Bill Gross and the Coming of Stagflation

It is time to make a slight change in my past prognostication of “stagflation” in the USA economy and the resulting investment implications. I think the “stag” is here to stay for a while, but am changing my position on the “flation”. I derive quite a bit of my economic and interest rate insights from reading Bill Gross’s monthly commentaries. This month, Bill is making a change in his call on the future of inflation and interest rates, so I will too.

What does this call mean for a USA investor? Bill argues for a practical limit on real interest rates of 0% (real interest rate = inflation minus nominal short term interest rates). We are currently at 1% (as shown by TIPS), so he makes the case that there is very little room left for further real interest rate reduction by the Fed. The real interest rate in early 2003 was 4% (at the end of the last recession when real interest rates were typically high as the Fed stimulates the economy. This stimulation can also be seen in a steep Treasury yield curve). A declining real interest rate is reflationary or inflationary and signals monetary stimulation. Since there is little more room to stimulate, as given by the low real interest rate, there is little chance for a significant increase in inflation, so the argument goes.

From this line of reasoning comes Bill Gross’s and Pimco’s interest rate forecast for the next 5 years on the 10 year Treasury of 3% to 4.5%, nominal, with inflation at around 3%, as it is right now. This bodes well for Treasury bonds and other high quality debt instruments (municipals, high grade corporates). It is also modestly positive for stocks since low real interest rates make corporate cash flow yield (CF/price) relatively more attractive.

There is still a case for hard asset inflation for those assets that are supply-limited with high demand in the developing world. Oil may be one such asset, grains another (with an improving diet among the billions in Asia who are seeing a rising standard of living). There is also a longer term case for precious metals. When the world comes off “Bretton Woods 2” (as Gross tags it, the use of the US dollar as the world’s reserve currency) and switches back to some type of gold standard, as is predicted, it will greatly increase demand for gold and related precious metals. China is likely to make a gradual move away from the dollar as a benchmark over the next five years. Since there is no other reasonable paper benchmark (the Euro, unlikely; the yen…No Way!), either gold, or an index of commodities is likely the future reserve for the Chinese currency.

But the outlook for financial assets, and real estate is more of a financial asset than hard asset in today’s highly mortgaged / leveraged world, is not so good. Financial assets rely on a contraction of real interest rates to increase their value, and as Gross points out, the Fed-orchestrated contraction has run its course.

Neither can a case be made for any type of manufacturing product, either the capital goods to conduct manufacturing or the consumer and industrial products made by manufacturing. This is a world marked by excess supply of manufactured goods, with low cost labor in developing economies, a flood of capital into those economies to build manufacturing plant and the remains of the manufacturing expansion of the late 90s. It is this excess supply of manufactured goods that keeps a cap on inflation, limits employment growth in the developed economies, an also limits the upside for the stock market, especially the capital equipment and technology sectors.

"Fool's Gold in Oil Patch" Makes Dorsey the Fool

TO: Patrick Dorsey, Morningstar Editor:

Patrick, I found your analysis of the oil sector in “Fool’s Gold in the Oil Patch” posted on the Morningstar.com website to be highly flawed in its assumptions. Although you try to support your arguments with data from Morningstar, the data does not at all confirm the points you are making. I found your chart on the price of gasoline versus demand in California to be particularly unimpressive. It makes the assumption that gas prices in the US respond to demand in California. I don’t think so. Gas prices respond to the cost of oil first, and the availability of refining capacity second. A maintenance shut-down at a large refinery has much more to do with short term price variations in gasoline than does demand. Demand for gasoline changes in the short term due to seasonal factors, not due to driving patterns.

To dissect your weak arguments, first examine your statement about the acceptable price of a barrel of oil to the makers of the market, namely OPEC and the Saudia Arabia princes. It is flawed from the outset. You make the point that they are implicitly targeting a mid-30s price for oil, yet on CNBC this morning, Prince Alaweed stated that Saudia Arabia has abandoned that target and are instead targeting $40-50 / barrel. He stated OPEC’s comfort with $50 per barrel oil based on the observation it was not causing significant global economic damage. So your argument about where the price of oil will settle is already in danger.

Next, you make the case for the long run price of oil per barrel to be around $20. This is incorrect. Please cite your sources when you make statements such as this. The long run price is closer to $40 per barrel. Someone “Infinitely” (your choice of words to describe where oil would have to go to make a good investment) more credentialed than you to make statements about the long price of oil is Ben Bernanke, one of the Federal Reserve Board members and the leading candidate to replace Allen Greenspan as chairman. In a speech / article he authored in October 2004 (http://www.federalreserve.gov/boarddocs/speeches/2004/20041021/default.htm) he makes the compelling case, backed up by serious research, that $39 is a minimum price based on industry data. He references that as of October last year, the futures market was implicitly pricing the long run value of oil between $38 and $60 per barrel (2/3 probability). Of course, the futures market has priced oil even higher recently (as of April 2005), but we will let that point go for now.

Your financial analysis of the market, using Morningstar “return on invested capital” data appears compelling and may “Fool” some of your readers. However, it does not take into account the backward looking nature of the data. 2004 industry returns were based on oil prices from 2003 and 2002, since most industry players hedge in the futures market to smooth their earnings. The industry profits do not respond instantly to changes in the sales price of oil. 2005 and 2006 oil prices will be much more informative about the effect on industry profits of price per barrel in 2004.

Also, your position is in opposition to (besides the Saudis), T. Boone Pickens and Tom Petrie (of Petrie-Parkman) all of whom know much more about the industry than do you. Check out their websites and do a little research.

What your thesis completely ignores is the significant changes in global demand and supply over the past 10 years. In the 80s and 90s, the Pacific Rim nations developed as suppliers of electronic and heavy industry goods to the USA. Their development did not require significant increases in oil-based energy. It did not drive demand higher at a time when global oil reserves were still sufficient for global demand. Now, however, nations with much larger land mass per capita are undergoing development (China, India, Brazil, and Eastern Europe and Russia to a lesser extent). These nations will be voracious consumers of oil-based energy to meet their public’s transportation needs. Alternatives to oil-based transportation are well off in the future. Fuel cell technology is more than a decade from commercial reality (check out the price of Ballard Energy stock). Even when it becomes a reality, the first versions of fuel cell vehicles are expected to run on natural gas. So your demand story based on replacement technologies is just plain wrong.

The supply story is equally wrong. In the past, there was always plenty of cheap oil to exploit when demand increased, allowing for supply to meet (or exceed) demand. This was the case in the 1970s when the Middle East oil infrastructure was not completely developed. Now, however, the easy oil is gone. There are no new discoveries where, like Jed Clampett, you can shoot your shotgun at the ground and have oil spurt out. All the world’s oil, even in Saudi Arabia, will require more expensive techniques for extraction, at the very least pumping and in many cases stimulation techniques involving insertion of chemicals and /or steam into the wells. This will raise the bar on the minimum economic cost of a barrel of oil. Producers do not produce for long below their break-even point which puts a floor under the price of oil. That floor is going from $20, where it was in the 80s, to $40, where it will be by 2010. This is the information you can glean from industry experts if you will take the time to research the industry, before spouting your wisdom.

The bottom line: I am glad there are people like you to scare investors out of the oil market. It leaves better investing opportunities for people like me.