Recession? I've Got a Solution

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 |  Includes: COP, CVX, DIA, QQQ, SPY, XOM
by: Saul Sterman

For months now we have been listening to bad news followed by more bad news about the U.S. economy and how over half the people, analysts and CFOs expect the U.S. to go into recession, assuming that we are not already in one.

Well folks, I've got the fix!

I'm not kidding. I'm for real. Though some who read this will say that the details are a bit sketchy and that I haven't included enough hard data and pie charts to prove the primary thesis, I have intentionally stuck to an article format as many do not have the patience for a white paper. Besides, Seeking Alpha doesn't publish white papers!

The Problem

In July 2006, Seeking Alpha published an article entitled The U.S. Economy: Finding the Balance between Production and Consumption. As stated in the article:

The first dose of reality is to understand that no economy can maintain a 66% consumption rate. The ideal situation is that production equals consumption. If you don’t produce, then don’t consume. The notion that supply side economics can spur economic growth indefinitely is bogus. Eventually you accumulate so much debt that everything goes kaput. Supply side economics works great for getting an economy out of a recession. Once achieved, the emphasis should be on production of goods consumed.

The U.S. economy cannot continue indefinitely accumulating a $700B a year trade deficit coupled with a $400B a year Federal budget shortfall. Something has to give. To 'grow' out of the deficit through inflationary growth is a fool's folly.

This is clearly evident as the average household is under severe stress from rising prices on everyday staples, without including the housing debacle. The country can be divided into two classes of citizens; those with housing issues and those without. For those without mortgage and foreclosure issues, inflation and wage stagnation is their biggest hurdle. For those with housing issues the problem is compounded.

The current thinking of this administration is to relieve pressure by pushing things off. In essence, lower rates will cause adjustable rate mortgages to reset lower and will ease the pressure for now. However, this is not a long term solution and is liken to treating the symptom, not the cause. Similarly, giving the average American family a several hundred dollar handout, starting May, will alleviate symptoms but not address the reason that the handout was needed in the first place.

First, to understand the problem we need to separate the two origins and tackle each one individually. We have two totally separate 'diseases' that need to be treated. Every doctor knows that a correct diagnosis is imperative. Once you have that you can begin treatment.

Diagnosis

In order to comprehend the two diseases that are afflicting our economy, we need to differentiate between ongoing consumption and past over consumption. The former is what is afflicting all Americans where the latter pertains to the housing/financial crisis. Both accumulated personal debt and public debt fall into the latter category. This article deals strictly with the former.

Bundling the two together leads to a misconception that begets a false perception that continued consumption can alleviate both. In reality, all it accomplishes is a bleaker future and renders the remedy to be more elusive.

Many economists fear the notion of reduced consumption as this will lead to a recession, perhaps even a depression. They are correct. Any downtick in economic activity will show up as a contraction which is a recessionary process. Today, we import $700B a year more than we export and if we were to stop importing $700B worth of goods today (hypothetically of course) this in effect would reduce the economic activity by the same amount. Naturally, this would lead to stagnation or even a recession.

On the other hand, if this $700B worth of imports were to be replaced by local production (once again, hypothetically - for now), we would maintain the same economic activity and continue on a growth pattern without the aftereffects of a trade deficit. The aftereffects include currency devaluation, inflation, unemployment and eventually loss of infrastructure and the ability to make a come back.

The key word in all of this is substitution, more on this later.

The Trade Deficit

The trade deficit is comprised of two parts and two components; the components being finished goods and raw materials. The better known component is the importation of finished goods. Raw materials for further manufacturing and processing can actually be a positive. It is the 'finished goods imported for consumption' that is a dead end import.

The U.S. trade deficit with China is correctly highlighted in the media but for the wrong reason. It is not only the sheer volume of imbalance that is of concern but more so is the type of goods that are imported from China and the nature of the U.S. exports to China. The U.S. imports primarily finished goods from China yet exports are a mixture of finished goods and raw materials that the Chinese finish into goods and re-export to the U.S.

This has been a bone of contention with trade negotiators on both sides of the Pacific. The Chinese assert that the U.S. simply can not compete due to the fact that wages are substantially lower in China in comparison with the U.S. The U.S. maintains that if China were to revalue their currency, this would alleviate the labor cost discrepancy thus even out the playing field. In reality, the wage discrepancy between the U.S. and China is so huge that it would take the better part of a decade of continuous 8% net inflation in China coupled with a 7% per annum revaluation (or dollar devaluation) to achieve a level playing field. In the interim, the U.S. would continue transferring wealth from U.S. citizens to the Chinese at an ever increasing pace. We shall call this the 'interim period'.

However, as stated above there are two parts to the trade deficit, not just two components. The first part is goods and services and as stated have two components; raw materials and finished goods. The second part is energy.

Energy is an ingredient that is prevalent in everything we do in any given economy. Similar to labor, the country that has an energy advantage can compensate for higher labor costs to some extent. For many years and true today as well, U.S. energy costs have been lower than in Japan or the European Union. When oil was below $20 a barrel, the energy factor mitigated the 'labor discrepancy cost' with China on a wider range of goods. As oil climbed above the $60 range, the offset was wiped out. The only silver lining was the fact that the higher energy costs meant that there would be inflationary pressures in China as well which would eventually lead to higher wages. Once again, this is a fool's folly as this does not deal with the ten to twenty year interim period and also neglects to take into account that the offset is only partial at best.

The Chain Reaction

Energy is a primary component in the cost structure of all economies. The more industrialized the economy is, the greater the direct impact energy has on economic activity and influences the input cost structure. In the past I have mentioned that using 12/31/2006 constant dollars, the threshold for the U.S. tipping over towards recession was an energy cost of $85 +/- per barrel. The way the U.S. is currently attempting to avoid surpassing this threshold is through the implementation of a dangerous game known as currency devaluation. Nominally, oil is above this threshold; however, the dollar is being devalued back to the threshold point.

I will not get into all the ramifications of currency devaluation, though I will state that this is so dangerous that Vegas wouldn't give odds on a long term positive outcome.

In essence, what the administration is doing is getting us back to the threshold point, thus pushing off a possible recession. This time around, there may or may not be a plan for a different outcome and let's hope it is not another ethanol like scheme that has negative inflationary side effects. Just in case the administration doesn't have a doable game plan, I do…

The Theory

I was delighted to read this weekend an AP article where the United States Air Force plans to wean itself from oil by up to 50%, a doable concept by 2016. It is important to read the entire article as there are many points in this article that I address below. Liquefying coal is not a new concept and the main impediments are twofold, infrastructure costs and pollution.

The first issue to contend with is the cost. According to the Air Force, the start up costs is $5B to produce 25,000 barrels per day. If I were to approach Exxon Mobil (NYSE:XOM), ConocoPhillips (NYSE:COP) or Chevron (NYSE:CVX) and offer them a well that can produce 25,000 barrels p/d for $5B, they would laugh and show me the door.

There are several items that are being overlooked here. First, we are not talking about a well. We are talking about a refinery equivalent with a guaranteed 100 or 400 year supply contract. The oil companies are accustomed to investing in high yield or quick return well sites. The average (U.S.) site runs its course in ten to twenty years and is then abandoned. However, refineries are built to last longer. No new oil refineries have been built in the United States for over twenty years. The oil companies need to view this investment as a refinery. This creates another problem as most refiners would prefer one 250,000 bpd refinery over ten 25,000 bpd refineries. So now we are talking about a $50B investment…oops.

As stated in the article, Wall Street is skeptical:

"Is it a viable technology? Certainly it is. The challenge seems to be getting the first couple (of plants) done," said industry analyst Gordon Howald with Calyon Securities. "For a company to commit to this and then five years later oil is back at $60—this becomes the worst idea that ever happened."

Gordon Howald is saying:

1) In order for the 'coal refinery' (Coal Liquid Energy Artificial Restoration; hereinafter CLEAR) to be profitable, oil must stay above $65 a barrel forever. This is due to the high infrastructure costs.

2) In addition, the price of coal can not rise substantially from current prices in relation to oil. In other words, if oil goes up 50%, coal can increase by the same percentage without causing losses as the price at the pump increases in tandem. However, if oil increases 10% and coal increases 50%, all CLEAR units start losing money. Likewise if the price of oil goes down, the price of coal must move down as well to remain competitive.

The second item is solvable as the majority of coal reserves are owned by the Federal government. All the government has to do is form a linkage mechanism to the price of oil while guaranteeing, if not a 400 year supply, a 100 year supply to the CLEAR unit.

I will deal with the cost structure in a moment, but first…

The United States imports approximately 10 million barrels of oil per day. This contributes approximately $330B a year or nearly 50% to the U.S. trade deficit. It would take 10 large $50 billion CLEAR units to reduce this by 25%. In other words, the Federal government would make an up front investment of $500B in order to stop sending $83B a year out of the country, that's over 16% a year! Another way of looking at it is that it would take six years to recoup the entire investment from a trade impact viewpoint. Had this been done eight years ago, we would have reduced our accumulated trade deficit by $860B at current prices (very rough approximation). It is costing us $30+B a year just to finance the interest alone!

Not only would (should) this money remain at home, but the Federal government would earn royalties on the coal which in return would have reduced the Federal deficit as well.

In addition, there is a very good chance that the remaining 75% that would be imported would be at far lower rates. True to say that in such a case the reduced accumulated trade deficit savings would be less for the CLEAR replacement, however the savings on the imported 75% component would more than make up for any shortfall from the $860B figure above.

No matter how you cut this or juggle the figures, from a financial viewpoint, the United States can not afford to postpone the CLEAR project any longer.

Employment

One of the concerns today is that we are facing rising unemployment as the construction industry slips further. Housing is not expected to pick up for several years to come. I find it ironic that a major infrastructure project that is doable in ten different locations is not even being considered by Congress as a means to reverse the recessionary trends that have emerged in the construction sector. By the time the CLEAR projects have been completed, the housing industry should be back to normal.

The Cost Structure

Taking a page out of the housing/finance debacle playbook, the cost/risk of building a CLEAR unit can be reduced substantially. Currently the United States can not afford to enter a recession due to the heavy debt load that has been accumulated. This is what is guiding the Federal Reserve in its numerous actions, including the assumption of risk masked as discount window loans and other endeavors.

It would make far more sense for the Federal government to make a $45B unsecured loan (using the CLEAR unit as collateral) to the likes of Exxon Mobil (XOM) and others at a fixed rate and for XOM to shell out $5B for a 250,000 bpd refinery with a 100 year guaranteed coal supply. Should oil fall below $65 during the 30 year term of the $45B loan, the Federal government could do the same as what the Federal Reserve is doing for the housing/mortgage/finance industry and stretch it out. This would solve the high infrastructure costs. Let's face it; the risk to the Federal government is far lower than the risk the Federal Reserve is taking on with all the toxic waste CDO's and the likes.

Notice how XOM isn't showing me the door on a $5B - 250,000 bpd refinery!

As an aside, instead of adding 2M barrels a month to the strategic reserves at a cost of $200 million per month, financing a single 250,000 bpd (7.5M barrels per month) CLEAR project at $2.4B per year yields a far bigger bang for the same buck. In other words, even if the loan was interest free, the U.S. would be better off!

Substitution

I am not advocating a reduction in consumption, rather a substitution. Instead of buying crude oil and refined products from overseas, we use the very same energy companies that supply our energy needs today to build new substitutions at home. Conservation is always welcome, however, economists will point out that conservation needs to be replaced with growth; otherwise this leads to contraction.

The flip side of all of this is that while the U.S. economy will get a shot in the arm and rekindle non inflationary growth at home, several overseas suppliers will endure a contraction. Frankly, one could say 'so what', but in reality on a global scale any contraction has a ripple effect. Having stated the obvious, it is noteworthy that at the rate India and China are growing; any substitution made in the U.S. will be picked up by others. Hence, we will not experience a contraction, rather a slower growth on a global scale for crude oil. Eventually and over a long period of time, as technology improves, CLEAR could possibly substitute oil in a major way. By then hopefully, solar energy will become cost competitive, but one never knows. In any event, it will take decades to phase out the consumption of fossil fuels, well after the CLEAR units have been fully amortized.

Pollution

This is where capitalism is at its best. I do not proclaim to be an expert on the pollution front, nor can I opine with any certainty that the latest technology proclaiming to be as clean as petroleum products are accurate or not.

What I do know from my own experience is that science and technology evolve more efficiently in a competitive capitalistic environment.

As a part time scientist, I will offer up the following analogy. Imagine for a moment that Henry Ford postponed the Model T because it would just be a matter of time before the modern day Cadillac would be developed! In reality, had he postponed the Model T, chances are that the modern day Cadillac would never have been developed at all! In other words, necessity is the mother of all inventions. Even if the first generation of the product does not meet all the requirements of the average consumer, eventually it will.

The same can be said about the first mobile phones…just look at them now, or only a decade later.

When it comes to pollution and fuel economy, the same applies. As the CLEAR units are built and run by competing companies, the more efficient companies reap the rewards. The Federal government has already initiated legislation requiring various fuel combinations regarding bio fuels. Likewise, it would be fairly easy to introduce legislation that clearly rewards cleaner CLEAR fuels as they are developed by the various companies. This can take on the form of government/army supply contracts as well as many other financial incentives that would make a cleaner fuel worth while. In addition, the newest and best technologies would be leased to others and the list goes on.

The Fix

The first step would be to enlist 10 companies where each company would build a 25,000 bpd pilot plant and invest $500 million. The additional $4.5B would be financed through a Federal loan as mentioned above. There would be an option to increase capacity tenfold within a specified time frame.

At the very least, we have started 10 mega infrastructure projects and end up importing 7.5M barrels per month less oil, every month for the next 100 years. At best, we have replaced one form of fossil fuel that we are in short supply of with another that we know we have plenty off. Personally I wish that renewable solar energy would become a viable replacement, but we have run out of time and can wait no longer. In addition, solar energy technology is gearing up for the utility industry and has yet to make significant progress in the transportation sector.

Just like oil recovery technologies have improved drastically over the years out of pure necessity, likewise CLEAR technology will undoubtedly improve out of competitive necessity once we have created the infrastructure where the technology plays a major role. If you have what to lose and what to gain, technological advancements occur. If you have nothing at stake, nothing will happen.

Every day that we procrastinate takes us a day closer to a recession that we can ill afford.