Un-EasyEric & David Coffin
September 13th, 2005
In light of what probably is the largest natural disaster of US history we have put aside comments on longer term resource trends to focus on Katrina and its wake. Recrimination seems to have found a place that should be filled with resolve. That we find as troubling as the storm was tragic. To the million displaced souls we can only add our hope that with some focus having appeared, each can now grieve and seek out a semblance of normal life quickly.
Efforts continue to rescue the last of tens of thousands stranded by breached seawalls in New Orleans. The direct impact of Katrina’s passing was most heavily felt along the Gulf Coast east of New Orleans, literally flattening the waterfront in much of Mississippi and flooding part of Alabama. The human cost of this disaster is obviously enormous, and the more so with a weak initial response.
In an age when 24-hour news tends to exaggerate, Katrina’s build up seemed mild. Even after gathering strength and sweeping over the Gulf coast it seemed manageable. First appearances misled. We are no ones’ apologist, but do feel this needs recognition.
Yes, rescue was too slow to get started, but not we think from indifference. What the world has witnessed has in fact largely been the inertia of an elephantine bureaucracy attempting to turn and focus. Katrina’s progress may have been acting out its own place as metaphor — a glancing blow to a centre that seemed ready for its full brunt lulling an overly prepared bureaucracy into misreading damage by its wake. A storybook giant killer.
At an individual level, many witnesses to a tragedy are less likely to bring aid then is a single witness who realises he or she has to act if anyone is going to. From a Canadian perch, where Mounties still police for all levels of government in many areas (including parts of suburban Vancouver), the countless number and variety of uniformed and armed services in the US has always been mind boggling.
A multiplicity of US services meant to control government may well have overbalanced in this situation. Add to this the re-direction of many of them to terrorist watch, and makings of tragedy on top of disaster were laid. And the world has had no sense of how to respond to this, the floundering of an elephant in mud it had no way to avoid.
But Katrina was also a giant itself, drowning a major city and knocking flat major regional infrastructure. It will take months to properly repair New Orleans’ levees and seawalls and pump out the water and sludge, and to sweep away debris in the neighbouring states. That will be followed by years of rebuilding.
We hardly assume that Mounties or others will be better able to act when Vancouver has its “big” earthquake at some point in the next several centuries. We know its coming, being overdue in a statistical sense, but who is every really prepared for an inevitable disaster they will likely not witness. Disasters are inherently not normal. They define what we take for granted, and what we shouldn’t. The next weeks and months will be doing that for Americans and by extension for all of us.
In our mid August Dispatch we had made the point that jumping crude prices then were counter intuitive against refinery shutdowns. Fewer refiners, regardless of the reason, should mean a lower crude oil price. Though many see refineries as simply and extension of the oil delivery process they are, in fact, the crude producer’s largest customer base. They are the manufacturer/wholesaler in the supply chain. It appears Katrina has underscored this seemingly basic point for traders.
Somewhat less than 1.5 million barrels of crude production and a similar level of natural gas output were knocked out by the storm. Oil rigs lost and damaged by the storm were secondary to refining and transport systems damaged to a similar degree.
Gasoline and other derivative products are in short supply. The hasty retreat of crude’s price after an initial surge indicated a concerned market, though one that was finally accepting that shut down refineries should ease, not worsen, the crude supply problem.
Severe damage includes 10% of a US refining capacity that is barely adequate to supply the domestic market even while operating full bore. There was also a larger temporary loss of pipeline capacity that caused gasoline prices to spike as filling stations ran out product.
The crude production lost to Katrina has now been supplanted by two million barrels a day from emergency inventories, for the next month or so. A month may be needed just to determine time lines to bring the Gulf of Mexico output back on-line.
We expect sufficient crude oil, and refined product from Europe’s strategic gasoline reserves, to keep the global system fuelled for the immediate future. What happens in October is really up in the air. Oil producers are assessing their potential to increase supply near term, but most are after all pushing hard already.
The time frame for bringing refinery capacity back in the Gulf Coast is still uncertain. Keep in mind that these are old systems. No new refineries have been built in the US for a quarter century. Refiners will now be faced with bringing back to life equipment that should probably be put to rest after Katrina’s damage. Though many refineries went off line for safety reasons and due to power outages several of the larger ones are damaged. It’s likely that refined product capacity will be constrained into next year.
Likewise at least one report described lost oil rigs as “older”, which could make the cost of re-drilling some lost wells questionable if they are already well into their decline curve. A theme we have touched on before, the lack of upkeep for the resource sector, is being forced to surface by Katrina’s shove. Some larger production platforms have been damaged, particularly the Shell Mars operation that pumps 250,000 barrels of oil and 365 mmcf of natural gas a day. It’s likely that the longest shut-ins will occur in the offshore natural gas fields since the myriad lines running together under the Gulf of Mexico have to be checked for damage.
US gasoline prices were reaching the inflation adjusted pricing of the ‘70s oil shock, due mainly to lack of refinery capacity. There have been significant price declines over the past week as markets rationalised the situation and strategic reserves came into the picture. However, it is unlikely crude will now drop below the $60 level. If, and it’s a big if, pre-Katrina demand is sustained it is likely crude prices would rise again next month.
Gasoline prices that are felt immediately by consumers filling the SUV’s tank may be slower to come off. Europe and Canada are moving what they can into the US market and the end of the summer driving season will help but until refineries are back on line pump prices will remain high, in US terms. As we’ve noted in the past, even current US prices would be considered a bargain in most of the world.
The biggest problem is certain to be natural gas. As noted above, a major platform was lost and it will take weeks to check all the undersea pipelines before they can be brought back to full capacity. Gas prices were moving to multi-year highs even before Katrina struck and are now sitting at close to $12 per mcf, roughly twice last year’s level.
September—November is the shoulder season for natural gas, when the air conditioners are being turned down but its not cold enough to turn on the furnace. In-ground gas inventories have been high the last couple of years and this will give the market some wiggle room but a sustained shut in of any size will keep natural gas prices at their lofty heights.
This is where we think the real potential drag on the economy lies. Because it was plentiful and cheap for 20 years natural gas became the fuel of choice for both homeowners and factories. There is no simple way to switch fuels even if that was cost effective which is by no means certain. Natural gas consumption in 2001 in the US was 81mcf per capita. That means that an average family of four could be paying about $1000 more for natural gas through the winter months. In northern areas where winter usage is concentrated the increased expense to natural gas users could be considerable. At current prices winter heating bills could add several hundred dollars a month to household expenses. In an economy that reported a savings rate of zero in July only the truly naive believe this won’t result in some reallocation of income away from consumer spending in other areas.
Our assumption for the better part of a year has been that oil price gains would impact demand. In fact Detroit automakers are indicating demand for gas guzzlers is starting to wane. That seems likely to become a trend. And concern about a broader decline of US consumer demand has been around for a while. Katrina only heightens that concern.
It has become a basic axiom that highly destructive events like Katrina initially knock an economy down as it deals with life’s necessities, but that is followed by a rebound based on rebuilding. Recent hurricanes in Florida have followed this pattern. So too did most of the globe after World War II, and many natural disasters in between.
This has been an evolution from the European winners extracting wergild from Germany after World War I, only to spawn fascism from the rot they caused. North America’s infrastructure survived World War II and the west wanted to strengthen former enemies against communist encroachment.
The psychological benefit of helping others has been as important as the economic benefit in the creation of post war disaster markets. Without that psychic benefit driving rich donors, poor areas would find it difficult to fund rebuilding. The case in point, and perhaps the lesson, is the Indian Ocean tsunami of last Boxing Day. It generated a huge and immediate response, both of field units for triage and immediate care and funding.
It should be pointed out that in contrast to Katrina, the Boxing Day tsunami was a complete surprise that happened during the planet’s least active week and when many are in a giving mood. But then it was obviously an event without precedent for scale or scope. And some regions were as obviously poor. In short, it was about the best day of the year to seek aid for a major disaster.
By all accounts Thailand's resort beachfront is well on the mend. Private capital to repair it already existed in insurance policies, or could be borrowed against a history of earnings potential. In northern Sumatra, most heavily decimated by the wave, a civil war has ended but rebuilding barley begun. Elsewhere bureaucratic inertia slows rebuilding efforts.
The Thai rebuilding is the sort of disaster market that analysts expect for the Gulf Coast. If it goes as expected, the next several months will be bad stats months, followed by an up-tick as rebuilding gets underway. That has been the pattern in Florida for several recent hurricane years. But then, Florida is one of the fastest growing areas in the US at any rate.
The difference along the Gulf Coast is Katrina’s much larger scale than past hurricanes, and that it hit areas that have been, at best, slow growth regions. People being moved to temporary shelter in Houston are finding the city welcoming. If they have little or nothing materially to go back to at least some will stay put. It will be weeks if not months before we know how many tens of thousands of dwellings will have to be destroyed in New Orleans. One thing we already know however is that the worst damage has occurred in areas where most if not all the residents are uninsured and unable to fund rebuilding themselves.
It will tough getting people to move back to below sea level housing, once it is rebuilt unless someone else is paying for the rebuilding. In this case, that “someone else” will be state and federal relief organizations.
Estimates of damage vary wildly but $100 billion seems like a realistic number. Those expecting a big boost later in a disaster market are thinking in terms of these expenditures. But, if much of this comes out of government coffers the spending period will be much more attenuated than it would be if it was private insurance payouts.
This means that the “short term” effects (large scale employment losses, higher energy costs) could all but wipe out the rebuilding premium that comes later.
The one silver lining in this horrible situation is that it suddenly has many thinking we’ve seen the end of interest rate increases for a while. We talked before about all the reasons the Fed wants to keep raising rates. Those haven’t changed but the danger of overshooting with rate increases has vastly increased in the wake of this tragedy. We’re not going to second guess the Fed (this time) but the market clearly already has, to the benefit of resource investors.
The Dollar was losing steam before the hurricane hit and it’s seen some of its biggest losses in the storm’s wake. This is unsurprising since a lot of the Dollar’s recent strength was about rate differentials, not optimism about the US economy. With estimates of 0.5-1% reductions in GDP for the next 2-3 quarters the reasons to be bullish on the greenback became a much tougher sell. These losses have fed directly into $US price gains for virtually all commodities, helping to make a fall market we thought would be strong even stronger. The one fly in the ointments is that a weakened economy could stall demand for some items, like base metals, though they too will be in demand for rebuilding once it starts to occur.
We are not jumping to any conclusions about whether New Orleans will come back. Rather, we are pointing out that there is no certainty that it will come back as it was. And, if there is evidence of permanent migration to parts of the US, then some lost asset values in New Orleans will stay lost. In an economy being driven by consumer debt against property values, that is a concern. A pause in rate increases will help mitigate the effects but there is already anecdotal evidence that the housing market is starting to top.
These effects all point to the likelihood of continued strength in the gold market. Other metals need to be watched to see if a slowing US economy cuts demand enough to weaken prices. A secondary “benefit” of spiking gas and natural gas prices is that they will feed directly into inflation numbers on the next few months. Although Wall St likes to ignore energy and food costs when looking at inflation numbers the price increase are large enough to start pushing even the “core” rates. Here too, these increases will be pushing against demand reductions from a Katrina slowdown but it’s very possible that the “inflation card” will again be played in the gold market. This will simply add to demand generated by those buying it as the “anti-Dollar”. The effects on both government finances and private spending will be large enough that you should be very cautious about the major markets for a couple of months at least. Wall St. is factoring in disaster gains already, before it even starts accounting for disaster costs.
Eric & David Coffin
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