipeline transmission, and sometimes convert it into natural gas liquids, which are the feedstocks like ethane used in chemical plants.

A company like Kinder Morgan Energy Partners has a safe business because it just gets paid for pretty much running a toll road-for the volume of gas that goes through its pipes. Not so for these other, more dangerous MLPs.

Cramer's targeted sells are Duke's MLP and Williams' MLP. Personally, I think he is crazy and wrong. Fractionation is fee based - similar to pipeline ownership.

Decide for yourself. See his full "Sell Block" column here.

Christmas Comes Early

Other glorious headlines from Accuweather tonight are:

• Cold Is King
• Let's Talk About Snow
• The Lakes Are Angry
• Another Whopper of a Storm

Yes, Virginia - there is a Santa Claus and his name is Joe Bastardi!

Should We Bail Out Detroit?

Consider this article from Newsday:

The danger we face at this fork in the road is the conventional wisdom that associates more regulation with better regulation and more restrictive policies with less risk. History teaches us that the opposite is usually true and that the costs of getting it wrong can last for decades.

Bullish and Bearish Predictions - Win Some and Lose Some

The R-Squared Energy Blog has a great post about crude oil prices and the nature of predictions. The focus of the commentary is the extreme difference between the predictions of the Goldman analyst Arjun Murti (The BULL) and Deutsche Bank's Paul Sankey (The BEAR). The entire post and its links are worthwhile. This is a statement that struck me as precient.

There are some things to be said about predictions. If a person makes enough predictions, they are going to miss some - no matter how well they know their subject matter. On the other hand, when many people are making predictions, some will inevitably get it right for the wrong reasons.

Bond Family Schoolhouse Rock

See the video here, and then reminisce about Conjunction Junction.

I had to pull down the embedded video from the original post - it was about 1/2 inch too wide for my screen format.

A Heating Oil ETF for End Users

A post from Seeking Alpha talks about buying a heating oil ETF (UHN) as a proxy hedge for a prebuy:

In the summer, my local heating oil services let me "lock in" the price of heating oil if I want. At $4.25/gallon, I passed. But with oil down at $2.50/gallon, locking in the price is more attractive. Trouble is, my oil supplier ends its "lock-in" window in August.

With UHN, however, I have a chance. I'm guessing I'll spend about $1,625 this year on heating oil. Right now, UHN (which tracks the price of near-month heating oil contracts on the NYMEX) is trading for $28.20/share. So all I have to do to lock in my fuel costs is buy 58 shares of UHN, stick them in my brokerage account, and sell out in May.

Of course, it's not a perfect hedge. Local oil costs don't match perfectly with national costs, and the timing when I get oil deliveries will influence my expenses. But if oil goes back to $3.50/gallon or more, I'll make a tidy profit on UHN to counteract the rising costs of my heating bill. Is that worth a $20 round-trip on commissions? Maybe.

Daniel Yergin on Charlie Rose

National Gasoline Price Map

A fantastic graphic. Zoom out and you can see prices by state. Zoom in and you can find your county, city, or street.

OPEC November Oil Market Report

Highlights are as follows: Slowing Demand, Strengthening Dollar, Volatility Increasing in all Markets, Synchronized Recessionary Phase brutally effecting all global economies

Listen to all four minutes here.

Statistics are for Losers

Allow this post to be a little from the commodity/economy talk.

Check out Urban Meyer's take on Statistics in Football.

They say statistics are for losers, but losers are usually the ones thinking that," Meyer said. "Statistics are great. Our whole game plan is based off statistics. Our management of the game is based off statistics. Our recruiting is based off statistics. Everything we do is analyzed.

Consumer Concern with Price Programs

Delaware Online has this article, about buyer's remorse in volatile times.

[Monica Harvey] agreed to a price-cap contract with Burns & McBride this summer after reading stories that projected prices would only go up.

The program, common among oil dealers, has customers pay a fee equal to 50 cents a gallon for however much they want to reserve at a price cap of $5.60 a gallon. The price couldn't go up, and if it came down they would pay the market price -- now $2.89 a gallon.

Harvey now gets the $2.89 price, but she's out the $150 she put up to "protect" 300 gallons.

"They made it seem like, seriously, do or die, you'll be out in the cold," she said. "Let's have some common decency here and return this money."

That's not possible for the 4,000 or 5,000 customers who took advantage of the offer, said Tom McBride, the president of the company that serves Delaware, Maryland and New Jersey.

McBride said his company used the upfront fee cash to buy options and hedges to keep prices reasonable in the event they exceed the cap. His company doesn't make any more money on the deal, no matter how high or low prices go, he said.

The frustrating thing about this article is the quotation marks around word "protect." Ms. Harvey spent 50 cents a gallon to receive a benefit (through reduced oil costs) of OVER $2.00/gallon! That she has the lack of understanding is understandable - our customers are uneducated when it comes to the "insurance premium" type nature of program enrollment fees.

However, I think it is incumbent upon a responsible journalist to report that Ms. Harvey received a four-fold return on her invested enrollment fee. Not a bad deal in these markets.

The End of Wall Street

One of my clients told me to read Liar's Poker. So I did. And now, I recommend it to everyone I can - as a great insight into the world of Wall Street Investment Banks during the heyday of junk bonds.

Later, the author (Michael Lewis), wrote Money Ball (about the Oakland A's GM Billy Beane). Now, he has penned an article called The End of Wall Street. It is excellent. You can find it here.

Chinese Construction Not Adding to GDP???

A significant amount of this blog has been spent investigating China. That is because Chinese consumption was the most significant driver to the 5-year bull market (and the most bullish component to the bullish IEA World Energy Outlook that was released yesterday). For example, before the Olympics, it was said that the Chinese government was hording heating oil (and thereby contributing significantly to the price rally of over $1.00/gallon). There have been news reports of how China is bringing 1 coal-fired power plant online each day for 8 months. All bullish considerations for commodities...all demonstrations of the emerging power of the Chinese Dragon. Now consider these comments from James Chanos, a hedge fund manager, which can be found in video form on CNBC -

"I don't think things are that stable. I think it's worse, and I think it's going to get worse. Depending on your estimate, 35 to 50 percent of China's GDP is construction, and that's a very important thing to remember, and if we are still building things that we don't need in China, like factories, are you really adding wealth to the country? Like any capital project has a rate of return associated with it, and in China, I'm afraid, a lot of projects, as well as in south Asia and the Middle East, do not have economic returns associated with them, yet, during their construction, they contribute to growth.

"Remember our telecom boom, when people were building out things, left, right and center? Then the building stopped. It was the Wile E. Coyote moment. All of a sudden, we looked down, and there was no there there."

I saw Field of Dreams....I thought the mantra was "If you build it, they will come"?

The Grizzly Bear Market

At Seeking Alpha, it is reported that the current bear market is the biggest the market has ever seen on a percentage basis. And it only took 51 days.

Timeless Wisdom from Another Time

"There is always a disposition in people’s minds to think the existing conditions will be permanent. When the market is down and dull, it is hard to make people believe that this is the prelude to a period of activity and advance. When prices are up and the country is prosperous, it is always said that while preceding booms have not lasted, there are circumstances connected with this one, which make it unlike its predecessors and give assurance of permanency. The one fact pertaining to all conditions is that they will change."

Those are the words of Charles Dow, from 1902. The emphasis (as always) is mine. Consider the tech bubble, energy prices, or this equities bear market. Aren't there more trend followers than folks that say "this lunacy will end at some point?"

"Be fearful when others are greedy and greedy when others are fearful."

- Warren Buffett (approximate quotation - 2008)

Propane Inventory Concerns

From This Week In Petroleum:

Propane Inventories Post October Draw
Total propane inventories reported an atypical 0.5 million-barrel stock draw during October, the first since 2002, despite nearly normal temperatures during the month. In comparison, the most recent 5- year period showed inventories gaining an average of nearly 1.9 million barrels. The final week of October saw inventories remain relatively flat at an estimated 60.4 million barrels.

Inventories are nowhere near where they typically are (and arguably where they need to be), but the chem consumption rate is abysmal, too. Right now, propane to crude values are at ~50%. This is because when the chems aren't running at a high percent of capacity, there just aren't enough buyers of NGL's - we run a surplus of NGL's in the country. But the forward curve of prices has the propane to crude spread in the 50% range well into the future.

If one assumes that the economic downturn that we are experiencing will be handled by the loose monetary policies of the US central bank and the central banks of the civilized world, then chem operating rates will rebound at some point in the next year, and that percentage of propane to crude will improve.

What does that mean for the dealer? Well, often a low percentage value in the propane to crude relationship helps indicate (along with other factors) a potential buy-point in the marketplace. What retail price can you sell to your customers for Winter 2009? If you can take the current hub price, and your differential and your retail margin and make your customers happy - maybe this is a price that you should own for your business.

OPEC's opinion

Check out the Market Fundamentals Podcast that OPEC released last month.

OPEC's Market Fundamentals Podcast

The audio is 4:00 minutes long. It is 50% press release, 50% market overview, and it comes directly from the business office of OPEC - no intermediaries or folks to color the facts.

8 days to the November OPEC meeting...

Monday Reading Links

A few articles worth your time:

From NY Times:
Merrill's Downfall
Lax Risk Controls Led to aggressive CMO and CDS deals

China's Problems with Slowing Growth
And aggressively fixing the problem, with a stimulus package worth $586 billion

From the New Republic:
Meet Tim Geithner, He Might be Your New Treasury Secretary
The NY Fed Governor is young, aggressive, and qualified.

The Propane to Crude Spread Gone Really, Really Wrong

Atlas Pipeline Partners reports 3q08 earnings. Lookie here at one of the disclosures (bold emphasis mine):

The Partnership's financial results for the third quarter 2008 include a $71.5 million cash derivative expense resulting from the completion of the early termination of approximately 85% of its crude oil derivative contracts that it entered into as proxy hedges for the prices it receives for the ethane and propane portion of its NGL equity volume. The Partnership funded this transaction through its June 24, 2008 sale of 7,140,000 common units for aggregate net proceeds of approximately $262.1 million, including a capital contribution of approximately $5.4 million from its general partner to maintain its aggregate 2% general partner interest in the Partnership. These hedges...became less effective as a result of significant increases in the price of crude oil and less significant increases in the price of ethane and propane. The Partnership terminated these derivative contracts during June and July 2008 at an aggregate net cost of approximately $264.0 million. The Partnership's $71.5 million cash derivative expense recognized during the third quarter 2008 resulted from July 2008 net payments of $93.6 million to terminate the remaining portion of these derivative contracts. The attached hedge schedule reflects the current hedge position of the Partnership, adjusted for the crude oil derivative contracts that were terminated in June and July 2008. As a result of the termination of these hedge contracts, the Partnership's future cash flow should more accurately reflect the revenues generated from its ethane and propane volumes produced in its natural gas processing operations.

Translation: Propane and Ethane are hard to hedge (due to liquidity), and there's lots of data showing that these commodities trade in a relationship with crude. So Atlas did a little cross commodity hedging (sometimes called a "dirty" hedge). But the correlation broke down this year, and they incurred significant unexpected losses as the percentage of propane and ethane to crude got hammered in the extreme volatility.

Price correlations have been breaking down everywhere in the energy sector this year. (As I have written in previous blog posts, Nasim Taleb is not surprised.) More on the breakdown of price correlations in an upcoming post. Interestingly, had management not busted those trades when they did, the losses would have come close to doubling. My philosophy professor always told me: "correlation does not imply causation." Likewise, Warren Buffett cautions to "be wary of geeks bearing models."

Helicopter Ben and the Economic Stimulus

Here are some interesting money supply comments from the Fed Chief. Apparently, he has no reticence to move the fed funds rate to zero, and has more tricks up his sleeve after that. (This is from a speech given in 2002.)

"As I have mentioned, some observers have concluded that when the central bank's policy rate falls to zero--its practical minimum--monetary policy loses its ability to further stimulate aggregate demand and the economy. At a broad conceptual level, and in my view in practice as well, this conclusion is clearly mistaken."

"But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost."

And they can drop those dollars to folks using helicopters.

Oil Megaprojects Get Sand in the Gearbox

This from RigZone:

Oil sands companies were the first to feel the pain of plunging oil prices and the credit crisis. Mining tar-like bitumen and shipping it to refineries costs more than extracting hydrocarbons from more conventional fields, bumping up the oil sands' price threshold. Analysts estimate some projects may need a long-term oil price of $100 a barrel or even higher to make a decent return.

The high upfront capital costs often lead to heavy reliance on the credit markets, especially for start-up firms with no independent cash flow. But this option has slammed shut amid the global liquidity crisis, and oil sands developers have already started rejiggering project plans as a result....

Five years ago, the capital cost of building a project that mined bitumen and processed it into high-quality crude was around C$40,000 per barrel of production, reckons Andrew Potter, a UBS Securities analyst. The same project today could cost C$180,000 per barrel, or around C$18 billion for a typical 100,000 barrel-a-day development....

"Companies indicated they were comfortable with costs around C$100,000 (per barrel of production) but when we started getting estimates of C$160,000 or C$180,000, then we heard a collective gasp," First Energy's Lacey said. "That's when investors put their foot down and said, 'Enough.'"

You know what they say...High prices cure high prices and low prices cure low prices.

Long-Term Weather Forecasts

Accuweather

Farmer's Almanac

NOAA

Price and Volatility Strain Dealers

The broader news media is starting to report about the challenges that price volatility has created for our industry:

Borrowed cash infuses nearly every step of the supply networks that bring heating oil from refiners to individual homeowners and businesses. For wholesale suppliers and door-to-door distributors, loans cover the weeks or months between when fuel is purchased and when it is sold to the next step on the chain.

Most companies managed to secure fresh loans to carry them into winter, despite the global credit crisis that has made it difficult for even solid businesses to borrow. But evidence is emerging that not every company succeeded.

"A lot are starting to bounce checks," said a trader at a wholesale heating oil supplier, who requested anonymity to protect the supplier's standing in the physical fuel market. "Credit lines are definitely strained."

Shift Happens

This is a presentation created by some Colorado high school teachers discussing the demographic and technological shifts the world is undergoing. If it doesn't surprise you at least once, email me and I will issue a written apology.