Oil Down $16 to $130, Everything Wonderful Again: Not

I hate to pop the balloon about how everything's wonderful again now that oil has collapsed from $146 to a mere $130/barrel--no, scratch that. I delight in popping that nonsensical bubble.

Before we allow euphoria to lift us to a heady height so great we're ready to believe Lehman and Merrill and all the other "players" are suddenly whole again, let's look at a chart.

As a proxy for the oil sector, let's use the XLE:

Here we see a number of interesting points:
1. XLE just touched key support.
2. Every time XLE pierces its 200-day moving average and the Bollinger Band on the downside, a sharp rally to a new high has followed.
3. The downside breaks are very sharp and very short. The XLE can drop 20+% in a few weeks, and then bounce back within 6 weeks as it extends to a new high.
4. The MACD is at an extreme--even lower than when the XLE touched a "death of the Oil Bull" low in January 2008.
5. The uptrend is still intact.

Based on this chart, I would expect a rally from 75 to 85 in short order. Let's just say the chart makes me skeptical of calls for the end of the Bull market in petroleum.

The "recession-Lite" scenario that's getting a lot of airplay nowadays is based on the idea that demand for petroleum will plummet in a recession, leading to a collapse in oil prices.

I highlighted the fatal flaw in this fantasy in Saturday Quiz: Demand Destruction of Gasoline in the U.S. (July 12, 2008): reducing demand for gasoline 3-5% in the U.S. is supposed to deliver a crushing knockout blow to oil prices, but that works out to a meager 300-500,000 barrels a day in a world that produces 85 million barrels a day.

Meanwhile, what nobody mentions when recounting this rosy scenario is that oil exports to the U.S. from Mexico are falling at 30% per year--and the U.S. gets 20% of its imported oil from Mexico and Venezuela.

Frequent contributor U. Doran sent in this link from the Association for the Study of Peak Oil & Gas-USA: Peak Oil Is A Done Deal .

Bottom line: Saudi Arabia and Russia, which together pump about 23% of the world's oil, are both in depletion decline. So are Mexico, the North Sea, etc.

Simply put: every time the "Oil Bull" is declared dead, as it was in January, it rises with extraordinary alacrity to new heights. The reason is not gol-durned speculators but supply and demand--even as demand inches downward, supply is declining even faster.

Let's put "demand destruction" in the U.S. in its proper context. 300,000 barrels a day is chump-change in a nation which burns 21 million barrels a day. if supply were increasing by leaps and bounds as it was in the 80s, fine, then you could have a huge demand-supply imbalance in favor of supply. But by even the most optimistic estimates, "excess capacity" (all in heavy crude few can refine) is about 1.4 million barrels a day--a razor-thin margin.

I have predicted one last "head-fake" decline in oil prices, but it's going to take serious reduction in demand, on the order of 4-5 million barrels a day globally, to get that drop.

It takes a long time to locate, drill, pump and process new reserves of petroleum. I was fortunate to receive a report from a working petroleum geophysicist, who due to the nature of the business, prefers to remain anonymous. His report is a real eye-opener. Read on:

I am an exploration geophysicist working for a large oil company. The quiet consensus in the industry is that yes, we are at peak oil. (emphasis added, CHS) Such an idea was not even discussed even a year ago, but now it is a silent consensus.

I also agree with your assessment that a serious downturn can cause the oil prices to go down temporarily for the last time. Worrying thing is that it is a "perfect storm" coinciding with a large economic downturn and with the long-term trends of an aging population and of global warming. Weakened immune systems from aging, stress and poorer nutrition and the disturbed ecosystems may also cause some super-virus to spread.

However, it is crucial to make the transition to the new world (petroleum-less, older, changed climate) as slow as possible so that we can adapt. Otherwise it's finally the day the guys at survivalblog.com have been yearning for :-) I will do my best to prepare myself and my newly-started family, but ultimately it comes down to chance. Was it you who posted the story about Aaron Schwartz, the smartest man in the 20th century, who foresaw Hitler's rise and moved with his family to a quiet Pacific island called... Guadalcanal?

It's possible to have a long career in petroleum as everyone either goes back to old wells to extract a bit more or drills a lot of dry holes looking for the elusive super-giant field which will save us all :-)

The strong job market for geophysicists has more to do with the fact that the oil industry downsized massively between 1983 and 2003 than with peak oil. Why? Assume you own an oilfield or hold a long-term lease on one. If you believe that the current price is just a cyclical high, then you will do all you can to explore the land to find oil, or to do extra surveys to find bypassed pockets in the reservoir, and get the oil to market before the price falls.

However, if you expect the price to keep rising, and rising, why would you work so hard today to find new oil / get some more now, when if you do the same amount of work a couple of years down the road, you will sell it for much more? And maybe more capacity will come on the market for drilling rigs and oilfield services, so you would not pay those outrageous prices to your service providers either. Companies do have to replace reserves (they usually have about 6-8 yrs of reserves in their portofolio), but they don't do much more.

BTW re: the dramatic capacity cuts, they were indeed amazing. In 1983 there were 730 land crews doing land seismic surveys in North America, and in 2003 there were only 37. These statistics were published by The Leading Edge (TLE), the monthly magazine of the 25,000-members Society for Exploration Geophysicists (seg.org). That's 20 x reduction in capacity, for God's sake!! How does one expect to find more of something with 20x less people?? Technology did not make much of a difference, as for land seismic the crews still have to go and plant geophones by hand.

Companies were downsizing entire departments. As late as 2004 you could read in "career advice" articles in TLE leading geophysicists saying that they are not advising their children to go into this field, that they should only do it if they really love it and they should expect to be out of a job half the time... Walter Lynn, SEG president 2001-02, was downsized from his company (PGS) the day after his president mandate was over (it's visible in his CV at http://www.lynn-inc.com/).

I spent the 2000-05 period working towards a PhD at a top U.S. university, and we were in contact with many companies. 2003 was the bottom; out of about 15 graduate students, only 2 or 3 got internships although most tried. That was in a leading research group in the field. Unemployment in geosciences as measured by the Houston Geological Society was above 10%. In 2004 an American colleague of mine graduated after working for 7 years for a PhD and he only got a menial job warranting a BSc with a company in Houston. You see, supply and demand.

In 2005 things turned around and I quit my PhD as soon as I got a job offer in hand, because I believed that by the time I would graduate (the last of my cohort "got out" 1 month ago) oil prices would be again at a low. In the early 2000s US produced only about 100 (yes, one hundred) graduates with decent BSc degrees in geophysics. China produced easily 20x more, and well prepared too, not some junk diplomas. In 2004 85% of the graduate students in the Petroleum Engineering department at Stanford were foreign. Now oil prices are high everywhere and they start to have good employment in their home countries as well...

My former research group is down to half the number of students... Things are not always what they seem, and the level of activity in the oil industry now is still FAR from a emergency-level, all-out effort, WWII kind of thing. The industry is still recovering from 20 years of capacity cuts!

In other words: additional capacity might well come online, but it will take an entire new generation of geophysicists/geologists and an effort which dwarfs current exploration levels.
Oil insiders also note that there are no spare rigs or drilling platforms lying about; every rig is already in use. So we have to construct, at enormous expense, an entire new generation of equipment.

Let's say this takes 10 - 15 years, which is what knowledgeable sources like Matt Simmons guesstimate. That means we can look for new oil flowing in about 2021.
All that new production will do, of course, is replace some of what's been lost to depletion in the next 13 years.



Maybe I'm wrong and oil is heading to $100/brl or less. If so, it's the final head-fake before Peak Oil strikes with a vengence:



Note: I will be away from my desk through next Tuesday, July 22.

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Where the Rubber Meets the Road

I received this excellent and timely inquiry from astute reader Paul B.:

I’m interested in # 1, while you seem to take into account 300 million people in your writings—would you comment on rubber-meets-the-road impacts and proactive actions we can take to help shield ourselves (and our local communities) from the economic problems we’re facing?

I’ve recently discovered your website by a link from one of the survivalist blogs (sorry—I don’t remember which one). During this time I’ve enjoyed reading your commentary with your economic emphasis. Would you consider including concrete actions "average" people could take to protect themselves in one of your future columns? I’d certainly appreciate it and I bet many others would, too. (emphasis added, CHS)

That's big challenge but I'll give it a shot. None of this is startlingly new--it's just common sense, and I will undoubtedly leave a few things off--but as a start:

1. Build/strengthen a small community based on sharing, generosity and reciprocity around yourself and family. My critique of much survivalist thinking--and my alternative view--can be found here: The Art of Survival, Taoism and the Warring States (June 27, 2008)

The strongest "survivor" is not the most heavily armed individual but the individual surrounded by a community which values his/her contributions and support, and who cares whether he/she lives or dies. Nobody gives a damn if the individual holed up in a bunker somewhere lives or dies, and that's the fatal weakness in all too many survivalist scenarios.

A community can be a small as three neighbors, or a block, or a church, or an extended family. The way to build a commmunity, or join a community if you don't have one at the moment is to extend yourself via generosity. Provide something of value without worrying about whether you'll get back an "equal value." Believe me, if you surprise decent people with something useful/good, their delight will exceed all known monetary value of whatever time or product or service you offered.

Just cleaning up the trash on your street or baking some cookies and giving them away can have huge consequences. We as a society have become selfish, greedy and isolated behind an insane wall of "entertainment," TV and other electronic mind-control crap (videogames, etc.) The way forward is to be selfless occasionally, and then those who have benefitted from your generosity will start caring about you.

That's always the way humans have survived extremely trying/difficult times. For instance, the 13th century: Food Shortages, Rising Prices, Stagnant Wages: Welcome to the 13th Century (June 23, 2008).

Here are two related entries:
The Remnant, the Pareto Principle and You (June 26, 2008)
A Critique of Reinventing Collapse (June 25, 2008)

2. Cancel your cable or satellite TV. Wean yourself from the souring insanity of "cable news", "sports" and other soul-deadening wastes of time. Sure, see an occasional movie/DVD, but by cutting off the 200 channels then you will find something better to do than watch TV for 6 hours a day (the U.S. average). Your kids will scream and cry and whine, so tell them you're not raising zombies any more. They can go plant a garden or contribute to the community doing something they enjoy. Watching TV, adding mindless crappy songs to their iPod and going shopping are out, over, done, gone, history. You want music? Then learn to play an instrument. Yes, it's hard and time-consuming, but the result is rewarding in a way no idiotic "guitar hero" game can ever be.

Set the example by stop watching TV yourself. NOVA, Nature, American Experience and a few other PBS shows are worth watching--the rest, including the food and history channels, are fluff. You want history? Then read a book; there are literally a hundred great history books listed in my "books/films" link at the top of this page. Go actually cook something instead of watching some sappy/lame "entertainer" whip together something which has all been prepped for them.

3. Get lean and prepare to heal yourself. One of the first things to go will be the bloated, unaffordable, and largely ineffective "healthcare" a.k.a. "sickcare" system. Hundreds of thousands of people blindly trust the medical system and enter the hospital like sheep to slaughter, where they contract incurable infections, get the wrong meds, or endure an operation of some sort that only makes them worse.

Yes, if you have operable cancer, then by all means go get it cut out, radiated, etc. But get on the Web and learn everything you can about the condition and treament options first.

Example: I have high blood pressure, even though my BMI is 22 or 23. My doctor prescribed some blood-pressure lowering drug, and when it didn't seem to have much effect I went online and discovered that it generally lowers pressure by something like 3%.

Our blood pressure varies by 10% or more every day just naturally, so 3% was practically statistical noise. Then I read about how too much salt is the known cause of high blood pressure (along with too much weight), and I started noticing how all the packaged/canned/prepared/restaurant/fast-food in the U.S. has extremely large amounts of salt. So I stopped eating all that and use a salt substitute (potassium) or a little 50/50 potassium/salt.

From what I have read on the Web, it seems all blood-pressure meds either don't work well, or don't work for long, or they have side-effects. Better to cut salt out of your diet and shed some pounds--that works a lot better than all the drugs being shoved on us. But you can't count on your doctor to tell you that, unfortunately. We all have to take responsibility for our own health except in emergencies such as trauma/accident and operable cancer--and even then, you better hope the trauma center hasn't been shuttered due to budget cuts.

4. Become politically aware and active in your local community. As I outlined in Welcome to Sadr City, U.S.A. (June 20, 2008), local municipalities and agencies will be going broke, and it will be up to the local citizenry to take back control of their city/town/county funds from the public unions and "professional" managers. What we face is simple: the benefits and pensions government employee unions won during the "flush times" are simply unaffordable/unsustainable. In all too many cases, firefighters, police officers, library workers and others "game the system" to retire with overtime-boosted retirements and gold-plated benefits the rest of us can only dream about as things deteriorate.

You can be assured that the public employees will be screaming bloody murder about "what we were promised," but the money's no longer there. So it will come down to some difficult choices that we the public cannot leave to the unions or "professional" city managers: do you want to pay people $80,000 a year retirement plus another $20K in medical benefits, or do you want a library that's open more than 4 hours a week?

Look, circumstances change, and we have to change with them. Just because some agency/city caved into absurd demands back in the tech boom doesn't mean we have to be enslaved to those no-longer-affordable retirement/benefits packages. Make the agency/city go bankrupt when the money runs out and start with a clean slate. Demand that municipal workers work 40 years before they earn a retirement, like the rest of us, rather than a mere 20 years.

Get online and educate yourself about the incredible waste and fraud in your own local government, and then let your elected officials know you want some accountability and services and a sustainable level of salaries, pensions and benefits. Tell them you want the public-employee retirees who are sitting at home on their duffs retired after 20 years to get back on the street for another 10 years, and ditto for every other early-retiree. Tell them 50 is the new 30, and nobody should retire until they're 65 or 70--public employees included.

Yes, I know not every city and agency is filled with cronyism and people who call in sick so their buddy can get double-time, but if you work for a sterling municipality, please don't assume your well-managed burg/agency is the norm. I know for a fact that around here in bloated California, library employees have retired with a small pension after a mere 7 years of part-time service. (Once you hit 55, you can retire after just such minimal service.)

Around here, public employees retire with pensions larger than their salaries, pensions boosted in the final year with legerdemain and bogus tricks to boost the pay on which their pension is based.

Around here, cops and firefighters routinely draw paychecks with overtime in the range of $150,000+ (please search Mish's site for City of Vallejo-bankruptcy for the chart listing the hundreds of city employees drawing well over $100K each).

Around here, a retired university police chief draws a $150,000/year pension and then goes back to work under a contract which pays her an additional $250,000/year. This is just business as usual when it comes to taxpayer funds, public unions and public-sector fraud/cronyism/waste.

Maybe your city/town/county/state is blessed with hardworking public employees who draw modest benefits and retirements and who work 30 years before they draw a dime, managed by people who don't run things according to cronyism and gaming the system--if so, you are fortunate indeed. The rest of us aren't so lucky. We pay high taxes and make a fraction of what the public employees make and have nowhere near their healthcare benefits, working or retired, but then we get to hear about how poorly paid they are compared to private-sector jobs. Get real, people; the pay in the real-world private-sector is crappy and going down. If you're so underpaid, go onto monster.com and get yourself one of those plentiful high-paying private-sector jobs. You will find them less plentiful than you might have imagined.

If you don't get involved, well then a relative handful of protected folks will collect most of the taxes and public services will be sacrificed left and right: no road repair, no libraries, falling-apart schools, etc. It's our choice. Get involved or get happy with whatever crumbs the public unions and graft/waste "experts" leave you.

5. Eat lower on the food chain. Let's start with the fact that it takes about 10 pounds of meat to grow a pound of salmon or tuna, and 10+ pounds of grain to grow a pound of chicken, pork or beef. There will be plenty of food for humans if we stop feeding 90% of the grain to animals and then eating the animals.

Those of you who have hiked or wilderness-camped or equivalent know that a human can get by on remarkably little food. The idea that we're all going to starve to death is unlikely. Corn bread and beans is a damned fine meal and it uses about 10% of the energy/soil/feedstock etc. of an equivalent weight of meat.

Eat what's grown locally, and if you can, eat meat which fed on algae and grass or leftovers and not a whole lot of processed grain: catfish, range-fed cattle, your neighbor's chickens you traded something for, etc.

6. Start growing some of your own food, however little that might be. The value here isn't just the cost of the food you raise--it's reconnecting you and your family with where food comes from in the first place.

If you have a real spread, consider going no-till. No-Till: How Farmers Are Saving the Soil by Parking Their Plows The age-old practice of turning the soil before planting a new crop is a leading cause of farmland degradation. Many farmers are thus looking to make plowing a thing of the past. (Scientific American)

7. Look into permaculture. Comsider this astonishing "on the ground" permaculture report:

Dear Folks,
I would like to inject some real world experience into this otherwise abstract discussion of food and permaculture.
In addition to being an ecological biologist, a permaculture production food farmer for 9 years, and an expert on biomass fuels, I have also been teaching permaculture since 1997 and have worked in many countries on food/energy production design issues. I have certified more than 400 people in permaculture design since 1997. For more info on this see my site at permaculture.com.

So in light of my experience I have a couple of things to say...

I produced enough food to feed more than 300 people (with a peak of 450 people at one point), 49 weeks a year in my fully organic CSA on the edge of Silicon Valley. If I could do it there you can do it anywhere.

...My yields were often 8 times what the USDA claims are possible per square foot. My soil fertility increased dramatically each year so I was not achieving my yields by mining my soil. On the contrary I built my soil from cement-hard adobe clay to its impressive state from scratch. By the end I was at over 22% organic matter with a cation exchange capacity (CEC) of over 25.
...At most times I had no more than half of my land under production with the rest in various stages of cover cropping. And I was only producing at a fraction of what would have been possible if I had owned the land and could have justified the investment into an overstory of integrated tree, berry, flower and nut crops along with the various vegetable and fruit crops.
...I grew over 45 different kinds of crops...

The math is easy. With a polyculture, yields of 3-10 pounds of food per square foot are easy to come up with in most climates. For comparison, commercial agriculture in California , which is way inefficient, routinely runs about 1.5-2.5 pounds per square foot per year across a wide variety of crops...

...There are two main reasons known for the dramatically increased productivity of a polyculture?\the benefit of mycorhyzzal symbiosis (which is destroyed in chemical agriculture) and less solar saturation. Solar saturation is the point at which a plants' photosynthetic machinery is overwhelmed by excess sunlight and shut down.

In practice, this means that most of our crop plants stop growing at about 10am and don't start again until about 4 in the afternoon. Various members of a polyculture shade each other, preventing solar saturation, so plants metabolize all day. Polyculture as we pursue in permaculture uses close to 100% of the sunlight falling on its mixed crops. Monoculture rarely can use more than 30% of the total sunlight received before saturation.

Here's a fascinating, extremely provocative story about folks who created an oasis in Arizona with rain catchment alone: harvesting rainwater in Arizona.

8. Blow off your high-interest debt. If you can pay it off out of earnings, great, if not, go bankrupt once the laws change (probably next year). Don't feel bad, just get it over with. Scrape up the cash and hire a real bankruptcy attorney. Get debt-free except for your low-interest fixed-rate mortgage.

9. Stop shopping. Nuff said. If you don't need it to literally survive and be healthy, don't buy it.

10. Stop "consuming" brainwashing "entertainment" and get involved in real life. You like sports? Then turn off the TV and go play some yourself. Throw out that idiotic "martial arts" videogame and go learn a martial art yourself. It's not just about kicking, it's about the principles of Wushu and self-cultivation, responsibility, self-defense and self-control. Stop watching and start doing.

Go canoeing, snowshoeing, toss the football around, put some air in the tires of that old bike, but build up to it (I'm 54, so I know about injuries and warming up.) Don't be a weekend warrior and hurt yourself. Remember: we're responsible for our own health now; don't count on somebody else "saving" you.

11. Try to get a job closer to home. Nuff said, Shorter commute=less oil burned, less time wasted fuming in traffic.

12. Stop moving around the country. No wonder we're so messed up as a culture; so many people have no roots in the community and no family within a thousand miles. Most of the crazy homeless people in my city have been abandoned by their family. They don't just have a psychiatric problem--they have a family problem, which means we as a nation have a family problem, too.

13. Get your hands on an old, cheap, low-weight/small engine vehicle. I mean a Chevy Geo, or a little Ford, or a Nissan, whatever. Not all of us can afford a new Prius or Ford hybrid or whatever "high-tech solution" is presented (ask yourself what's the profit margin on all those "solutions"), so what we have to do is simple: make do and improve what we have.

In the Japanese cars, the older the better, in some ways; the engines and cars were smaller and got great mileage without hybrid technologies. I am pretty sure my 1998 Civic gets about the same mileage as a new hybrid.

If you keep the engine tuned, the oil and filter changed often, tire pressure up and drive a sane speed, even a mid-sized vehicle can turn 35 MPG. The same vehicle, poorly maintained and driven with a heavy lead foot will get 20 MPG or less. The difference isn't the technology, it's behavioral. Meaning: it's up to you.

14. If at all possible, try to figure out how to walk or bicycle somewhere useful. By that I mean, is there any possible route which enables you to walk or bike to a store or do some errand, at least in seasonable weather? If not, then maybe you should go to a city council meeting and ask why your town/city doesn't have any safe bikeways.

On reasonably flat ground/modest grade, 8-10 miles on a decent bike is no big deal, meaning any destination 5 miles away or less is bikeable if there's a safe route (i.e. not sharing a highway with cars going 55 MPH.)

15. Be positive and fact-based. Nurture the Inner Light regardless of which religion/faith you believe/follow. We're in this together, and we need to support reality-based solutions and those around us who are ready to deal with reality. Our mental health is as important a survival advantage as our physical shape.

16. Acquaint yourself with the idea of hedging. Don't trust the dollar to retain it's value? Maybe it will, maybe it won't. A little gold or silver is a hedge. If precious metals plummet and the dollar goes gangbusters, great, most of what you own is dollar-denominated. But if the dollar tanks, you've got a little hedge.

Here in earthquake country, I keep dozens of gallons of potable water on hand (i.e. enough to share). It's a hedge against an earthquake that breaks the water mains. If an earthquake never hits, great, I'm not out a dime. But the hedge is there just in case. If you're game, you can even learn how to buy commodity hedges, or find a fund which does the hedging for you. (I don't follow funds, so I can't give you any tips at the moment.) The main point is to start doing the research and thinking for yourself.

Along these lines, I recommend this little essay by frequent contributor Harun I.:
The Principles of Trading Also Apply to Life (June 19, 2008).

This isn't an exhaustive list but it's a start. Much of it will not be popular because it isn't a "high tech solution" and it all requires work, learning, responsibility and paying attention--all the traits which our "entertainment" obsession erodes, discounts and destroys.

New Reader commentaries and essays:

Readers Journal commentaries week of July 14, 2008 Democracy led by citizenry, China oil and inflation, blaming oil speculators, mortgage madness and more.

What's For Dinner at Your House has been updated! Two new recipes: Papillotes de Poisson and Craisin Bread/Cream Cheese/Walnut Sandwich

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Is this Election Just More 'Bread and Circuses'?

In yesterday's entry, Harun I. made use of the phrase 'bread and circuses,' which refers to ancient Rome's jaded citizens' hunger for handouts and entertainment at the expense of their political rights and liberties. Here is the Wikipedia entry: Bread and circuses:

In context, the Latin phrase panem et circenses (bread and circuses) is given as the only remaining cares of a Roman populace which has given up its birthright of political freedom:

... Already long ago, from when we sold our vote to no man, the People have abdicated our duties; for the People who once upon a time handed out military command, high civil office, legions - everything, now restrains itself and anxiously hopes for just two things: bread and circuses.

And what is American Idol, NASCAR et al. but modern-day circus, and what is the bailout of defunct mortgages and lenders but "bread" on a vast scale?

My longtime friend G.F.B. recently wondered if the entire presidential election is fundamentally a distraction on the level of entertainment/circus. This is not to say that there is no difference between the candidates; regardless of our biases and views, we can all agree that the U.S. would not be precisely where it is today had Al Gore been elected President in 2000.

But has any presidential candidate, winner or loser, actually spoken to the fiscal and moral consequences of depending on ever-greater borrowing for so-called "growth"? Back in 1992, independent candidate Ross Perot was widely mocked for referring to the U.S. budget deficit as the "crazy aunt in the attic," which ran counter to the Reaganomics fantasy that huge deficits "didn't matter."

Enough people supported Perot's "straight talk" that the Republican candidate, George Bush, lost the election that year. That political pressure for fiscal restraint led to the Clinton administration and the Republican Congress limiting spending via "reinventing government" and "The Contract with America," which coupled with an Internet-fueled growth spurt, actually created the illusion of Federal surpluses. (If the government hadn't spent the Social Security surplus, it would have still reported deficits.)

Since those brief (and spurious) "surpluses", the American electorate and governing class has become remarkably immune to any concern over deficits or borrowing, public or private. $400 billion deficits are now accepted as "normal," and spending nearly $300 billion a year on interest on the national debt--surpassed by only Defense, Social Security and Medicare expenditures--also elicits only yawns.

Th facile reason might well be 9/11--after that shock, the government rushed to "normalize" the economy with cheap, easy to borrow money. But as Harun noted yesterday, the reliance on low interest rates and deficit spending go back much further than 2001-- and even after the economy righted itself in late 2002, rates and liquidity were not tightened, they were eased even further.

The past two days we have examined the folly of attempting to reinflate/bail out the credit/debt bubbles the U.S. government agencies, elected officials and public have enabled. What few seem to realize is that the U.S. simply does not have the savings pool needed to cover trillions in housing/real estate losses, or to fund trillions more in new mortgages.

What we have foolishly taken for granted is the global savings pool which has enabled the U.S. to borrow recklessly, without consequences, until now. The apologists are quick to claim that 401K and IRA pension plans are America's true savings, and the negative savings rate reported in the media is bogus. But not every worker is socking away money in 401Ks, and those are retirement plans, not savings--there is a difference.

As the dollar plummets anew--80 on the DXY was widely viewed as "the line in the sand," and here we are at 71 and declining--everyone holding assets denominated in dollars is seeing their equity literally destroyed. (Chart courtesy of Harun I.)

The poster child for a credit/debt bubble which is "fixed" by massive new borrowing for 15+ years is Japan. The problem with borrowing trillions in an attempt to reinflate the credit bubble or recapitalize the economy is that, well, you owe interest and principal--and so will your children and grandchildren.

As we see below, the Japanese central government draws an astounding 41% of its annual expenditures from debt (bonds), and even with interest rates at the absurdly low 1% level, the interest on that ballooning debt accounts for fully 22% of total expenditures and an astonishing 42% of tax revenues.



It seems self-evident that we as a nation have a choice: the Japanese model of two decades of crippling decline, or an immediate reckoning of losses and recapitalization via domestic savings. But even this is a false choice, for we don't have enough domestic savings to enable the sort of stupendous deficits the Japanese have been running for years. We must turn to the world economy to fund our borrowing (as we have for years), just as the global economy is sinking into a credit/profit/asset contraction of gargantuan proportions.

In the vernacular: ain't gonna happen.

So as we watch the two presidential candidates dodge and weave the hard necessity to renounce bad debt and take the losses, whatever and wherever they may fall, and the hard necessity to align government spending with actual revenues, we have a choice: shall we support the one who panders most and panders best, the one who promises us more bread and circuses, or shall we choose the one who most directly faces the reality that trillions have been lost and cannot be recovered, and who most directly states that it is not the taxpayers' job to "save" those who gambled on risky debt/financial instruments and lost.

The candidates want to win, of course, and they are acutely sensitive to the whim and will of the voters; if the voters (us) demand bread and circuses, the candidates will respond with pandering and corporate welfare and rousing cries for more taxpayer-funded giveaways to "victims."

But if we reject pandering, bread and circuses, then they will respond to that, too. The leaders are not actually leaders, they are followers of the public will. If we fail to will anything but farce, distraction, giveways and the entertainment of ersatz "debate," then our "leaders" will give us precisely that--bread and circuses--regardless of who wins the election.

And if pandering and denial are our collective choice, we will enter a decline that will make the Japanese "lost decade" look like fabulous prosperity.

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Why Fannie and Freddie Have Doomed Housing Prices, Regardless of Bailouts
(July 14, 2008)

If you got a penny for every word written during the past week about Fannie Mae and Freddie Mac, you'd be a millionaire, if not a billionaire. It is highly likely that no stone has been left unturned in this great torrent of words and analysis, but it seems two points have been generally ignored or under-emphasized:

1. Regardless of whatever bailout is proposed for Freddie and Fannie, interest rates and thus mortgage rates will rise significantly. Even if all the distressed garbage loans are fobbed off onto the taxpayers (as wrong as that would be), that won't put the bloom back on the U.S. housing rose. Is there even one person left on the planet who thinks debt based on the U.S. housing market is basically risk-free?

And what happens when risk is priced into debt? The interest rate must include a hefty, if not outrageously gigantic, risk premium. That's how 6% mortgages quickly become 9% or even 12% mortgages. Or how 30-year mortgages might simply vanish and the longest term you can find will be 15 years--at a stupendous premium.

2. Since Freddie, Fannie and Ginnie end up owning up to 75% of all mortgages originated in the U.S. housing market, their inability to sell new garbage loans to now-wary investors means 3/4 of the mortgage market has been impaired. Mortgage availability will contract most savagely.
Let's take a look at a chart that depicts the see-saw effect:

Please go to www.oftwominds.com/blog.html to view charts.

Recall that banks and lenders of all types and sizes are suffering from impairments in their capital. Whatever assets the banks have on the books are depreciating rapidly, essentially gutting their capital base and their ability to originate new loans.

Recall that capital requirements have been as low as 1%, meaning a bank need only retain $1 million in actual cash to write $100 million in loans. If those loans drop in value by 2%, the bank must raise cash or it is essentially insolvent.

As astute correspondent J.F.B. has noted many times before: how can banks make money in an environment of depreciating capital and distressed debt? The short answer is they can't: all the capital they're raising is simply bringing them up to bare solvency (at best; if all the off-balance sheet garbage is forced onto the balance sheets, then the majority would be hopelessly insolvent.)

So what happens to the housing market if rates skyrocket due to risk premium, and mortgage availability dries up? It tanks even further. As noted here many times, housing depends entirely on cheap, readily available mortgages. Once those two conditions go away, housing dies a slow, agonizing death. Prices have to fall--recall that a $600,000 mortgage at 6% is equivalent to a $300,000 mortgage at 12%--and buyers will find they cannot find mortgages without hefty origination points.

And without buyers, then the market freezes up, becomes illiquid. Few sellers will find buyers and prices will decline to the point that cash buyers appear. (Hint: that isn't $500,000, or even $300,000.)

The bond market seems to have been sniffing out this possibility for several years.

Knowledgeable reader J.B. was kind enough to provide the following chart; though he notes a strong cyclical pattern which suggests ultimate yield lows in the 2011-2012 time frame, the triple-bottom I have indicated and the yield's obstinant reluctance to dip below the upper channel suggest to me we are close to breaking out of a 24-year downtrend in yields, and entering a 20+ year cycle of rising rates.

So while much heat and light are being devoted to past debt--who will suck up the enormous losses in Freddie's and Fannie's trillion-dollar portfolios--I am looking at the staggering effects their demise as providers of "low-risk" debt will have on the housing market in the future. If nobody's dumb enough to trust the U.S. housing market or the garbage paper being kited by Freddie and Fannie, then mortgage availability will simply blow away and rates will climb rapidly up to the point that investors are being amply rewarded for taking the grave risks of betting housing won't decline precipitously in the U.S.

Ironically, the "poker hands being called" will trigger the very decline in valuations everyone fears. Think about it. You're responsible for $1 billion of a pension fund's money; are you going to risk your capital on a huge gamble that U.S. housing has bottomed? On what evidence? Hope? Hope is what got us in this mess in the first place.

And recall that despite the implicit government backing of Freddie and Fannie, the market for mortgages is still private: you still have to con a private investor to part with cash to buy the mortgage or mortgage bond. And if nobody's dumb enough to give you cash for depreciating paper, then you still can't sell mortgages, regardless of any guarantee in the world except "You can't lose money because the U.S. taxpayer will buy every single mortgage originated in the U.S." Are we collectively going to approve that $10 trillion bailout?
Craig M. recommended this link to Nouriel Roubini's take on such a bailout, which is the U.S. government losing its AAA rating: Insolvency of the Fannie and Freddie Predicted Here Two Years Ago. What Happens Next? Or How to Avoid the "Mother of All Bailouts".
Is anyone who manages big money really dumb enough to believe housing can't fall another 15-20% or even more? I don't think so. Smart money will be demanding risk premiums large enough to protect against further declines in real estate values: huge down payments, big points (origination fees) up front and high interest rates.

OK, sources:

This is slightly dated (2001), but this report from the Federal Reserve Bank of Atlanta shows how incredibly dependent the mortgage business has long been on Freddie, Fannie and Ginnie:
Fannie Mae and Freddie Mac at Work in the Secondary Mortgage Market

Of this amount, 29.3 percent were sold to Fannie Mae, 24.5 percent to Freddie Mac and 22.7 percent to Ginnie Mae. (CHS: That adds up to 76.5%.)
Contracts with Fannie Mae and Freddie Mac make up 62.5 percent of the outstanding principal of serviced mortgages by commercial banks. Ginnie Mae contracts constitute 19.2 percent. (That's 81.7%)

Back in the good old days of, say, a year ago, Freddie and Fannie were actually seen as beneficiaries of the subprime meltdown (heh): Fannie Mae and Freddie Mac enrich shareholders in subprime's shakeout (Bloomberg, June 2007)

Fannie Mae and Freddie Mac, which are U.S. government-chartered companies and the biggest source of money for Americans buying houses, accounted for 46.9 percent of all mortgage bonds sold through April, according to Inside Mortgage Finance, a newsletter.

Fannie Mae and Freddie Mac, which together own or guarantee about $4.5 trillion of residential mortgage assets, are offering the capital after foreclosures increased 62 percent in April from a year earlier, according to a recent report by RealtyTrac, which sells information on defaults.
Fannie Mae and Freddie Mac finance about 40 percent of the $10.9 trillion of U.S. residential mortgages. More than $6 trillion of mortgage bonds are outstanding, making it the largest debt market in the world and about 50 percent more than the amount of U.S. Treasury securities.
The prices that investors pay for the bonds help determine the rates lenders charge consumers.

Back in 2006, after billion-dollar questions arose in their accounting, Fannie and Freddie were slapped with modest restrictions which shrank their ability to buy more garbage oops, I mean mortgages and mortgage-backed securities: Fannie, Freddie Retreat as Mortgage Bonds Mutate (9/6/06)
The companies accounted for 38 percent of mortgage-bond sales this year through June, down from a record 70 percent in 2003, according to data service Inside MBS & ABS. The bonds, which help determine rates homeowners pay on loans, have risen 51 percent since 2001 to $6.2 trillion, Bond Market Association data show.

They were losing market share just as a growing economy and low borrowing rates fueled a boom in housing. The amount of residential mortgage debt rose to a record $9.17 trillion last year from $5.57 trillion in 2001, according to the Federal Reserve.

So regardless of what bailout is proposed, we're still sitting on a $10 trillion powderkeg with about an inch of fuse left. I cannot repeat this often enough: with all the risks of further valuation declines now visible, who is going to step up and buy another couple trillion in housing debt? The taxpayers? No way. We're already on the hook for the $1 trillion+ losses in the existing garbage mortgage pool.

Again: who would be dumb enough to be buying mortgages or mortgage-backed securities with the sizzling fuse just an inch away from the powderkeg?

Of course not every mortgage owned by Freddie or Fannie is garbage (yet); but the question remains: how many mortgaged properties in the U.S. are truly immune from future valuation declines? How safe are even conventional 80/20 mortgages? What about all those markets which have declined 25-30% Even a conventional mortgage with 20% down in these markets is completely underwater.

But here's Fannie's own website to reassure you: Discussion of Credit Book of Business (rest assured it's all under control)

Several readers have recommended my esteemed blogger colleague Karl Denninger's clear-sighted analysis of the situation, and as a longtime reader and fan of Mr. Denninger I heartily concur: Fannie, Freddie, Banks and Government Debt.

Thank you, Carlos C. ($100), for your stunningly generous contribution to this site. I am greatly honored by your support and readership.


Is the U.S. Alcoholic, or Merely Schizophrenic?
July 15, 2008

Please go to www.oftwominds.com/blog.html to view humorous images.

Since it runs in our family, I do not use the word "alcoholic" lightly. Those of you who have to deal with alcoholics know the drill: the liquor stashed behind the fridge, as if everyone doesn't know it's there; the stumbling into the pool, the humiliating rescue, the tearful promise of change which goes nowhere, and all the rest.

I seriously suspect the entire American culture is alcoholic--not about liquor, but about debt. In all the thousands of words printed about the subprime meltdown, the meltdown of Bear Stearns and now, the crispy-crittering of Fannie Mae and Freddie Mac (can Ginnie Mae be far behind?), not once have I seen anyone in the MSM or mainstream financial press confess that "borrow our way of out of trouble" is not just financially bankrupt but morally bankrupt as well.

Like a full-blown alcoholic, the U.S. populace and government stagger from debt source to debt source, weaving drunkenly between "stashes" of new debt in the Fed, Treasury and private sector markets. Meanwhile, behind the scenes, you can bet you last depreciating dollar that the Fed and Treasury are leaning on all their pals in other central banks to buy T-bills and U.S. mortgage bonds, to maintain the alcoholic's ever-important image of low-rate, low-risk normalcy.

As our overseas friends suffer stupendous losses propping up their free-spending alcoholic "buddy," the loan-soused, totally debt-addicted U.S., the apologists for the alcoholic debt-binge continue to claim the risk of systemic failure and collapse of asset values is low.

Like the closet alcoholic who quickly comes to the defense of the full-blown addict, the mainstream media is careful to treat the debt-hurricane as if it were an act of Nature. We just need to help those poor people who have found themselves at the head of investment banks, throwing up all the bad debt they swilled in such quantity, and those poor homeowners who were struck by the terrible uncontrollable urge to leverage a few thousand bucks into a mountain of mortgage debt. Poor, poor people, we really need to bail them all out.

This is the classic "enabler," the folks who yearn to help the poor alcoholic mend his ways--if only the rest of us were more sympathetic and generous. In other words--don't demand a dose of reality for your neighbor's little drinking problem--then your own debt addiction might attract some unwelcome attention, too.

The media's role as enabler/apologist for the privatization of profit and the socialization of risk is well-stated by knowledgeable reader John H., who recently wrote:

The media doesn't control what you think about the issues, it controls what issues you think about.

That's why we talk about abortion, gun control, and missing white girls in black countries. It's irrelevant to the Powers That Be if you are for or against abortion, they just don't want you discussing economic policy or how 'free markets' aren't free at all."

And a free market is precisely what our government (the Fed and Treasury) are fighting so hard to avoid. If our nation is as debt-drunk as it appears to be, perhaps we need a national 12-step program, which would begin with this:

1. We need to appeal to a higher power: an open, free market.

And you already know what much of the off-balance sheet portfolios of investment banks and other institutions will be once they're marked-to-market: zilch, nada, zero. Like the full-blown alcohoic who fears "cold turkey," the Fed and Treasury just keep hoping that another bottle or two of Wild Turkey (as opposed to cold turkey) will ease the delirium and we can all go back to hiding our addiction behind the fridge.

Like an alcoholic's pathetic attempts to con listeners into believing he's got his "problem" under control, the Treasury announces a $2 billion loan to Fannie, as if a little nip of the good stuff will "cure" the dementia of the U.S. real estate market's debt addiction. My esteemed blogger colleague Karl Denninger pegged Fannie and Freddie's mortgage losses at a minimum of $900 billion, and I agree with him that this number is being extremely charitable.

Let's be a little more hard-nosed and say that $2 trillion (out of $10 trillion in total loans and mortgage bonds) has already vanished; and when the bubble has well and truly deflated, Freddie and Fannie's $5 trillion portfolios will have lost $2 trillion themselves, with another $2 trillion being lost by the other bagholders.

Does anyone see the absurdity of the Treasury plinking down $2 billion to "cover" a $2 trillion loss? This raises an even more horrendous possibility: the U.S. is not alcoholic: it's schizophrenic, literally unable to discern reality.

Frequent contributor Harun I. recently provided this troubling summary of our plight:

"All the banter about Fannie and Freddie is interesting but no one seems to be asking: how did the people in a democratic republic, the world's largest economy, host to the world's reserve currency, the only remaining super power, let their economy become solely dependent on the ability to process and reprocess debt on homes? How did we let our government legislate into being, through the GSE's, the largest Ponzi scheme ever?
Isn't this the crux of the matter?
The legacies of Wilson, Roosevelt, Nixon and Reagan are coming to a tragic and chaotic apex."

I would agree. We all know what happened in the past decade:

1. Thanks to intervention by the Fed and Treasury, money became insanely cheap and easy to borrow.
2. This fueled a frenzied, utterly unsustainble, insane real estate bubble.
3. Homeowners and businesses alike borrowed vast sums based on these inflated valuations, a.k.a. the home equity ATM.
4. As valuations begin returning to reality, howmeowners and businesses now have negative equity and can no longer borrow more.
5. Without trillions in borrowed money flowing into the economy, the economy sinks into recession.
6. As the recession/credit contraction takes hold, people lose their jobs and businesses lose their lines of credit, further restricting their ability to service their massive loans.
7. As defaults and impaired debt rises, lenders fall like dominoes into insolvency.
8. A feedback loop takes hold: credit contracts, more businesses close and workers lose their jobs, which further reduces the value of assets backing outstanding loans, which then further reduces credit and consumer spending, sending more borrowers and lenders into bankruptcy/insolvency.

So what caused our collective blindness to risk and the consequences of relying on an addiction to ever-rising debt? I asked Harun for further comments, and he responded thusly:

"My main point was that the mess we are in is the fault of the people. It was not just one generation but several generations of greed, ineptitude and apathy on the part of the citizenry that has allowed this to happen. (emphasis added, CHS) We have gotten exactly what we deserve because it could be no other way. At every juncture the American people had the ability to raise its voice and demand a new direction. But generation after generation, administration after administration, the lies were told and we bought into it when we knew or should have known the consequences.

What is happening is no freak happenstance of history. This con has been perpetrated so many times throughout history we should hang our heads in shame that we let it happen again. It would take a book to go back through history and bring us up to date on where we are today.
From Wilson's establishment of the Fed and the IRS under cover of darkness (Christmas holiday) to appease the bankers that got him elected, to Roosevelt's theft of gold and establishment of GSE's, to Nixon's unilateral destruction of the gold standard, to Reagan's Voodoo Economics (Greenspan era), to Clinton's NAFTA, to Bush's preemptive perpetual warfare doctrine, the collective never batted a critical eye because they were mesmerized by, if not intoxicated by, the bread and circuses.

The one thing people in a democratic republic must do well is think critically. Unfortunately the bar for inductive and deductive skill is abysmally low. Our collective grasp of history as a practical matter is virtually nonexistent.

All governments, at some point, will do what is necessary for its survival and hold on power rather than real and only purpose of serving the people. Our government is uniquely structured to prevent this but because of the vices of man we are watching it go the way of lesser governments before it.

At the close of the Constitutional Convention in Philadelphia on September 18, 1787, a Mrs. Powel anxiously awaited the results, and as Benjamin Franklin emerged from the long task now finished, asked him directly: "Well Doctor, what have we got, a republic or a monarchy?" "A republic if you can keep it," responded Franklin."

It is a terrible thing to hope that the U.S. is only alcoholic and not completely out of touch with reality. The alcoholic knows he has a problem, and fears the solution more than the destruction he is wreaking on himself and everyone around him.

Will we ever get tired of listening to the media enablers, who manage to cast everyone as a victim of forces beyond their control and responsibility? Will we ever get tired of a Congress, Fed and Treasury filled with prevaricators and liars of the most alcoholic sort, too drunk on their own lies and power to countenance anyone else speaking truth to a higher power?

If you know any alcoholics, you know how painful it is for them to face reality --that they have to stop drinking, totally, completely, and now, not tomorrow. You also know that it all too often takes a crisis to instigate this admission of their sorry state.

I don't expect any change until the crisis forces it upon us. The years of denial and enabling are about to end. The long 24-year era of ever-cheaper, ever easier money is ending, and a 20+ year cycle of ever higher interest rates is poised to begin.

How can I know this? Easy. The U.S. debt addiction is now so large that the global financial markets will soon be unable to finance its continuation. As global recession cuts profits, incomes and assets across the board, there simply won't be enough money to fund trillions more in new debt to keep the U.S. debt machine staggering on. Other nations are running huge deficits, too; everyone joined us on the debt-binge, and the only answer--cold turkey--is about to be forced on us all.

New Reader commentaries and essays:

Readers Journal commentaries week of July 14, 2008 China oil and inflation, blaming oil speculators, mortgage madness and more.

What's For Dinner at Your House has been updated! Two new recipes: Papillotes de Poisson and Craisin Bread/Cream Cheese/Walnut Sandwich

Thank you, John H. ($20), for your generous contribution via mail to this site. I am greatly honored by your support and readership

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Turning a Profit on Abandoned McMansions and SUVs

Capitalist extraordinaire Ronald Dump is touting two "huge" profit-center ideas: converting abandoned/worthless McMansions into modern tenements, and recycling abandoned/worthless SUVs into gas-sipping 3-wheelers.



It's been a while since we checked in with trend-setting uber-investor Ron Dump, who was last seen pitching his "forget innovating products, innovate financial services" CEO seminar.

After laying low in his Bahamas tax shelter estate for much of last year, Dump has resurfaced--his "patriotic" lapel pin still firmly in place, just like the ones our beloved political leaders wear--to launch two new ventures which he describes as "huge, beyond huge, so galactically profitable even the Martians will be flocking in for a piece of the action."

The first business takes "creative destruction" to a new level, as described by the latest issue of "This Old McMansion":

You gotta hand it to innovators like Dump--dynamiting McMansions is sure to draw thrill-seeking crowds seeking emotional closure on the housing bubble debacle, and the need for cheap tenement housing is sure to explode as millions more lose their houses and jobs. With rents rising in desirable cities, where better to warehouse millions of newly poor than abandoned McMansions in the distant exurbs?

His other venture is even bolder, if that's possible: chop abandoned SUVs in half and install recycled lawnmower engines into the hulks. Here is a visual depiction of the idea (with kind regards to Strawgold):

Dump waxes enthusiastically about the new venture. "Look, we have about 50 million more vehicles than we need, real gashogs nobody wants. Why sell them for scrap, when so few people can buy a new car anyway? We also have a bunch of unemployed blue-collar guys with nothing to do all day except watch TV, which is garbage. So get these guys a blowtorch, some old fan belts and other salvaged parts, and let them go to town on these millions of worthless SUVs."

Dump scoffs at the mechanical challenges of adding a steering mechanism to the rear half of an SUV, or stabilizing the front half with a small third wheel. "Listen, pal, we're talking about people with no transpo at all, zip, zero, nada, stuck in a crumbling McMansion in the boondocks without any rail service or even bus service. These people are crying out for some sort of affordable transportation, and so what if the steering wheel is now a stick, or the thing only goes 25 miles an hour downhill? The option is walking or bicycling, and with the roads going to Heck a bike ride can be bone-jarring. This way, you still get the comfort of a SUV seat and a nice soft ride."

With the three U.S. automakers heading for bankruptcy and even the Japanese automakers scrambling to retool their U.S. factories to make smaller, lighter vehicles, Dump is confident that "chopping and recycling" the tens of millions of existing vehicles is the real growth market for the decade ahead.

"I don't care what crap the TV pundits spout, unit sales of new cars will drop from 15 million a year to 5 million, tops. There's a big need for cheap transpo, and we're going to provide it in an ecologically sound way which will create tens of thousands of new jobs and spark all kinds of innovations. Instead of criticising me, the Mainstream Media should be calling me a hero. But to Heck with them, this is huge and I'm in on the bottom floor."



Note: the above is a reality-based parody.

Thank you, Wesley M. ($15), for your unexpected and generous contribution to this site. I am greatly honored by your support and readership.

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