The
BIG Picture Transcript
May 10, 2008
Part 1 Real
Player | Win
Amp | Windows Media |
Mp3
Part 2 Real
Player | Win
Amp | Windows Media |
Mp3
Part 3 Real
Player | Win
Amp | Windows Media |
Mp3
Part
1
What's
Wrong with Gold Stocks?
The
Art of Creating Shortages
Part
2
Behind
the Numbers: The Make Believe Economy
Other
Voices: Bill Reinert, Nat'l Mgr., Advanced Technology Group, Toyota
Motor Sales USA
Opportunities
Inside the Oreo
Part
3
Q-Calls
What's
Wrong with Gold Stocks?
JOHN: Well, it is no secret that gold prices have been heading higher. In March, gold prices headed north of $1000 an ounce; and since then of course, as could be expected, they pulled back. Today they’re close to 900 an ounce – in the high 800s there – which is up from last year; bullion prices of gold and silver equities rose in tandem. However last year, precious metals equities lagged bullion as they have this year. So people are wondering what is behind this divergence? Does this spell either a) trouble or b) opportunity? And that’s our first conversation here on the Big Picture today.
JIM: Looking at bullion prices, we commented actually that performance is starting to change because right now, year to date, we’ve got bullion prices up a little over 3% and you’ve got the HUI up about 2.8% and the XAU up about 2.6%, so they’re getting closer. This divergence which was widespread last year is narrowing this year and I think we’re at that tipping point where you’re going to see gold equities and silver equities start to outperform the bullion.
But anyway, there were probably three or four factors that were behind this divergence. One was costs that were rising faster than bullion prices; 2), with the emergence of the credit crisis last year there was an aversion to risk; 3) the credit crunch, which made it more difficult for some companies to get financing; and 4) is a reversal of hedge fund activity from being long to going short because there were only a handful of five or six stocks within the HUI that made money (a good majority were either neutral or they lost money.) And of course, if you look at the junior sector, juniors were down last year as they are this year.
So one thing that stands out – and I think the reason for this underperformance as it relates to producers is that costs in the mining sector were rising faster than the price of bullion. Remember, up until last August, gold prices were at 650 an ounce and it wasn’t until this credit crisis burst upon the scene that bullion prices really rose at double-digit levels and above the rate of costs. Mining costs have been rising at an annual rate over the last two years between 25 and 30% a year; and it’s attributable to a number of factors. You had rising labor costs; you had the rising cost of energy – look at energy costs where oil went from $50 a barrel to $100 a barrel; material costs – everything from steel to plastic pipe; and also government take – governments began demanding a higher share of mining profits. So as recently as the fourth quarter of last year, margins were hurt as costs were going up faster than the price.
For example, if we take a look globally last year, in the fourth quarter you had costs were up 30% in South Africa, they were up 23% in Australia; Canadian mining companies saw their costs rise 23%; in the US costs rose close to 20%; in the UK, costs were up 23%. So if you take the average of global prices, they were up 28%. Now, if we boil that down to companies, the large producers: Newmont saw its costs rise 19%; Barrick’s costs rose 31%; if you take the South African producers such Anglo, Gold Fields and Harmony – their costs rose anywhere from 31 to 40%. Globally we’ve seen average costs rise from about $175 an ounce in 2001 to around $390 an ounce for 2007. So costs are up over 120% over the last six years and more importantly, they have skyrocketed over the last two years. In 2007 alone, the average cost for producers went from 300 to around $400 an ounce, so that cut into margins which is why a lot of the gold stocks –especially the large caps – underperformed bullion. [4:39]
JOHN: So looking at it from a pragmatic standpoint, if you were an investor should you avoid the stocks and just buy the bullion – I know we see these questions come into the Q-Lines a lot and emails – or what should the strategy be here?
JIM: We have always advocated on this program that you start your base building in precious metals [with] bullion and some people like to recommend at least a 5% position in bullion. So you start out with your bullion base. But now right now, if you take a look at where the value lies in the market, and I think we are seeing this change before our eyes even on this day that you and I are talking – but the real value lies in the precious metals stocks versus the bullion. But as a consequence, also the risk is higher. But I believe if you look at the markets today, the opportunity lies with the equities. Prices have finally risen – on the day you and I are talking the price of gold is at 886 – so the price has finally risen high enough now that margins are also rising for the producers.
A good example is the recent earnings report for Newmont which reported first quarter earnings of 82 cents a share; that’s up from 15 cents a share a year ago and a loss 63 share in 2006. So if prices remain high as they are now at close to $900 and head higher as I expect – I expect we will retest 1000 and then eventually we’re going to go beyond 1000 – so the producers are going to be minting money if prices of gold bullion stay at this [level]. And remember they are very leveraged to the price of bullion if they’re unhedged and that to me represents a better opportunity in my opinion than bullion. [6:31]
JOHN: I know you favor the growth producers who are building resources and growing production but if we do some comparison, how have they fared up against the super majors?
JIM: I actually think the growth producers are doing much better. Some of my favorites actually have negative costs. If you take a look at Agnico-Eagle, their cash costs are a negative $184; Yamana’s costs are a negative $9 per ounce; and the numbers are even looking better as you look at the firs quarter of this year. So these growth producers continue to be the low costs producers, meaning they are making a lot more money per ounce of gold or silver sold and I think that situation is only going to get better going forward. [7:16]
JOHN: Up until recently costs were rising faster than prices and as a result you would expect that would hurt profits which it did, which in turn damaged stock performance. But can anything else be factored in here to explain this divergence between stocks and bullion?
JIM: Sure. I think there is a broad aversion to risk which came in last August with the credit crisis. When that crisis erupted, investors basically said “where did this come from?” and everybody rushed for safety. And what happened is in terms of asset allocation there was a shift to safe haven type investments. And those two safe havens were Treasuries and bullion. Gold and Treasuries became the safe haven of choice and if investors went into precious metals equities – which they did because they did rally in the fourth quarter – it was mainly the large cap producers; the rest of the sector, from junior producers to junior development companies did very poorly since May of last year. And even in the case of some of the majors, investors have been mainly trading in and out of them. When gold pulled from 1000, you saw companies like Agnico whose share price went from 83 and dropped all the way down to $59 a share. So even the shares of majors have pulled back sharply as bullion prices pulled back. [8:41]
JOHN: And what about juniors? I mean I know you favor them – that’s been no secret here on the program.
JIM: Oh my goodness, I mean they have taken these companies out to the woodshed and beaten them up severely. In many cases, you can take a look across a broad spectrum – they’re practically being given away. But juniors sort of travel to their own individual cycle. I know a junior that I’ve been involved in was beaten up severely last year due to management problems; there was heavy shortselling that came in to the stock – in fact, a naked short position came in due to financing. But this year the stock is up almost 130%. What I find I think remarkable is even as things have gotten better for a lot of these companies and especially this one in particular the short position has actually increased. But what is happening to this company I see happening all across the sector. Companies announce spectacular drill results, they increase their reserves and the stocks go down, the short positions go up. [9:42]
JOHN: We’ve done shows before on shortselling. What is behind this anyway?
JIM: I think that part of this explanation is due to hedging, especially with the markets becoming more volatile; a lot more uncertainty was injected into the markets with the credit crisis last year. So, with hedging let’s say you take a long position in bullion which has been the dominant trade, then you hedge against bullion going down by shorting the gold stocks; Or, if you’re long the majors you short the juniors.
Gosh, going back to the turn of the Century, I’ve been involved in this sector since 2000 and 2001, when we got heavily involved in this sector and John, I’ve never seen short positions like I’ve seen today. They short the majors, they short the intermediates, they’re shorting the juniors. [10:35]
JOHN: What would really help here is some examples of what you’re talking about.
JIM: I’m not going to get into specific names but I’m just going to give some examples. One of the companies we own just reported that their sales were up 172%, their profits were up 400-something percent and John, this is a company whose stock is down 19% this year. And the short position went from nothing to almost 5 or 6% of the outstanding stock – and this company is very tightly held. So management is a key holder as well as certain other respectable firms that own this company, but you know, they reported these results and yet the stock got hammered.
Another company that reported spectacular drill results: They reported for example, 8 meters of gold averaging 55 grams of gold; they had 10 meters of 46 gram gold; they had 32 meters of 15 gram gold. You’re talking about an Aurelian-type deposit here and it was amazing because when they announced these results the stock went up and then all of a sudden the stock got hammered and it was actually reported – it went on the naked short position that came into this stock; and short positions just multiplied.
Another company reported drill results: 16 meters of 4.6 grams of gold; 1300 grams of silver; 7000 grams of silver, 28 grams of gold. And this is a company that within a three month period of time reported drill results with these kind of results and each time they reported this, what happened is the short position increased in the stock. So a lot of people are saying, “what’s wrong with juniors!?” There’s nothing wrong. A lot of these companies are either if they’re junior producers are reporting almost in one case, 200 to 300% increase in sales; 4 or 500% increase in profits; drill results that we haven’t seen; or for example they increased their reserves or their resources by 20 to 30%. And what has happened, instead of the stocks going up or if they do go up on the results immediately heavy short selling comes in to drive these stocks down because that’s been the dominant trade – you go long the bullion, you short the stocks. And this is all across the whole spectrum. [13:06]
JOHN: Is this whole process legal or is there something fishy here?
JIM: Shorting is legal and is actually quite bullish, if you think about it, because eventually short sales have to be covered. What is illegal is naked short selling and that is actually equivalent to what we call counterfeiting stocks. And there is a lot of that going on right now and the regulators, just as they were asleep with the accounting and scams of the Enrons and just as they were asleep with this credit problem going on with these CDOs, they’re also asleep now with this naked short selling. In fact, the SEC probably opened the door to this kind of activity when last year they got rid of the uptick rule to accommodate the hedge funds. So there are a lot more shares sold short than shares that are registered.
So part of the problem is the regulators are allowing this to occur because if they really pressed a lot of the funds to come in and cover their naked short positions because its so widespread they would actually trigger another major financial crisis and I think that’s what they’re dealing with right now. This sort of lying underneath and nobody is giving recognition to this in terms of how widespread [it is.] I read a report on a New York Stock Exchange – I think it was like 25 billion shares sold short and it goes way beyond the number of shares that were registered in the companies that were sold short. So it’s a widespread problem right now, not just with the juniors but all across the board. [14:43]
JOHN: It’s something like you said that can’t be unraveled because if they did unravel everything really would unravel if they tried to deal with that issue. You know, speaking of crises: What about the credit crisis because banks are tightening their lending standards, they’re deleveraging their balance sheets so this would seem to be presenting a problem for juniors with credit conditions that are really, really tight right now compared to what they were a couple of years ago?
JIM: Well, look, if you look at the junior sector there are probably about 2,000 juniors out there; and out of those 2,000 probably less than 5% of them will ever turn into a mine or go into production. So for many of these companies times are going to get tough. However, if you have a project that has a defined resource of– I don’t know – anything over a million to two million ounces or more, is in a friendly jurisdiction (especially with political problems of nationalization on the rise), with good mining economics, with good management that is probably equivalent to like having a FICO score of 800. And companies with 800 FICO scores are having no problems getting financing. We’ve been involved in three different financings this year and all three were oversubscribed with money waiting in line to get in. So like the real economy, if a company has a viable project, a defined resource with plenty of blue sky, you’re having no problem getting money. [16:13]
JOHN: So if shares haven’t been performing as well as bullion and hedge fund shorting, then who is buying? I mean for every seller there has to be a buyer in this deal, so who is on the other side of these trades?
JIM: If you take a look a look at what’s happened, probably going back to summer of last year, most of the day-traders and the momentum traders have exited this sector. What I see now is a lot of big, smart money moving into the sector. You see this almost daily. In fact, on the day that you and I are talking, John, I’m looking at my screen of majors, intermediates, and juniors – you have the HUI, the XAU is down and a wide swath of juniors are in the green. Several of these juniors are up 7, 8%. So I think what has happened is there a widespread recognition, I think this short in this sector is in the process of reversing itself.
And if you think about it, ‘buy low, sell high’ we’ve always been told that’s how you make money in the market. Well, when gold was at 1000, everybody was high-fiving going into the major gold stocks. Look at where we are today. The sector is beaten down, it’s ignored; pessimism runs rampant in the junior sector. It reminds me a lot of what I saw in the year 2000 and 2001 when I first began to accumulate juniors. I mean the tech bubble was bursting, the economy was heading into a recession, you remember all the scandals with the Enrons, the WorldComs. Investors were putting their money in cash. Nobody wanted to invest in gold. It was unloved, undervalued and underowned. But gold and gold stocks were being given away during that period of time.
A similar story by the way for oil because nobody was buying oil between let’s say the years 2000 and 2003 when oil went from $30 a barrel; and it wasn’t until oil prices got over 40 and headed towards 50 that money began moving into the oil sector. Even on a day that we are talking where our forecasts for $125 oil was reached on this Friday and the oil prices closed at just a few cents below 125, you know what, they were selling off the oil stocks. And it’s like people are saying, “well, you know, this can’t last – this is not going to be there.”
So if you take a look the fundamentals for gold have never been stronger, especially as we head into that crisis window that you and I have been talking about that begins in 2009 and goes to 2012. In respect to gold equities, the situation has never been better. And as Warren Buffett likes to say, you’re being given a perfect pitch. [19:07]
JOHN: Well, the role of patience or the lack of it in this situation?
JIM: We have talked about this over the years. If you’re not a long term investor, if you don’t understand the fundamentals that are behind gold, and especially gold equities, then you know what, quite frankly you don’t belong in this sector. Keep your money in a Treasury bill or a bank CD. However, if you’re a long term investor and have a long term horizon when you make investments, it just doesn’t get any better than this. [19:41]
JOHN: Okay, but let’s create a theoretical scenario here. What if prices don’t go back above the $1000 mark. I mean gold prices are usually soft during the summer months, so what if the conditions you’ve named that keep juniors from performing, what if they persist now?
JIM: Quite honestly, my ideal scenario I would love for these conditions to stay at these levels for the rest of the summer and early fall. But you know what, I’m in the accumulation mode so I hope they keep prices low because that enables me to buy more shares at much lower prices. And you know, that’s all I care about right now because I know that gold prices are heading much higher. I know that oil prices are heading much higher, commodity prices are heading much higher. And John, when price are going to recognize that – will it be this month, will it be next month, will it be by the end of summer? I would say by the end of summer the price of silver, the price of gold is heading higher. By summer, we’re going to be looking at much higher natural gas prices and as we get into fall, as we’ll get into the next segment I have now revised my price forecasts where we’re going to be looking at 145, $150 oil and certainly by the end of next year, $200 oil. So I don’t care what the price is now – if they want to short the stocks, drive the prices down – I’m in the accumulation mode just as I was in 2000 and 2001. And all I care about is how many shares I’m going to be able to buy and I think that is what is more important. So I hope they keep this down. But you know what, if you take a look at these conditions, they will not last much longer. They never do. In fact, I wouldn’t be buying bullion here as prices at close to $900, I would be buying shares because that’s where I think the value is in this market right now. [21:38]
JOHN: I have to admit that as long as I’ve know you you’ve been a long term investor, but that’s in many cases sort of a contrarian position from what I would call the knee-jerk day to day of what’s been going on out there. It’s a whole different mind-set, let’s face it.
JIM: I’ve always looked at long term investing – I’ve been in this business over 30 years and you know what, the long term thinking or long term investing is the only way I’ve ever figured out to make money. I’m more comfortable getting on board a long term trend early and riding it until it plays itself out. And in my opinion - it’s not just mine but others that I respect – I believe that this commodity bull market will move on well into the next decade. And I certainly believe that because we don’t have excess supply, we don’t have excess inventories and we’re living in an age that I would describe as an age of scarcity. So that’s what’s worked for me. Other people may be better at trading in and out of this sector than I am – I’m not a trader so I don’t subscribe to that view because as I mentioned I’m a terrible trader.
But if you look at this market, so either you enter this market as a long term investor, buying on weakness, building your positions or you trade this sector. But when it comes to juniors, you make more money by buying quality companies, holding, building your position on weakness and when it comes to juniors, John, this is as good as it gets. [23:08]
JOHN: So if we have to summarize the whole thing, we basically believe that gold and silver prices are heading much higher – that’s pretty much given where everything is going right now as far as the economy and oil and everything else; precious metals equities have underperformed due to a series of factors – rising costs, there is risk aversion, and the short selling that goes on. But, that whole process is in the act of reversing itself right now. Prices are higher today so mining companies are back in the black and good quality companies are having no trouble getting financed and short positions will eventually – I mean they have to be covered sooner or later. So of course the question to all of this is just one of timing.
JIM: Yes, and it becomes a question of patience and taking advantage of opportunities. Does anyone really think that the credit crisis is over, the dollar is going to get stronger, central banks will stop printing money or that inflation rates are heading lower or that the gold industry will expand and discover elephant-sized projects that will flood the markets with excess supply? That is not happening. If you take a look at it I’ve never seen a period where all the stars are lining up for a higher bullion, and what I believe is going to be an explosive run in precious metal equities. In fact, I think we’re at that tipping point where things are beginning to reverse themselves. Like I said, on this day, we’re seeing the price of many juniors move up and I think it’s going to be a process that’s going to reverse itself. And when these short positions have to covered, it’s going to be explosive because the liquidity – I mean if you’re short 5, 6% or 8% of a company and a lot of these companies are held in strong hands, where in the heck are you going to get the shares? The only way you’re going to get those shares is actually by coming in, paying a higher price for it and that’s what I expect to happen. [24:58]
JOHN: You’re listening to the Financial Sense Newshour at www.financialsense.com.
I’m Andy Looney. This weekend is Mother’s Day. I don’t know if your mother is like mine, but choosing a gift for her is like waterboard torture. I think I’m drowning. You know, men are cursed with the ‘I just don’t understand women’ gene. We can’t help it. We were born that way. It’s genetic. Don’t you think? I do. I mean how many gift cards can you get away with before you get “you never take the time to buy your Mother a gift.” Oh yes. And just when you think you’ve sound a safe gift, you find out she really didn’t want it after all. Like a box of chocolates and she tells you she’s on a diet. Oh boy! I’m in trouble. There’s always jewelry but you financial types know the price of gold is through the roof. If you’re Warren Buffett, hi Mom; If you’re not, bye Mom.
Maybe somebody should invent gold futures jewelry. Now that’s an idea. Don’t you think. Let’s run with it. You don’t have to buy the jewelry just short the little gold certificates out of gold-plated chain. But if gold doesn’t go down they’ll issue a margin call on mom. Ooops, sorry Mom. See you in 5 to 10.
No, no, I’ve got it! How about I buy Mom a $20 bag of rice. It’s big, she’ll like it. My friend Charles says rice is becoming scarcer so why wouldn’t she like that. I would. Maybe I’ll just get Mom a prepaid gasoline card so she won’t have to be stressed out about the prices at the pump. Last time she filled up I had to go down and drive her home, she was too weak from the meter shock. Actually, I think what I’m going to do is what I always do. I’ll beg my wife Sandy to get my mom something. That’s the only way to avoid the cursed male gene. You know, women know what to buy women. Don’t you think that will work. I do.
Happy Mother’s Day to all you mothers out there, and remember, go easy on the men in your life. Even if they’re great businessmen, they still have a big, congenital handicap to overcome.
For Financial Sense, I’m Andy Looney. [27:29]
JOHN: It is interesting to note that certain things seem to happen throughout history. There’s an old Chinese proverb that says “may you live in interesting times.” It is absolutely amazing as you watch or read the news today: oil at – well, it cracked through 125 this week; gold at close to 900; shortages of rice; other food – corn selling at over $6 a bushel largely due to ethanol and also a rise in cost of production because of energy; the emerging world financing America’s deficits right now – how much longer they’re willing to do that remains to be seen. Ten years ago they were in a crisis mode, now they’re buying up large portions of our debt or taking major stakes in some of our largest corporations.
As we go through this conversation, when we talk about how to create shortages –or the ‘gentle art of creating shortages’ should really be the way we title this – you need to understand when trends move through a culture they largely start – let’s take for example the concept of peak oil – they start with a few visionaries or in some cases elitists in terms of agendas; then they move to the media. They win over adherents in the media and academia. Then it sort of moves into the public consciousness as a result of the media and finally then – and only then – does it get to the politicians.
So by the time the politicians figure out what’s going on, the trend has moved on – it’s either gotten worse or something along that line – and then politicians begin trying to pull all the levers to make things work in response to the public outcry. Look at what we’re seeing with oil right now and both parties are trying to posture themselves, saying, “We were dealing with this all along, yes. Can’t you remember this?”
Well, that’s horse puckey, they weren’t even looking at this six months ago and now they’re trying to posture themselves. And now of course they’re so far behind the power curve they’re almost always doing the wrong thing. And so that is the gentle art of creating shortages. Maybe what’s happening right now in Myanmar – formerly Burma – is instructive as far as the fact that they’ve had a major cyclone over there and the UN and other organizations are trying to send in aid and the government there is interfering with it. It’s a military government. And it’s instructive that sometimes governments can make things very, very worse especially when the governments are busy defending themselves against there own people.
But we’re going to talk about the age of scarcity right now and this is going to be largely worldwide, government-caused in one form or another – depending on which government is involved. We’ll be looking at food and energy in this hour, which of course are the two staples of almost any society in the modern world. [30:30]
JIM: I want to begin this segment with food and then we’re going to get into energy because we’re going to revise our oil forecasts in terms of price. But if you take a look a food today and if you look at food in the grocery store, most grocery stores are designed to carry between three and five days worth of food. Outside of canned food, John, a lot of stuff spoils, like produce, meats and things like that. And so if you take the situation with rice – and as an example with just-in-time inventories, let’s say as a family you consume one pound of rice a week. All of a sudden you hear stories about shortages and you’re thinking “shortages! I’m not going to be able to get rice.” So you go to the supermarket and instead of buying one pound rice you buy three pounds, five pounds or six pounds of rice. What happens to what you see on the shelves? [31:21]
JOHN: That automatically accentuates the shortage because suddenly there is a run.
JIM: And so you get a run because we live in an era of just-in-time inventories where nobody wants to keep large amounts of inventory on hand because it costs money to finance that. So anytime you get an increase in demand because of a shortage or an event all of a sudden people start running in and accumulating and as a result you see this huge upsurge in demand. And so that what we’re seeing in rice right now.
I’ve got a good example of this with water. The summer before last – we stay down at the beach during the summer and I had come into town to buy some groceries and I wanted to buy some bottled water; and when I went to the bottled water section of the grocery store it was completely empty, and I’m thinking “wait a minute. This is the middle of the week, what happened here?” And I went to one of the cashiers and I said, “what happened to your water?”
And they said, “well, you haven’t heard?.” And I said, “No. what happened?”
There was an outbreak of E. Coli in the local area and as soon as that hit the news –and they’re talking about it on the 10 o’clock news – everybody immediately rushed to the store and grabbed water so there was no water left. You see this where you have hurricanes where you have people run to Home Depot, they grab candles, they grab batteries and things like that. And that’s the world we live in today with just-in-time inventories – any time there’s a surge all of a sudden the product disappears off the shelf.
And then on top of that: what does government do when these things happen? If you take a look at the case of rice where the price has gone up over 100%, our large exporting countries are now cutting their exports. They are forcing local farmers, they’re freezing the price - in other words, they’re putting in price controls. And John, you know what happens when you have price controls. You start putting in price controls – China is doing this, other nations are doing this – what happens is the people that produce say “wait a minute, I’ve going to pay more for diesel fuel to run my tractors, I have to pay more for fertilizer to grow my crops, why in the heck am I going to do that it you’re capping the price.” I mean China had this problem not only with its producers, they had this problem last year with the price of energy going up. A lot of the refiners in China are what they call ‘teapot refiners.’ They’re small refiners that produce between 10 and 15,000 barrels a day. The government was freezing the price and they stopped producing because how can you import oil at $90, or today $125 if the government is freezing what you can charge. And so what has happened is production went down in China, they had riots in terms of truckers lining up; they had shortages. And so now China is going out into the world market and buying finished gasoline prices from diesel fuel to gasoline, competing with the US which has to import close to 4 million barrels a day of refined products because we don’t make enough. [34:55]
JOHN: So isn’t that the ultimate result though whenever something like that happens (and it’s usually a government entity that jumps in and then tries to artificially mandate what the market is going to do) that there’s a compensation almost immediately elsewhere. That’s because let’s face it, there are certain rules of monetary exchange that you really can’t override in the long run. You may be able to do it in the short run.
JIM: Yes, and unfortunately whether it’s the United States Congress mandating ethanol in 2005, last year they passed a bill that’s going to mandate ethanol be 31% of our corn crop is going to go to ethanol. And what that’s creating is higher prices for food, grain which is a feedstock which goes into the production of chickens, cattle, dairy farming, pork. And you know, you and I were talking about this off the air recently, that what the ranchers are doing now is they are now slaughtering their herds because they can’t afford to feed them and so what we’re going to see – and I just want to tell you if you’re a consumer and you have a freezer, buy your beef and chicken now because by the time the third and fourth quarter you’re going to see escalating beef prices, escalating chicken prices, salmon prices are going to go up because they’re restricting fishing. All of these prices are going to be going up because a lot of government policies – you can’t mandate that over 30% of your corn crop go to making ethanol, which is the dumbest thing we’ve ever done, and not expect some kind of side-effect to be carried through in terms of the feedstock to our main protein source. So here’s a good example.
And you’re seeing governments come in, they’re making mandates like the Congress is. You’re seeing overseas more and more governments – in fact there was a story this week: food prices of rice and other type of products are rising not only just in the United States, but in Latin America, in China. India, the world’s second largest importer of vegetable oils, is banning future trading in soybean, rubber, chickpeas and potatoes as the government seeks to reign in the fastest inflation they’ve seen since 2005. There’s absolutely no proof by banning futures trading – and you know, you could see that come next with the idiots that are running the country right now. [37:03]
JOHN: I was thinking about something you were saying talking to some dairymen in California. A lot of them are having to dump milk – raw milk that they have produced – because they can’t get it into market due to a lot of conditions. They’re being squeezed by regulation and taxes on one end, and then what the market will bear in terms of what the food processors will actually pay for it. And so here we have a situation where we talk about a worldwide food shortage and yet we’re throwing stuff away. Another image that should be presented here: we have had record harvests in the past in recent time and yet our grain stocks are now at the lowest that they’ve ever been. They going to go towards critical levels here. It’s very strange we have these dichotomies.
JIM: You’ve got world population which you’ve got another 2 ½ billion people on the planet. We’re using less of our land – whether it’s in China or elsewhere in the world because you know, what’s the Joni Mitchell song “pave paradise, put up a parking lot.” And that’s what we’re doing, we’re plowing over agricultural land and we’re turning it into cities.
And here’s the scary part: We have had 18 years of record harvests due to great weather and this warming weather has been great for producing crops, but the unfortunate thing is you would have to go back – I forget what the figure is – 5 or 600 years to find an equivalent period of time when you had 18 years of back-to-back good weather.
And despite that – as you mentioned – our grain stockpiles are the lowest that they’ve been since 1960. So here we have had record harvests. By the way, wheat output last year was up one percent and yet our wheat stockpiles are the lowest that they’ve been in probably three or four decades. And so what happens as you know, the head of Potash made a comment, he said “we are one storm from famine.” And that’s what we expect to start seeing as weather conditions change because it’s just asking too much to have perfect growing weather for 18 years – that’s never happened. You’d have to go back like I said, multiple centuries where that actually occurred.
And so if you have a bad harvest – and we’re already having with problems right now with corn which is temperamental. Corn needs to be growing, when it needs rain it needs to rain; when it needs to be dry it needs to be dry. So they’re already delayed in planting this year’s corn harvest. So what can happen going forward is I think you’re going to see shortages of certain food staples as demand begins to outstrip supply and where we get into a situation where we have less than perfect weather. [39:53]
JOHN: We’ve been talking about food here, but a very closely related one is energy and we need to look at something we were talking about at the beginning of the year here on the program.
JIM: The other thing I expect this year is oil prices will hit at least $125 a barrel. It may even go higher if we get into a crisis.
I would say your credibility is lacking here, Jim, because you were off by $1.25 – the June futures for oil closed at 1.2625 and instead of being in December, which is what you had allowed it for, it actually happened earlier in May which I think events are transpiring here more rapidly than we had anticipated to start.
JIM: And you know what is absolutely surprising given all of this, the latest response by politicians: “this is speculators.” And what they don’t understand is OPEC production – especially Saudi Arabia – has been flat; conventional oil production has been declining, it peaked in May of 2005. So conventional oil production has already peaked and we’re a country that has to import close to 70% of our energy needs in the form of raw oil; we’re importing somewhere close to 13 million barrels a day and then we’re importing another 4 million barrels a day of refined products. And so I thought we would probably see 125 oil, but I thought we would probably see it by the end of the year.
But one thing that has been remarkable is actual consumption of energy is down in the United States but on the other hand energy consumption is up in OPEC; it’s up in China, it’s up in India, it’s up elsewhere. So for every one barrel decline of consumption here in the United States, you’re seeing between 10 and 14 barrels of increased demand coming from the rest of the world. And John, that is something that they don’t understand. Our politicians in Washington do not understand. In fact, let’s go to a clip here between Bill O’Reilly and Senator Clinton:
SEN. CLINTON: I do want a gas tax holiday but to pay for it by putting a windfall profits tax on the oil companies.
BILL O’REILLY: But what does that mean though?
CLINTON: What it means is that the oil companies have made out like bandits. You know that.
BILL: Right. Record profits.
CLINTON: We all know that; right?
BILL: Yeah.
CLINTON: and there is no basis for them to have these huge profits. They’re not inventing anything new.
BILL: So what do you do? Take 20% of their profits away from them.
CLINTON: You set a baseline and above that baseline you begin to tax their profits.
BILL: So Congress has got to say yes to this.
CLINTON: Congress has got to say yes. Now, I know that’s an uphill climb.
BILL: You bet!
CLINTON: But I’m trying to lay the groundwork so that when I’m president we can get in there and say, “this has been going on way too long.” I also want to take on OPEC. You know, OPEC is a cartel. It’s a monopoly.
BILL: You want to take them on?
CLINTON: Yes.
BILL: They don’t care what you say. They’re in Saudi Arabia and Venezuela.
CLINTON: Nine of the 13 biggest oil producing countries that are in OPEC are also members of the WTO. I would file complaints. I would also change the law so that citizens and businesses could file antitrust actions. We’re going to begin to hold them accountable.
BILL: And then if you hold them accountable, they say “we’ll slap another 20 bucks on the price of oil. So there!”
CLINTON: See, but at the same time, we’re not going to be sitting idly by acting like we can just get away with this. We’ve got to change the way we behave, the way we drive, we have not paid attention for more than 35 years as to what’s been happening to us.
BILL: And I’m with you 100%.
CLINTON: Good. Good.
BILL: Your husband was president for eight years and Al Gore – Mr. Global Warming – was vice-president for eight years and they didn’t do bupkis about this.
CLINTON: And I say we’ve got to elect a president who’s a fighter, who’s going to take on the oil companies, is going to take on the oil countries. And is going to say to Americans, you know we’ve got to really be focused on how we’re going to save money and be more efficient.
BILL: As long as you understand that I’m angry and so is everybody watching here because both parties sold us out. [43:43]
JOHN: So that was sort of a ship of fools conversation there, wasn’t it?
JIM: You know what’s funny because on Friday there was an article on Bloomberg by Caroline Baum called Silly Solutions and I’m just going to read a couple of things here, but it’s going to dramatize some points:
The confluence of record oil prices and a presidential election year is providing to be an irresistible combination for Congress and the candidates. Two of the three presidential contenders are promoting the idea of a federal gas holiday this summer. Two of the three U.S. presidential contenders are promoting the idea of a federal gas-tax holiday this summer. Two of the three (a different duo) want to enact a windfall profits tax on oil companies, a bad idea whose time has apparently come (again).
And then Carol goes on here in talking about:
Populist millionaire Clinton (millionaires make the best populists) …labeled OPEC (Organization of Petroleum Exporting Countries) a monopoly and threatened to file a complaint with the World Trade Organization…
And then talking about price gouging that a lot of the candidates are accusing the oil companies and as Carol Baum pointed out:
Never mind that the Federal Trade Commission has never found evidence of price-gouging when Congress has asked the FTC to investigate oil prices. Or that oil companies aren't more profitable than other manufacturing industries…
If you take a look at the oil companies, believe it or not the oil companies made more per gallon when oil was at $30 a barrel than it was when oil was at $125 a barrel. That’s because, once again, going back to the first segment, costs were rising faster than price. And this is something that they don’t talk about. Or as Carol goes on in her article:
Or that taxing businesses' excess profits -- How much is excess? -- will lead to a decline in oil exploration and development. [JIM: Look at Alberta. They raised the royalty tax; production is down, taxes are down] Or that taxing business usually means taxing consumers.
The Energy Information Agency of the government said from 1981 [JIM: now this is going to blow people’s minds] through 2006 cumulative oil industry profits totaled $1.12 trillion compared with cumulative taxes of $2 trillion; 1.65 trillion in taxes on domestic production and another 519 billion on foreign income taxes.
It just gets back to…it’s almost like one-way capitalism. We don’t want to subsidize oil companies when they’re losing money or when the price is down. It’s okay to lose so then their profits go back to normal. And oil company profits are 8 to 9%, or one of the best run companies, Exxon – Exxon’s net profit margin has averaged between 10 and 11%. It’s been that way for probably the last two or three decades. [46:42]
JOHN: Let’s do a comparison between Exxon – that seems to be the favorite for people beating up – and pick some other company in a different sector (for some reason, Microsoft comes to mind, but you could pick it) in terms of what their profit margins are.
JIM: Well, if you take a look at Exxon – and this is a comment I made earlier – they actually made higher profit margins when the price of oil was much cheaper; and that’s because the cost of finding oil, developing oil, producing it and transporting has gone up faster than price. In 2005, and 2006 when oil prices were much lower Exxon’s net profit margin was 10.3 and actually the highest point it got was 11.7 in 2006. Their profit margins fell last year because costs went up higher than price to 10.3. And then in this year, it’s anticipated 10%; and in the next two to three years, the profit margin is expected to drop down to 9 ½% as the cost of finding energy is going up much faster. [47:47]
JOHN: And since O’Reilly is always talking about the oil companies and their horrible profits, why don’t we look at what News Corp is making – that’s the company that holds Fox News.
JIM: News Corp’s profit margins have gone from 8.9% to 10.6% to 11.7%. So why is it okay for Fox News to earn 10, 11, 12% but it’s not okay for Exxon?
JOHN: Okay, so that’s what news companies would be doing there. Let’s look at microchip producers or corporations like Intel. Intel makes the processor chips. What do they do in terms of a profit margin.
JIM: If you look at the late 90s, Intel’s net profit margin after taxes was in the neighborhood of anywhere from 27 to 32%. I mean lately they’ve fallen down to almost 19%, you know. So it’s okay for Intel to make 18, 19 percent because they’re in technology – and less capital intensive by the way than oil companies. Exxon spent tens of billions of dollars last year yet their production was still down 5 percent. And that’s something that we just don’t want to talk about, John. [48:56]
JOHN: Let’s look at Microsoft now because obviously everybody – it’s a huge distributor of Windows and other products. What do they make?
JIM: Microsoft’s net profit margins range from 40 percent in 2001, to this year their profit margins are expected to be anywhere from 28 to 29 percent.
JOHN: 40 percent at some point? Wow!
JIM: Yes, that was their most profitable year going back to the tech craze. In 2000, Microsoft’s net profit margins were 41%. [49:27]
JOHN: Let’s go back into entertainment. We were talking about Fox News Company. What about general entertainment companies let’s say, Disney, of course which is more like a holding company for entertainment parks and movie production houses
JIM: Well, Disney’s earnings have been on the down-cline until recently. In fact, their profit margins dropped down to four or five percent; they’re back up to 10 percent though. This year, 2006, their profit margin was 9.8%. 10% for 2007 and their profit margins –depending on how well their film studio does – is expected to rise to 11%. [50:01]
JOHN: So the oil company profits then –just by the numbers that we’re looking at here across quite a broad array of different types of sectors, that’s not an unusual profit margin. I think the reason everybody is astounded is because of the large dollar amounts involved simply because of the volume that is sold. That’s what accounts for those numbers; right?
JIM: Yeah, because if you take a look today, Exxon’s sales have gone from in 2003, Exxon’s gross sales were 213 billion; in 2007, they were 358 billion. But more importantly, the reason being is that the price of the product they sell – and remember, Exxon imports a lot of oil because what they refine they don’t produce all by themselves. So it’s coming from other areas of the world. If you remember, we talked about last week the amount of oil we import from various countries in the world –from Mexico to Nigeria to Algeria, Iraq, Saudi Arabia, from Venezuela; and you know, if Hugo Chavez says “look, I’m going to sell my oil to you for $125 a barrel,” that’s going to be the price that you’re going to pay; you’re going to pay $125 a barrel.
But if you take a look at operating costs and things like that, operating costs are going up much faster. It’s the same thing we talked about in the last hour with the mining companies. I mean some of these drills like for example you take a look at where the oil companies have to go – they have to go out to places like offshore, drill deep – some of those drilling rigs are costing these companies anywhere from 600,000 to over a million dollars a day; or if you take a look at Conoco Phillips or Shell Oil, they’re drilling in the Arctic and costs there can run easily over a million dollars a day. So the oil companies are having to go to harsher environments to find the oil and that means higher costs. [52:02]
I will tell you it’s taken us a while to get in this fix and therefore it’s going to take us a while to get out of the fix, but I want to remind you that an energy policy that basically prohibits America from finding oil in our own land is an energy policy that has led to high gasoline prices…
PRES. BUSH: But in the meantime, in the short run, we didn’t allow exploration for oil and gas in places like Alaska or outer continental shelf. And guess what happened? World demand exceeded supply and now you’re paying for it. If Congress truly is interested in helping relieve the price of gasoline they would do two things: they would recognize that we can drill for oil and gas in environmentally friendly ways here in the United States where there is good reserves; and they would build refineries, they would encourage the construction of refineries. Do you know there hasn’t been a new refinery built in America since 1976. No wonder there’s constricted supplies.
That’s the very familiar voice of President George Bush.
If you notice, Jim, this whole thing is polarizing out now and there are some pitched battles coming over this whole issue as the country continues downward into this crisis. [53:12]
JIM: You know, it’s amazing, for example, we know there’s 30 billion barrels of oil off the coast of California. John, in Santa Barbara, oil is seeping up on the beaches and we don’t want any drilling. [53:27]
JOHN: Okay. That was President Bush. Let’s go for some contrasting voices because this battle now is going to increase in fever and pitch over the next 48 months.
SOLIS: And the suggestions that I don’t want to hear are that we’re going to keep drilling where we already know folks in our district, particularly California, do not want to allow for more drilling along our coast and opening up old refineries like in the city of Whittier – Nixon country it used to be known as where we have some oil fields owned by, I think, Chevron.
That was the voice of Congresswoman Hilda Solis from California.
Here’s another voice in the mix.
RAHALL: This morning your committee on natural resources once again defeated a ho hum proposal to open up ANWAR for drilling. This proposal was defeated by a large margin and to follow up on what the speaker has said, we simply cannot drill our way to lower gas prices….
There is simply no correlation between opening federal lands to oil and gas drilling and lowering the price of gas. It’s not there. You cannot drill your way to lower gas prices.
Congressman Nick Rahall, Democrat from West Virginia. One more voice.
PELOSI: The price at the pump is a terrible threat to the economic security and health and well-being of the American people. In light of that, and for a long time now, the Democrats and the new direction Congress have tried to address this issue. It is a national security issue to reduce their dependence on foreign oil. It is an economic issue in terms of what it means to the US economy and the economic security of America’s families; it is an environmental health issue and that’s why we’re so pleased in our energy bill last year to pass the fuel-efficiency standards for the first time in 32 years. And again, it is a moral issue to preserve our planet. This new direction Congress has made this a priority from day one. On day one – on day two actually, we passed HR 6 to reduce our dependence on foreign oil by supporting renewable energy sources. The leader in that fight was Mr. Rangel who is going to report to us on that in just a moment.
But first I want to say that two weeks ago we sent a letter to the President. I’ve talked with you before about this, asking him to take several steps to help either pass legislation or enforce the law in a way that would help reduce the price of oil and certainly the price at the pump. I received a response from the President –which many of you may have – which basically was that he not only did not support what we were doing, he would veto any of these initiatives to reduce the price of oil and he would instead drill. Veto and drill. Veto and drill. Veto and drill. That is the President’s message. [56:30]
And that was the voice of House Leader Nancy Pelosi. But you have to understand she was talking about alternative energies. Jim, we know from guests we’ve had on the program, these alternatives must be worked on but they are 5 to 10 to 15 years out before they will be commercially viable – meaning we’ll have the infrastructure in place to let people use them. What do we do in the meantime?
JIM: Well, in the meantime we’re going to have to work on alternatives but at the same time, cars, trucks, trains, planes, boats run on liquid fuels. And the only thing that we’ve done in the way of liquid fuels is ethanol. And look at the consequences of that and the surprising thing about ethanol is it’s energy neutral. In other words, it costs as much energy to produce ethanol as it gets in output of energy. So you know, there is no net gain and then look at the side consequences of what it’s done to our food costs. And so, granted, yes, we need to go to hybrids – and we’re going to get into the next hour with an interview with a gentleman who was on the design team at Toyota that designed the Prius – but planning for automobiles are 5 years in the making, and our average automobile in this country is somewhere I think around 9 years. And so it’s going to take a full decade before we can convert the existing automobile fleet to more fuel efficient vehicles.
And it’s going to take an increase in technology. But in the meantime, our production of oil and natural gas decline; in the meantime our imports of oil from countries that don’t like us increase; and what are you going to do in the transition? There is nothing Congress is doing. Raising taxes on oil companies reduces production, reduces supply which makes us more beholden to foreign producers. And that’s why a country that imports 70% of its energy needs today is not in the driver’s seat anymore. And you know, you heard Sen. Clinton’s proposal “we’re going to file a lawsuit against OPEC.” You think that’s going to bring oil or they going to drop the price down? I think these people think that gas comes from a gas station. [58:54]
JOHN: Let’s see if we can see if we can tie this all together so that people understand. Right now, we look at the situation we’re headed into: alternatives will not be online, so we are faced with a liquid fuel situation for the 5 to 15 years. That’s just the way it is in reality. Ethanol is the only thing out there that we’ve been moving on at all on the part of Congress. The only response, first of all, is to stop drilling; 2) there is a fight whenever someone wants to put in a wind farm or a nuclear, there is a fight for that one so we’re not doing that one; and 3) what we call the carrier battle group option means we’re going to station our troops offshore wherever the next conflict is going to be as far as oil is concerned, rather than making ourselves oil independent. Other than that there is no comprehensive energy policy, and as a result we’re headed into this crisis window and with all the posturing and whatever they’re doing, they are guaranteeing we are going to hit it full on. That’s where we are headed right now.
All right. Let’s just take one incident. If we start to look at our crystal ball here, you did predict 125. It happened in May of this year rather than in December which was the original call; if we look over the next couple of years what’s the price of crude, where will everything else be?
JIM: We’re revising our energy forecast and by winter I think we’re going to be looking at somewhere between 140 and 150 on a barrel of oil. By the end of next year we should be closer to $200 a barrel; and god forbid, either a conflict erupts or a terrorist attack on the Saudi oil facility or you know, they blow up the pipelines in Nigeria; and especially if you take a look where the United States gets its imported oil, I mean we get it from Canada, we get it from Mexico. And we know by 2012 Cantarell will be dry, in other words, Mexico’s exports to the United States are going to drop. If you take a look at Chavez, Chavez has already cut exports to the United States by 300,000 barrels a day and is diverting that to China and he plans on reducing that even more. We get oil from Nigeria, you had a Shell platform that just shut down; 160,000 barrels a day because the rebels blew up the pipeline. You take Iraq – we’re getting half a million barrels a day from Iraq. And so all you can do at this point…let’s put it this way: it takes 10 years to build a refinery and as the president said, we haven’t built one since 1976, so as a result today our oil imports of finished products are now close to 4 million barrels a day – that’s going to get larger.
And so we’re heading into an energy crisis and I really don’t think personally…all you’re going to do is see this bickering “we’re not going to drill, we’re not going to build refineries.” And I hate to tell speaker Nancy Pelosi, but you’re going to run cars on wind turbines, and ethanol is not going to bring us energy independence. That does not work. And so we’re heading towards $200 oil and by the way, at $200 oil we’ll also be rationing oil. So it’s not until you’re in gas lines, it’s not until there’s rationing…if they’re unhappy about $4 gasoline now which we’re over in California, what are they going to do when gasoline in the two years goes up to 7 and $8 a gallon? What are they going to be saying then?
But I think, as Matt Simmons has said on the program and this is something that I agree with Matt – we’re going to rationing, we’re going to higher prices and we’re going full bore right into an energy crisis because as the price rises, as supply struggles to keep up with demand because we’re competing now with 3 ½ billion people on the other side of the planet and their economies are growing, their incomes are increasing, their consumption of energy is going up, and that’s absorbing all of our excess capacity. And in the meantime, another factor that we have to deal – and this is something I’ve pointed out on a couple of programs that people aren’t picking up on: OPEC is consuming more of the product that it produces. The more they consume of what they produce means there is less for exports. That’s why exports from OPEC has been stagnant whether it’s Saudi Arabia or other countries. And then more importantly, they’re taking it a step further beginning with Saudi Arabia where they’re actually going to be building petrochemical complexes and refineries because they’re looking at the opportunity. “Why should we sell raw oil to the United States when they don’t even have the capacity to refine all that they import. So what we’ll do is we’ll build the refineries and get even higher profits by selling finished products instead of just raw oil.”
So we’re heading into a crisis window, John. We’ve been talking about it and this example of this debate that you just saw, I mean there was also a debate where you had some Congress people that were upset that the government of Iraq is subsidizing oil to their people. Well, you know what? They own the oil! And they’re not the only ones. Saudi Arabia does it, OPEC countries do it. They do it in Venezuela because those who own the oil have that ability as a government to subsidize the product to their own people. And we absolutely do not understand this whole oil scenario. And I think a lot of this stems back to the fact that the United States up until 1970 was the world’s largest producer of oil. We were producing in 1970, over 10 million barrels a day. We were the Saudi Arabia of the world but that’s no longer the case, we only produce 5 millions barrels, we import 13 million barrels and 4 million barrels of refined products. So a crisis is on the way. [64:55]
JOHN: So basically what we’ve said here in this part of the Big Picture is the fact that our politicians are steering us directly into the perfect financial storm: we’re going to see food shortages, higher prices of food couple (those naturally go together); higher energy prices (we’re already seeing that); and there may well be shortages and rationing at the rate we’re going.
So now the question is – and we’ll deal with this on the next hour here on the Big Picture: what can you do? Since this is where we’re steering us, and I agree with you, Jim, they are not going to do anything until reality sets in. When reality sets in, politicians panic. But at least people on the street, the little guy, can do something for him or herself.
You’re listening to the Financial Sense Newshour at www.financialsense.com. And Jim and John will be right back.
Behind
the Numbers: The Make Believe Economy
JOHN: During the station break, Jim, I came to realize that some things never change. I’ve got to read to you a paragraph from Time magazine, March 24th, 1980 – that’s how far back we’re going here, almost 30 years. This is right at the height of President Jimmy Carter trying to battle all of this inflation. Here’s the quote:
As this barrage of resolute rhetoric might indicate, inflation is not only a frightening economic problem but is rapidly becoming Carter’s most dangerous political liability as well. Campaign audiences for the President’s numerous rivals are showing at least as much interest in the economy lately as in Iran or Afghanistan.
Gee! Where have we heard that one before. Keep listening.
In Carter’s own party, Ted Kennedy has made a demand for wage and price controls his major issue, and is apt to answer any question on any other subject with an attack on inflation. On the Republican side, front-runner Ronald Reagan has been hammering increasingly harder on economic issues. Said he, campaigning in Illinois, Friday night: “It’s government that causes inflation and government can make it go away by cutting out deficits and stopping the printing of money.” George Bush assails Jimmy Carter’s raging inflation during almost every appearance.
The rhetoric – including Afghanistan and Iran – hasn’t changed. This is amazing. I just happened to run across this.
JIM: Yeah, here we are almost 30 years later dealing with the very same issues: inflation, Iran, Afghanistan. Well,...
JOHN: Some things never change. All right.
We’ve been talking for a long time here on the program, Jim, it’s been one of your better topics about funny numbers as far as government stats and other sources. John Williams, of course, has been a guest on the program here a number of times from Shadow Government Statistics. So let’s look at that. And of course, this also by the way, in the debate to try to get something done if you’re dealing with funny numbers which aren’t real world numbers and then everybody quotes them, but we’re trying to use that as a guide to correcting a problem.
JIM: If you take the big three numbers today that are reported in the economic press, you know, the big one is the unemployment rate; then follow that by the GDP numbers –you know, “what is GDP growth?”; and then of course another factor, which we dismiss all the time, is the CPI rate.
And you know, Americans – if you’re talking about consumer sentiment being the worst it’s been in probably two or three decades – and the reason is the numbers that we report bear no reality to what is actually occurring in the economy. In other words, instead of a five percent unemployment rate today, the unemployment rate is probably closer to eight and nine percent if we reported it accurately. And if you look at the economy, instead of 0.6% growth rate, we’re probably experiencing a contracting of two to three percent. Even the headline inflation number, which is about 4%, the real inflation numbers are more than double that. And that’s why I think there is a big disconnect. You know, you turn on the evening news and they report, “Gee, the economy is not in recession, it grew at 0.6%, the unemployment –“ we didn’t lose that many jobs because last month thanks to the birth-death model we were creating jobs in the construction industry, the finance industry and the restaurant industry and retailing. And you know, John, it just doesn’t add up when you take a look at what’s actually occurring in the real economy. [3:28]
JOHN: So how do we reconcile that with the real economy, meaning what would the real numbers look like?
JIM: A lot of this, believe it or not, politicians have been fooling around with the economic numbers because obviously if you are in the White House or you’re trying to campaign for reelection you want the economy to look good. And if you can report better numbers. And believe it or not, this goes back all the way to the Kennedy administration.
There was an article in Harper’s in the May magazine. You can pick up a copy and it’s called the Numbers Racket: Why the Economy is Worse Than We Know. It’s Kevin Phillips who has written this new book. And as Kevin Phillips outlines in his article, changing economic numbers go all the way back to the Kennedy Administration which was experiencing high jobless numbers, which was tarnishing this Camelot image. And what the Kennedy administration did is they took what they called – and they came up with a category of “discouraged workers.” These were people who had lost their jobs and couldn’t find one. And the first thing that they began to do is they excluded these discouraged workers from the ranks of the unemployed where many if not most of them had been previously classified. And as Phillips talks about, it even got to the point where in the Johnson administration, Lyndon Johnson used to ask the BLS “I want to see the economic numbers before they publish them;” and if he didn’t like them he’d have them change them.
And he also began a very clever thing. Remember, the United States began to run deficits with the Great Society programs and the war in Vietnam. And it was Lyndon Johnson who took and changed the way the government accounted for its budget. What the Johnson administration did is they came up with the concept called the unified budget where they combined Social Security with the rest of federal outlays, which we still do today. So in other words, the deficit numbers that we report each year are actually much higher because we’re taking surplus Social Security funds that are generated from higher Social Security taxes and we’re spending the money and we’re putting over into the general fund.
Every single president has changed the economic numbers. Kennedy changed and excluded discouraged workers from the unemployment. Johnson gave us the unified budget where we began to spend the surplus revenues from Social Security; Richard Nixon came in – and remember, Nixon was the first one to implement wage and price controls when inflation rates hit 4%,which is where they are today – but Nixon asked Arthur Burns the Fed chairman then to come up with the core inflation number. Basically the core excludes inflation if you want to look at it. [6:30]
JOHN: Basically, Nixon messed with the unemployment rate. They ultimately began diddling with the CPI. What about other indicator factors that suddenly began suffering ‘tamperage’ shall we say?
JIM: Well, in 1983 the Reagan administration added owner’s equivalent rent to the economy measurement based on what a home-owner might get renting his house and we added that to GDP. Also during the Reagan administration we began to reclassify members of the military as employed instead of outside the labor force. The big one really came - it began in the Bush administration with the Boskin Commission and it was implemented by the Clinton administration where we changed how CPI was measured. And the underlying goal was this worry over federal budget deficits, especially with these COLAs that were going into government pension programs and Social Security. The idea was to reduce the inflation rate in order to reduce federal payments from interest on the national debt to cost-of-living outlays for government employees, retirees, and Social Security recipients. So in 1996 the Boskin Commission on changing CPI was implemented and it was promoted by then Fed chairman Alan Greenspan. But in 1994, the Bureau of Labor Statistics (BLS) redefined also the workforce to include only a small percentage of discouraged workers. So if you take a look at in this Harper’s article they take the way we used to measure unemployment – and if you were to take the way we used to measure unemployment today, that unemployment rate would be closer to 10% versus the 5% rate that we’re reporting now.
And then also, if you take a look at the current Bush administration where the Federal Reserve stopped reporting M3 which was capturing rising inflation impetus coming from credit activity. And so if you take a look at these economic numbers these statistics which are the big three that we report almost every month – we report the unemployment rate, and of course the inflation rate for each month and then every quarter we report what the GDP numbers. But I mean you take a look – remember when last week we reported the unemployment report we only lost 20,000 jobs but you know what happened, John, is it turned out that we were creating – I forget what the birth-death number was like – 267,000 jobs; we were adding jobs in construction – how believable is that? We were adding jobs in finance – how believable was that? And we were adding jobs in retail and restaurants – I mean how believable was that when discretionary income is contracting by most consumers? [9:27]
JOHN: So basically what this accounts – if we put this in layman’s language is I think the person on the street senses some kind of a disconnect. There’s this dissonance and he or she feels it, but they can’t always put their finger on what it is. But you have these numbers coming out from – what do we call it? the Washington/Wall Street complex telling us that the economy is growing, that jobs are doing okay, that inflation is not bad, that “okay, well, I guess yeah, I guess we are in a recession but it’s going to be a shallow one.” But what the people are feeling out here is a lot greater and they can’t put these two things together – there is no basis for that.
JIM: Yeah. I mean if you take a look back at 1983 when we substituted owner’s equivalent rent for homeownership costs – I mean look what happened to housing, the cost of housing from 2001 to 2007, imagine where our CPI would be had we included housing prices. And what’s even more, there are many people saying that the interest rates would have never been this low had the inflation rates been reported at much higher levels. And the thing that is happening here is this distortion, you know, where homeownership has gotten to be unaffordable, and yet here we are trying to pass bills to prevent foreclosures, to prevent prices from adjusting downward which is exactly what the markets need to do. And just like in our last segment about how to create shortages, the more the government gets involved in saying “look, we can’t have market forces at work here, we need to intervene with price controls, mandates such as ethanol and things like that.”
We create all these distortions and the worse the by-products of these distortions, the greater the call is for more tinkering. And so there is talk now about redoing the Consumer Price Index because there are many people at least in Washington, especially the baby boomers, now starting to collect Social Security checks so the number of recipients is going to grow and get even larger, they’re talking about changing CPI. I mean you take a look at the things – you know, you’ve heard about they began using substitutions. So if beef prices go up on steak, you switch to hamburger. If hamburger goes up, you switch to chicken. I don’t know what they’re going to do this fall on substitution when you have beef prices going up, chicken prices going up, pork prices going up, fish prices. Maybe we become vegetarians.
Or you have other things like geometric weighting which if you understand what it does, geometric weighting – the things that are going up the most get reduced weighting in the index and the things that are going down the most get an increase in weighting. And then the other thing – and this one I love – is hedonic adjustments which is let’s say the cost of a car goes up a thousand dollars but they say through quality improvements it really only went up $70. And these are the kinds of distortions we have here and that’s why I think there is this big disconnect. People are saying “gosh, I’m seeing it everywhere. I’m paying more at the pump, and yet we don’t want to expand energy production.” I’m paying more for food prices and yet we just mandated more ethanol in our gasoline. And as a result of that there’s this sort of disconnect people can’t figure out who it is. They’re getting angry and yet the more dangerous thing is they’re looking to government –which is the cause of this problem – to fix it. [13:03]
JOHN: So if we look out there at what the funny numbers are telling people – at least, this is the official party line – we would say inflation is growing about 4% and that means the core rate is at about 2%. The unemployment rate is 5% and the economy they’re saying is actually growing 0.6%. But there is that cognitive dissonance again. That doesn’t mean anything to people: What do the real world numbers mean – if we create the Puplava Index of all of these things?
JIM: A lot of people that track the way that we used to account for unemployment – including discouraged workers or for example, when your unemployment benefits run out, you’re no longer counted as unemployed, you theoretically have a new job – the real rate – people are saying the unemployment rate today is averaging somewhere between 9 and 12%; and the inflation rate, depending on whose measurement you look at is probably closer to 7 to 10%, and the economy is clearly in a recession.
In fact, even after the recession of 2001, we probably remained in a recession all the way to 2003 instead of coming out of it in the fourth quarter of 2001. So the recession was much longer lasting, it was much deeper; and you know, if you think about this here we have a situation where you have bond yields that are at 4% when the real inflation rate is somewhere between 7 and 10%. Or you have short term rates such as the two-year Treasury note a little over 2%; the headline inflation number is 4% and even that number is grossly understated by almost 100%. In other words, the real inflation rate is probably closer in that 8% range. So it is distorting not only the economy and actions and decisions that business people and individual consumers make, but it’s also distorting the financial markets because bond yields…if there is another bubble that’s going to burst that bubble is going to be the bond market because these yields in terms of where they are today have no basis in reality when you consider what the underlying inflation rate is. I mean how can you stay even when you have real headline inflation numbers between 8 and 10% and pre-tax you’re earning anywhere from 2 to 4% on your fixed income investments. It just doesn’t make sense and as a result it’s forcing people to go out and get more speculative in their investments. In other words, that’s why people were buying these CDOs and these complex mortgage investments; that’s why people were in emerging market debt; that’s why people were going into junk bonds, which is not a good place to be right now, because people were looking for higher yields to help keep even with the rate of inflation. [16:00]