Friday, September 29, 2006

Energy, the U.S. $, and South Florida Real Estat

``There's no gentle way of saying this, we need to find oil fast.'' Han Wenke, 51, deputy director of the Beijing based Energy -Research Institute, an arm of China's planning ministry.


Crude Oil fell from a peak of $78+ to under $60 as of this morning’s trading. A sense of “well, we don’t have to worry about energy anymore” has descended upon mankind. As the famous game show host used to say: “EEGHGHGH!!! Wrong! Thanks for playing!”

“All I know is what I read in the newspapers” – Will Rogers

If all you know is what you read in the newspapers, you have been misinformed. For the past 20 years Crude Oil (and its derivative products) experienced a seasonal decline in price each Fall, averaging nearly 20%. This year’s decline was earlier and steeper than expected, but in hindsight, the steepness of the rise in price was warranted at that time considering the supply risks – and the steepness of the decline was warranted by the removal, even if temporary, of these risks. Further, several large hedge funds have experienced tremendous losses on heavily leveraged positions, and were forced to sell billions of dollars of commodities and securities positions in less than 2 weeks. Yet, the futures market has prices in the mid 70’s going out 5 years. In other words, the pros think controlling oil in the mid 70’s for the next 5 years is going to make them money – and that the price will be higher than the contract price (otherwise one would buy at the spot price).

After review of the supply numbers for the U.S. for January to August, 2005 vs the same period for 2006

(You can review U.S. domestic production and imports yourself, just go to: and

total supply actually went down... The U.S. Energy Information Agency (“EIA”) reports that demand was 20.73 million barrels per day (“mbd”) in 2004, 20.66 mbd in 2005, and expects 20.66 mbd in 2006. Let me be the first to point out that NOT ALL OF THE NUMEBRS ADD UP PERFECTLY (the data sources are disparate, but it’s the trend we are looking for)… but if imports are down, and domestic production is down, and demand is flat… why are inventories “high”? Maybe they are not. Total supply is not the correct method of measurement – the number of day’s supply is the correct unit of measure.

“OECD inventories began the second quarter at the upper end of their past 5-year range for this time of year. However, when measured on the basis of how many days of demand the current supply could meet, OECD inventories were only in the middle of their observed 5-year range. By the end of 2007, EIA projects days of supply of OECD inventories to finish at the bottom of the 5-year range for that time of year, which is expected to make the market even tighter.” U.S. Department of Energy, Energy Information Agency, 9/12/06

Which begs the question: With the economy growing at better than 3.5 %, on average, every year, since 1999 (these are the years the reported comparisons of inventory encompass), why has there been no corresponding increase in storage facilities? If you expected growth in supply and consumption to continue unabated, wouldn’t you increase your capacity to hold inventory in proportion to maintain the same level of days of supply? Well, we have not, and it is either a strategic blunder - or brilliant planning. Why might it be brilliant? If future supplies do not increase, increasing storage capacity would raise unutilized production capacity.

At times like this it is important to “keep your eye on the ball”, the supply/demand equation. For better or worse, circumstances have not improved on this front and the energy dilemma is still with us, and not to put too sharp a point on it…
The production of Oil from the leading exporting nations has been flat for 2 years, yet their own domestic consumption has been rising. It then follows that their export capacity will fall. If this continues, importing nations (like the U.S.) will, by necessity, compete amongst themselves for the remaining oil.

“At a time when questions exist concerning the ability of the top 14 states to increase production, dramatic increases in domestic consumption of oil in these states is ominous. Morgan Stanley Hong-Kong based analyst Andy Xie in 2005 wrote that the only reason the price of oil was going up was because of growth of Chinese demand. This view is ridiculously incomplete. Oil consumption growth in the major exporting states – OPEC and Russia – without corresponding increases in production, will lead to declines in the amount of exportable oil, leading to increased competition for the remaining exportable barrels of oil.” - Randy Kirk

China, India… China, India… “Chindia”… there is no doubt that these gigantic populations are going to drive the majority of the increased energy demand picture over the next decade. Here is something the market (and those screwy media reporters) have not factored into the demand equation. The collapse of the Soviet Union and subsequent economic fallout depressed the consumption of the countries of the Former Soviet Union (“FSU”) by at least 4.3 mbd during the 1991 – 2005 period.

“In retrospect, the best way to review key fundamentals is to look carefully at changes in global supply and demand, and where they’ve come from. Between 1991 and 2005, global demand for oil grew by 16.6 million b/d. More astonishing is that non-FSU demand grew from 58.9 million b/d in 1991 to 79.8 million barrels a day in 2005. In other words, outside the unanticipated collapse of the Former Soviet Union, the rest of the world's oil demand grew by 20.9 million barrels a day in just 14 years (35%; 2.5% per year) vs. the projection by many oil pundits that oil demand growth was certainly slowing down.” (emphasis added)… in the meantime, non-OPEC oil supply, outside the FSU, grew in that same 14 years, but only by a modest 6.7 million b/d, from 31 to million b/d to 37.7 million b/d. That’s less than 0.5 mbd per year. Too many important regions peaked and went into decline. Had the FSU not been able to grow from 10.4 million to 11.6 million b/d and OPEC grown from 25.6 million to 34.2 million b/d, the world economy would likely have been in very hot water.” - Matt Simmons, Author, “Twilight in the Desert: The coming Saudi Oil Crash and the World Economy”

And therein lies the rub. Supply is simply not going to be able to keep up with demand in this brave new world of Russian, Chinese, and Indian ascension. The U.S. has 2 % of the world’s oil and consumes nearly 25% of world’s annual production. One does not need a background in mathematics to visualize the intersection of the 2 sloping lines on that graph.

And while I am on this rant, I keep hearing the loud, vitriolic, and idiotic claims by certain special interest groups that the problem is those g-d-forsaken environmentalists! If only we could drill anywhere we wanted to we could get out of this mess! Buffalo bagels (and I’m a Republican)! These people are successfully manipulating the media and the benefit of this action will be assigned to a very few. We cannot drill our way to energy independence, no matter what those dim wits in the media report, and “strength by exhaustion” – Steven J. Strong, (I LOVE that quote, defining the silly concept of depleting the very last of our hydrocarbons as quickly as possible) would be an incredible national security blunder. Just imagine: we produce the last known domestic hydrocarbons - it would not take very long - and are now 100% reliant on imported oil, just like Japan. Students of history will remember how that worked out for their national security in WWII.

Last year we told our clients that the big story in business for 2006 would be energy - so far, so good. The oil depletion issue, “Peak Oil”, if you will, was considered the lunatic fringe in 2005. In 2006 it has been covered by Forbes, Fortune, Business Week, CNN, CNBC, and The Wall Street Journal, and nearly every daily on the globe. True, it has been derided by the likes of OPEC, the Oil Minister of Saudi Arabia, CERA, Big Oil, and other special interest groups. I would like to point out that these are the same entities that spent BIZZILIONS OF $$$$$$ over the past 2 decades trying to convince the public that global warming was not caused by CO2 emissions emanating from their product…


Why, indeed? Denial perhaps? The implications of this issue are simply mind-boggling. If these scientists and academics are correct (I believe they are correct, but I am not certain they are correct – there is a difference), it is likely that the new car you purchased in 2007 will outlive its fuel supply. If and when this dawns on John Q. Public… well, how do you figure that works out for the Auto and Housing industry, not to mention the owners of those far-flung suburban developments 50 miles from the nearest employment center? It is just too inconvenient to consider; denial is a lot easier. If, however, you are not into denial, there is a convention hosted by Boston University, October 26-27, 2006, on the subject of “Peak Oil”. Scientists, Physicists, and Mathematicians from Princeton, Cal-Tech, and Oxford University, among others, will be presenting. Guess how many members of the U.S. Congress will be there? One. The Honorable Roscoe Bartlett, R- Maryland. Guess what his background is? He’s a scientist (the only scientist in Congress; your average Congressman, if there is such a thing, is a lawyer by training. They don’t cover a lot of probability theory, exponential function, or logarithmic function in Law School). If you are interested in attending please call me.

Another symptom of denial is the constant stream of reports and articles about Ethanol, Tar Sands, Oil Shale, Methane Hydrates… While the Canadian Tar Sands are positive in their energy return (you get more energy out of the process than you put in) they are an environmental disaster in the making, and even the most optimistic projections do not place their total production above 4 to 5 mbd, by 2025. Oil Shale is an energy sink (you consume more energy in the process than is returned) and would be a bigger environmental problem than the Tar Sands. Ethanol is mildly energy positive (this is in dispute; after all, if ethanol was energy positive, why don’t ethanol plants run on ethanol?) but will never replace more than 5 to 10% of our current gasoline consumption – and our use is growing. Get the picture? You will undoubtedly be pitched this BS from politicians, the media, and investment gurus. Consider yourself warned.

OPEC? Watch what they do, and why – not what they say. OPEC is irrelevant at this point. What’s the point of a cartel if you are pumping as fast as you can? Only a fool thinks they will actually cut production voluntarily with prices anywhere over $40 per barrel… not to mention the fact that Saudi Arabia has ordered so many drilling rigs that the daily rental price has more than doubled worldwide! Now, why would you want to develop more production capacity if you are going to cut production? Somebody, please, give that CNBC reporter a V8!!!

Real Estate

The residential market in South Florida is at the beginning stages of a 5 – 10 year correction. That 6% year over year decline in price? It was 9% in REAL dollars (you gotta count inflation, too), and it will be 30 – 40% in REAL dollars over the next 10 years (for example, flat prices for 10 years with 3% inflation, compounded…). It is not as bad as Japan, 1992, but its pretty bad, and it is not just current “prices, supply, and demand”. Healthcare and construction have been the only legs on the stool, and construction is in contraction. Healthcare? It has been great, but I cannot see how things can improve in the coming years – this is as good as it gets. Government reimbursement drives the industry and growth from this quarter is coming to an end. Did I mention your potential employees cannot afford to live here on what you pay them? Commercial property investors might get some relief in the form of lower, long-term interest rates, but it’s a catch 22. To get the lower rates, the housing correction (crash?) would have to get worse. You might get some relief on debt service, but your vacancy rates are going higher still. And if rates were to go higher? I don’t even want to think about it. Let me remind you that the most beautifully designed building, at the finest location, brilliantly financed – without tenants is on the fast track to foreclosure. If you have any doubts about this, call me, and I will tell you the story of the Resolution Trust Corporation…

It is important to look at the trends. The Palm Beach County Public School systems, for the first time in 50 years, experienced a decline in students. That ain’t good (my spell checker hates that word). Can the commercial Real Estate market prosper in an absence of workers, higher insurance costs, higher energy costs, and a slowing economy? Sure, and I look good in tights…

Guess what was the best performing Real Estate asset class for past 12 months: Agricultural property. Yep. Not those shimmering condos in Miami overlooking the bay - it was a cornfield overlooking a feedlot full of manure – go figure. Now, who told you about this last year? The same guy who wrote in early 2005 that speculators in South Florida single-family homes had lost their marbles… but I won’t mention any names… but he rides a bicycle to work.

The Real Estate industry has a boom and bust cycle to it. It is as good as it gets during the boom. The bust is tough on your nerves. Where are we at this time in the cycle? Residential is a no-brainer. Office? Industrial? Retail? There is no substitute for knowing your market, but under no circumstance are the prices of properties that are being offered in our market cheap, leaving no room for error, and worse should the economy enter a recession.

Speaking of recession. One of the reason I write this newsletter is to market my perspicacious acumen by letting it all hang out in this forum and then letting prospects see how my prognostications worked out. I think a recession, or at the very least a significant economic slow down, is highly likely, if not unavoidable. There, I said it. Next year you can either call me an idiot, or a genius. But call me. I need the business.

The U.S. Dollar

The Dollar can’t make up its mind – but I can. If rates go lower the dollar gets killed. If rates go higher, the dollar has already gotten killed and the Fed is trying to save it and will kill everything else in doing so. A decline in the dollar’s value can be a good thing for real estate, Gold, Silver, and Oil. I say, “can be” in regard to real estate investors. The U.S. Dollar heading south is good for Oil and the precious metals in nearly all circumstances, but that is not necessarily so for Real Estate. For the rest of us, it is not so good. If you actually have assets, this is quite the conundrum.

The Financial Markets

The bond market tells me we are headed for a recession. The equity market tells me we are in the “Goldy Locks” zone – neither too hot nor too cold. They can’t both be right. If the economy is going to continue to expand at the clip expressed by the stock market’s recent gains, the bond market would be taking some serious heat and long rates would be headed much higher. After 20 years at this I firmly believe that the bond market participants do much better homework.

Let me bash those pretty, but intellectually stunted, talking heads one last time. It is constantly reported that the equity market is closing in on a record high… Donkey Dust! It has been 6 years since the market, as measured by the Dow Jones Industrial Average was in the same neighborhood as today. Didn’t these reporters do any research? In NOMINAL dollars we are closing in on the record; in inflation adjusted REAL dollars we have another 18 –20 % to go. If measured by the S & P 500 we have about 30% to go (give or take) and if measured by NASAQ, we have several generations to go. Central Banks exist to print money and therefore inflate prices and devalue their currency in an orderly fashion (the price of a postage stamp the year (1961) I was born was 3 cents - it is 39 cents today).

A little known fact is that we NEED inflation – just not too much. Ours is a fiat currency system (some hardcore students of economics with a political bent would debate this with me, but they’d be wrong), one that is not backed by gold but by the full faith and credit of the U.S. Government, the world’s largest debtor nation! Mild imbalances in the system can, for the most part, be cured by some judicious inflation. The point is this: Extremely unbalanced conditions take decades to recover from completely – just take a hard look at Japan. After you’re done looking at Japan, take another HARD look at the residential housing market. The only cure is to inflate, and China and India are making it harder and harder to do so. Why? Because, other then healthcare and construction we have had ZERO job growth in the U.S. since 2000. Hard to believe, but that’s the way it is. We have exported our manufacturing capacity and now our service jobs to India and China and have experienced little wage inflation at the time our Fed was lowering rates. Problem was, we did experience inflation in some sectors – housing and commodities, and we leveraged housing like crazy. Now, it is getting difficult to pay back the debt. In other times, a little inflation and - Voila! Problem solved. So, either we inflate to save housing, and kill the dollar, or housing sinks like a rock in a pond.


mentatt (at) yahoo (d0t) com