The Daily Reckoning PRESENTS
In part one of this two-part essay, Justice Litle looks at an existing problem - energy infrastructure - made worse by Hurricanes Katrina and Rita. Read on...

There is a common saying among strategic planners: “Hope for the best, prepare for the worst.” In Katrina, we have seen the worst, or close to it - and not just in terms of physical destruction.

The stories range from heart-rending to gruesome. The level of human suffering was staggering, with thousands of Americans subjected to conditions resembling a third-world combat zone. And the idea of a great city washed away is almost too big, too alien, to fathom.

In the deluge of news and commentary following Katrina’s wake, Bloomberg columnist Joe Mysak offers particular insight:

“This is a story being told on the ground right now, in hundreds of stories detailing human misery, particularly of the poor. But you know what? All those little stories don't give you the big picture any more than the obsessive, agonizing stories of individual casualties in Iraq tell you about what's really going on over there. Individual human tragedies offer insights into the human condition, not into what's going to happen next.”

This is not meant to trivialize the scope or seriousness of suffering, but to put it in context. The bigger picture cannot be distilled into sound bites, and will take time to reveal itself. As long-term investors - not to mention participants in the global economy - we have a vested interest in trying to make sense of what the aftermath will bring.

There is open debate as to the long-term effects Katrina will have. The most optimistic argue with a straight face that natural disasters have a “net positive effect” on corporate profits. This may be true in certain past cases, but not when an energy crisis is embedded in the mix.

The real viewpoint distinctions were made before the storm took shape. Observers and commentators can be placed in two groups: those who believed we were already in a dangerous place pre-Katrina and those who thought things were fine before the hurricane struck. For those in the concerned camp, the greatest natural disaster in American history has sped things along, moving the world closer to an inevitable endgame that was already on its way.

There are three areas in which Katrina has created urgency by magnifying an existing issue: energy infrastructure, consumer spending and building inflationary pressures. Today, we will look at energy infrastructure, and at the other two issues in the second part of this essay, to come next week.

“Americans have taken cheap energy for granted for years...Now it’s coming home to roost.”
- Robin West, PFC Energy Chairman

When it comes to rebuilding and upgrading the nation’s energy infrastructure, America has been hitting the snooze button for too long. The devastation in the Gulf Coast is a painful wake-up call. Prices have eased somewhat with the release of emergency reserves from the IEA and SPR, but the long-term horizon is still unclear. For quite a while, we have had the luxury of postponing action; now we are forced to take emergency measures in the face of a catastrophe.

America’s energy infrastructure is cracked and strained, patched together with duct tape, outdated in some areas and pushed to the breaking point in others. Power grids are in dire need of upgrade and replacement; fuel distribution networks are inadequate and subject to disruption; desperately needed refineries and liquid natural gas terminals have fallen victim to excessive environmental regulation, stifling government procedure and, worst of all, a nearly impenetrable wall of NIMBY/ BANANA style politics (Not In My Back Yard; Build Absolutely Nothing Anywhere Near Anybody).

The problem can be described on one level as “out of sight, out of mind.” Basic necessities are often taken for granted. In normal times, none of us thinks too much about the electricity that runs our homes, the water that pours from our faucets or the gasoline that fuels our cars. When the flow is disrupted, however, we notice very quickly.

The same benign neglect applies to the hidden web of energy infrastructure that makes modern life possible. As long as things are working, we don’t pay much attention. If the system is being put under increasing strain, we don’t notice - until something goes wrong. But the old cliché, “If it ain’t broke, don’t fix it” is very bad advice in this area. The farther infrastructure lags behind growth, the more disruptive it is when the creaking framework breaks down. The fewer fail-safes in place, the greater the likelihood of a small disruption causing big problems. And that is where we are now: Stomach-lurching volatility in fuel prices is the result of small demand shifts at the margin, thanks to a ”lack of slack” in the system.

The climate for capacity increase and capital investment has been stymied by one of the biggest flaws in the political process: an overwhelming bias toward short-term time horizons. There is little political incentive to address long-term problems hidden from the public eye. On the other hand, there is usually strong incentive to seize on the popular “quick fix” whose long-run effects are hidden or postponed. Furthermore, those who benefit from sound policies are typically the unorganized silent majority, whereas anti-energy special interests (think NIMBY) are organized and vocal. Last but not least, the pool of political dollars is always finite - so issues without immediate political resonance are ignored. The system works against common sense. Promises are made without analysis, favors are doled out without foresight and the eventual mess is left to be cleaned up on someone else’s watch.

This logjam of neglect and aggressive special interests requires a jarring shock to be broken through. That shock is now upon us. Daniel Yergin of Cambridge Energy Research Associates makes an argument for why Katrina’s aftermath has created an “integrated energy disaster”:

“What makes it an integrated crisis is that the entire energy supply system in the region has been disabled, and that the parts all depend upon each other for recovery. If the next weeks reveal that the losses are as large as some fear, this would constitute one of the biggest energy shocks since the 1970s, perhaps even the biggest. Unlike the crises of the ’70s or the Persian Gulf crisis of 1990-91, this does not involve just crude oil: It includes natural gas, refineries and electricity.”

Fortunately, as of this writing, the assessment of the situation is a little less pessimistic (though there are still plenty of unknowns). It looks like damaged ports and refineries may be brought back on line faster than feared, and worst-case scenarios may yet be avoided. The most intractable problem may be rebuilding communities to which the tens of thousands of displaced oil workers can return. Wage costs will no doubt have to rise sharply in efforts to convince them back. Regardless of details, we have learned a powerful lesson here; wake-up calls don’t come much stronger. Hopefully, the point has been driven home strongly enough to dislodge the special interest groups who fail to see the gravity of the situation. Yergin expands on what needs to be done:

“This more expansive concept of energy security requires broader coordination between government and the private sector; more emphasis on redundancy, alternatives, distributed energy and backup systems; planning and prepositioning of vital supplies (“strategic transformer reserves” for electric substations); and methods that can quickly be applied to promote swift market adjustment. As with the August 2003 blackout, this crisis underlines the need for modernization and new investment in the energy infrastructure that supports our $12.4 trillion economy.”

All these elements were critical pre-Katrina, and circumstances would have demanded implementation sooner or later. But now that public awareness is high - and the dangers of complacency are thrown into stark relief - the timetable will be accelerated. There is a lot of work to do, and no avoiding it. In the event of a recession, energy prices may fall as global demand slows. But even then, energy security would be critical as ever, as businesses and consumers would show more sensitivity to price shocks in the midst of a downturn.

A wave of rebuilding is coming, and it will encompass more than what was destroyed. There will be expansions, upgrades, new technology and new safeguards put in place. The Gulf of Mexico will be rebuilt to Category 5 standards. Legislation pressing for new refineries and new LNG terminals will finally gain the upper hand. New avenues will be explored. Uncle Sam will be whipping out the checkbook, big time. The situation demands it.

Regards,

Justice Litle
for The Daily Reckoning

P.S. In the second part of this essay, I’ll look at the effect that this hurricane season has had on consumer spending and increased inflationary pressures. In the meantime, check out my latest report - you could find out how to actually profit from this global energy crunch. See here: The Story of Energy http://www.agora-inc.com/reports/OST/WOSTF420

© 2005 Justice Litle, Outstanding Investments
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Justice Litle is an editor of Outstanding Investments. He has worked with soybean farmers, cattle ranchers, energy consultants, currency hedgers, scrap metal dealers and everything in between, including multiple hedge funds. Mr. Litle also acted as head trader for a private equity partnership, and made contributions to Trend Following: How Great Traders Make Millions in Up or Down Markets, a popular trading book by Mike Covel (FT/Prentice Hall)

Justice Litle is also a member of an elite group that meets occasionally to debate and discuss the new trends in the financial world and investment ideas - among other things. This monthly gathering includes the cream of the crop of financial minds - and for a limited time, the Agora Financial Reserve is open to the public at a 98% discount. Get your invitation here: The Birth of an Elite Club http://www.agora-inc.com/reports/AFR/WAFRF972 

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