The
BIG Picture Transcript
November 10,
2007
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Part
1
The
Confidence Game
FSN
Follies: Shakespeare at the Fed
It
Ain't Over & It's Not Behind Us
Part
2
Which
comes first? Peak Oil or Global Warming?
Other
Voices: William Kovacs, VP of Environment, Technology and Regulatory
Affairs
Part
3
Q-Calls
JOHN: This is one of those weeks that is a newsman's delight because there is never a lack of anything substantive to talk about. You know, if you look at what's been going on this week – the crisis that we're looking at in terms of the dollar and its relationship to other currencies, and just trying to keep the economy afloat – the Fed is stuck between a rock and a hard place. If it raises rates one thing happens. If it lowers rates, something else happens. Both undesirable. It would seem that the old rules are simply not working. The last time we went through a rate raising cycle, we did it in incrementally in little steps. Remember way back in the days of Paul Volcker, there would have been radical changes of interest rates and nobody would have thought anything about it. Now every little tweak one side of the other causes an issue.
JIM: You're right on this. The old rules or the old paradigms don't seem to be working. And I'm just going to run through them briefly, but things have been unusual this decade. We went into a recession in 2001. Normally you see real estate lead us into a recession or an economic slowdown, much as it's doing now. That didn't happen in 2001. Instead real estate prices took off. When we went into this recovery period, all assets rose as the economy came out of that recession: you had bond prices going up, commodity prices going up, stock prices going up. And then when the economy became overheated and there were visible signs of inflation everywhere, when the Fed went into its rate-raising cycle because of the amount of debt in the system it had to do it in incremental steps.
Likewise, here we are now on the other side of that curve and the Fed is going through a rate-lowering cycle. And just as it did not have the freedom to really jack up interest rates in 2004 to 2006 – it had to do it incrementally – I think the Fed is put in the same bind this time on lowering rates. They are going to have to do it incrementally. They are not going to be able to do what Greenspan did and just take the federal funds rate from 6% down to 1%. I just don't think they are in a position today where they could get away with something like that. So I think they are going to have to take us through the rate-lowering cycle and they are going to have to do it incrementally because of all of the various things that they are trying to juggle. [2:36]
JOHN: So basically, the falling dollar and rising commodity prices – and these are going worse in both directions – that we see out there are really placing a very tight clamp on what the Fed's maneuvering room is. And this all creates a really serious political situation too.
JIM: Absolutely. And this is one of the comments that we have been making for quite some time now. What is different is in 2001, when Greenspan began to cut interest rates as we went into a recession (we were in the bear market, we got hit with 9/11) oil was at 18 to $20 a barrel, gold was in the 250 range, we had copper at 60 cents. You look at it today, we have oil prices hovering close to $100 a barrel. We've got gold easily holding its own over $800 an ounce. Silver, instead of $4 is at $15. You've got copper prices and wheat prices hitting a record. And unlike some of the other problems that were occurring in the world at that time, this time the US is the epicenter of the storm. It's the US financial system that is having a major problem now. And unlike the past where we had low commodity prices with not much demand, this time we've got high commodity prices with large demand coming in at the margin from developing countries like China and India. [4:06]
JOHN: And speaking of China, one of the announcements this week that just sort of added shock waves to everything going on around the world was when one member of the standing committee there said that China was going to have to shift something like $1.43 trillion.
into stronger currencies. There is that exit from the dollar we've always been talking about as being a serious threat. We've been talking about it for five years here on the show. I don't know; are we starting to see the beginning of that?
JIM: Well, we had a big selloff in US securities in the month of August. And we're going to get news coming out – I think it's next Friday – but if you follow the Fed data, the balance sheet of foreign custodial holdings at the Federal Reserve have actually been going up in the month of September and October. So because we have such large amounts of debt with our trade deficit – although it's been going down – that we have to borrow, I think it's a matter of not as much money as coming into this country as we need. I mean it's still coming into the country, but it's not coming in fast enough to absorb the money that we need to borrow. And so as a result, the dollar has a lot more competition today. And it's my view as I follow inflation rates around the world, as I follow money supply figures around the world, all central banks are inflating; inflation is rising all over the world because we're on a fiat money system. The only difference, I think right now, John, is that the dollar has competition. So if you're saying, “well, gee, the dollar is really falling and it's depreciating the fastest out of all of the currencies,” well, maybe I have an alternative. I can go into the euro, I can go into the Canadian loonie, or I can go into the Australian dollar or I can go into the Japanese yen or some other currency.
So the dollar has a lot more competition and then there is the ultimate currency, which is gold and I think that's the very reason we're seeing gold prices at over $800 and silver over $15 because precious metals are the ultimate currency. They are the only currency that isn't dependent on a debt. They are debt-free currencies. And also they are the only currencies that aren't depreciating. [6:21]
JOHN: Well, looking at the fact that the dollar is at its lowest level since 1981, it would seem that we are marching right into a dollar confidence crisis right here which really has longer term implications from the geopolitical level as well.
JIM: Sure. We're in a transition where the dollar is losing its status as the world's currency. And even more serious for the dollar is some of the major exporting nations within OPEC and also within the former Soviet Union may want to bill their oil in a foreign currency, let's say in the euro. So we do have a confidence problem right now. And just as you mentioned, John, that Chinese official who said they were going to diversify some of their currencies, they are already in the process of doing that. The Chinese dumped about 5% of their dollar holdings in the last five months. So that is weighing in on the dollar as well and that goes back to the competition. There are more places that you can put your money today than just the dollar. And so the dollar is still going to be around because the euro isn't strong enough to take the dollar's place nor is the Japanese Yen, nor is the Canadian loonie, or any other currency; but basically we've got a lot more competition and there is going to be some alternatives. So it's not going to be all of your money in dollars if you're a foreign central bank. There's going to be money in euros, there is going to be money in other currencies. But you're absolutely right; what we have right now is basically a confidence crisis. [7:51]
JOHN: Well, given that, this sort of reminds me of when you're sliding down a ski slope out of control, it takes a while to skid to a stop. Depending on how far down we go on the this slope, when do you think a trade war would kick in? Is that a viability?
JIM: Well, you're exactly right. There was a story on Bloomberg Friday where the European Central Bank president Jean-Claude Trichet and Canadian finance administer Jim Flaherty were basically speaking out against the sliding dollar. And this was less than a month after they had a Group of Seven officials chose no not to raise any alarm. The last G-7 meeting everybody was saying things are okay. On Thursday Trichet called the slide in the dollar brutal. He also talked about currency shifts as unwelcome; Flaherty said he's concerned at the dollars surge because it's really starting to hurt the Canadian economy. You had on Friday France's president Nicholas Sarkozy step in with his own criticism of the US dollar dropping to a record low; and that's probably going to intensify as the European finance ministers convene in Brussels and the Group of 20 meet in Cape Town next week.
Without a shift in signals from either the Bush Administration –which is hailing the dollar's decline as a stimulus to US growth – they are talking about that here in terms of either intervention or something that they are going to have to do. Sarkozy has been very vociferous in saying: “You're not going to export your inflation here. We will respond in kind.” And certainly if you look at European money supply growth it's in the double-digit range. If you look at Canada's money supply growth, it's at 8%. If you look at most of the major competitors to the US, they are experiencing double-digit money supply growth. And of course you've got the Treasury Secretary saying, “yeah, we support a strong dollar,” as they wink; but I suspect –as it's been suggested here in this Bloomberg article – that there is going to be some kind of response to this. And Friday, Canada's prime minister said Canada's trade surplus narrowed to the smallest that it's been since 1998 as exports have slumped. So the fact that the dollar is going down isn't hurting other countries is simply not true. We are seeing it take place. And I suspect it's in nobody's interest to see the dollar collapse because it is going to have an impact on other economies. [10:10]
JOHN: You know, you were talking about the fact that President Sarkozy of France was getting concerned. Foreign lenders, by the way, are getting really vocal about this whole thing. But isn't the problem also that the dollar is depreciating against the wrong currencies too?
JIM: Sure. It's falling the hardest against Canada, and some of the hard currencies or petro-currencies – the Russian Ruble, if you can believe that. But there are a lot of currencies like China, which still has a peg – yes, it's allowing its currency to appreciate, but it hasn't appreciated as much as, let's say, the euro has against the dollar; and you have, like, for example, a lot of the Asian currencies are still pegged to the dollar. So one of the problems is the dollar should be depreciating more against the Asian currencies where most of our trade imbalance arises, especially with China. [10:59]
JOHN: Here we are. We're in one great big free-fall right now. What is it going to take to break this before we hit the bottom?
JIM: Well, in the Bloomberg article on Friday, they are already talking about intervention, or coordinated intervention, by central banks. And if this continues, I would suspect at some point there would be some kind of policy response: “If you're going to devalue, we're going to devalue.” Especially if it starts eating into the point where let's say Canada goes from a trade surplus to a trade deficit, or you see the European economy slow down dramatically as their exports fall. They can export to China, but can they export as much to China to, let's say, to make up for what they won't be exporting to us as their currency gets stronger? I don't know.
The problem that we have right now is the Fed is sort of caught in a bind. They’re in a high wire act; and you can picture the clown at the circus that's juggling all of these balls in the air. The Fed is trying to keep the financial markets stable. They do not want to see the financial markets go into a free fall like we did between 2000 and 2002. They are trying to juggle the economy which they know – contrary to the way they speak – is slowing down. In fact, they alluded to it's going to slow down even more in the fourth quarter and next year. And at the same time, they are trying to juggle the dollar. They don't mind the fact that the dollar is going down. What they don't want is a free fall. So in a way, the Fed is sort of trapped in its own little perfect storm. They’ve got a storm going in the financial markets, they have a storm going in the economy and they also have a storm going on with the currency. [12:39]
JOHN: We're also seeing this is a storm of its own creation as a matter of fact. It's like a self-feeding hurricane. And if you watch C-Span this week, I would say the confrontation between Congressman and presidential candidate Ron Paul, and Fed chairman Ben Bernanke was equally as stormy. Let's listen to what Ron Paul had to say about it being a storm of its own creation.
RON PAUL: And the bubbles occur when we have this malinvestment and the creation of new money. So my question boils down to this: How in the world can we expect to solve the problems of inflation, that is the increase in supply of money, with more inflation?
BERNANKE: Congressman, first just a small technical point. On the growth in money, money growth has been pretty moderate over the last few years. The increase in MZM is probably related to the financial turmoil. People have been taking their savings out of, you know, risky assets, putting them into the bank and that makes the money data show faster growth. So I'm not sure that's indicative of policy necessarily.
What we are trying to do is follow the mandate that Congress gave us, and the mandate that Congress gave us is to look at employment and inflation as measured by domestic price growth. And as I talked about today, and I think you would agree, that we do see risk to inflation and we are taking those into account and we want to make sure that – that prices remain stable as possible in the United States.
PAUL: How can you do this and pursue this, the policy you have, without further weakening the dollar? There is a dollar crisis out there, and people’s money is being stolen. People who have saved, they are being robbed. I mean if you have a devaluation of the dollar at 10 percent, people have been robbed of 10 percent. But how can you pursue this policy without addressing the subject that somebody is losing their wealth because of a weaker dollar and it's going to lead to higher interest rates and a weaker economy.
BERNANKE: If somebody has their wealth in dollars and they are going to buy consumer goods in dollars – then for the typical American, then the decline in the dollar, the only effect it has on their buying power is it makes imported goods more expensive.
PAUL: Yeah. But not if you're retired and elderly, and we have CDs and they are – their cost of living is going up no matter what your CPI says, their cost of living is going up and they are hurting and that's why people in this country are very upset.
JOHN: I think the whole bit about “where you keep your money,” at one point, is where the whole argument on the part of Ben Bernanke just fell apart; right there.
JIM: It's amazing to listen to that exchange with Ron Paul and Bernanke. Paul is the only guy who gets it. And I think the markets are starting to pick up on this. And I think, John, that’s why you've been seeing gold rise, oil rise, and commodities rising. M3 in this country is growing at 15% a year. That's the reconstructed M3 as reported by John Williams at Shadow Statistics. But you know, Ron Paul referred to MZM growing at an annual rate of 20%, or nearly one trillion dollars in the last 12 months. And I think what you're seeing here that no matter what central banks are doing, I think it's starting to dawn on the smart money what's really happening to paper currencies. In fact, if you were watching the cable channels, I think there was one point, where Ron Paul was talking, that the traders in the pits there were starting to rally. Let's go to that clip if we can.
Rick: When Ron Paul was firing every revolver in Ben Bernanke's direction, there was a lot of people cheering down here with regard to the only tool the Fed ever seems to use is the easing tool; and on the inflation front, many traders are reading the subtitles and they went back and checked, he made statements like “import price with respect to the weaker dollar, it affects import prices but not domestic prices.” That's kind of an inconsistency. His performance was far from a command performance. And I’m being kind.
CNBC: It didn't look like he felt very good either, Steve. What did you hear the Chairman talking about that today?
STEVE LIESMAN: Not what Rick heard, I think.
CNBC: That's interesting. How so?
STEVE: I mean Ron Paul's economics really leave a lot to be desired. He talks people having their savings wiped out because the dollar devalued. I think Ben Bernanke, the Fed chairman, correctly points out that it is devalued if you're spending all of your money abroad. It's the domestic prices that matter. I also think Rick is wrong, that Ben Bernanke has been very consistent about the impact of the weaker dollar on the US economy. There is a portion of it where prices increase because of imports. Also export prices can adjust to reflect those higher import prices and be higher. There are impacts throughout the economy, but they are not decisive for the US economy on inflation. [17:28]
JIM: That's two guys that don't get it, Bernanke and Liesman.
JOHN: Yeah. I think Liesman doesn't get it. He had this argument about how it's only if your currency goes abroad that you're going to notice the difference between the two.
I thought: “Wait a minute. If the dollar is worth less and less and you can't buy as much, then the things you have saved for during your life, basically it's eroding the value of the currency that you have put into storage. It is stealing from people.”
So what's their problem? Frankly, Ron Paul is the only person so far that gets it.
JIM: Well, it was absolutely amazing too because Liesman was saying “look, if you buy everything in dollars...” Well, guess what, Steve, the things that you have to pay for in dollars are made overseas and if the dollar is worth less, that means we have to give them more dollars to buy those goods; that means they go up domestically as well. These guys, they really don't get it. So there was a perfect example of a well know economist and our own Federal Reserve Chairman not getting it.
And I think the problem that Bernanke has and this is really critical to playing the confidence game is if Alan Greenspan would have been up there with Ron Paul, he would have said something that would have taken you around in so many different circles. You would have been sitting there and saying like “what the heck did he just say?” And he could baffle them. Bernanke doesn't have the baffling capability and his performance just wasn't a confidence builder. And I think he's going to come under more and more fire because he just doesn't have the baffling ability that we always saw with Greenspan. [19:10]
JOHN: Well, in addition to that, I'll be honest with you, as people discover they are in more and more desperate straits, like Ron Paul talks about, and people are discovering that, they don't really care who babbles what. They just stop believing what they are hearing coming out of these lines because they just know it doesn't match the reality of their everyday lives. That's what we're hearing. They can't understand it, they can't interpret it, they don't know enough about it, but they do know they can't make the paycheck work anymore.
JIM: And they don't know what's causing it. But watch the off loading. And this is what politicians and central bankers do is Bernanke was making reference to headline inflation going up over the next couple of months but he was talking about oil prices, food prices and stuff like that. So once again we get to the three things that are often blamed for inflation. In other words, rising prices are a symptom of inflation, not the cause of inflation. And they are attributed to either greedy people trying to get profits, labor unions trying to get more in wages or acts of God like hurricanes. So right now we've got an off loading on to oil prices, rising food prices. And you hear this comment, “the Fed can't control oil prices and food prices.” Well, they can control it by creating a lot of money that expands the demand that comes from increased money and credit into the system. [20:30]
JOHN: Well, obviously, they are in a bind and they need to get themselves out. Can they do it and how?
JIM: Well, here is how the confidence game is played and you're seeing a lot of that. I call it the “good cop, bad cop” routine. On the days the dollar is going down and you have some kind of inflation report, you'll have Fed governors coming out and they will say: “That's it, we've done enough. I'm not sure we should even have cut it as much as we did, we're concerned about inflation. We're watching it very closely, we're going to keep a close eye on that.” And that's sort of like okay, we've got our eye on the ball, we're worried about inflation.
Then you have days where the good cop comes out because now they are worried about an economics statistic that shows that GM lost a ton of money. You've got banks writing off all of these loans, you've got the economy slowing down, you've got retail sales are weak, you've got more problems in the housing market and then the good cop comes out: “We're really concerned about the economy. And if we're that concerned, well, look, we’ll lower interest rates.” So it's kind of like this good cop, bad cop.
And a good example of that is Mishkin saying: “Hey, we've lowered it enough, I'm not even sure we should have lowered it as much as we have.” He's one of the bad cops. On the other hand this week, you had Poole who comes out – and he's one of the good cops – and he's trying to maintain that: “If it gets worse, we can cut further. We've got room to cut, the core rate of inflation has been heading down and inflation expectations are under control.”
So that's how they do this. They do this good cop, bad cop depending on what the market needs that particular day, wherever the public sentiment is going. [22:12]
JOHN: Right. So that's why we keep hearing different rhetoric, depending on what month we're meeting in the Fed's open mouth committee. It changes based on their barometer indicating what's going on out there, and they say they can even contradict themselves out there at some point.
JIM: Oh, sure. You can look at any week and take the statements made from various Fed governors. They are always contradicting each other. At the September FOMC meeting they were worried about a weakening economy, and inflation was not a problem; one month later they are worried about the economic growth was strong; now they are worried about rising inflation, it could be a problem; and that these two risks are evenly balanced whereas for the month before they were unbalanced. So what they are trying to do, John, is they are always trying to appeal to both sides. They are playing this sort of confidence game.
And what they are really worried about here – and Bernanke made a reference to this – is what I call the Inflation Expectations Index and that has been creeping up here. And the higher this goes this is going to make it harder for them to inflate and get away with it. The expectations index is what I call the keep-them-fooled index; and that's what they keep a close eye on because as expectations rise, then people begin to react to that and say “well, gee, the money I'm holding is going to be worth less and the things I'm going to buy are going to cost more.” So you get more turn over. People start to spend their cash because they don't want to hold it because cash is depreciating. [23:47]
JOHN: As a matter of fact, talking about that expectations, here is what Ben Bernanke said this week:
BERNANKE: The Committee projected overall in core inflation to be in a range consistent with price stability next year. Supporting this view were: Modest improvements in core inflation over the course of the year; inflation expectations that appeared reasonably well anchored; and futures quotes suggesting that investors saw food and energy crisis coming off their recent peaks next year.
But the inflation outlook was also seen as subject to important upside risks. In particular, prices of crude oil and other commodities have increased sharply in recent weeks and the foreign exchange value of the dollar had weakened. These factors were likely to increase overall inflation in the short run, and should inflation expectations become unmoored had the potential of boosting inflation in the long run as well. Weighing its projections for growth and inflation as well as the risk to those projections, the FOMC in October 31st reduced its target for the Federal funds rate an additional 25 basis point to 4 ½%.
In the Committee's judgment the cumulative easing of policy over the last two months should help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in the financial markets and promote moderate growth overtime. Nonetheless, the Committee recognized that risks remain to both of its statutory objectives of maximum employment and price stability. All told it was the judgment of the FMOC that after it's action October 31st, the stance of monetary policy roughly balanced the upside risk to inflation and the downside risk to growth. [25:14]
JIM: Are you convinced, John?
JOHN: No.
JIM: Basically he was making a reference there to inflationary expectations. The higher inflationary expectations rise, the greater chance money velocity will start rising which raises the accelerating rate of inflation. And he's already made reference and everybody knows this, headline inflation has been rising as a result of the increase in the money supply that we've seen over the last 12 months whether you're looking at MZM, M1, M2, M3, which we don't report which is running around 15%. So it's already baked in the cake. They know that with all of that monetary inflation, the headline inflation numbers are up anyway because we're tracking around a CPI rate now that's about a little over 5%. That's the official number. Now, given the fact that the number itself is understated it's probably closer to 8 to 10%. In fact, if we go to John Williams Shadow Statistics, I think he has got inflation running somewhere between 6 and 7%. So inflation is already running high and what the Fed has just told us: it's going to get higher. [26:40]
JOHN: It would seem like the Fed – we've said before – is in a bind. And what they are really confronting here is they have to take into account three things, the markets and then the economy and the value of the dollar itself. And these are at war with each other right now. They are not running hand in hand.
JIM: They also have another issue that they are going to be confronting too and that's on the credit front because the commercial paper market outstanding continues to deteriorate. It stabilized roughly, John, for about a five week period after the big cut in the discount rate. But in the latest weak reported, November 6th, the commercial paper markets fell by another 15.6 billion after six weeks of basically remaining flat. And if we take a look at it since July, the commercial paper (that market is roughly about 1.9 trillion right now) is down 16% since July.
And there was another report that came out that tells us we've got more problems coming and that was the Senior Loan Officer Survey that Fed reported which showed substantial tightening, not just in the subprime market but now spreading over into the prime market. It's spreading throughout the credit markets; lending standards are tightening. And we'll get into this in the next segment because a lot of banks can't shuffle the paper. In other words, the loans that they used to be able to make –just package them and off load them on the investors – they can't do that as easily today. Any loans they are making, they are going to keep on their own books. And the one net result of that immediately is the tightening of lending standards.
This is from the Fed's October Senior Loan Officer Survey which was released on Thursday by the Fed. It confirmed that tightening in lending standards that began with sub prime mortgages has spread out. According to the Fed a significant firming is evident across most loan categories.
And just briefly going through it: For non traditional mortgages, 60% of domestic banks reported stricter requirements and that's up from 40.5% in July, and 45% in April; for subprime loans the net tightening has been reported by almost 56% of banks; a net 45% of banks reported weaker demand for non-traditional mortgages – subprime, interest-only; and 50% of the banks are reporting a drop in demand. And this has carried over into the prime market.
Do you remember, John, when they told us earlier in the year, “it's contained.” Well, as you see, it's not contained. It's starting to spread because 51% of banks reported a drop in demand for prime loans; and that's up from 10% in July.
And it's also getting over into the business side. It's not just with consumers. Lending standards have tightened considerably for commercial and industrial loans. And especially for medium to large borrowers, bank tightening has gone, from 7 ½% of banks reporting that they were tightening their standards, up to 19% at the end of the first quarter. And a lot of that had to do too with the commercial paper freezing up. So the cost of a lot of these loans has increased substantially; about 35% of domestic banks also increased the spreads from medium and large borrowers. So lending standards are increasing for the consumer in non-traditional mortgages, subprime mortgages, prime mortgages; it's increasing for businesses on commercial real estate and that's been one of the strong markets in the real estate market.
So you've got a lot of problems that it's facing on the economic front, and when the Fed sees that credit lending standards are tightening, it means that credit is going to be made less available to the economy then they know the economy is slowing down. So that's what they were sort of trying to give people a heads up. When you really think about it, John, what Bernanke was describing on Capitol Hill on Thursday was stagflation. He was basically saying “rising headline inflation and lower economic growth.” That is stagflation. [30:47]
JOHN: And where they are winding up right now is they are really fighting fires on three fronts. They are fighting fire with high voltage guard wires around it, so to speak. One is the economy versus a recession; the financial markets crashing is number two; and then the dollar really plunging. And you can tell this is one of those things like the pie plates in the air, sooner or later, one of these three pie plates is going to be crashing down on the ground.
JIM: Yeah. And I think you're already starting to see it with the response that we are getting from Canada and Europe and other central bankers on Friday is – because remember, the other central banks have not wanted to cooperate – we're going to continue to do this because there is nothing at this point that can replace the dollar. Can everybody go to the euro right now? No. Can everybody go to the yen right now? No. Are there enough other smaller currencies in the world that everybody can flee to? No. You're still going to have a dollar currency block, but what's happening is not as much money is going to be going into the dollar. It's going to be more dispersed, which is what the Chinese central bank is doing. That’s because actually if you take a look at foreign depositories at the Federal Reserve, they are still rising. So, yes, there is money that came out of this country in the month of August, but if you'll take a look at the Fed's custodial holdings for foreign central banks in September and October, that number has actually been rising. So are foreigners completely jumping out of the US? The Fed data would show otherwise. [32:20]
JOHN: So far.
JIM: So far.
JOHN: I wanted to put that caveat on there: So far.
And you're list thing to the financial sense news hour at www.financialsense.com.
FSN
Follies: Shakespeare at the Fed
The following program is made possible by a grant from the Hugo Chavez foundation and the Putin Oil Trust: Promoting energy security and independence in the Western hemisphere. Remember – you want it, but we've got it.
Welcome to Shakespeare at the Fed. In tonight's program, Shakespeare heads to the Hill to testify before the House Finance Committee.
SENATOR: Thank you for being here, I thought the responsibility of a Fed Chair was to speak in tongues, so I've been a little shocked that I actually understand you.
SHAKESPEARE: Stooping to your clemency we beg your hearing, patiently.
SENATOR: But we have, through a process of borrowing, accumulating debt and over 40% of our debt is held by foreign nations. Should we be concerned about that much debt?
SHAKESPEARE: Neither a borrower nor a lender be; for loan oft loses both itself and friend, and borrowing dulls the edge of husbandry.
SENATOR: That was such a quick answer I wasn't ready for the next question.
SHAKESPEARE: Why, day is day, night night, and time is time for nothing but to waste night, day and time. Therefore, since brevity is the soul of wit and tediousness the limbs and outward flourishes, I will be brief.
SENATOR: And there is great optimism for our economy. But regrettably, some of my constituents are not feeling optimistic and I share that concern.
SHAKESPEARE: The lady doth protest too much.
SENATOR: But then you say you think it might be more than you think. I mean, if you think it might be more than you think, why didn’t you think it?
SHAKESPEARE: There is madness, yet there is method in it.
SENATOR: If our economy is depending on consumer spending, wouldn't it better if we sort of spread the wealth a little bit?
SHAKESPEARE: ‘tis true, 'tis true 'tis pity, And pity 'tis, 'tis true.
SENATOR: You're a breath of fresh air in the sense that whether I agree with you or not, at least you're speaking in English.
SHAKESPEARE: You are an ass!
Do not forget to specify what time and place shall serve that I am an ass.
Here, here.
It
Ain't Over & It's Not Behind Us
JOHN: In the first segment of the Big Picture we were talking about the fact that the old rules really aren't applying, especially when we look at how the Fed used to keep things afloat in the past. This is important to understand. Remember, we always talked about the herd always running in the wrong direction, and the people looking in the rearview mirror trying to understand a new situation with the old rules – which can basically be as damaging as not having any rules at all. So how did we actually get ourselves into this mess in the first place? Let's lay down some background.
JIM: All of these problems are caused by monetary policy. The Fed has been in an expansionary mode under the Greenspan Fed from the moment he took over the Fed in August of 1987 to the first stock market crisis that began in October of 1987. The Greenspan response to any kind of problem was to inflate, flood the markets with money, slash and lower interest rates. And this worked out fine for a while.
And during the 90s, after 1994, when the Fed really began to inflate the money supply – you can see this if you look at ate a graph of M3 before they stopped reporting – on November of 1994, they really began to crank the printing presses. Now, as we have talked on this program in our Dying of Money series, when money is created, it has to go somewhere. It has two outlets. It can go into the financial markets driving asset bubbles or go into things driving inflation in the real economy. Well, we got the good kind of inflation in the economy with the rising stock market with all of that money printing. People just thought it was a new era in the stock market as equities went up 20% a year.
But eventually you have your day of reckoning and we got that day of reckoning when the Fed began to take away the punch bowl by raising interest rates beginning in 1999. Well, what did that cause? It brought us a recession, it brought us a bear markets in stocks. The Fed typically when we get into a recession or bear market, then they go through countermoves and they start lowering interest rates. And that's exactly what they did in 2001, where they began slashing interest rates and they took the federal funds rate from 6% down to 1%. So that in effect, what we saw from the year 2000 when long term interest rates as reflected on the 10 year Treasury note were around 7%, they got all of the way down to as low as a little over 3% in June of 2003. And as a result of that, as interest rates came down, the next bubble or malinvestment in the economy began in the real estate market. [37:58]
JOHN: So what this basically did was sort of kick off a buying spree in the housing market because people were now able to go out and buy larger homes or get into homes where they had never been able to do that before and that was something we'd never seen before. It created quite a bubble in this whole housing area. It was actually a euphoria.
JIM: Yeah. And there were two problems that were responsible for the mess that we're in today. One deals with the buying of homes themselves. In other words, rather than telling people, “wow, you're going to be taking on a half a million dollars of debt to buy this home,” the way real estate began to be sold was with the concept of “what would your monthly payment buy.” And instead of saying you're taking on this kind of debt, it says, like, what can your budget have?
Let's say for illustration purposes, let's say that all I can spend on housing a month is $1000. I'm going to do this just to make it easy to illustrate. If interest rates had not been brought down, and let's say they stayed high, a thousand dollars a month at an 8% mortgage rate would only be able to support a $150,000 mortgage. At a 7% interest rate, it would be able to support $170,000 mortgage. But what happened, John, as we brought interest rates down to 3%, people were going out and getting these creative financing where they would have these teaser rates for let's say a variable rate mortgage – when you had the federal funds rate at 1% you were getting teaser rates at 2 ½%. So a thousand dollars a month at a 3% rate would be able to support a $400,000 mortgage versus an 8% interest rate which would only be able to support a $150,000 mortgage.
So as interest rates came down, a bigger house was sold to the public and the public were thinking of “my thousand dollars can buy me a $400,000 house versus a $150,000 house.” And what they weren't thinking of is with all of these variable rate that's went into effect, what happens when your teaser rate of 3% gets reset at 5 or 6%; and what happens when the real estate market goes down?
So the problem that we have today with this concept of variable rate interest rates, and what your thousand dollars would buy you in terms of what kind of mortgage it would support, is that people weren't thinking of the price of real estate going down because for decade after decade real estate did nothing but go up; except for periodically you get these downturns. So they weren't thinking about what happens if real estate prices don't go up and what happens if interest rates go up. That’s because remember, even before the Fed began raising interest rates, you had people like the Fed Chairman Alan Greenspan encouraging people to go out and take variable rate mortgages which is exactly what they did. So that was problem number one. [41:26]
JOHN: In addition to people who got into homes say for example to live in them, then you started the speculative frenzy as well, people went out and started house flipping, so that drove this thing on even further. And then compounding on top of that then, it became just doggone easy to get a loan, especially with no-doc loans and everything connected with that whole process. So that's what drove this thing to the next stage.
JIM: Sure. And the next stage is what we're dealing with now which is the securitization of mortgage debt, or installment debt, or credit card debt. Because as interest rates began to rise in 2004, 2005 and 06, in order to keep the game in real estate going banks then began to get more creative. They got into interest-only loans, they got into negative amortization loans, they got into the teaser loans, they got into no-documentation loans. Imagine, John, a banker – and I have a friend who is in the banking business and the stories he has told me of no-doc loans. I think we’ve talked about them on the air, somebody coming in and saying, “yeah, I sing for the church choir and I'm making 100 Grand a year.” How believable is that?
And the reason that these loose lending standards came into being is because banks were no longer responsible for the loans they were making. Basically it became a manufacturing mill for credit: The more loans they could make and process and repackage the more fee income they would take on. And what happened is instead of the banks having to worry about “hey, we're making a lousy loan and if we keep this on our books we could lose money there,” they weren't worried about that because they were passing on the risk – the securitization – onto somebody else. So you had two combinations here. You had a misrepresentation, in my opinion, on how debt was sold to finance these houses because nobody was saying: “Look, yeah, your thousand dollar payment will buy you a 400,000 dollar mortgage. That's only good for about a year or two and two or three years from now. You might want to think about what happens if from rates go from 3% to five, six, seven percent, will you be able to afford this?” That's not the way it was sold. The amount of debt that a consumer has taken on wasn't the way it was packaged or sold to an individual. It was sold simply with a thousand dollar payment, this is how much house you can buy. So that was the one problem.
The second problem was banks were just going through this like a – almost a manufacturing machine or printing press and just recycling these loans, pushing them out the door, securitizing them, packaging them, selling them to Wall Street. They were sliced, diced to all of these things we know as collateralized debt obligations (CDOs) or SIVs. And it became a money making machine where like the Structured Investment Vehicles they can go into the money markets like the commercial paper market, borrow money at a low rate and turn around and buy these mortgages at a higher rate.
It was almost like a perpetual carry trade that was carried on through the entire economy. And so now that's where we are; we've packaged this massive amount of debt. And now, as Bernanke testified the other day, for every quarter going forward well into the end of next year, 450,000 mortgages are going to be reset. And a lot of these mortgages, John, were taken out initially at this 3 and 4% interest rate which would enable a person for $1000 to support a much higher mortgage. They are not going to be able to support that higher mortgage as these mortgages have to be reset. So now, we've got two problems that are facing the consumer: The mortgages are going to get reset, they are going to be at a higher interest rate. And at the same time, the banking industry which now since the CDO market, much of the mortgage market securitization has come to an end. Any loans they are going to have to make, they are going to have to keep on their own books so lending standards have tightened. So you have two things they are working against a lot these mortgage resets. Higher interest rates and tougher lending standards. [45:50]
JOHN: So what you're telling me is this thing is not over yet despite comforting words.
JIM: No. And I’m trying to think was it three or four weeks ago we talked and did a show about when this is all said and done you're going to probably have about 300 billion in losses that are going to have to be written off. And we're just getting started here. And the latest figures are going to be anywhere from 300 to 500 billion – half a trillion – in losses. So you know, remember, John, when they were talking about this is all contained, that it's all just “the brush fire has been contained it's just in the sub prime market.” No. It's in the Alt-A market. It's even moving over into the prime market. And as a result of that, you're going to see a lot more write downs; and these write downs are going to be carried forward well into next year as these mortgages are reset. And so this is just getting started. It's moving it's way through the brokerage system, it's moving it's way through the big money center banks. It's moved its way through the intermediaries and it's just beginning. It's going to get worse. [46:57]
JOHN: So first of all we know the mortgages are going to reset, banks will not be able to off load these. They are going to have to hang on to these packages, so this is going to create another round of defaults etc. But remember back in 2005 – and we talked about this on this program several times about them taking a safety valve and a very bad situation on a boiler and closing the safety valve. Remember they put into the bankruptcy bill that people can't walk away from their debt anymore. They’ve tangled people up in this. And I'm predicting sooner or later the clamor to undo this bill is going to be there. But isn't that another factor in this whole continuing?
JIM: Sure, because with the bankruptcy bill that was passed in 2005, consumers couldn't file Chapter 7 and cleanse the debts, and so they could only file Chapter 13. So what the new bankruptcy law actually did help to do is drive foreclosure to a record as homeowners default on mortgages and struggle to pay their credit card debts. So what cash strapped consumers are doing now is they are saying: “I can't walk away from my credit card and I need those, but I can walk away from this house.” And so this bankruptcy bill is coming back to haunt a lot of these banks. In fact, many of them have been reporting that here's one thing to watch for is delinquency in credit cards with payments more than 30 days late. We're already starting to see some recognition of this thing happening.
So you're right: What's happening right now, people are putting their credit card payments ahead of their mortgages. You take a look at companies like Capital One, the largest independent credit card issuer, its customers are at least 3 months late on their mortgage payments; 70% are current on their credit cards. So they are late on their mortgage payment, but they are making their credit card payments. What they are doing is they are paying the ones they have to pay. [48:50]
JOHN: Some banks are – the big banks, the big money center banks are snooping on their customers lives. I don't think people know this that, depending on the bank that you're with, they will most likely be checking your credit score almost daily to see what's going on in your account. And some people have their account slammed shut suddenly and they can't figure out why. It's because the bank is trying to determine risk in there. But other banks you can see where that would work quite feasibly because of the fact that the bank isn't checking every day. They don't care. If it's a different bank than the one that floats your mortgage so to speak then they don't care whether your mortgage payment is late as long as they get your credit card payment. You could see how that would work.
JIM: And as a result, we're seeing this reflected in personal bankruptcies which were up 48% in the first half of 2007 from the year earlier and chapter 13 filings accounted for more than one third of those bankruptcies. So what is happening here is you've got to make a choice. Well, if you purchased a house and you put no money down it's much easier to walk away from that mortgage and that house. And that's exactly what you're seeing; the consumer is saying: “Wait a minute, I have no equity in this house but I still need my credit card, so I'll make my credit card payment, they can have the house back.” And that's what a lot of consumers are choosing to do. [50:07]
JOHN: Because I have nothing in the house so I'm not walking away from anything.
JIM: Yeah. And I'm going to have to be forced to even if I file Chapter 13 – I'm going to have to be forced to make some kind of payment on whatever I've charged or put on my credit card. So it's a whole combination of circumstances which are here, but this thing isn't over. [50:31]
JOHN: Well, I'm still going to stand by my prediction here from three years ago that once the fertilizer hits the air conditioner – if you notice it’s splattering all over the place right now – once the fertilizer hit the air conditioner, there was going to be a clamor before Congress to pull that back.
JIM: They are already in the process. I think there is a bill trying to work its way through the House that the House Judiciary Committee is working on a new bill to unwind that 2005 bankruptcy bill because it's just blowing up. So it was great for the banks during good times, but it's not going to survive in tougher times. [51:02]
JOHN: No. I can see that one coming real fast. Anyway, transparency – and I think transparency is an issue here too that we haven't touched on enough.
JIM: Yeah. There is something else that I think we're going to get hit with. There is an FASB (the Financial Accounting Standard Board) Rule 157, and it's going to make it harder for companies to avoid putting market prices on securities considered hardest to value. And this is really going to affect the markets because basically, John, we've got three tiers of assets. Under the FASB terminology, you have Level 1, which means mark to market. That means if you bought, let's say, a mortgage security for a dollar and its market value –if it's known – is 80 cents, you've got to mark it down to 80 cents because that is what it is. That's level one.
Level 2 is mark to model where you have maybe a complex security like an over-the-counter derivative that is quite complex and what you're going to do is valuing it based on some kind of modeling input. And there is a lot of this stuff out there – especially with hedge funds, pension funds, and with other institutions – where they are holding assets on the book and they are modeling the value of those assets based on some computerized model.
And then you also have something called Level 3, which is based on “unobservable inputs reflecting companies own assumptions.” Imagine that! “Well, we don't have a model, but I believe the value of this asset is exactly what I say it is, which is a dollar.”
And so what's going to happen is if they have to start marking these assets, let's say that up an asset on your books and it's a level two asset and you're pricing it exactly what you paid for it, but now you have a similar type asset, let's say in the ABX where it's priced at 60 cents, 30 cents or 40 cents. That's exactly what you're going to have to do. So you're going to see a lot more writedowns as a result of this FASB rule when the new rule goes into effect November 15th. And when it's all said and done, you can see, John, probably another couple of hundred billion dollars of assets that are going to have to be written down here as a result of this new accounting rule, because what it's going to do is make it more difficult to keep these assets and keep this market opaque as it has been where people are saying “we really don't know what this stuff is really worth.” And you really don't until you turn around and try to sell it to somebody. And you may be carrying it on your books at a dollar, but when you have to price it in a market that is now more risk conscious as our market is today, you may only get 20 currents on the dollar, 30 cents on the dollar. So you're looking for a lot more write downs coming our way. [54:06]
JOHN: Is this where we call in Bruce Willis because it's Armageddon, or are we going to be able to float in thing upward and keep disaster from finally striking planet earth?
JIM: No. I don't think this is the Armageddon yet. I do think as we pointed out these losses are going to be somewhere in the neighborhood of 300, but I think originally we were looking at 200 to 300 billion. But if they come up as this new FASB rule 157 is implemented you may see probably an extra couple of hundred. So it could get as high as maybe 500 billion on the high end of losses. But you've got to put that into perspective to the total size of the mortgage market; and you have to put that into perspective to the total size and amount of liquidity out there.
But let me put it this way, the headlines as these losses are written off, we're going to see some Maalox and nail biting moments in the market. And it's just going to create more and more volatility. It's going to be very similar to the S&L crisis that we saw in 90 and 91 as Savings and Loans were going under. But look for them to repackage them, to reprice them; there are already venture pools that are raising vast amounts of capital that are salivating at the idea of going out and buying an asset for 20 cents on the dollar. So it's not the end but it is going to get worse and it's not over. [55:30]
Which
comes first? Peak Oil or Global Warming?
JOHN: www.financialsense.com. Time to move on to the next issue because this is going to focus on whether or not our wonderful Congress critters are running in the wrong direction. Just when everybody's been running around pronouncing the debate about global warming to be closed...And remember we're talking about four issues here on global warming: number one, is there global warming; number two, is it within historical norms; number three, if it's not within historical norms, is mankind responsible for it; and number four, even if we are responsible for it, will Kyoto do anything – and bear in mind in November they are going to be meeting in Bali to try to resurrect Kyoto 2 because most of the countries of the world are not meeting their targets.
...But just when this debate has been pronounced over, founder of the Weather Channel John Coleman came out and said that global warming will ultimately turn out to be the greatest scam in history. In a couple of decades we'll look backwards...
But we're not going to engage in that debate here. What we're going to look at is the whole issue of which comes first, global warming or peak oil? How are we going to tackle both of these, are they wise or unwise? Taxes, credits, incentives or penalties. I guess we've opened the field there, Jim. Where do we jump in?
JIM: We've been talking about that rising oil prices, peak oil here, John, for, gosh, how long have you and I been doing this show? Six years now?
JOHN: Something like that.
JIM: Probably going on seven. And we've been talking about peak oil, one of the reasons behind this. And every time oil has climbed up the ladder in price, when it went from 20 to 30, I remember I had Jimmy Rogers on my program. He had just gotten back from going around the world and he wrote his book and he said, “I don't think you'll ever see $25 oil again in your life time.” And he was absolutely correct. Oil went on beyond 30 and when Rogers said that, by the way, it was somewhere between 20 – I think it was 28 to $30. It went beyond 30 and then in 2003, it went up to 40 and of course everybody was saying it was the Iraq war premium. There is ten dollars in the price of oil and when the war is over oil will come back down, which is what it did during the first Gulf war.
And then, you know, well, the war was over and it continued to go up. And then all of a sudden they said, “well, it's speculators and hedge funds, they are adding 10, $20 to the price of oil. Then it went through 40. And you remember, John, when it went from 40 to 50 they were talking about, well, the dollar – the fundamentals argue against it and the Fed is now – this was like in 2004 when we moved above $40 and they were talking...And remember, the Fed started to raise interest rates and in 2004, it got almost to $60 a barrel and the Fed began it's interest rate hikes...And they talked about how this is going to slow the economy down; it is going to stop demand.
And there was also the China scare in 2004; that the Chinese economic growth was going to slow down; therefore less demand for energy. So they gave us the economic reasons, so they were blaming the premium on something.
Then in 2005, we get to $70 a barrel, especially during the summer of that year during the hurricanes in the end of August and September. And then they said that's weather-related. So the price of oil came down and then in 2006 we had a correction, it went back up, touched roughly around $75 a barrel; and then remember, the Fed is still raising interest rates in 2006. And they said eventually economic growth will slow down.
The point we're making here is since 2001, we have one series of – you know, you always hear about, well, it's the war premium, it's the terrorist premium, it's the speculator premium, it's the dollar premium. The fact is, John, it keeps going up. So you can talk about all of the premiums. I heard somebody say, “well, there is probably a speculator premium of about $30 in the price of oil that the intrinsic value of oil right now should be around 55, $60 a barrel. [4:25]
JOHN: The question would probably be whether or not this is a speculative issue or simply just something of demand really just outstripping supply; which does happen?
JIM: More than anything else in plain, simple economics, if you take a look at the demand growth between the US and China, over the last decade and a half, that alone, just in the increase in demand coming from just the US and China, that has added 7 million barrel per day in terms of consumption. And we've had all of these assumptions. And Matt Simmons talks a lot about them. In fact, I just want to let our listeners know, Matt will be a guest of mine next week in Other Voices.
But in the 90s we said it was the modern economy didn't consume much oil, oil demand had peaked. And then we had the Peso crisis 94, the Asian crisis in 97, Long Term Capital Management in 98; and that was going to kill demand. And we actually had oil prices down to $10 a barrel. And then we had the recession and events of 9/11. The fact is between all of these periods of time where we were making these assumptions about demand growth, demand globally from 1995 to 2007 grew by 16 million barrels a day. And if you take a look at the fourth quarter of this year, oil demand is projected to reach another all time record. So demand has not dropped as the experts have been telling us for nearly two decades. [6:04]
JOHN: Okay. Then what is driving global oil demand? Obviously there are several different factors involved.
JIM: Plain and simple, it's economic growth. The one factor that we're contending with today that we didn't contend with two decades ago are the industrialization of China, India and the developing world. And those industrialized economies, where a lot of the manufacturing takes place, are more energy intensive per dollar of GDP than more service-oriented or financial-based economies such as the United States. And so it is economic growth. And especially coming from countries like China and India, which are becoming the new economic power houses that are driving this demand. So it's economic growth. And despite the fact that, yes, we use less oil in the United States per dollar of GDP, I mean a lot of our GDP is fluff stuff, it's wedding planners – no offence against wedding planners. [7:07]
JOHN: Talk show hosts, things like that. People that don't contribute anything useful in to the economy; right?
JIM: Yeah. But in a service-based economy, we're consuming less energy per dollar of GDP. But the fact is our economy, service-based as it is, has gotten larger. And the US today is consuming more oil today than it did five years ago, 10 years ago or two decades ago. So despite less use for GDP, we are still consuming more of this stuff. [7:34]
JOHN: That's an increase in demand, not to mention internal usage by various countries, even producing countries. What about the supply of oil; are we hanging in there? If we just dug a little harder, would we find more? What?
JIM: That's the other side of the equation, John, and that's where the problem lies. Non-OPEC supply had basically flattened out; the large spare capacity in OPEC has narrowed considerably and it's now somewhere around two million barrels. And crude oil growth fell behind petroleum demand. I mean oil companies – the majors, the national oil companies – have simply not been able to increase oil output at a fast enough rate to keep oil demand. And then something that we have pointed out on this program, what most people don't realize, not only is OPEC not able to increase –and we only have a couple of countries within OPEC that do have the ability to increase production – but they are also consuming more because within OPEC countries, they are subsidizing oil. Whether it's Venezuela, Saudi Arabia or Iran, they are basically consuming more of the product that they produce. So the more that they consume and if they are not able to increase commensurately with that consumption, the less they are going to have to export. So a lot of what might be excess surplus is also being cut back by the fact of their own increase and their own domestic consumption. [9:07]
JOHN: Obviously, we have a collision coming here because if oil demand continues to flow and oil supply is not increasing, then this is a point of – not a point of no return, but it's obviously a situation that gets worse and worse as time goes on.
JIM: Sure. And I think that's why as Matt Simmons and others in the peak oil camp have been saying, the wolf is at the front door, and peak oil is a serious issue. And what we're doing to make up for what has happened that we're not able to meet this demand – we normally get a very strong increase in the fourth quarter as the weather changes and gets colder – is we're liquidating our oil stocks; we're dipping into our supply of oil in storage to make up the short fall. And you know what? You can't do that for ever or do it for long. I mean, it will get you through a winter and maybe keep a lid on prices, but you don't think traders and analysts are taking a look? I mean smart people are watching that and saying “wait a minute, here is OPEC production, here is non-OPEC production, here is demand and demand is higher than supply, so supply is not meeting demand and we're drawing down our stock.” We have a problem here and that's the market’s way. That, I think, is the real reason that we're seeing oil prices where they are. And if you look at the Energy Information Agency itself, conventional crude oil production peaked in May of 2005. And it's gone down since that, so that's where I think we are right now. [10:47]
JOHN: But the other side of the argument, and I've been wanting to bring this one up, is the global endowment. “If we just explored more new technology would come on board, there really are big caches of oil that we're not exploiting,” yada yada yada. How does that factor into the equation?
JIM: Let's take some of those arguments and this gets back to the reserve idea. The Canadian oil sands are expected to have an oil endowment somewhere around 160 million barrels of oil. But John, the Canadian oil sands, they are not going to be producing 10, 15 million barrels of oil a day. Maybe by the middle of next decade they are going to get up to 3 million barrels of oil a day. So they always make a mistake. They take the total number of reserves, take the current production rate and say we'll just divide that into it, we've got more. The argument just doesn't hold up. Yeah. We've got a lot of potential oil but whether the Canadian oil sands will ever go beyond three, five, or maybe five or six million barrels a day is a debatable issue because it's very expensive oil to produce. It is also energy intensive to produce so it uses a lot more energy inputs in its production.
And then as far as the price issue of if high prices go up, it will unlock more oil supply. Well, folks, the price of oil has been going up since 2001 where it was at 18 to $20 a barrel and we're at 96. And you would certainly think a four-and-a-half fold increase in the price of oil, if you buy the economists’ argument higher prices will bring more supply – it hasn't. We're talking almost $100 oil. Where are the major oil discoveries? Where are the new North Seas, the new North Slopes, where are the Ghawars, where are the Cantarells, where are all of this major oil that's supposed to be out there that's supposed to come online? Though there was a state-owned oil company this week that made a major discovery off the shores of Brazil which will add to the reserves. But it's not a North Sea, it's not a North Slope. So prices have risen, but we haven't seen a commensurate increase in supply. [12:57]
JOHN: What about infrastructure? How would that factor into this whole thing? For example, say the Gulf of Mexico turned into a giant vat of oil? Could we use it?
JIM: First of all, we don't have the facilities to process it. We have the capability, I think the figure is somewhere around 17 ½ million barrels. The fact that we haven't built a refinery since the 70s, that's another issue in terms of oil security that we don't talk about. It's not just the fact that we're importing oil, it's not just the fact we're importing natural gas, we're also having to import more finished products because as our demand for finished oil products increase – for gasoline, diesel, jet fuel – we do not have the capacity to produce it or refine it. So not only do we have to import the raw stuff, we also have to import more and more each year of the finished stuff.
And our pipelines – we don't have enough pipeline to carry for example natural gas; we don't have enough refineries to refine the type of oil. And especially now, a lot of the excess oil that's being pumped out which is the sour crude instead of the light sweet crude which a lot of refineries were designed to process. So we have less of that. We also have even some of the oil platforms out in the Gulf and some of the oil infrastructure itself is aging, John. We have refineries in this country that are 50 to 70 years old. And when you get old, stuff starts to break down. And we're putting increasing demands on these refineries to run at hotter levels to process the new fuel requirements of the new refined gasoline with less sulfur. So there is all kinds of stuff that we're doing here. The point is where is this coming from?
Energy is a very, very expensive process. Finding oil – we mentioned that finding oil has gone up by almost 26%; lifting oil has gone up 31%. This is just in the last year. And the cost of getting this stuff becomes more expensive and as those costs go up, you're going to have people that are going to say: “You know what? We can't afford to produce unless we get $80 or $90 and are afforded a profit.”
So despite all of this, John, where is the beef? Where is all of this excess supply they are talking about? Where are all of the new discoveries that they are talking about. And, yes, we have new fields that are coming online, but the one thing that they fail to talk about is the number of fields that are declining and at a very, very rapid rate all around the world. And the number of countries that have reached peak oil and are now into decline. So Matt Simmons has said it, and I think he said it last year, didn't he? he made a repeat prediction on our show and he said within the next 12 to 18 months peak oil will overshadow global warming as the number one single topic of importance. In other words, the whole political spectrum is going to change.
And you would have thought, as we approached $100 oil, our politicians and those running for president would be talking about it other than just giving the lip service about it. But you know what, John, I don't know what that figure is going to be. Maybe it's going to be 125, 150 or 160. I certainly think that as the price stays up here and continues to go higher, that as gasoline goes to $4, $5, eventually $7 and $9 – I have people that tell me in Europe they are paying $9, of course part of that is taxes, but – as that price goes up, it will overshadow the global warming debate. [16:38]
JOHN: I tend to think that if global warming does not manage to merge itself into the issue of oil, then it's really going to subside quite a bit. You're going to see that. I said that a couple of years ago and I'm still standing by that. If they do succeed in reframing the global warming issue in terms of energy policy rather than oil, then there is a chance it may keep on going. Other than that, like I said, they'll take it to the side of the ship and throw it off.
JIM: Yeah. But if you take a look at it, global warming pales in comparison to the immediate devastation or impact of peak oil. I remember, I think it was Robert Hirsch’s report that was issued; he was commissioned by the government in 2005 and he looked at peak oil and he said it's coming. He said whether it's 2015, 2010, 2020, 2030 – there is a debate there because it could be forestalled through economic contraction or some of these alternatives. I mean the reason we've been able to increase output since May of 2005 when conventional oil peaked is because we've been able to use coal-to-liquids, gas-to-liquids, ethanol, biofuels; and that's what's making up the difference. You've got global demand in the fourth quarter, which will be over 87 million barrels a day and, you know, conventional oils only producing around 75; so another ten million barrels a day is coming from all of these other sources.
But anyway, getting back to the Hirsch Report, he said, “peak oil is coming. And the best alternative would be if you take steps and plan for it 20 years before it occurs.” And he goes on, if that is done –you conserve, you get better gas mileage, you go to mass transit, you start using thing to conserve and then start coming up with alternatives – we can get through this painlessly.
He said the second best scenario is that maybe it becomes conscious 10 years before it occurs. You're going to have some difficulties because changing the whole energy infrastructure cannot be done over night. He said the nightmare scenario is if it is immediate. And that is the question right now because conventional oil production peaked in May of 2005, and these alternatives are what has been making up the difference since then. So as Matt likes to say, if the wolf is inside the door or the elephant is inside the living room, we've got a problem here. [19:15]
JOHN: How soon can we expect this, because the IEA was saying by 2012, by the end of 2012, we were going to be smack in the middle of this bottleneck problem that we have. In other words, you can't ramp up fast enough. What are the chances we're going to smack into it and what are the chances we're going to dodge the bullet?
JIM: I don't think we're going to dodge it. And their crisis window (and this is the very same crisis window we've been talking about on the program) opens up in 2009 to 2012. We do have more biofuel plants coming on stream, we do have some new oil fields coming on stream. We have coal-to-liquids, gas-to-liquids. That is still coming on stream and that's what's kind of getting us through this pinch. But the other thing is we're draining our oil stocks –our inventory in the warehouse – to make up these shortfalls. And so maybe we can draw on inventories over the next 12, 15 months to sort of get us through. But I think the oil markets are already sensing that as we sit here on this Friday where WTI crude closed at 96.32 in the futures market and Brent crude closed at $93.18. And you know, John, we haven't really got to some real cold weather yet. [20:41]
JOHN: Just trying to plumb out whether or not it's really going to make the dive in the crisis window. I'd like to think not, but unfortunately I think it's heading in that direction.
JIM: I know it's heading in that direction because right now the way we're getting through this is we're drawing down our oil stocks and we’re looking at $96 oil. What happens when our oil stocks really begin to deplete and they are not replenished and as demand continues and the price goes over 100. I suspect, John, if we're over 100, $125 one of the reasons that the price at the pump has not caught up as quickly is a lot of refiners have been burning off and using their older inventory; that's one reason we've seen some stocks decline. And as they use up some of the older inventory which was bought at an older price, that's reflected in the blended rate between what they have to buy at a new higher price in terms of what we're paying at the pump. And as the prices stay up at this level, we're not too far away from going over $4. I don't know what it's going to take. Maybe it's $5 here, $6. I would have thought it would have been $3, because if you take a look at where we've gone, we've basically doubled the price of gasoline. But as a percentage of most American's income it's a smaller percentage today. So I think that probably I would suspect when you get close to five dollars or six dollars people are going to start saying “Ouch!” [22:11]
JOHN: Yeah, and it depends on how far you've got to drive every day as to how bad the ouch is going to be.
JIM: I suspect by the time we get to November of 2008 that I think oil will become more of a dominant issue in the presidential campaign.
JOHN: On an increasing frequency. In other words, we'll actually have it in the presidential campaign. But then as this crisis window opens up, you are going to see it become more and more of a Capitol topic. I still believe whoever sits in the next Congress and whoever sits in the White House is going to be presiding over an incredibly turbulent period coming at them from a half dozen different sources. I really believe a lot of things that they are talking about that right now under the presidential debates – aside from the fact that I think the inmates are running the institution – is the fact that those will just be shelved. People will be so busy dealing with alligators, there won't be time to push a lot of those agendas.
JIM: Yeah. I would say by the time we get to next summer, when both parties choose their candidates for the presidency and we get into the fall election campaign, that energy is going to be one of the dominant issues. And I really believe and this is one of the questions I'm going to ask Matt Simmons, who will be a guest on this program next week. And I'm going to talk to Matt and say, “Matt, what is the likelihood that energy becomes the number one issue in the political campaign as we head into November of 2008?” [23:26]
JOHN: So basically by the time that oil gets to, he says, $150, $160 dollar oil, like I said, you're going to see the global warming debate will come screeching to a halt; or any action on it will come screeching to a halt because the economy will be crippled enough that also – as people will see from our guest on Other Voices coming here shortly – people are going to realize what the costs of these caps and credits and trades and other things are going to be related. And by that time it's either going to successfully merge in or be forgotten. That's where it's going to be at that point. www.financialsense.com. Coming up: Other Voices.
Other
Voices: William Kovacs, VP of Environment, Technology and Regulatory
Affairs
JIM: One of the worse things that can happen to all of us as citizens in this fair land is when Congress is in session because that's when they enact bills, some good, some bad. We're here to talk about one that doesn't look so good. Joining me on the program is Bill Kovacs, he’s Vice-President of Environment, Technology and Regulatory Affairs for the US Chamber of Commerce.
And Bill, Congress just passed a bill, the Leiberman-Warner Global Warming Bill. Why don't you take us through it and what are some of the issues that the Chamber of Commerce finds wrong with this?
WILLIAM KOVACS: Sure. Well, first of all, they just passed it out of subcommittee, but it's expected to go to committee next week. The essence of the bill is to, over a period of 40 years, begin regulating how the economy is going to reduce emissions of CO2. So what they do is set a limit as to the amount of CO2 that can be released into the atmosphere; and every year it's got to be less. And CO2 generally comes from fossil fuels – coal, oil and gas. Unfortunately what the bill doesn't do is it doesn't have any emphasis on technology. So as you begin putting more and more restrictions on the energy that can be used, you need more energy to come into the marketplace in the form of non-fossil fuels. And that presently doesn't exist. And so how they handle it is that it's literally the old style 5 year, 10 year, 15 year planning that we used to ridicule back in the 50s when the old Soviet empire used to have these long term planning process. Only, this is a 40 year planning process.
And they then allocate which segments of society are going to have the ability to use energy. For example, they give some of the credits to the Climate Change Credit Corporation. Others are given to companies who have already reduced credits and then they give some to Indian tribes and states they give some to poor people because they won't be able to pay their energy bills. They give some to the Secretary of Agriculture for forestry projects; and then they give some to the electric utility industry and the manufacturing industry. So it's literally a planning process over a 40 year time period. They are not mandating or using technology that doesn't exist.
And the financial one, I guess, the impact – they had some economic witnesses today testifying the impact is going to range somewhere from a tax on a family of about $1000 to about $3500 depending on what the price of carbon is. It's going to have a direct impact by 2015 of about $160 billion to $250 billion loss to the GDP. And going out to 2040, which is where the final part of the planning process ends, it's going to have a negative drag on the economy by about $800 billion to a trillion dollars. [27:23]
JIM: Is there anything in this bill that addresses okay, if we're trying to clean up CO2 – and it sounds to me like central planning in the Soviet Union – what about China, India? And isn't this a little bit more radical than even the cap-and-trade system that's currently being proposed or used in Europe?
BILL: It’s much more radical. But you hit the key point what about China and India. If you were going to ask us what is the biggest problem with the bill is that it's only a domestic bill. And even the increase of omissions from the developing world is so great that if you shut down the entire United States – just pretend you wiped us off of the map – in seven years the increase in emissions from the developing world would equal all of the emissions that the United States currently generates. And no matter what we do in the United States, no matter how much economic harm this bill would inflict, the emissions of CO2 will still increase worldwide. [28:24]
JIM: And there are even some individuals, a lot of scientists that are even questioning the validity. I mean, you and I emit CO2 emissions when we breathe, so I guess we could probably stop breathing.
BILL: If you looked at just the world and you ask how much CO2 is in the world, I think the numbers are roughly on an annual basis about 207 billion tons; and of that about 7 billion tons is attributed to humans. The rest is naturally occurring. [28:57]