Governments Role in the Free Market

Free market advocates (I am one), believe the government should have a minimal role in managing how any market operates. The winners and losers in any market should be determined purely by market forces, with the government not taking any sides. However, in the real-world, there are very few markets which are truly free of the influence of the government.

The world’s financial markets provide a striking example. Even though the restrictions on the movement of capital across the globe are perhaps at the lowest level ever, the sentiment in the financial markets is heavily influenced by the decisions of central bankers. Bonds issues by the United States Treasury continue to be safe-havens of last resort with the 10 year bond yielding around 4% even when inflation threatens to explode. The Federal Reserve continues to play a vital role as a lender of last resort, trying its best to prevent a collapse of the financial system.

All over the world, industries deemed to be vital to national interest are under some form of government control. In the United States companies providing basic utilities like electricity, natural gas, telecommunications, public transportation etc. are regulated by Public Utility Commissions (PUC) of individual states to provide ensure a reliable supply and stability in prices. These industries are deemed to be essential to the basic functioning of a modern economy and protecting them from the extremes free-markets can take is considered essential. Reducing the uncertainty associated with their availability and pricing, allow other segments of the economy to function better, and increase our overall prosperity.

Oil and Government Regulations

Though oil plays a critical role in our national economy, and shaping our foreign policy, the oil industry is not heavily regulated and does not come under the purview of the PUCs. Since we import a bulk of the oil we consume, our energy security is closely tied to maintaining access to the sources of foreign oil. As a result oil companies are the 800 pound gorilla when it comes to our energy policies and thanks to national interest our foreign policy. Our energy policies are designed to help our oil companies in providing us with reliable supply at stable prices. The United States offers a variety of incentives and subsidies to oil companies to achieve their goal.

Federal Assistance

Oil companies get leases to Federal lands for the purpose of exploration and development of new fields at a minimal cost. A report published in 1999 (when oil was near a long term bottom), by the International Center for Technology Assessment, a non-profit, bipartisan organization with the goal to provide the public with full assessments and analyses of technological impacts on society concluded that:
“…Together, these external costs total $558.7 billion to $1.69 trillion per year, which, when added to the retail price of gasoline, results in a per gallon price of $5.60 to $15.14…”
Some of the subsidies mentioned include:
• The Percentage Depletion Allowance
• The Nonconventional Fuel Production Credit
• Immediate expensing of exploration and development costs
• The Enhanced Oil Recovery Credit.

Since 1999 the Congress and the Bush Administration has added more programs to help oil companies maintain our energy security, while some of the credits have become inapplicable as the price of oil soared in recent years.

The Cost of See-Saw Oil Prices

Though the US Government provides incentives to ensure reliable supply at stable pricing, the price of crude-oil has gone through significant gyration over the past few decades. On an inflation adjusted basis the price of oil has varied from the $20s/gallon in much of the 50s and the 60s, with a spike up in the 1970s which peaked in 1980 with an average price of $98/gallon, followed by the Saudi led glut in the 1980s with oil falling as low as $16/gallon in 1998 and the current super spike with average oil prices not projected to be well above $100/gallon in 2008 (EIA estimates $122/gallon in 2008 and $126/gallon in 2009).

The massive swings in the cost of oil have a huge impact on the economic well-being of our country. Any long-term project with a significant energy component becomes much riskier: Do the planners use oil at $20/gallon or $130/gallon in their planning? A study sponsored by the US Department of Energy (published December 2000) and conducted by the Tennessee based Oak Ridge National Laboratory’s National Transportation Research Center, tried to measure the impact of the gyration in oil prices on the US economy. The study came up to the following conclusions:

“Estimates of the total economic costs to the United States of such oil market upheavals during the last 30 years are in the vicinity of $7 trillion, present value 1998 dollars, about as large as the sum total of payments on the national debt over the same period. Transportation is at the center of the oil dependence issue. More than 25 years after the first world oil crisis in 1973-74, the U.S. transportation system comprises 67% of U.S. petroleum demand (25% of world oil demand) and relies on oil for more than 95% of its energy needs.”

Energy Policy: Expediency Wins

The decline and fall of the former Soviet Union and the military stability provided by the US presence in the Middle East in the 1990s resulted in two decades of low oil prices from the mid 1980s to the early 2000s. During this period the United States dependence on foreign oil increased significantly. The availability of inexpensive foreign oil resulted in pressures from environmentalists to limit exploration and drilling in the United States.

Why Drill in the US When The World Is Awash?

The low price of oil meant that Big Oil companies had very little incentive to explore newer oil fields. For a long time Big Oil used oil price value at $20/barrel to determine the viability of any new project. As shown in the chart below (taken from this link) a result the replacement rate for Big Oil’s has been in a free-fall since the 1990s.

Missed Opportunities

While Big Oil’s proven reserves where falling faster than they were being consumed, the economies of emerging markets in Asia were cranking up. It did not take much to figure out that the energy demand from these economies would increase as more than 2.5 Billion people emerge from a subsistence lifestyle to the consumption focused lifestyle we export to the rest of the world.

It was in this period of lull that the United States missed a great opportunity to wean itself off foreign oil and establish itself as the leader in more sustainable energy technologies which are not completely dependent on discovery of relatively scarce natural resources.

It was not for the lack of trying; California passed an initiative to encourage the use of Electric Vehicles in 1990. However, the initiative failed due to strong opposition, primarily from the US automobile and oil industries, which feared an erosion of the dominance of internal combustion engine in the US’ transport system.

Big Oil’s off-course did not want our reliance on the gasoline to end and tried their best to kill electric vehicles. The big automakers were afraid of the electric vehicle since they have much lower wear and tear and hence last for a longer time, while requiring much lower maintenance during their life-time. The brakes in electric cars use regeneration technology to convert the kinetic energy of the car into electricity which recharges the battery, instead of expending the energy as heat in the brakes. There is no high-temperature engine where gas is exploded in a controlled environment.

The NiMH battery patent lock-up was an egregious example of how the Big Oil and GM colluded to push back the development of electric cars by at least a decade.

Electric-Only Cars, NiMH Batteries and Big Oil

During the 1990s Nickel Metal Hydride batteries were considered the ideal candidate for plug-in electric cars. Their reliability and ability to store a lot amount of energy make them especially valuable for vehicles which do not have a gas-powered engine to supplement the battery power. These batteries powered the first generation of electric cars launched in the US, including the EV1 (GM) and RAV4-EV (Toyota).

In 1994, GM acquired controlling rights of the company, Ovonics, which invented and patented NiMH batteries. It sat on the patent for a few years, while the first generation of electric cars met their pre-destined end. In 2001 it sold that stake to Texaco which was then acquired by Chevron. The battery venture was spun off as a 50-50 venture, Cobasys, between Chevron and the original owners,
Ovonics-Energy Conversion Devices.

Cobasys has been following a policy which prevents the use of large-format NiMH batteries in transport applications in the US. It sued Panasonic EV Energy (PEVE), a joint venture between Panasonic and Toyota, which supplied large format NiMH batteries used in RAV4-EV for patent violations, which resulted in a sealed settlement.

The terms of the settlement involved a compensatory payment to Cobasys, licensing of some patents, and above all some unspecified restrictions on the size of NiMH batteries which could be sold to the transportation industry. Right after the agreement, PEVE stopped selling large-format NiMH batteries targeted towards the transportation market in the US.

Toyota’s RAV4-EVs are running great, but may have to be moth-balled since there is no legal way for Toyota to provide new batteries to replace the 10 year old NiMH battery packs, if and when they need replacement. RAV4-EVs owners have to contact Cobasys for replacement batteries; Cobasys has refused to deal with anyone in non-OEM quantities. Under the terms of the settlement, Toyota can use small-format NiMH batteries in hybrid vehicles like the Prius which have an Internal Combustion Engine to burn gasoline and supplement the electric power.

To complete the picture: Cobasys, the firm which refuses to sell large-format NiMH batteries to RAV4-EV customers, or license its technology to other manufacturers, is on GM’s list of distressed suppliers in poor financial condition. I wonder why a firm in financial distress is unwilling to generate extra revenues by addressing the needs of an existing market.

Detroit should be thankful that the horse and carriage industry of the 19th century did not have the protection of the US Patent Office to prevent the Internal Combustion Engine from being used in cars.

Opportunity Cost of the EV Failure

The opportunity cost of the failure of electric cars is not only in terms of what we lost in the US (less pollution, reduced dependence on foreign oil) but also the message we sent to the emerging markets. When China and India develop their transportation system, they do not have a working model based on electric vehicles to look at. Distances travelled in those countries are typically much less than the average American commute, and our ideal for electric vehicles.

Further, we lost the chance to be the leader in a technology of the future. America’s prosperity is built upon being innovators; in the future we will have to work much harder to maintain the edge as the rest of the world catches-up. By missing the boat on the next wave of transportation systems, the American economy has lost billions in economic benefits.

Towards a Cogent Energy Policy

It is clear that our energy policy needs a radical overhaul to wean us of foreign oil. Our new policy should be multi-pronged; while in the short term we continue to seek more oil, especially domestic oil, in the medium to long term, we have to focus on weaning our self off oil, and fossil fuels in general. Our nation will pay a high strategic cost for the enormous amount of wealth we are transferring to oil exporting nations, which more often than not, are not amicable to our national interest.

Restrictions on domestic drilling and refinery capacity have to be reviewed to come to terms with reality. Similarly the NIMBYs of Cape Cod, who are afraid of wind-farms spoiling the view from their vacation homes, need a reality check. More significantly, we need to take charge in becoming the leader in developing alternative energy resources.

Big Oil’s Financial Strategy: Wait and Watch

In 2007 Exxon-Mobil spent $31.8B in stock buybacks and another $7.6B in dividends. Big Oil in total increased their share buy-back programs from $10B in 2003 to $60B in 2006. The return of capital though laudable, also indicates that Big Oil companies are unable to find better alternatives for investing capital to drive future growth.

The irony of the situation is mind-boggling: In the past five years, the price of crude oil has gone up 4x, the replacement rate of Big Oil companies has plummeted to below 100%, but Big Oil companies are unable to find better alternatives for investing their capital?

Purely from a financial point of view this seems like a prudent move: if the importance of oil declines and prices fall, not making investments in new fields will turn out to be a wise decision. On the other hand, if oil continues to be important, the rising crude oil prices will ensure huge amount of profits from the existing resources Big Oil has. It is a win-win for the investors in Big Oil. But what about the interest of a nation, which has hitched its wagon behind oil?

Big Oil, National Interest and Renewable Energy

Big Oil’s decision to limit the growth of capital invested in discovering new oil fields puts the United States in a precarious position. Our transportation system, economy, and way of life, depend on oil. While Big Oil fiddles with its wait and watch approach, the global economy is on the cusp of falling into a major recession. Big Oil has wielded tremendous power in shaping our energy policy and now they seem content to watch while our economy unravels, and we ship our wealth to countries amicable to our national interest.

The best way of unshackling ourselves from the vagaries of the international oil market, and gaining technological leadership in the energy market, is to focus on renewable sources which are not dependent on fossil fuels. This is where Big Oil companies can pay a leadership role.

If history is any guide, initiatives to drive the adoption of renewable energy sources, will face a big political challenge by Big Oil. As long as the interests of Big Oil companies’ are completely opposite to those of renewable energy companies, the growth of renewable energy companies will be stinted. However, if the Big Oil companies develop a stake in the progress of alternative energy projects, they are likely to show less opposition.

One is tempted to argue that Big Oil companies have no business dabbling in alternative energy and by returning capital they allow their existing shareholders to determine where to invest. If they feel that alternative energy has as future, let them invest in that sector. Though this sounds good in principle, the dynamics are quite a bit different in real life. The percentage of investors who will sell their Big Oil holdings and then invest them in alternative energy resources is going to be small. Since many alternative energy companies are private, most investors can not invest in them. Since the total market capitalization of alternative energy companies pales in significance with Big Oil, a rush of capital into those companies results in speculative equity valuations, which will deter the buy and hold big-cap buyer who invested in Big Oil.

Any potential capital reallocation of investment from shareholders of Big Oil companies to alternative energy companies cannot be as effective as direct investments by companies which are already major players in the energy industry. With the precarious situation we are in, we do not have the luxury to see whether the capital reallocation will occur in a timely fashion.

Last but not the least, Big Oil has benefited immensely from the patronage of the United States foreign and military policy. At a time when the industry is making mind-boggling profits, it behooves it to help the United States and her residents, and not just the short-term interests of her share-holders.

Government Spending and Big Projects

While no one likes to pay taxes, it is easy to forget that the government has a big role to play in spurring major innovation and increasing the adoption of newer technologies. The Manhattan Project, the Apollo moon-landings were all government funded projects which have transformed the world as we know it. The technological superiority of our armed forces is a result of massive government spending.

Right now ensuring our future energy security is of vital national importance. Due to our extreme dependence on foreign oil, we have put our self in a situation where traditional free market mechanics will be unable to fix the situation quickly enough; the fact that Big Oil is not keen on spending capital to find new oil does not help the situation either. To set things in perspective, the head of the state-owned Russian oil company Gazprom, greeted us on our Independence Day with a restatement of his view that oil is likely to hit $250/barrel and natural gas will trade at $1000 per 1000 cubic meters.

Encouraging Big Oil to Invest in Renewable Energy

The next question which arises is that where we will find the money to fund initiatives to accelerate the adoption of renewable energy. I feel that ensuring that Big Oil companies participate in that project is a key to its success. If Big Oil does not have a skin in the game, they are unlikely to change their ways and will use their financial and political muscle to defend oil’s share in the US energy markets.

This is where the current proposal to force Big Oil companies to invest in alternative energy resources comes into play. The crux of the proposal is that unless Big Oil invests in alternative energy resources, they will have to pay 25% windfall profit on excess profits; the level of excess will be determined by looking at the current oil price versus the oil price in the recent past.

Comparison with the Carter-Reagan Era Bill

The knee-jerk reaction to any windfall profit on oil is to compare with the failed windfall profit tax imposed by President Carter’s administration. A comprehensive analysis of that tax is available from the House Republican whip’s Office. The Carter era tax was passed as a quid-pro-quo for deregulation of the energy markets in an era of high oil prices, to pass on some of the resulting profits back to the people of the United States who are the eventual owner of its national wealth.

Critics of the Carter-era windfall profit bill say that the bill succeeded in reducing domestic oil production since it reduced the incentive for Big Oil to explore domestic oil fields when they could import foreign oil which was exempt from the tax. The critics ignore the fact that domestic oil production had already been declining since reaching a peak in 1970 of 3,517,450,000 barrels. It had dropped to 3,146,365,000 by 1980 when the windfall profit tax was initiated. In fact, Oil production actually rose to 3,274,553,000 barrels in 1985 before starting another downward trend which has continued till today.

Further the critics discount the fact that the 80 and the 90s was the era of cheap Saudi oil flooding the world market reducing the incentive for domestic oil exploration. President Reagan replaced President Carter in 1982, but he did not see any need to repeal the act which continued till extremely low oil prices made the tax meaningless in 1988.

The current bill is dramatically different from the Carter-Reagan era bill both in its structure and goals. Specifically:
1. Oil companies can avoid paying these taxes by investing in renewable energy and refinery expansions.
2. The tax rate on excess profit is 25%, and not as high as 70% as it was on the Carter Era Bill.
3. The money collected from the new tax will go to a fund focused on expanding renewable energy sources and reduce our dependency on foreign oil
4. Any profits gathered by Big Oil from investments in renewable energy will be exempt from the tax

Further, the world energy situation is dramatically different today. Saudi Arabia no longer has the capacity to flood the world with cheap oil, while demand for energy is sky-rocketing as billions in Asia integrate with the world economy. The price of oil has gone up so much that even if companies pay a 25% excess tax, they will still reap huge profits on every barrel they are able to extract.

Boarding the Alternative Energy Train

With the dramatic growth in world energy demand, it is almost a foregone conclusion that fossil fuels cannot continue to be the primary source of the world’s energy needs. However, on June 11, 2008 when sponsors of the bill which would tax windfall profits could not get enough support to bypass a Republican filibuster, another bill which would have extend expiring tax breaks in support of wind, solar and other alternative energy projects, and for the promotion of energy efficiency and conservation also failed to progress. If nothing else, the failure to extend existing credits on alternative energy and conservation points to the immense power wielded by Big Oil (and of course partisan politics), highlighting the need to co-opt the oil industry in our pursuit of alternative energy.

Four decades ago, the area now famous as the Silicon Valley, was full of fruit orchards. Now it is home to the highest median home prices in the nation, which continue to rise even in the current housing downturn. There is nothing which prevents the current centers of the oil industry in becoming the Energy Alley to the world, if Big Oil is willing to take a longer term view.

Right now Google with its RE ]]> http://multithreader.com/TheInquisitiveMind/2008/07/07/can-big-oil-balance-shareholder-interest-against-national-interest/feed/ http://multithreader.com/TheInquisitiveMind/2008/07/07/does-big-oils-apathy-justify-proposals-to-tax-windfall-profits/ http://multithreader.com/TheInquisitiveMind/2008/07/07/does-big-oils-apathy-justify-proposals-to-tax-windfall-profits/#comments Tue, 08 Jul 2008 00:44:12 +0000 BMWFan http://multithreader.com/TheInquisitiveMind/?p=38 Crude Oil’s relentless march towards the near term spike target of $150 is now threatening to send the Global Economy into a recession. Big Oil companies (Exxon-Mobil (XOM), Chevron (CVX), Royal Dutch Shell (RDS.A), BP (BP) and ConocoPhillips (COP)) are in the thick of the controversy as the rising price of oil has seen their profits sky-rocket. Congress smells an opportunity to cut the Federal Deficit and score election year brownie points, and is pondering legislation to impose windfall taxes on Big Oil companies. As expected these bills did not garner enough support to even get to a vote in the Senate and break the Republican filibuster.

Many conservatives and pro-business commentators are aghast at the thought of taxing excess profits. Big Oil companies have increased their public relations campaign against any windfall taxes. Their supporters point out the following:

1. The profit margins of Big Oil companies are not very high compared to other large corporations. Karl Rove recently published an opinion piece in the Wall Street Journal where he dismissed the claims of excess profits by focusing on the fatter profit margins in the technology industry (between 14.5% and 27.5%) versus those in Big Oil (8.3%)

2. Big Oil companies control just 10% of the world’s crude supply. They buy the rest of the crude in the open market and pay market prices.

3. Taxing Big Oil profits will deter them from making future investments in developing new fields which will further exacerbate the supply squeeze.

4. And finally the fundamental principle that in a capitalist society, the government has no business to determine how much profit is too much.

In this article I will explore the broader context in which the oil industry operates with a focus on our Government’s energy policies.

Energy Security and International Politics

Energy security is one of the cornerstones of any major nation’s military and foreign policy. In the early part of the 20th century the discovery of easy to extract oil within the US, and the adoption of the internal combustion engine, meant that oil became a cornerstone of US energy security. Oil is easy to extract, convenient to store and transport, has a high energy density, and allows vehicles to go hundreds of miles before a fill-up. Americans love their automobiles, and for a long time, the fate of US economy was closely associated with the fate of Detroit’s automobile industry.

As the American economy expanded, the gap between demand and domestic production started widening and secure access to foreign sources of oil became a corner stone of our foreign policy. The Middle-East with its vast oceans of oil has been a focus of our foreign policy since WW-II.

As early as 1953, the CIA’s station in Tehran, headed by the grandson of President Theodore Roosevelt, Kermit, led the effort to oust Iran’s Prime Minister Dr. Mosaddeq, when he threatened to nationalize Iran’s oil resources. After the 1970s oil shock and the Islamic Revolution in Iran in 1979, Saudi Arabia flooded the world with inexpensive oil in exchange for our military umbrella. Saudi supply kept oil prices depressed affecting countries like Iran and the Former Soviet Union. The financial shock of oil at $20/barrel helped get the FSU, a major energy exporter to her knees; they could not keep up with President Reagan’s strategy to spend big on strategic initiatives, leading to the eventual collapse of the FSU.

Today Indian and Chinese oil companies are jockeying for drilling rights all over the world, often bidding up the price of fields. China has been turning a blind eye to Human Rights violations in many parts of Africa, as they rush in to lock in access to oil and other basic materials.

Worldwide more than 80% of oil resources are nationalized; oil continues to shape the economic, foreign and military policy all over the world. Only the truly ingenuous will pretend that oil trades in a free-market and governments have no role to play in it.
Energy Policy: Captive Market for Oil Companies

Our domestic government policy has created a situation, where Big Oil companies have a secure, captive market for their products. Our policies, heavily favors the use of oil based private means of transport versus public mass-transit systems.

We have a nationwide highway system which brings a huge country together. However, passenger trains are neglected; Amtrak continues to be on life-support depending on Congressional bail out every few years. Unlike Europe where trains are the primary means of travel between cities, we prefer to fly even along the densely populated North Eastern sea-board. Our system is a lot more energy intensive compared to other parts of the developed world.

Congress provides a variety of subsidies, both direct and indirect, to keep our oil based transportation system rolling. Whether it is investments in highways (versus rails) or tax subsidies for oil companies, our policy is focused towards an oil based economy.

In the past there was little government support for alternative energy systems which would wean us away from our oil based economy. California took the initiative to legislate the use of electric cars, but without any Federal support and an unsupportive automobile industry, the initiative died a slow death. Subsidies to encourage the use of photo-voltaic solar cells lag those in Western Europe; the solar industry has to battle it out continue subsidies every year or two.

Though the US was a pioneer in the development of nuclear technology, our policies have not encouraged the use of nuclear power and no major plant has been built over the last three decades. This is in contrast with France which gets about 80% of its electric power from nuclear plants.

Thanks to the decades of government driven investments in the oil based infrastructure, changes in energy usage pattern require will take a lot of time to happen. As oil prices rise, Americans living near metropolitan areas can alter their lifestyle to reduce their use of the automobile. However, rural America will continue to have a dependency on the automobile. Rural areas have a low population density which makes mass-transit unfeasible; plus the distances are vast and require a personal vehicle

Our way of life depends on oil, just as human beings need air, water, and food to survive. As long as Big Oil can find and distribute oil, they are guaranteed to make a profit on every gallon sold. Big Oil’s role in the economic landscape is more akin to a grocery store distributing staples, than technology companies producing discretionary items.
Big Oil and Exploration Risks

A major task for Big Oil companies is exploration, and development of new oil fields. However, over the past few decades, Big Oil’s share of world-wide oil production has rapidly declined and now stands at 10%. Clearly, Big Oil is in not investing enough in discovering new resources.

A bulk of Big Oil’s capital expenditure goes into finding new ways to extract oil from existing oil fields. While soaring oil prices lead to big profits for Big Oil, the total expenditure on exploring new oil fields went up to just $10B in 2006 compared to $6B in 2003 even though the replacement rate of oil reserves has been plummeting and has fallen below 100%.

One reason that Big Oil is unable to invest in exploration is the strong presence of nationalized oil companies which now control the exploration rights. However, many times nationalized oil companies from other major importing nations like India and China, bid for drilling right in foreign lands, and Big Oil rarely, if ever comes into the picture. Even within the US, Big Oil companies are drilling on a fraction of the Federal land they have drilling permits for; only 28% for on-shore permits, and an even lower 20% for off-shore permits.

Big Oil companies are now content in acting as processors (refinery) and distributers of oil based products, rather than pioneering explorers who invest a large amount of resources in finding new fields.
Big Oil: Microsoft or Safeway?

Comparing the profit-margins of Big Oil with those of large technology companies like Microsoft (MSFT) is not fair. After defense, oil industry gets the most assistance from our government. American soldiers put their lives on the line every day in Iraq to ensure our long term Energy Security and help Big Oil. Microsoft loses Billions of dollars due to software piracy but we do not hear any news about our Armed Forces invading another country to prevent software piracy!

Currently Big Oil is operating in the grocery store model where they process and distribute oil, but do not take much risk in the process. Why shouldn’t the profit margins of Big Oil be like those of grocery stores (low single digits)?
Big Oil and Alternative Energy

Another area where Big Oil has severely underinvested is the Alternative Energy area. Exxon-Mobil has pledged to spend around $10M/year for the next ten years to spur Research and Development in renewable resources. To put this number in context, Exxon-Mobil spent $31B in stock-buybacks and paid its CEO in excess of $50M last year. Their entire renewable energy budget is five times less than the CEO’s annual compensation!

In fact Big Oil is spending more money in ad campaigns which will help build their green credentials, than they spend on efforts to develop renewable energy. The irony of the situation is not lost to a few of Exxon-Mobil’s largest shareholders, the members of the Rockefeller family. They recently proposed changes to increase Exxon-Mobil’s focus on increasing investments in renewable energy, and lowering emissions, but the resolution failed to pass at the annual shareholder meeting earlier this summer.
Pay-back Time?

As a strong believer in free markets I also agree with those who are aghast at the prospect of the Congress determining profit margins. Though I do find the idea of windfall taxes abhorrent, a deeper look at the structure of the new bill reveals something less ominous.

The proposed Consumer-First Energy Act would create a 25 percent windfall profits tax on companies that don’t invest in renewable fuels or electricity production. It also would zero out some $17 billion in tax breaks for the oil industry and use the revenue to help consumers by investing in an Energy Independence and Security Trust Fund.

Big Oil has taken very little initiative to either strengthen our energy security by investing in exploration or pursue alternatives which will reduce our dependency on foreign oil. The bill will force Big Oil to invest in renewable energy resources to reduce our dependency on foreign oil, or lose out on recently granted subsidies and pay a larger percentage in taxes.

It is indeed a sad day when we need Congressional laws to force Big Oil to help alleviate our energy crisis. The US government has spent billions of dollars to help Big Oil function and thrive; our Armed Forces have made immense sacrifices to provide access and security to Big Oil operations; our domestic policies guarantee Big Oil a captive market; government subsidies provide Big Oil with billions in tax breaks. However, even their major shareholders like the Rockefeller’s feel that Big Oil needs to do more in return; investing 20% of its CEOs annual pay in renewable energy research is just not enough. By completely ignoring their social and patriotic responsibility, Big Oil has pushed things too far.

Big Oil was asking for it; they are now going to get it.

Close at the heels of the SPR bill, the current Farm Bill has provisions which will plug the so-called ‘Enron Loophole’ which allows speculators to bypass regulations regarding position limits enforced by the Commodities Futures Trading Commission [CFTC]. The bill again passed with a veto-proof majority.

This bill empowers CFTC to monitor trading on electronic platforms, like the Atlanta based Intercontinental Exchange (ICE), which presently is outside the purview of the CFTC. ICE, and other similar exchanges, will have to limit the number of contracts a single investing entity can own and will require large traders to report their positions.

Margin Requirements

There are also some rumblings to increase margin requirements for energy futures trading. Right now speculators need to put between 5-7% cash margin to trade crude oil futures. This provides a huge amount of leverage and which stands out in contrast to the 50% margin typically required for stocks. Low margin requirements are a useful tool for commercial hedgers to manage their exposure without undue financial burden. However they also permit speculators to control a huge amount of oil supply with a significantly lower financial outlay.

Increasing margin requirements will reduce the degree to which speculative money can influence the price of oil. Ideally, the exchange should adopt a two-tier system which enforces one set of margin for commercial hedgers who take physical delivery of crude oil, and speculators who do not take physical delivery. The margin for speculators should be significantly higher than commercial hedgers; some observers have suggested even 100% margin requirements!
Investor Classification Conundrum

Another area of review should be the classification system used by the Commitment of Traders report which breaks down positions between commercial hedgers and speculators. Over the past few years banks like Goldman Sachs have offered total return index swaps, linked to commodity indices, which allow investors to speculate in the commodities market. With the commodities market outperforming other asset classes like equities, bonds and real estate, a large number of institutional investors, including large pension funds like Calpers have invested in index linked products. The banks have been selling these products under the umbrella of asset diversification and passive index based commodity exposure exceeds $250B today. Bloomberg carried an article by Caroline Baum, with a detailed discussion of how these positions are showing up as commercial hedges instead of the speculative positions, since they are traded via the intermediary bank, even though the original investor is a pure speculator.

Presently, the Commitment of Trader reports show that commercial hedgers are net short while speculators are net long. The true picture will be even more distorted if the effect of the money invested via passive index funds is considered. As Ms. Baum put it, this is a classification conundrum; this should be resolved before creating a two-tier margin structure.
Sour Crude: Refining Capacity to Spike Up

Earlier this week, crude oil rallied on NYMEX trading on the news that Iran was thinking of cutting production. Further investigation revealed that Iran has run out of storage facilities and is renting tanker ships to store its crude oil off-shore, while it waits for buyers. Iran is one of the largest producers of sour crude oil, which has a higher Hydrogen Sulphide content than the Light Sweet Crude.

Sour crude is better suited for producing distillates products like diesel, jet-fuel, gasoil and heating oil. Heating oil, which is often treated as a trading proxy for distillates, has been on a tear lately due to shrinking stockpiles in Europe. The shortage is being attributed to seasonal maintenance related shut-down in refineries. However, with all news being bullish, traders bid up crude oil, including the sweet crude contract traded at the NYMEX following the run by heating oil. However, the shortages in distillates are likely to end soon as a new mega-refinery comes online to soak up the sour crude piling up in the Gulf.

In July, Reliance Industries, the petro-chemical giant based in India will be bringing its second large refinery on-line. This refinery has a capacity to process 580,000 barrels of oil per day. Further it is designed to thrive on sour crude, and not only produce the traditional distillates but also high quality purified gasoline which means tight Western standards. This refinery will go a long way in increasing the uptake of sour crude and reduce the pressure on sweet crude.
Russia: What Decline?

The fear of drop in crude oil output from Russia is one of the key drivers of the peak-oil scare and the current bull-run. Over the past week Russian leaders have come out swinging, addressing concerns about oil production. Putin has pledged to extend tax breaks to companies exploring for oil beyond the current Eastern Siberian region. Russian tax policy was seen as the key barrier to the growth of the Russian oil industry since it discouraged investment. Deputy Prime Minister Igor Sechin went on to say that he does not expect a decline but an increase this year. These statements sent the RTX, the country’s benchmark stock index, to a record high of 2,406.05, surpassing the previous high hit last December.

It will be interesting to see whether this news affects the bullish sentiment in the oil trading pits. The June contract traded in a $6 band on Thursday, with the June futures options expiration adding to the volatility introduced by the Farm Bill.

Proxy Fight: Complete Slate of Directors
Mr. Icahn will try to replace the entire board of directors at Yahoo with his nominees. The Wall Street Journal reports that Mr. Icahn has hired D.F. King a proxy company, to facilitate the solicitation. The move to seek a complete slate came as some surprise since typically activists investors have a much easier time getting shareholder support for a partial slate of directors.

Since the Yahoo Microsoft takeover saga has been going on for more than three months now, it is likely that a significant number of Yahoo shares are now held by merger arbitrage funds that will be eager to see the deal closed. Further given the premium Microsoft was willing to play, and the deterioration in Yahoo’s competitive situation, even non-activist shareholders are likely to press for the consummation of the deal.

Yahoo’s Competitive Situation

Yahoo has pinned its hope on the Panama Ad System to improve the profitability of its search advertising business. The launch on the Panama was used as a justification by Yahoo to decline Microsoft’s overtures at $40/share a couple of years ago. However, Yahoo has been losing share to Google and its search advertisements generate significantly less revenue than what Google does. Comscore today reported that Google has overtaken Yahoo as the most popular web destination in the US.
During the takeover battle, Yahoo had set up a trial with Google, where it outsources the advertisements generated in response to search queries to Google’s ad engine. The results of this trial were considered positive and there are whispers that Yahoo will sign a longer term deal with Google.
Though a deal with Google will help Yahoo’s bottom-line in the short to medium term, it will be an admission of defeat by Yahoo. Over time, it is likely that Yahoo’s role as a search engine will diminish, and this will further strengthen Google’s grip over the market.
Google’s Perspective: Not a Done Deal
From Google’s perspective, a deal like this will not only attract unwanted anti-trust scrutiny but will also expose its trade secrets to Yahoo. Since Yahoo will not shut down its own ad platform, it can use the information it gathers from Google to improve the quality of its own products. There are reports that such concerns are being raised within Google, especially since Yahoo’s fate is uncertain and the secrets might end up in Microsoft’s hands.
Google did act as a good neighbor to help fend off Microsoft with the trial. However, they need to weigh the risk of exposing their trade-secrets, and possible anti-Trust investigation, against the prospect of competing against a combined Microsoft-Yahoo. Google has beaten these well funded competitors before and in the short term the merger related distractions between Microsoft-Yahoo will help Google to strengthen its position even further. Since the entire online advertisement space is very dynamic, there is no guarantee that any prospective synergies which evolve out of Microsoft-Yahoo will hurt Google more in the long-run.
Google is going to be a reluctant partner in any comprehensive deal with Yahoo. They might do enough to provide Yahoo’s management with the fig leaf to rebuff Microsoft’s advances and ward off unhappy shareholders. But it is unlikely that they will lay bare their bag of secrets to Yahoo, in the long run.
Mr. Icahn’s Strategy: Put Pressure on Yahoo’s Board?
Mr. Icahn’s decision to go for the full slate of directors suggests that he wants a quick resolution to the merger saga. Mr. Icahn knows that he has to strike before Microsoft decides to overpay for another web firm, while rebounding from Yahoo’s rebuff. On the other side, he cannot give Mr. Yang to find other suitors to complicate the Microsoft bid.
Mr. Icahn’s proxy bid put Yahoo’s current board in a tricky situation. Their role in this entire saga has been under immense scrutiny. Getting voted out in such a high profile proxy fight, will not do any good to their reputation as senior business leaders.
However, it is also clear that Yahoo’s biggest shareholders, the co-founders Mr. David Filo and Mr. Jerry Yang (CEO) did not inform the board of Microsoft’s revised offer of $33. Further though they were authorized by the board to accept an offer of $37, they asked Microsoft for at least $38. There have been whispers about dissent within Yahoo’s board regarding Yahoo’s handling of Microsoft’s offer. Mr. Icahn’s proxy bid might provide the spark needed for Yahoo’s current board to become more assertive and force a new dialogue with Microsoft.
Microsoft’s Strategy
During the past two weeks, Microsoft has not made any new statements about their interest in Yahoo. Officially, they claim to have moved on, with Mr. Ballmer having given up on Mr. Yang. The Wall Street Journal reported that Mr. Icahn has not received any response from Microsoft to his overtures but has still decided to proceed with the proxy fight.
However, the business case for the merger remains as strong as ever. Microsoft’s last quarter’s earnings exposed the cracks in their armor and they need Yahoo to have any hope of being a viable competitor to Google. Microsoft will keep quiet since they do not want to encourage any discussions on price. Further, by distancing themselves from the proxy battle, they are less likely to alienate the rank and file of Yahoo.
However, if Microsoft sees that Yahoo is indeed serious about the merger, they are likely to return to the table, and perhaps offer even more than the $33 they verbally communicated to Mr. Yang.
Mr. Icahn: The Counselor

Business observers have noted that both Microsoft and Yahoo mishandled the merger negotiations quite badly. Mr. Ballmer’s threat to withdraw the offer and Mr. Yang’s efforts to undermine the board did not show the level of maturity expected from powerful business leaders.
Mr. Icahn might just be the right pre-nuptial counselor for both Mr. Ballmer (who needs lessons in the art of courtship), and the Mr. Yang (who needs to be reminded about his fiduciary responsibilities). My bet is that Yahoo’s existing board will work with Mr. Icahn to reopen negotiations with Microsoft and a deal will be struck in the mid $30s.

All the News is Bullish
It is clear that the market has an incredibly bullish tone after Goldman Sachs’ call for a super-spike which could take oil to as high as $200/barrel in the next 6-24 months. The market is focusing only on the good news and ignoring anything bearish.

Today’s rally came in spite of news that IEA had again cuts its forecast for demand for crude-oil (to 1.03 million bpd); the current estimates for growth of oil demand are more than 50% less than the forecast put out in July, 2007 (2.2 million bpd). The IEA expects a further reduction in the forecast as high crude prices, and a slowdown in the developed economies are likely to cut demand further. There is even talk of reduced demand projections in the non-OECD oil importing countries (emerging economies), since the cost of subsidies is sky-rocketing and can no longer be sustained by their respective governments.

Even in oil exporting countries, where gas often sells for less than a $1/gallon, the government is bearing the cost of lost export revenues at prices which are almost an order of magnitude higher. Iran, OPEC’s second largest oil producer, imports 40% of its gasoline.

Iran & Venezuela: Flag Bearers of the $200 Oil
Another factor contributing to the rally was a news report which suggested that Iran was seeking a cut in its crude oil output. This news of impending cuts was later refuted, though the Iranian spokesman did confirm that some discussions had taken place.

Earlier this month, Iran’s oil minister had made statements that disruption in Nigeria and the weak US dollar meant that crude oil could reach $200. Not the one to be left out, Mr. Chaves of Venezuela had declared that oil would hit $200 if the US attacked Iran.

Both Iran and Venezuela rely on their oil exports to fund their local economy; a fall in oil revenues can have a drastic effect on their ruler’s ability to continue to rule.

Goldman’s Long Term Projection: $75 in 2012?
Lost in the bullish talk of $200 oil was Goldman’s notes about demand destruction. The same report which predicted the super-spike also said that by 2012 the price of crude oil would fall to $75 normalized. Goldman expects the current euphoria to lead to a spike in crude oil prices, which will spur new supply development and also lead to permanent demand destruction.

OPEC has been using volatility in the oil market as a tool to limit the development of new oil fields. Volatile oil prices discourage investments in new oil fields if the cost of extracting the oil is significantly more than the current fields. Volatility keeps the average price of crude reasonably high, but the sharp dips in oil price make big investments in more expensive fields risky.

However, with oil projected to remain close to the $100 mark, a lot of these undeveloped fields will now become financially viable. Advances in technology also mean that oil sources like oil sands, shale oil and deep-sea oil, which were once considered too risky can now be harvested at a competitive cost.

In this article I shed some light on how high oil prices are resulting in a dramatic change in the energy industry and politics. High oil prices are accelerating the adoption of alternative energy resources and may signal the emergence of a new kind of peak oil fever: Peak Demand.

Political Rumblings: Congress Acts
The United States Senate today voted to approve a bill which will prevent any new additions to the Strategic Petroleum Reserve until crude-oil falls to $75, and stays below that level for 90 days at a stretch. The bill passed in the senate with a 97-1 margin which puts beyond any presidential veto.

Though the impact of the 70,000 barrels per day which are put into the SPR everyday is going to be minimal, it signals a shift in the political landscape where President Bush’ significant opposition for any interference with the SPR is being steam-rolled. The vote comes at just as President Bush begins a tour of the Middle-East and sends a message to the oil exporting countries of the region to take his requests to increase supplies seriously.

The vote is significant because it signals a shift in oil politics, and may be a harbinger of a complete overhaul of US energy policy after the Presidential election is over and the Corn Belt vote becomes less important.

Emerging Economies: Subsidies under Scrutiny
In the emerging economies of India and China, the cost of oil subsidies is becoming a significant economic issue. There is a limit to which the governments can subsidize petroleum products and like the developed economies higher fuel prices are likely to result in demand destruction or at least much slower growth than what may be priced in.

In China subsidies given out to oil companies for imported oil were at $45B and accounted for 5% of the government’s total revenue; they were as high as $87B if domestic production was also accounted for. The government of China is reluctant to pass on the increase to keep a lid on inflation. They also want to ensure that the summer Olympics do not suffer from any Energy shortages. But once the show is over, expect the Chinese government to start taking measures to increase the elasticity in the demand of oil by passing on the price increases.

In India, the price of gasoline (petrol) is close to what we pay here in the USA, but the price of distillates like diesel and kerosene is subsidized. Though it is unlikely that the subsidies on diesel will disappear, the gasoline and jet-fuel prices are likely to move higher.

New Discoveries and Supplies Coming On Line
A big contributing factor to the current bloom in the oil complex is the fear of peak oil production. There is a lot of talk about the gap between available spare capacity and demand narrowing, with demand likely to exceed supply soon. A lot of these forecasts tend to discount the discovery and harnessing of newer oil fields in non-traditional regions of the world.

Case Study: Brazil Deep Sea Fields
Amid the oil patch euphoria last week, Brazil’s state-owned Petrobras announced that it will start producing oil from the 8-billion barrel Tupi oil field in 2009, a year ahead of schedule. Brazil which is already a leader in ethanol harvested from sugar-cane (which does not come with the baggage associated with corn based ethanol) now wants to join OPEC!

The news about the production from the Tupi fields was a pleasant surprise since a lot of the peak oil proponents were very skeptical of the massive deep-sea finds off the coast of Brazil. The nearby Carioca oil fields could contain 33 Billion barrel equivalents and could be the world’s third largest oil field.

Case Study: India’s Deccan Traps
India’s state owned Oil and Natural Gas Corporation [ONGC] reported that it has found oil and gas bellow the Deccan Traps. The Deccan Traps, considered to be 65 million years old, consist of marine sediments uplifted during the formation of the Himalayas which were subsequently covered by hard volcanic rock. Most of the world’s oil is found in Mesozoic formations, and geographical surveys have found sub-trappean Mesozoic-Gondwana sediments with a maximum thickness of 3 km (2 miles) in this area.

This is the first time ONGC decided to explore this region which has long been considered to have huge potential but never explored since it lies below layers of deep and hard rock. The research paper about this study is available online. According to the former Indian oil minister, Mani S. Aiyer, this area can have more oil than the Gulf.

Though it is clear that harvesting deep-sea or Deccan Trap oil is going to be a lot more expensive than harvesting oil from the deserts of the Middle-East, at a $100/barrel, these ventures can be commercially viable.

Alternative Sources
High energy prices are also driving investment in alternative sources, especially renewable carbon neutral resources like wind, solar and hydro-electric power. Since most of the oil consumed in the US goes into transportation, electricity from renewable sources cannot be pumped in directly into the transportation network. Though electric cars are also coming they still have limitation when it comes to range and performance, which limits their utility.

On the other hand ethanol can easily replace gasoline in cars and will require a less drastic change in our lifestyle.

Ethanol: Getting over Corn
Ethanol is widely being touted as a renewable fuel which can replace petroleum when it comes to transportation needs. In the United States ethanol is being produced using corn as the input. Since corn is starch and needs to be converted into sugar before being fermented to alcohol, the cost of producing corn based ethanol is high.

It is estimated that the energy produced by corn-ethanol is just 1.3 times the energy consumed. In contrast sugar base ethanol produces 8 times the energy used to produce it. The use of corn for ethanol has driven up food prices and is being blamed for inflation.

After the election is over, there is expectation of big changes in US ethanol policy. It is likely that the high import-duty on sugar cane based ethanol (54c/gallon) will see its end, making Brazilian sugar-ethanol a viable alternative in the USA.

The following table taken from Wikipedia shows how sugar-cane ethanol is a cost-effective alternative to oil. One important item to note is that Brazil has 23% of the world’s arable land and at least 40% of that land is not being used and this is without any rain-forests being destroyed. Sugar cane is one of the most efficient crops when it comes to capturing solar energy and can be grown in a large part of Brazil and other semi-tropical regions.

Comparison of key characteristics between
the ethanol industries in the United States and Brazil
Characteristic Brazil
U.S.
Units/comments
Feedstock Sugar cane Maize Main cash crop for ethanol production, the US has less than 2% from other crops.
Total ethanol production (2007) [32]
5,019.2 6,498.6 Million U.S. liquid gallons

Total arable land [45]
355 270(1) Million hectares.

Total area used for ethanol crop [45][51]
3.6 (1%) 10 (3.7%) Million hectares (% total arable)

Productivity per hectare [45][35][51]
7,500 3,000 Liters of ethanol per hectare. Brazil is 727 to 870 gal/acre (2006), US is 321 gal/acre (2005/06)
Energy balance (input energy productivity) [37][51][73]
8.3 to 10.2 times 1.3 to 1.6 times Ratio of the energy obtained from ethanol to the energy expended in its production
Estimated greenhouse gas emission reduction [44][51][74]
86-90%(2) 10-30%(2) % GHGs avoided by using ethanol instead of gasoline, using existing crop land.
Ethanol fueling stations in the country[35][36]
33,000 (100%) 873 (0,5%) As % of total fueling gas stations in the country. U.S. has 170,000 (see Inslee, op cit pp. 161)
Fuel ethanol used by the road transport sector [39][38]
20%(3) 3.6% As % of the sector’s total on a volumetric basis for 2006.
Cost of production (USD/gallon) [35]
0.83 1.14 2006/2007 for Brazil (22¢/liter), 2004 for U.S. (35¢/liter)
Government subsidy (in USD) [45][36]
0 0.51/gallon U.S. as of 2008-04-30. Brazilian ethanol production is no longer subsidized.
Import tariffs (in USD) [37][35]
0 0.54/gallon As of April 2008, Brazil does not import ethanol, the U.S. does
Notes: (1) Only contigous U.S., excludes Alaska. (2) Assuming no land use change. [74] (3) Excluding diesel-powered vehicles, ethanol consumption in the road sector is more than 40% [35][36]

Brew your Fuel @ $1/gallon and Run your own Station!
A Silicon Valley start-up, EFuel100, has come with a washer sized fermenting machine which you can use to brew your own ethanol using sugar. With Federal tax breaks and E-Fuel carbon credits, they estimate that you can brew your own ethanol at about a $1/gallon. Their machine can also take discarded alcohol and generate ethanol at 10c/gallon! The machine costs less than $7000 after Federal rebates, and if gas continues to be close to $4.00, can pay for itself over 2300 gallons (or 46,000 miles @2mpg).

The machine comes complete with a 50 ft pipe and a fueling nozzle which allows you to pump as much ethanol as you would like to use. The company expects users to blend ethanol into regular gas. For those who want to kick the gas habit completely, conversions kits are available which can allow your car to run on 100% ethanol.

(Picture taken from www.efuel100.com)

OPEC: Who is in Control?
In the past decades Saudi Arabia was the leading voice in OPEC and helped manage supply and demand. With their immense reserves, the Saudis had the ability to suppress any dissent when it came to supply increases. Over the past decade, the maverick regimes of Iran and Venezuela have become vocal powers within OPEC. These nations’ economies are strongly dependent on oil revenue and short term spikes in oil prices help them strengthen their power. However, this approach is short-sighted. The oil spike is likely to accelerate the development of alternative fuel technologies, energize efforts to develop new fields, and eventually result in a peak in the demand for oil; especially exported oil.

Iran has run out of storage capacity and is hiring tanker ships to store oil off-shore. They cannot find buyers for their crude production at the current price, and the rental rates for oil-tankers is spiking. Perhaps this is a sign of things to come which other OPEC members should pay heed to.

The surge comes at a time when OPEC said that the oil markets are well supplied and unlike what is reported by many observers, there is at least three million barrels per day of spare capacity available. OPEC chief went on to say:

“Crude oil movements indicate that some member-countries are unable to find buyers for their additional supply,” he said.

Commodities as an Asset Class

Over the past few years a number of new financial instruments have come out which allow the average investor to add commodities to their portfolio. Investments in funds which track commodities have increased to $250B, up $71B from the start of the year. The ETF USO which buys US oil futures contracts has about $620M in assets and currently holds 5016 oil futures contracts corresponding to more than five million barrels of crude oil. These investments are all speculative; the holders of USO never intend to take possession of the crude oil.

This divergence shows up in the commitment of traders report. Commercial hedgers are net short; speculators are net long crude oil. Oil producing nations are commenting upon this phenomenon too.

Oil’s gain to almost $120 a barrel is caused by speculation by investors, OPEC members Kuwait, Libya and Qatar said yesterday. “The fundamentals aren’t controlling the price,” Kuwait’s acting oil minister Mohammed al-Aleem said in an interview.

Stocks versus Commodities

Bubbles in equity markets are common. By their very nature equity markets are speculative and tend to overshoot in both directions. With access to commodity market with stock like instruments, the commodity markets are also showing similar speculative behavior. However unlike stocks commodities have different market dynamics. Further unlike spikes in equity prices, the price of commodities has far reaching implications.

Little Short Term Elasticity in Oil

Stocks have elasticity on both the supply and demand side. Companies can do stock buy back when they feel their shared are undervalue. They can also issue more stock if they believe that they can have a better return on equity on the newly raised capital. Investors in stock sell when they believe the price is high reducing demand; they can buy if they believe the supply is more.

On the other hand, both the supply and demand elasticity of oil is limited in the short term. It is hard for users to change their energy usage patterns in the short term; the situation is further exacerbated with subsidies for oil in the emerging economies. Similarly it takes years to bring new oil supplies online.

Economic and Geo-Political Impact of High Oil Prices

Speculative bubbles in commodities have a serious, direct impact on the life of the common man on Main Street. Bubbles in stocks do not have the similar, negative effect.
1. Commodities are not paper assets; they can lead to drastic change in the life of people, especially in emerging economies. People cannot do without commodities; most people in the world do not care about the stock market.
2. Commodity prices are resulting in a net transfer of wealth between nations. Right now, many of the oil exporting nations are not amicable to US interests. High oil prices translate to the US funding its foes.
3. Energy prices are a tax and they will have a damaging effect on economic growth all over the world.

Futures Market: Marginal Barrel and Speculation

The price in any market is determined by the marginal trade. Due to the lack of elasticity in the supply and demand of oil, there can be extreme volatility in the price of the marginal barrel of oil. It is the price of the marginal barrel traded on futures exchanges which determines where oil gets priced at.
When there is a lot of speculative money in the futures market, the marginal barrel can be priced higher and higher, with little consideration to underlying fundamentals. There are some reports that commercial hedgers are watching from the sidelines since they believe that the current oil market is strongly disconnected from fundamentals.
Speculative money also gives oil producers the chance to artificially inflate the price of oil by intervention in the futures market.
Futures Market: Leveraged Effect of Intervention
The price in the futures market of commodities has a leveraged effect. For example the total open interest in the NYMEX June futures around 300K contracts. This corresponds to delivery of 10K contracts per day (10K contracts/day ~ 10 million barrels/day). The total consumption of oil in the US is 20.687M barrels/day. New York market not only serves the US but is used as a trading venue by a lot of international players too; so the total open interest on the NYMEX does not correspond to just US market only. The total consumption of crude oil is at least 83M barrels/day with at least 40% of that corresponding to international trade.
So an oil producing entity can intervene in the futures market to support pricing since they know that it will have a leveraged effect on their profitability. For example, if an entity needs to sell 10,000 barrels a day, you would expect it to sell 10 futures contracts every day. However, instead of selling they can also start buying future contracts at critical technical points. Since oil has a lot of speculative interest, buying at key technical trading levels can ensure that the speculative bubble can continue (see this article on high technical levels affect trading). Speculators by nature are looking at trends and momentum and the producers of oil can help support the momentum.
Ending Speculation

There is no doubt that the speculation is having a big impact on the rate of growth of oil; speculators are net long; commercial hedgers are net short. Since both the supply and demand elasticity of oil is limited in the short term, speculators can continue to push up the price with little risk of downside. The only way to break the trend is to reduce the attractiveness of the oil market to speculators; i.e. to replace greed with fear.
• Increase Margin Requirements: The easiest way to reduce the impact of speculators is to increase the margin requirements for trading in oil futures for non-commercial traders. This needs to be a coordinated effort with all the major oil exchanges in the world.
• Use SPR as a Price Management Tool: The US has 700 million barrels of crude oil in SPR. The Department of Energy continues to fill the SPR even though it is almost full. The DOE can start using the SPR as a price management tool. They can sell futures contracts against the SPR. Well times futures sales can change the sentiment away from greed towards fear and drive speculators away.

Strategic Compulsion for a Short Term Fix

As I had written in the earlier article, many of the oil exporting countries are not friendly to the United States and our interest. At a time when the US economy and the banking system are fragile, the high price of energy can have severe negative impact on the US. High oil prices also contribute to the increased trade imbalance, putting a downward pressure on the US Dollar. Interests not amicable to the United States can undermine the US without firing a single shot, by keeping oil prices high.

The current market system allows oil producers to not only control supply but also intervene in the futures market at critical points to provide support. We need a counter-weight to this which puts some fear in the mind of speculators. In the stock market, there is a saying ‘Don’t fight the Fed’; speculators in the oil markets also need a similar mantra of fear ‘Don’t fight the US’.

There have been some arguments that lower oil prices will encourage use of more oil. Even at $100/barrel oil prices are high enough for oil companies to invest in developing new oil fields. Further there is almost near unanimity in both the political and the investment community that investments in alternative energy is not only essential but will also be profitable. We have reached that critical point, and do not need oil at $125/barrel to drive home the message.

Many analysts are surprised at the current spike in oil prices since many of the factors which were thought to contribute to the rise in oil prices had reversed. The US Dollar has rallied against the Euro over the past two weeks as the Fed has signaled an end to the current interest rate cuts. The supply situation has improved. Even the rebels in Nigeria signaled a willingness to end attacks if former President Jimmy Carter agrees to mediate.

Why the Spike?

The spike in oil is being attributed to a report from Goldman Sachs which discussed the current supply and demand situation. The report noted that while oil supply growth and spare capacity is limited, the demand from emerging economies of India and China shows no sign of slowing down. The report says that it is likely that we will see a major spike in the price of oil, as high as $150-$200 in the next 6-24 months as rampant speculation about supply-demand mismatch creates a bubble and pushes oil prices to stratospheric levels. The report goes on to suggest that speculators are doing the rest of the world a favor, by accelerating the price increase, which will force governments to act and reduce the demand, leading to a subsequent decline in oil down to $75-$100 level.

One reason why Goldman’s prediction might come true is that a lot of emerging markets like Indian/China, which are the growth drivers on the demand side, have fuel subsidies in place. As a result the increase in the price of crude is absorbed by their government and not passed on to the end consumer. Unlike the developed world, there little price elasticity in the demand for oil in these countries. The governments are already worried about inflation and are reluctant to pass on the increase in oil prices to deter demand growth.

Price Discovery: Speculators versus Hedgers

The commodities futures markets were originally designed to assist large consumers and producers to hedge the risk of massive price movements due to unforeseen circumstances. They are valuable tool which allows corporations to manage risks and plan their budgets, without worrying about day to day gyrations in the commodity markets.
As growing demand from emerging economies led to a rally in commodity prices, a number of new vehicles have emerged which allow investors to invest in commodities without accessing the futures market. Many of these funds are in the form of ETFs which offer exposure to specific commodities. In the case of crude oil, there are at least two funds (USO, OIL) which are directly linked to the price of crude.
Unlike actual consumers and producers of oil, the money invested in these ETFs is purely speculative. These ETFs are long only products and they do not take short futures position. Though there were always speculators in the commodity markets, the ease of access which the ETFs provide means that universe of investors who can now speculate (on the long side) has increased substantially. Financial advisors now increasingly tout commodities as a contra investment class with an inverse relationship to the US Dollar (and consequently the US economy).
The huge amount of speculative money invested in the commodity market is creating an imbalance in the price discovery process. A process designed to be driven by supply and demand of the underlying commodity is now being controlled by speculative money betting on uni-directional price movement.
Margin Requirements: Pennies to the Dollar
An aspect of the commodity futures market which may not be obvious to the average person on Main Street is that, it takes very little money to speculate in the commodity futures market. A NYMEX crude oil contract corresponds to 1000 barrels of oil (corresponding to $123,780 of total oil value) but requires just $9788 in initial margin! So you could call a futures broker, deposit $20,000 and start speculating on thousands of barrels of crude oil.
The low margin requirements were designed to allow commercial users to hedge their exposure without the hedging becoming a financial drain. However, they also expose the market to manipulation and rampant speculation.
Black Box Trading and Technical Levels
As the money chasing commodities has grown, a large group of investors including hedge funds are trading in the commodity markets. Many of these groups use sophisticated algorithms programmed into computers to trade. These techniques, often called black-box trading, execute trades without direct human intervention. They study the price action, especially around key technical levels which are considered resistance (against upward movement) or support (against downward movement). If the price breaks through a support level it is likely to go down further; similarly if it breaks through resistance, it is likely to go higher.
One commonly used technical indicator is daily pivot points which are derived from the previous day’s high-low-close values. These levels act as support and resistance levels. For example, for Wednesday May 07, 2008 from low to high were (S2:119.407, S1:121.533, PP: 122.67, R1:124.793, R2:125.927). After the bearish IEA report, crude oil fell rapidly but rebounded right at the S1 level. The low for the day was 120.54, right at the S1 level! Later during the day the price hung around the PP point of 121.647 before spiking up after 1:00PM.

Technical Levels: Fuel for Manipulation?
The commitment of traders report indicates almost 30% of the open futures interest in crude oil is from speculators and traders, and not commercial hedgers. And unlike commercial hedgers where the long/short interest is balanced (with short interest about 4.5% higher), the speculators are net long (with short interest about 15% less than the long interest).
When a market has a lot of speculative interest, traders (and black box algorithms) closely watch key technical levels. An entity which is interested in moving the market in a particular direction can provide support at the key technical levels. For example, today if the price had fallen meaningfully below 121.54, it may have reduced the speculative excess and oil may not rallied to a new high.
Since the futures market determines the price of oil, intervention in the futures market at specific price points can have a leveraged effect to entities which profit from higher crude oil prices. You would expect oil exporting entities to sell future contracts to hedge. However the same entities can also go long futures at key technical levels and provide an upward support to the market, with speculators taking care of the rest. For example, today buying futures around the 121.54 level would have provided the support needed to boost the market higher after the bearish report.
Case for Intervention: An Economic War
We have a situation where the tradable production of a commodity is controlled by a handful of nations. A significant number of these countries are aggressively opposed to the United States and would cheer if America suffers. As the world’s largest consumer of energy, high oil prices are a tax on the United States.
Further we have an open futures market, where anybody can speculate with very little financial outlay. To add fuel to the fire, we have a strongly bullish investment sentiment, with investors pouring in funds into the long side. All it takes is support at key technical levels and the speculators will take the market higher.
In my opinion, this is the perfect storm. Countries which are not amicable to US interests have a vested interest in keeping oil prices high. This comes at a time where the US banking and economic system is under stress. Higher energy prices are likely to break the back of the already stretched US consumer. Oil exporting countries also know that insatiable demand from the emerging economies will always provide a support to oil prices, and will make up for any reduction in demand from the US.
We are fighting an economic war where the parties are fighting with different rules. On side we have the free markets of the US; on the other side we have the world’s most powerful cartel. We need different weapons to fight this war; traditional free markets dynamics will take too long to come into equilibrium. During this period, the average American will suffer, while we ship wealth to countries not amicable to American interests.
How to Intervene?
Though a lot of observers understand the problem, there are no easy answers to this situation. I have certain ideas which can reduce some of the speculative froth while still allowing an active futures market for commercial hedgers.
1. Commercial Hedgers vs. Speculators: A clear demarcation between commercial hedgers who take possession of the physical commodity, and speculators can result in different rules for two classes. The ability of speculators to influence the market price will be reduced by significantly increasing margin requirements (e.g. by 5x) for non-commercial entities.
2. Strategic Petroleum Reserves: The whiff of government intervention can take the wind out of speculators, and the SPR can be a valuable tool in sending that message.
a. The SPR can be used as a reserve to sell futures contracts against. Since commodity prices are driven by technicals, intervention at key points can have a leveraged affect. How would the price action been if the key technical levels were taken out by some well time selling after the bearish inventory report?
b. The government can declare that they will use the SPR as a price control mechanism; reducing purchases if the oil spikes up, and in extreme cases even release supply if needed.
3. OPIC (Organization of Petroleum Importing Countries): The US should work with the emerging economies of China and India which are being blamed for the speculative fervor to create a formal union of countries which import oil.
a. The US should impress upon the governments of these countries to aggressively reduce subsidies for petroleum products to reduce the growth in demand and provide incentive for more efficient consumption of oil. Since these countries are large net importers of oil, high oil prices are not in their interest.
b. Collaborative Bidding and Exploration: Currently companies from India and China are in a fierce competition with each other when they bid for exploration rights for different emerging fields. Instead of competing with each other which bids up the price, the US should lead efforts to form a block which bids together and shares technology for more efficient exploitation of existing energy resources.
c. Energy Efficiency: The US should encourage exchange of technologies which result in more efficient utilization of existing energy resources.
4. Gas Guzzler Tax: Current tax policies encourage small businesses to purchase gas-guzzling vehicles which they can depreciate quickly. This is a regressive tax policy which discourages energy efficiency. The tax policy should be changed to encourage the purchase of more efficient vehicles and penalize gas-guzzling vehicles.

Yahoo’s History: Massive Fortune Swings

Long term Yahoo stock holders are no stranger to massive swings in its stock price. As one of the pioneers of the internet age, Yahoo’s legacy is enshrined in history.

One of the first darlings of the internet, it saw its stock price rise to stratospheric heights of $120+ at the peak of the .com bubble only to collapse to less than $5 in 2001. Since then the stock has recovered, reaching a high of $40+ in 2006, and traded as high as $34 last fall. The stock price fell significantly over the past six months as the Nasdaq sold off on the fear of an economic slowdown. Further, Google’s continued dominance and the failure of Yahoo’s internal initiative created further downside.

According to Alexa, the most popular web-sites in the world are: yahoo.com, google.com, youtube.com, www.live.com (Windows Live), and msn.com. Based on Microsoft’s earnings reports, its online division is still not profitable even though they have the #4 and #5 web-sites in the world. Yahoo on the other hand, strongly lags Google when it comes to monetizing its traffic.

Yahoo’s Future: Is Growth Possible?

Yahoo detractors believe that the inability of Yahoo to monetize the eye-balls shows that it should not continue as an independent company and share-holders should accept Microsoft’s generous offer. The Yahoo supporters believe once Yahoo starts taking more drastic actions, including strategic partnerships with other firms, it will be quite easy to monetize the traffic and boost the share price. The online revenue model is highly levered and once the fixed costs are accounted for, a bulk of the revenue after the cost of sales falls to the bottom line. A 15% increase in average monetization per visitor, can almost double Yahoo’s earnings.

The View from the Valley

Silicon Valley and Microsoft have had a strained relationship over the past two decades. Valley entrepreneurs believe that Microsoft stifles innovation and growth by using the massive size of its installed base steam-rolling any competition. The valley is littered with companies who were destroyed by the Microsoft Borg.

As one of the brightest, though fading, beacon of Silicon Valley, selling out to Microsoft is not any task for Yahoo to swallow. Microsoft was always the evil empire, and going over to the dark-side does not appeal to a lot of Yahoo workers, many of whom are reasonably wealthy after reaping their stock option rewards.

Jerry Yang seriously believes that selling out to Microsoft at the current price would be morally wrong. As the CEO he has the right (or perhaps even the duty) to believe that Yahoo’s fortunes will become better; so a sell-out has to be at a price which justifies selling out.

Yahoo has friends in the valley. Both Google and Yahoo were spun out of Stanford and Yahoo had invested in Google. Yahoo can and will tie up with Google, if that is what it takes to make things work. The fact that a simple ad-serving trial got Microsoft to rush to the speed-dial to the Department of Justice, means that Microsoft realizes that too.

Microsoft’s offer came at a time when Yahoo’s stock had lost more than 40% of its value in a few months. It was timed and priced at a point to allay the fears of major institutional stock holders who had seen their asset values plummet. However for Yahoo, it was adding insult to the injury. The offer was still 10% less than what Yahoo was trading a few months before.

The View from Redmond

Financial: Isn’t 61% Enough

From a financial point of view, Microsoft is correct in believing that a 61% premium over Yahoo’s price before the offer is a rich enough premium. Many Wall Street pundits are banging the desks and saying that there is no point for Microsoft to compete against itself. Yahoo does not have any other suitor and the shareholders do not have any other option but to accept Microsoft’s offer.

However, what they miss is that Yahoo is a reluctant bride at best. It is also a proud company, secure about its legacy. Though the recent share-holders may not like it, the rank and file do not mind short term swings in stock price as long as they believe in the long term vision (lower short term prices mean cheaper stock options for the employees). And in spite of the missteps of the past few years, Yahoo continues to be the #1 site on the web. A few correct moves and they will be boogying in Sunnyvale.

Strategic: OMG!
With each passing day Redmond is realizing that Microsoft has the risk of becoming increasingly irrelevant. The last quarter’s earnings report showed that all its business units except for the one which makes the XBOX underperformed. Microsoft lowered it’s near term guidance, though it guided up on its 2009 guidance. Microsoft blamed the macro-economic weakness. But other firms like Intel, IBM, Apple and Google are not showing any signs of the weakness Microsoft is blaming. There is something more happening and the bosses in Redmond know it.

The PC: The Mainframe of the 21st Century
Microsoft is at the same point where IBM and mainframes were a quarter century ago. The PC and Windows freed the average user from dealing with mainframes and the gurus who ran them. PCs were much less powerful than mainframes but their power was good enough.
We are at a similar point right now. Users want to be able to do everything, anywhere, anytime. They do not want to be bound to their desktop or their laptop or even a particular brand of a smart phone. They rarely need the power of a quad-core CPU. They are no longer willing to pay a lot more for software than the hardware, especially when hardware multiplies. Like many users, I have at least three or four computers I use regularly. Purchasing a license of a Microsoft OS and Microsoft Office for each machine is too expensive and not worth it. I want to be able to use my applications from anywhere but I will not keep multiple copies of the same file or pay for multiple copies of the same software.

Operating Systems: Windows Everywhere No More
Another key fact which stood out is that Windows is no longer the impregnable castle it used to be. MacOS is growing its market share by leaps and bounds. The iPhone is likely to increase the adoption of the Mac, even in corporate environments. Since it is base on the UNIX framework, it can be easily extended for corporate applications. Linux is anyway the default OS for servers in many organizations.

Productivity Applications: Web-Apps Finally Arrive
The agreement by salesforce.com to start offering Google Apps to its clients was a water-shed event. For the first time, there is an option for a small business to use CRM, and Office Productivity Apps, without having to buy licenses up-front. The end-user can access the applications from any web-connected device and is not bound to any particular hardware or OS.
Anecdotal evidence suggests that about 70% of all Microsoft Office users do not have any need for the advanced features offered by Office. Another 20% use some of the features, but rarely. It is the top 10%, the power users who need the full-fledged power of Office. Microsoft is at the increasing risk of seeing the huge installed base of Office applications erode.

Microhoo: Can Yahoo! do it For Microsoft?

Microsoft has not digested a company as big and diverse as Yahoo before. Further it is not clear that how Microhoo will integrate and work together. Though challenges remain there are obvious synergies:
• Search: Apart from algorithms, search is a game of scale. The rapid increase in cap-ex by Google is an indication of how much the leader will have to spend. A combined Microhoo can get that economy of scale and offer a viable alternative to Google.
• Profitable Online Businesses: Microsoft’s internet divisions continue to lose money though Yahoo! has been profitable for years. Whether it is web-apps or cloud computing, Yahoo can help Microsoft wean-off its declining desktop franchise. Further, as a pioneer in the internet age, Yahoo! might (just might) have some of its original creativity and innovative spirit left in it.
• Foreign Relationships: Yahoo has made increasingly profitable investments in ventures like Alibaba.com in China. A less abrasive and more conciliatory Microsoft can use those as a launching pad into other emerging technologies and platforms.
There is no other company out there which can bring so much to Microsoft. A properly executed merger can revive the fortunes of both also-rans.
Mr. Ballmer: Forget the Bean Counters

Microsoft is at an inflection point. It needs to take actions to preserve its legacy. These actions are going to be strategic in nature and the ROI will be measured over years, if not a decade. These actions will require a leap of faith. Further, they will not get approval from bean counters who are not chartered to look beyond the current quarter or year.

However, it seems that Microsoft’s executives are spending too much time listening to the bean counters and Wall Street pundits who do not want Microsoft to bid against itself. These pundits forget that Yahoo, in its present form, is not for sale. A long drawn proxy battle will drain the value of Yahoo’s key franchise. Unlike Oracle, which bought companies for their installed base of customers, Microsoft also needs some of Yahoo’s DNA. That talent will flee in a hostile takeover.

A Higher Offer: How much will it Cost?

The $31 original offer corresponded to a deal worth $44.6B. A $35 offer, which many believe might do it, would correspond to around $50B. Microsoft’s current market cap is around $280B. Another $5-$6B is not a big deal in the big picture; it is just 2% of Microsoft’s market cap. However it can turn what can be a losing proposition into a win-win for everyone involved.

Microsoft’s bid in the first place was seen as a sign that the giant from Redmond is seeing cracks in its armor. No-deal now, will expose Microsoft to further questions about its future, especially after the weak results this quarter

Microsoft’s stock has traded within a range of $28-$32 since the offer was announced. How much difference will a 2% increase make? Microsoft has been underperforming Yahoo! over the past five years. Perhaps a merger with Yahoo is what Microsoft needs to get back on track.

Wall Street is a bonus driven environment where time horizon stretch to the end of the current quarter (for management fees) and the current year (for trading bonuses). Any perspective beyond that gets little mindshare in this uncertain markets. I in this article I will focus on what is happening in the internet space where Google, Yahoo and Microsoft are duking it out.

Google Beats by a Mile

Google reported its financial results Wall Street on April 17, handily beating the consensus earnings estimate of $4.52/share by 32cents/share. The stock reacted by making a $75 move the next day and has tacked on another few percentage points since then. Google has risen almost 25% from its mid-March lows, though it is still about 28% below the high set late last year. During this period the company has not issued any statements which could have justified the massive price swings.

Private Equity Model and Wall Street Analysts

It is not too hard to figure out why Wall Street goes through such massive sentiment swings when it comes to Google. Unlike a majority of publically traded companies, Google does not offer forward guidance about its financial results. Google sees Wall Street’s obsession with quarterly results as a distraction towards its goal of building a strong company and long term shareholder value. Similar sentiments are also shared by many private equity firms who believe that the focus on quarterly earnings artificially constrain public companies and hamper efforts to build stronger companies. Google operates under a private equity model while being a publicly traded company.

Since Google’s does not offer guidance, Wall Street analysts have to step out of their comfort zone when making projections about Google’s business prospects. Google business model is unique: it is a technology company while earns its revenues from advertising. Since Google has not faced an economic slowdown, there is very little historical data which can be used to estimate its performance in the current slowdown.
However, the magnitude by which the analysts were wrong is indeed surprising, especially since there are a lot of metrics which can be used to evaluate Google’s performance.

Wall Street’s Thesis on Google’s Eminent Collapse

The financial press was gaga over Google last fall, as it raced to new highs in the 700s. Henry Blodget, a master in attracting attention with outrageous projections, said that Google might go to $2000 (the fine print said in 2020).

However, the mood turned extremely gloomy this February. Blodget was very active this February, predicting Google’s demise, based on a warning he (incorrectly) discovered in Google’s 10K, and an anonymous industry insider’s thoughts (he meant an Ad agency insider and not a Google insider) about how Google was extremely vulnerable to a slowdown in ad-spending.

To add fuel to the fire, ComScore (an internet intelligence and metrics company) reported a significant slowdown in year to year growth in paid clicks. Since paid clicks account for a bulk of Google’s revenues, this was seen as a sign of the slowdown in ad-spending striking Google. Google has also missed its earnings in the results reported in January, and the Street was very receptive to any news predicting the demise of Google.

Building the Mosaic: An Analysts Job

After Enron and the .com bubble burst, companies could no longer leak information to their favorite analyst on Wall Street. Analysts were now required to have the same access and information as the general public. This also meant that to add value, analysts would have to dig deeper and identify trends which were not obvious at first. They are now expected to build a mosaic based on public information distribute by the company and more importantly from the information they gathered from third party sources and contacts. Wall Street analysts failed miserably in building this mosaic from publically available information.

International Revenue

Analysts failed to account for the impact of Google’s international growth. As I had written in an earlier post, SEM’s like Efficient Frontier were showing strong growth in ad spending outside the USA. They had specifically mentioned that international sales accounted for 48% of Google’s revenue and were growing at a significant faster pace. Further, lower tax rates in the rest of the world that international sales contribute more to Google’s bottom line. And unlike the US, Europe’s economy is not in a slowdown with the ECB in no mood to cut interest rates fearing inflation.

Search Growth and Google’s Market Share Growth

Metrics about the growth of online search were suggesting that not only was online search was growing at a decent clip, but Google’s market share was growing even further. Though economic slowdown does affect buying habits, consumers do not stop buying. Even with no GDP growth, the US is a huge consumer economy. The conclusion being reached that the consumers had suddenly stopped clicking on ads served by Google defied common sense. Consumer behavior, unlike Wall Street sentiment, does not reverse course in a quarter.

Click Quality

Google had talked about changes in the way the ads were being displayed which would reduce the chance of accidental clicks. However they felt that the reduction in the number of clicks would be compensated by the better quality of returns the advertisers would get from the genuine clicks. This is a unique characteristic of Google’s self-correcting feedback mechanism: poor performing keywords automatically get bid lower. The feedback is almost real time and advertisers can make changes within days instead of weeks and months with traditional media.

Ad Spending

In my opinion, the biggest disconnect, was in ad spending. Though consumer behavior is a factor, it does not change overnight, especially since it does not cost money. Ad spending however can and will react to changes in economic conditions rapidly. And at the end of the day, it is the money spent by the advertisers which determines Google’s fortunes.

All data released by Search Engine Marketers showed that growth in online ad spending was great outside the USA. Within the USA the financial services sector had cut back on spending but the rest of the market was growing as predicting. The disruption in financial services is a transient phenomenon. With the changes in confirming loan limits, and lower interest rates, I expect a massive wave of refinancing which will restore the robust ad spending by the financial services sector.

In another article, I had noted that during a slowdown, companies are willing to sacrifice margins to earn revenues. Revenues allow companies to operate and make up for their fixed costs. In this environment, ad spending will focus on generating immediate revenues with a reduced emphasis on brand building campaigns. Online advertising, and especially search engine marketing, is one of the most cost-effective mechanisms for driving sales. Advertisers view it as a cost of sales and not marketing costs. Online advertising’s share of the ad budget will grow much faster during a slowdown and these changes are typically sticky.

Google’s Future: Video, Display and Mobile-Search

Google is the cusp of opening up new horizons in advertising and becoming a full-service advertising provider. The DoubleClick acquisition gives it a strong position in display advertising. Traffic on YouTube is sky-rocketing and Google is gradually monetizing the eye-balls with non-intrusive video ads. With the arrival of the iPhone, searches from mobile devices are exploding. The ability to pin-point a user’s exact real-time location, gives advertisers the incentive to spend aggressively on location based ads, which will drive traffic to traditional brick and mortar retailers. Note that though many brick and mortar retailers have an online presence, the location based ads on mobile devices are perhaps the first real play in the click and mortar world, where a retailer without any online presence can start using online advertising. This bodes well for Google since it expands their revenue source to small retailers who do not have an online presence but will like to use online marketing tools.

Google: Building Order in Chaos

One interesting aspect about Google is that they thrive in becoming leaders in the nebulous environment which exist when any new disruptive technology emerges. They can gather real-time feedback and provide performance metrics to their customers almost instantaneously. They are quite nimble and are able to react to changes quickly (e.g. the change in the budget allocation algorithm in February). They are quick to recognize when they are not numero uno and are willing to spend their money where it matters in the long run (e.g. the YouTube acquisition when Google-Video was a distant second).

While the rest of the world ponders, Google takes action and delivers. Google is currently trading at 22x forward earnings estimates with a PEG ratio of less than one. This is why I believe that Google is the buy of the year.

Last week two major the chief executives at two major Wall Street firms made some encouraging statements about the current situation. Goldman Sachs’ CEO Lloyd Blankfein feels that the markets are probably in the late stages of the credit crisis though he did not predict when exactly the crisis will end. Morgan Stanley’s CEO John Mack was more definitive in his statements. He used a baseball analogy to say that the sub-prime crisis is at the bottom of the eighth or the top of the ninth innings. He feels that the broader crisis will go on for a few quarters more.

These views are significant since both these firms made the headlines during the crisis. Goldman Sachs was adroit in circumventing the crisis and booked handsome gains in betting against the sub-prime mortgages. Morgan Stanley also bet against sub-prime mortgages but their strategy underestimated the magnitude of the problem and the firm ended up taking losses of more than $9B. It also led to the departure of an entire chain of executives from the MD leading the desk which made the bet all the way up to the company’s co-president Zoe Cruz.

Sub-Prime Rate Reset Shock: No Longer a Major Issue

A note by Morgan Stanley research has reduced the reset cash-flow step-up (extra payments needed after resets), by 50% from what they estimated last year. The lower interest rates are making a difference since the mortgages are no longer resetting to a significantly higher rate.
A bulk of the sub-prime loans were 2/28 ARMs which reset after two years to a rate equal to LIBOR (6m) + 6%. The initial so called teaser rates were in the range of 7-9%, significantly higher than what a prime borrow would have paid. During 2006 and 2007, the 6m LIBOR was in the range of 5-6%, which meant that after resets, the rate went up to 11-12%. With the housing market slowing down and a lot of home owners caught with little or no equity, the sub-prime borrowers could not refinance into better priced mortgage products and were stuck with monthly payments which were significantly higher than their original teaser rates. Sub-Prime borrowers whose mortgages reset during this period were stuck in between a rock and a hard place, and many were unable to keep up with their mortgage payments.

However, over the past year, the Fed has cut the discount rate significantly and after some hick-ups, the LIBOR rates have also followed in. At this point, LIBOR rates are between 2.5-3% and the rate after reset is often equal to or even less than the original teaser rate. So as long as the sub-prime borrower’s income has not fallen, they will be able to make the payments as before.

What this means that home owners who truly want to stay in their homes will be able to stay in place often with lower payments than before. There are several Federal government programs in the pipeline which will assist sub-prime borrowers to refinance into fixed rate mortgages with lower payments than before. Speculative buyers who got in with little money down will continue to walk away from their homes.

Alt-A Mortgages: Reset Shock Much Less

There has been a lot of media attention on Alt-A mortgages which are taken by home buyers whose credit is either not prime or income is not substantiated. Since the income is stated, these loans have been labeled ‘liar loans’. The bubble in housing encouraged speculators to sign up for these loans. Many market watchers believe that Alt-A is the next shoe to fall.

However, a lot of these loans are made to self-employed professionals especially those in the early stages of their career. These loans are unlikely to have a significantly higher default rate.

Many speculators who took Alt-A loans are existing home owners who do care about their credit-history. Though the default rates are going to be higher, many of these folks will not walk away from these homes since they have a lot more to lose over time with a mortgage default on their credit history. Further, these buyers are naturally bullish about housing as an investment and will be more willing to take the short-term pain for the long-term gain. Like the sub-prime borrowers, the lower interest rates mean that once the Alt-A mortgages reset, the change in monthly payments is unlikely to be significant.

A U-Shaped Housing Bottom

In February 2008, the US Housing Affordability index published by the NAR reached 135, its highest level in 5 years. This is a result of falling home prices, lower interest rates and rising incomes. This is significant since 2003 was in the early phase of the housing boom and affordability rising to that level means that the excess has leaked out of the bubble. Home prices are gradually coming to harmony with wages and the cost of mortgages.
Though the ability to pay has risen, there is still a big supply overhang which will continue to put downward pressure on home prices. The increasing number of foreclosures will dampen the market further. Prices are likely to fall further, but the rate of price decrease will reduce in the latter half of the year. Home builders are cutting back on new construction, home sellers are cutting prices to move homes and first time buyers have started coming back to the market.

I expect the prices to start stabilizing by the end of the year and form a U-shaped bottom where the prices will not go up much but stop falling. The bottom of the U might be quite long (2 years perhaps), but the end to the decline should be visible soon. Rising private sector interest in buying foreclosed properties this spring is a good indication of the beginning of the bottom.

Credit Crunch: CMBS

The expected fiasco in the performance of Commercial Mortgage Backed Securities has yet to materialize. Fitch Ratings reported that the February CMBS delinquencies rose to 0.30%, a whopping 0.03% higher than the historic-low of 0.27%. Banks and other holders of CMBS paper have been rushing to hedge their exposure and have pushed the cost of protection on these instruments to absurd highs. For example, on March 22 the WSJ reported that:

Securities are priced at levels that imply default rates could reach 80%, or even 100%, of their underlying loans, they say. Historically, though, the worst period in the commercial-real-estate debt market saw defaults on those bonds reach roughly 31%

This action reminds me of the way banks have taken write-downs on their sub-prime holdings, often estimating that the collateral is worthless. Typical commercial loans have significantly lower loan-to-value ratios than home mortgages. Further most of them fund income producing properties with a steady cash-flow. The borrower has a huge financial incentive to keep the loan current since they run the risk of losing all their equity. Even if the bonds default, long term principal losses are not as severe since there is a big equity cushion.

The recent market action is not based on any observable change in the fundamentals of these bonds, but a result of the panic in the market surrounding the Bear Sterns debacle, which was exacerbated by hot money from Hedge Funds swinging in to make a quick buck.
Though CMBS will suffer during an economic slowdown, they cannot be compared to sub-prime mortgages; both the losses and the total outstanding amount are significantly less.

GE Results: The Credit Crunch Strikes

The equity markets were rudely surprised by the big earnings miss by GE, the company that never misses. The results were down due to a big miss in the GE’s financial segment, with some minor miss in the Healthcare and Appliances. All the three under-performing segments are a direct fall-out of the housing related credit-crunch. Due to the dysfunctional Muni Bond and Auction Rate Securities markets, public institutions at the state and local level have been unable to obtain credit to finance big-ticket items purchases like the expensive medical equipment GE sells (e.g. MRI machines). GE’s Commercial Finance division took a major hit since GE was not able to close on certain real-estate sales since the buyer could not obtain financing on time. GE has been timing the sale of its real-estate assets to smoothen out the earnings over time and the credit-crunch caught the company on the wrong foot.

Transient or Permanent?

GE’s results make it clear that the credit crunch will affect the performance of companies who rely on big-ticket transactions by US based buyers. The credit crunch was at its worst towards the end of March, the last few weeks of the quarter. As a result, the effect on earnings will be magnified since companies did not have any time-cushion to close deals which were stuck in the pipeline.

I believe that the credit-related misses we will see this quarter are a transient phenomenon and not a reflection of a fundamental shift. The credit-markets are opening up and such extraordinary events like the collapse of Bear Sterns are unlikely to reoccur with an activist Fed.
However, CEOs are going to be cautious of their forecast since we have just off a major dislocation. The equity markets are likely to react negatively to the coming misses and cautious comments. We might see another test of the lows and a wash-out capitulation in the coming weeks. I believe that this test will be a great buying opportunity, perhaps the last of this bear market.

Inflection Point

Last week, Dennis Gartman’s letter noted that tax receipts at the W-2 employee level are now showing signs of strength, in contrast with the slowdown in growth observed in the second half of 2007. He believes that they are best estimate of the current income of the American consumer and signals the start of th