Why $140 a barrel crude is unsustainable

(graph courtesy of wtrg.com)

Despite the hand wringing about crude prices, there is plenty of evidence to suggest a top forming and prices headed in one direction --- down. The basic economic principle, which has stood the test of time and applies to this day, is that, supply rises in response to prices while demand has an inverse relationship to prices.

Following the 1973 oil embargo prices which earlier had been at a nominal $20 a barrel since the twenties (in 2007 dollars) tripled and seven years later, following the overthrow of the Shah, hit almost $70 a barrel.

By turning down thermostats, using better home insulation, driving slower and buying smaller more fuel efficient cars, Americans conserved energy and consumption crashed. In the meantime, production had just begun to soar as high prices stoked greater exploration. As a result oil began a 7 year decline back down to it's historic average of $20 a barrel.

With a few shocks along the way, oil continue to limp along until the housing mania around 2003. Forgetting the lesson of the early eighties, Americans bought bigger cars, built Mcmansions and raised their energy consumption. Easy credit fueled the buying binge and cheap energy made it feel good. As a corollary exploration slowed down at the very time that newly industrialized economies began to demand more oil to fuel their growth.

Today with oil at $140 a barrel, we hear the message that this time it's different and that cheaper oil is no longer in the cards. Well, we seem to be going by the same play book as consumption has already started to slow. Developed economies are using less oil as drivers consider making unnecessary trips and airlines cut routes. In the developing world, India and China have cut their fuel subsidies resulting in higher prices and it's only a matter of time before demand slows, if it hasn't already. Crude inventories continue to build and supply may become even more plentiful as newly discovered oil fields such as in Brazil come on tap.

The most telling feature of a world awash in oil is the following statement from an Aramco manager from a recent story by the New York Times on the Khurais oil field in Saudi Arabia (http://tinyurl.com/5em4e7):

“We’ve asked all the international oil companies that buy from us if they want more oil,” Mr. Nasser said. “But we can’t find customers.”

Rising oil may fuel reverse globalization

As oil continues it's upward trajectory so have the costs of transporting goods and materials across oceans. In a globalized world reliant on shipping raw materials to one place to be made into finished goods and sent someplace else, this trend in costs is bound to make the economics of manufacturing in far off places questionable. This is especially true for low value to freight ratio products such as raw materials, furniture, apparel and machinery.

At $200 a barrel shipping a container from Shanghai to New York will cost $15,000 compared to $8,000 today and a mere $3,000 in 2000 when oil was $20 a barrel. This portends a fundamental realignment of trade which, has to some degree, already been set in motion--a number of US manufacturers have regained their footing and have restarted their production lines in the South East.

How much of manufacturing comes back from China remains to be seen. During the 1974 OPEC oil shock consumers bore the brunt of the additional costs but in time markets adjusted to substituting for goods that were sourced closer to home. In some capital intensive sectors such as steel, the US already has a competitive advantage as the cost of labor is a small part of the process.

Rather than finding the cheapest labor, producers are going to have to find places within reasonable distance to their markets. This may be a second opportunity for Mexico having earlier lost some of it's maquiladora production to Asia.

As an unintended consequence, shippers, just as the airlines, have reduced ship speeds to save fuel. Consequently there is less cargo space available at any given point in time--more ships are at sea rather than in port. The changing winds have also impacted the exporting of agricultural products from the US (California grows 80% of all worldwide almonds) leading to lower revenues to growers.

While liberalization and technology have facilitated globalization, transportation costs may once again change the economic landscape.

Wal Street expertise

Many large Wall Street firms tout the depth and breadth of their research expertise. But as we face one of the greatest financial crises since the Great Depression, it is interesting AND revealing to see how major financial services firms have fared. According to Bloomberg.com (4/1/08), some experts estimate that there has been $1 trillion in write downs and credit losses through April 1, including:

UBS ..................................................... $38 billion
Merrill Lynch......................................$25 billion
Citigroup..............................................$24 billion
HSBC.................................................. $12 billion
Morgan Stanley..................................$12 billion
Bank of America.................................$8 billion
JP Morgan Chase...............................$5 billion
Wachovia ............................................$5 billion
Goldman Sachs...................................$3 billion

The irony is that these losses have occurred in areas of the market once regarded as relatively safe and secure.

The firms tout their experience, the range of their resources, their research prowess, even the “safety” of investing with a large institution. Given what has happened recently, these claims ring a little hollow.

Commodities - What next?

Commodities have sky rocketed in the past 6 months as speculators bid prices to stratospheric heights. There isn't a day that goes by without a new ETF, index fund or mutual fund touting commodities. Prices are so far ahead of themselves that there is talk of the next bubble forming. Not that was until the Fed made noises about inflation and uncharacteristically let some of the air out before the bubble popped.

Of course, there is no way to read the "tea leaves" and make an accurate prediction. However, it's interesting to attempt to make sense of the future by observing investor behavior.

A chart from Barrons indicates that sophisticated investors, energy companies, food processors and farmers, shall we say smart money, are betting heavily against commodities. We think of them as smart money as they trade commodities on a daily basis and have an understanding of their markets. On the other hand, speculators who represent dumb money are hoping for a continuing boom. As with any bubble when too many such investors move in, it's time to head for the exits. I'm reminded of a story by a portfolio manager who once told me that when his mother called in to ask him what he thought about a high flying internet stock, it was his signal to sell.

Inheritance is not always a good thing

"From shirtsleeves to shirtsleeves in 3 generations".

Families are finding it difficult to maintain their wealth for multiple generations.

There are a number of potential problems with the transfer of great wealth. Many children have a difficult time coming to grips with the unearned wealth that they acquire. With wealth comes responsibility and unfortunately young people are not easily taught about responsible action.

Children in wealthy families often feel a sense of unworthiness questioning what they had done to deserve the wealth through no effort of their own. Research also shows that children of wealthy families suffer from low self-esteem for this very reason. Success becomes defined as being primarily through lineage and not by way of personal achievement.

For this reason more and more of the wealthy are choosing not to leave their wealth to their children.

That's not to say that a family might abrogate on it's responsibility to ensure that preceding generations do not spend their lives in squalor. Warren Bufffet said it best when he declared that he's leaving enough for his children so that they will do something and not so that they do nothing.

Momentum Venture Partners and Mentor Capitalism

As some first time entrepreneurs may already have experienced, attempting to get through to a VC with the hopes of securing a Series A round is really tough to do right now. There is a funding void left by VC firms shifting their investments downstream. This has left many unseasoned entrepreneurs to fend for themselves to bring great ideas to fruition.

Filling this void is Los Angeles based Momentum Venture Partners, founded in 2004 by a pair of veteran start-up executives - Matt Ridenour and Andy Wilson. Momentum works closely with a company's founders to shape their business plan, find experienced management, finalize a product and gain customers - a process that typically takes about nine months to complete. At that point, they pitch the company to VCs with hopes of securing a $4 million to $5 million Series A round.Momentum’s distinctive model dedicates far more time than a typical angel or seed-stage investor while also assuming considerable risk. A typical assignment begins with a six weeks first phase - usually for a fee of less than $20,000 - validating a business plan, building chemistry with the founder and carrying out due diligence before committing to the start-up. Upon approval, one of four Momentum partners then takes on an interim CEO role, moving the founder to the chief technology officer role. During the process, Momentum provides a bridge loan - typically $250,000 to $500,000 from a bridge fund pooled from high net worth individuals - to keep the company operating, all for a ‘nominal' monthly stipend.Unlike a traditional VC who might split his/her time with many companies, Momentum partners typically work with, at the most, two companies at a time spending half of their time on each, with an operating associate subbing in the other half as a project manager and director of operations. Momentum's ultimate goal is to deliver the company to venture capitalists and secure that first round of capital, when the firm's bridge investment converts, often at a discount, into Series A preferred stock. It's at this point the firm gets paid for its work after having deferred the majority of its management fees during the previous nine months.So far all seven of its start-ups have made it to the Series A level, focusing on Los Angeles-area technology companies that require less than $10 million in funding to break even on a cash-flow basis. The seven have raised a total of $30 million in Series A funding. The firm had its first exit in 2006 when Discovery Communications Inc. acquired Academy123 Inc., which had raised a $5 million Series A round the year after Momentum brought the company to venture firms Arcturus Capital and Hanseatic Group.

Momentum is especially beneficial to VCs because it's bringing only companies with proven business models and customers. From the point of view of the entrepreneur, Momentum understands what VCs want and helps clear up legal and other issues that prove invaluable to companies who make the grade to be part of the Momentum portfolio.

Snakes and ladders

It seems to me that for most people, their financial affairs, more often than not are akin to a game of snakes and ladders.

A lot of intelligent, educated people are finding out the hard way that it is easier to earn your wealth than to preserve and build upon it. Consequently a lot of people are worried about how not to lose their hard earned capital and if they're not worried, they ought to be.

Here then are the "snakes" to watch out for:

1. Putting your finances on the "back burner"

2. Investing in a poorly conceived manner

3. Having little or no risk protection

4. Not contributing to a retirement fund

5. Not planning for your heirs

6. Misusing debt

7. Not managing cash flow

8. Depleting a retirement portfolio

9. Mishandling windfalls