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Wednesday, June 25, 2008

And Nothing Ever Changes?

Durable goods still shows us in the same territory, with substantial improvement over the prior year. The shipment/inventory ratios are what I use to figure impetus, because when you see such large price moves, the dollar figures are unreliable. Usually at the end of June I sit down and look at the trajectories over the longer term to see if I can pick up patterns; maybe I'll get that done and post it next week. My hunch is that this is slowing, but I can't prove it from the figures so far. Also, the auto slowdown is distorting things. It still amazes me that the figures look so good considering the depth of the auto sales drop, but this is consistent with other reports I watch like NACM. Somewhere there is strength in production, and it isn't just in grains. Fabricated metals ratios are surprisingly good, and both non-defense and ex-aircraft capital goods are decent.

Overall, the midwest had been the worst area for mortgage defaults for the last few years. That wave seems to have bottomed out, which is another indicator supporting the general picture in this report.

New Home Sales shows a little more movement. Most of it is downward. The first thing that's notable about this report is that the YoY monthly drop entered the 40% range. Not a good sign at all. The second notable point is that MoM sales declines in the west and the northeast are much more pronounced. The debacle in the financial industry probably has more to do with the YoY 57% plus drop in the northeast. Needless to say, this augers a lot more trouble for mortgage companies and mortgage insurance companies! Sales in the west dropped sharply in May -11.6%. That is not statistically significant, but it does fit the general pattern. In any case, because of the regional changes, the median and average sales prices mean absolutely nothing.

As to whether we are close to bottom, I think not. First, the number of completed new homes for sale this May is exactly what it was last May - 182,000. Second, median months for sale has risen from 5.6 last May to an awesome 8.5 months this May. Sales of completed homes dropped from 21,000 to 18,000 MoM, whereas sales of not-started homes rose from 12,000 to 14,000 MoM. This is the reason I believe the western drop - I think the REO inventory in the higher brackets is building enough to blow up builder sales there.

More builder bankruptcies are to be expected!

As to the petroleum report, it seems to indicate that the drops in demand are concentrated at the retail/consumer level, not in industry:
Total products supplied over the last four-week period has averaged 20.2 million barrels per day, down by 2.3 percent compared to the similar period last year. Over the last four weeks, motor gasoline demand has averaged about 9.3 million barrels per day, down by 2.1 percent from the same period last year. Distillate fuel demand has averaged nearly 4.1 million barrels per day over the last four weeks, down by 1.1 percent from the same period last year. Jet fuel demand is 3.6 percent lower over the last four weeks compared to the same four-week period
last year.
Oil prices cannot hold much longer. For background, this 2007 BBC article is pretty good. The OPEC basket is still rising, but a shelf formation shows in WTI:

This is going to blow out big time. Here's why:

The next big demand wave in the US is heating oil, and at the current offered prices, people are going to cut way back. A lot of people have a budget plan, and a lot of people buy a contract in the summer. Well, those contracts are way, way up. I spoke to one of my brothers, and his offering was more than $2 a gallon higher than last year's. At these prices, people just won't be able to buy anything near the same quantities. Also, at these prices, people will substitute electric heaters and wood heating (which already happened to some extent last year) for a portion. So demand for heating oil will drop substantially.

You can buy a few electric strip heaters and pay considerably less for that portion of your heating in most of the northeast. And when people get those offers from their heating oil companies, the panic will be on. A $2 rise will fund a lot of equipment replacement in one year! At 1000 gallons, that's $2,000 to pay for installing another type of heating plant, insulation, etc.

Utility companies in the north that don't depend substantially on oil may do well this year. On the other hand, some of them will find themselves selling energy for less than it costs to produce....

YoY gross imports are down 2.7%. I think this trend will continue, because one of the ironclad rules of economics is that people don't pay for what they can't pay for. Ignoring that simple rule caused the mortgage boom and collapse, and it will do the same for oil.

Now that the Asian countries have pretty much all reduced subsidies, adjustments will occur there as well. However there is a big difference between futures prices and delivered average prices, and a substantial lag. The futures price now is sharply higher than the delivered price that is causing demand to shrink in the areas in which that price increase is reflected in enduser prices. So the real bet that the futures junkies are making is that the Asian countries will continue to make up the difference. But they can't, as has pretty well already been proven.

If they did, India would end up with something like a 7-9% current account deficit. Eventually many of the other Asian countries would follow. In India, which tipped over this year, it has already caused the rupee to drop substantially and is fueling the exodus of foreign capital, which is jacking inflation considerably higher. And China, Inc., is facing the same limits. People look at figures like 30% plus export increases, and they don't realize how much of that is inflation in prices versus increase of volume. When your volume of business is stagnating, you cannot continue to raise prices forever. What happens (and probably what accounts for the relatively good US durable goods report) is that your prices eventually advantage other locations. You then lose business, and your fuel usage stops escalating or escalating so much.

The same fallacy that caused the mortgage collapse is going to cause the oil bubble to collapse. It's going to hit hard and it's going to hit quickly. I very much doubt how much oil is going to actually trade at $130 plus a barrel. Most of what is actually moving is moving at substantially lower prices. Marginal demand will fall rapidly to compensate. It will fall unevenly in different countries because of differing price levels, but it really doesn't matter over six months to China if it can sustain its current level of subsidies while they lose a bunch of exports because US consumers are spending all their money buying bread at $5 a loaf and shivering in 60 degree houses. There are limits to this price system, and they will start asymptotically breaking toward sustainability if they haven't already. Sustainability is a hell of a lot closer to $100 a barrel than $130!!

There is a double effect here as well. To the extent that US consumers do pay increased costs for gas, heating and utilities, it withdraws spending power. We are already seeing that in auto sales. Just sit down and think about how much energy is not consumed when the yearly average of cars sold drops a couple of million units. The steel, the factories, the shipping of all those parts and cars....

Anyway, the Chinese consumption curve will lag the US consumption curve by about six-nine months, the US consumption curve is going to keep slumping, and the first impact in Asia has already been felt with the pretty widespread increases of end user costs. For countries like Malaysia, that produce a lot of their consumption, the effect is less dramatic but shows up in higher export shipping costs and lower demand for their goods. China would be in between Malaysia and India, I think.

OIl contract prices in Northeast, last few years

2008 $4.599
2007 $2.629
2006 $2.499
2005 $1.739

That says it all.
We'll call that a blowout, game over.

I'm cutting back substantially on driving. So are many other people that I know.

Somebody is going to get stuck taking delivery of some very expensive oil or take a financial beating offloading the contracts.

We've overspent in a huge way over the past decade. Now is not the time to buy things that are at record highs.

Give it a year or two.
MAB - I do believe you're right! Maybe it would be a good conversation piece, but that amount of oil wouldn't look good in my living room.

Financially it's not a good buy right now.

Uranium, maybe.
Great Article MOM,

What about the demand destruction already happening with people trading in there SUV's. I may live in California but I am seeing tons of new cars purchased, very few new trucks.
MOM, could the energy business, particularly oil drilling rigs, pipeline construction, well servicng rigs, etc. be part of the durable goods holding up? I have a nephew in the oil exploration business in Colo. He cannot find enough rigs to do the drilling he needs to do. The demand is there and companies are going to build new rigs to meet the demand. There is a new gas pipeline being built from the North Slope in Alaska to the lower 48. The oil sands operations in Canada need huge trucks, earth movers, shovels, etc. A lot of that equipment is built in the U.S.

The real estate business here in the Puget Sound area has slowed a lot, but I don't think prices are down much, if at all. The slowness of the market seems to be associated with high mortgage rates. I have a gilt edged credit rating and want to refinance my mortgage, which is a 6% - 5 year ARM with 4 years left to reset. 6.75% seems to be the going rate for a 30 year fixed right now. The rates are probably higher for lower credit scores, so people probably are waiting for better rates. If a 2% Fed rate and a 4.2% T note won't get mortgage rates down then I guess we'll have to wait for the financial crisis to finally resolve itself. It seems every time I watch Kudlow his pundits all proclaim the financial crisis is easing, but the banks keep declaring big write downs and it seems to go on and on.

As you say the price of oil has got to drop in the face of slowing demand. At least that's the way it's supposed to work. We'll see.
Yes, NMoerBeek, and the replacement effect grows with time. Many Americans are driving less, but swapping a vehicle for one that gets 10 miles more per gallon has a long-term effect.

Jimmy, I think you are right on the rigs.

As for oil dropping as demand drops, remember that the prices that are forcing changes in the US haven't been seen in huge countries like Indonesia, India and China, and even with adjustments sometimes remain well below ours. That has caused the demand for energy to rise quite quickly in those countries (as well as in OPEC countries).

But the bottom line is that the majority of Americans who used heating oil last year won't be able to use as much this year, and marginal changes won't do it.

When people can't pay for something they don't. That's the bottom line. Many things may happen, but Americans cannot sustain heating oil consumption at these prices.

Using an average NE household income of 66K, which is probably too high:
- 10% federal
- 5% local
- property tax which could vary from 2-10K
- 7.65% FICA
Somewhere around 46-49K net. Heating oil is going to cost one month's take home? You can put a price on it, but you can't make people buy it! That 2K rise for 1000 gallons is going to push people over in a major way.

Most retirees have been falling behind inflation steadily for years. This will kill the ones who rely on oil for heating. It looks like it really will kill some of them - they won't be able to heat their homes.

You're going to see a political apocalypse when people realize this. By August, the word will be out. Obama is way less likely to win this election than people think unless he gets that good old drillin' religion in time, dumps the carbon tax BS, and stops talking about conservation. At these prices, conservation doesn't even come into it.
Further details:

The prices quoted are not spot market, but contract prices, that is what you pay if you are willing to purchase the oil up front. That means a check for 4,600 dollars in July for up coming winter (for 1000 gallons). A fellow that just got a tank at the spot market paid 4.939 per gallon. Ouch.

Folks who have oil heating and want to pay the minimum have for years planned on buying a contract. They know they have to save the 1,500~1,700 dollars payment in July. Starting 4 years ago this price has steadily gone up, but @ 2,500 or so the price was still manageable. This year sees a 75 percent increase in one year, or around 2,000 dollars for 1000 gallons. No inflation my ass!

Now consider this. In areas of the Northeast that are subject to real cold, you really cannot put the temp below 58 degrees, for fear of freezing your water pipes. Yes perhaps you can put it down to 56 or something close, but I know of one family who had just that problem in an upstairs apartment. The problem is in those rooms that do not get good heat, walls with poor insulation and those nights when it gets down to -5 or so.

So if a family is trying to reduce their bill by say some drastic percentage, they can go down from 68 to 58 and use space heaters in some rooms, but not much below that. This will help a bit but not dramatically, on the order of 10 to 15 percent. Such folks are still looking at a pretty hefty increase. Consumer spending will have to drop.

This is likely to be a year without Christmas……
Home Heating Oil is diesel. When the lack of demand crushes the price the product will reposition and take out diesel prices. Gasoline will be much slower to decline but a fraction of every barrel generally has to go to gas so even they will see some unintended supply to help lower prices.
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