2nd Quarter 2006: The U.S., China, Oil, and Trade

Second Quarter 2006
Market Commentary

The U.S., China, Oil, and Trade
Comments and Observations

Much has been said in recent months about the staggering trade deficits the U.S. has been suffering in our bilateral trade with China and other emerging nations. Indeed, the trade deficit for the year ending December 2005 was $720 billion, a number that averages $60 billion per month. Over $200 billion of that sum is with China alone.

Our nations's balance of payments has two components: the first is a trade deficit, which is an actual net figure between goods and services produced in the U.S. and sold abroad, versus goods and services produced abroad and sold here. The second is a current account deficit showing investment flows between ourselves and others. We are running deficits on both counts, ending with the $720 billion figure mentioned above.

In turn, our trade deficit has two primary drivers; oil and imports of goods produced outside of the U.S. for domestic consumption, much of which is from U.S. companies operating abroad. In this report, we will provide updated comments on how these forces impact inflation and interest rates, oil, the dollar, and the stock market.


Let's take oil first. The numbers are as follows:

Oil production worldwide averages approximately 84 million barrels of oil per day. Worldwide consumption is 83.6 million barrels. So there's not a whole lot of marginal production that isn't immediately gobbled up in the world markets.

The U.S. produces approximately 8.2 million barrels per day, but consumes 20.6 million barrels per day. So we account for close to 10% of world production, but 24% of world consumption. Therein lies the (first) problem.


Let's take it a step further. As a nation, the U.S. isn't finding any major oil fields onshore; in fact, the last major domestic onshore field was Prudoe Bay in Alaska, which produces 680,000 barrels of oil per day, and its production has been declining. In the aggregate, it is estimated that total Prudoe Bay production, over time, will equal approximately one years consumption. This is why there is so much discussion and controversy over drilling in Anwar, the Alaska National Wildlife Refuge. There is controversy because of its pristine location. There is discussion because of a field that some think could rival Prudoe Bay. Chevron drilled one well there some 30 years ago, and it's the result of that one well (plus other technologically advanced seismic readings) that has its proponents excited about its possibilities. However, even if it were to be developed and become an offset to Prudoe Bay it would still only represent about one year of total U.S. consumption.

Further, given the fact that the continental U.S. has been pretty well combed over, the big oil companies are going offshore in the hopes of finding larger pools of reserves. The problem here is the cost of finding it. Offshore drill rigs, depending on their structure, can cost several hundred million dollars. These oil rigs are drilling up to hundreds of miles offshore, with pipes extending down several thousand feet, and encountering 50-60 foot waves in the process. So the cost of drilling offshore is significantly greater than onshore, and is reflected in the fact that incremental supplies, which in essence are replacement costs, are coming in at prices two to three times the average carrying costs of reserves held by the major oils.

Chevron just paid close to $50 per barrel for proven (and probable) reserves in their recent acquisition of Unocal. A lot of Unocal's reserves are offshore, and Chevron was criticized for paying too much. Chevron didn't agree, and it appears now that their purchase was very timely. To sum up, what we're seeing is a decreasing supply coming on at a higher cost.

Let's analyze the demand side of the ledger, and focus on the emerging nations, particularly India and China. Begin with the U.S. If we take daily U.S. consumption of 20 million barrels per day, multiply by 365 days, and divide it by our population of 300 million people, we arrive at a quotient of 24 barrels per year for every American man, woman and child. This takes into account everything containing oil; from gasoline, diesel fuel, heating oil and propane, to PVC pipe and even aspirin.

Similar numbers for Europe run in the high teens. The developed nations of Asia, such as Japan and South Korea average about 15 barrels of oil per person per year.

India uses about one barrel of oil per person per year, China slightly more. However, both countries are accelerating their consumption of oil and energy at an increasing rate. India and China between them have a population of 2.4 billion people, over seven times the U.S. population of 300 million.

In fact, China and India, with a significantly larger population base, are growing their energy usage concurrent with their factory growth; about 7% and 9% respectively. So what we are confronting, just by taking into consideration these two countries alone, is a large critical mass, several times the size of the U.S., coming off a relatively small usage rate, increasing their consumption of a critical commodity at accelerating rates - two to three times our incremental usage. We are increasing our consumption at about 3% per year; despite advances in alternate fuels, and efficiencies in using oil.

Our observation is that we have now reached an inflection point in oil usage by China and India, wherein their rate of growth in energy consumption is absorbing any and all excess production.

Compare this with the supply characteristics mentioned above, and you have all the ingredients of a major problem for years to come, with a high probability that energy prices are not coming down.

In addition, what is also happening now are a combination of geo-political factors that are throwing an additional monkey wrench into the oil equation, and causing prices - now running at $70 per barrel to stay high.

The first factor again is China. In addition to being an economic concern, China is also a geopolitical concern. A few years ago they were a net exporter of oil; now they are the second largest importer. In the process, they are not only exerting a tremendous upward pressure on the pricing of oil, but are also aggressively seeking economic and political agreements with countries worldwide, many of which are less than friendly with the U.S.

A case in point is Venezuela, where Hugo Chavez, a known communist, has invited China into Venezuela at the same time that he is forcing western oil companies to cede control of their fields to the Venezuelan government. Venezuela provides 12% of our imports.

Mexico is about to have presidential elections. The mayor of Mexico City, who has been given a good chance to win, is a socialist and regarded as one who might be more inclined to shift Mexico's oil production more towards China than the U.S. Mexico is an important supplier, whose exports to the U.S. were 12% of our imports in 2005, and are currently approaching 16%.

Nigeria is in the midst of civil uprisings, with rebels damaging oil facilities in that country, and threatening terrorist attacks. Nigeria provides close to 10% of our imports.

That brings us to the Middle East. Iraq presently supplies about 5% of our imports, and Saudi Arabia 13%. While Saudi Arabia has been relatively stable, unrest in the countries surrounding it, including Iraq, leave a lot to be desired in terms of a trading partner; and the House of Saud itself has been a recent target of terrorist threats. The stability of Iraq is also open to many questions. If and as we pull out, can we count on their oil being available? Last but not least is Iran. Fortunately, we don't buy any oil from Iran. Iran, however, is the fourth largest producer in the world, with 9.8% of world reserves.

As a consequence of both U.S. and European insistence that Iran curb their nuclear ambitions, Iran has threatened to curtail oil production, and direct their output to Asia, (read China) or some combination of the two. Either or both of these possibilities will only aggravate the tight supply situation even more. Recall that we only have marginal worldwide production of less than one million barrels per day.

Further, Iran has threatened to withdraw their deposits from European Banks, and shift those assets elsewhere. (Again, read China.) We found it of interest that Iran has signed a $70 billion long-term contract with China to provide China with liquefied natural gas (LNG), and also gave the Chinese drilling rights on attractive oil properties within Iran.

So there appears to be a lot of instability creeping into our sources of supply. One bright spot however, is Canada, wherein world geological reviews have catapulted our northern neighbor into second place in the world in terms of oil reserves, just behind Saudi Arabia. This is largely due to quantifying the huge tar sands deposits in Northern Alberta. Canada supplies 16% of our imported oil, and is becoming our most important supplier.

China, though, is not oblivious of this fact either, and they are reportedly investing large sums of money to establish a presence in the Northern Alberta tar sands as well.

Imported Goods

Given the preceding arguments pertaining to oil, it seems doubtful that we're going to get much, if any, help on our trade deficit from any possible price relief or increased allocations of oil. We mentioned that the other major driver of our trade deficit is imported goods; and that a significant part of that comes from imports of manufactured goods from U.S. companies operating abroad.


So where does all this lead us? As a case in point, let's take a look at General Motors as an example of our trade problem. General Motors, which was once the largest industrial manufacturer in the country, now makes a significant percent of their cars overseas. In fact, Mexico, which has been the chief recipient of our auto technology - now ships almost two times the numbers of cars built in Mexico back to the U.S., than the U.S. built cars that we ship to the rest of the world.

General Motors went to Mexico for cheaper labor, and got it. Not being satisfied with the labor price differential between the U.S. and Mexico, (which by the way is approximately 10 -1) General Motors went to China. A year ago Business Week3 featured a Chinese auto plant on their cover, and exulted about much money GM was making in China. A subsequent article in Investors Business Daily told a different story. They reported that General Motors was having second thoughts about their investments in China because the Chinese had set up a duplicate plant right across the street, and were building all but identical cars from that plant for domestic consumption, thus competing with the GM plant. The same thing happened to McDonnell Douglas. They wound up creating a commercial aircraft industry in China, in order to complete a contract with China Air. China insisted on building the planes in China - staffed with Chinese workers - who were trained by MD employees. MD is now part of Boeing, quite possibly as a result of that contract. Boeing, by the way is now the last surviving U.S. manufacturer of commercial aircraft, and they too, have outsourced much of the production of their aircraft overseas.

If we expand our analysis beyond oil, one can safely say that China, and to a lesser degree India, are inhaling all the raw materials worldwide they can get their hands on, in order to feed their hungry factories.

This has led to price spikes not only in oil; but also copper, steel, iron ore, aluminum and uranium as well. So one consequence of this pattern of world trade has been to create an inflationary climate in the price of materials, which is working its way, all the way through to finished goods. It's these forces that are causing the Fed to raise short term interest rates; ostensibly to fight these inflationary trends.

In effect, we are exporting the knowledge and skills of how to produce high tech products to countries that we can't compete against as long as these countries maintain policies which pay wages that are only a fraction of our minimum wage, plus zero benefits. We are also displacing a significant number of US workers in this process.

Such are the cold, hard facts of the world we're moving into. It is a global world, and one built upon the concepts of free trade. Yet free trade does not necessarily mean fair trade. There are all kinds of production costs in the developed world that don't exist in the developing world of emerging countries.


What is happening is that emerging nations, specifically China, India and Mexico are inviting American and European business to their shores, with the inducement that these countries will not impose a cost of labor anywhere near, let above equivalent, to those of developed countries. In addition, they will not impose the cost of such items as social security, health benefits, workman's compensation, retirement benefits, or environmental restrictions. The U.S. government goes along with this, and as such, this global world, or Globalism, is changing the landscape of America.

We mentioned earlier that much of our trade deficit comes from goods produced abroad by U.S. Companies. In fact, and possibly more significant, is that over 50% of our manufacturing base in now overseas. For instance, Nike shipping shoes from China to sell in America, or Dell or Hewlett Packard making computers in China and selling them in the U.S., all come in as imports, and are a big component of our deficit. Nonetheless, when we buy more products made overseas than we sell abroad, whether or not they're made by U.S. companies, this leads, and has led us to the huge and growing trade deficit described earlier.

When this occurs, the profits from U.S. sales are sent back to the country of origin, and are retained in those country's banks. Further, one interesting fact is that profits made by these foreign subsidiaries of U.S. companies are not only allowed to stay overseas, but are not taxed in the U.S. This helps bottom line profits of large world wide conglomerates (which is one reason why we favor U.S. industrials); but does nothing to contribute to balancing our budget deficit (now running at over $300 billion), and is directly responsible for that part of our trade deficit caused by U.S. manufacturing plants abroad.

Meanwhile, the huge build up of cash is foreign banks from export earnings has caused emerging nations in general, and Asian nations in particular, to use surplus trade dollars to come back into our markets and buy U.S. Treasury debt. Asian nations in the aggregate, now hold over $1 trillion of U.S. government securities. The sheer magnitude of China's purchases alone, (now totaling close to $250 billion) has caused the prices of our debt obligations (U.S. Treasuries) to rise, thereby causing the market interest rate of these obligations to fall - despite the 15 short term interest rate increases orchestrated by the Federal Reserve over the past 22 months. So conditions in the bond market, a "conundrum" according to Alan Greenspan, from our perspective boils down to the following conclusion.
We believe that the increase in the cost of raw materials due to inflation is essentially offset by the reduced cost of labor of imported goods. The end result is a bond market where short rates have been rising; and up until a few weeks ago, long rates have been falling. This has led to a flat yield curve wherein short rates are approximately equal to long rates at between 4¾ % and 5%.

Having said this, just as we sense that the oil markets have reached an inflection point and are rising in price because demand exceeds supply; so too do we sense that we may have reached an inflection point in the treasury market; where an increase in the supply of new debt (to finance our trade and budget deficits now totaling $1 trillion annually) may exceed demand. If so, it will lead to a reduction in price (and thereby an increase in interest costs.) In fact, just this week, the rate on 10-year treasury obligations, considered a prime barometer of the cost of money, rose above 5% for the first time in several years.

If we're correct in our perception, it means that further interest rate increases by the Federal Reserve could negatively impact prices of corporate and municipal debt. In turn, this will cause us to further shift allocations of capital away from fixed income obligations.

Stock Market

One might conclude from the macro observations listed above that the stock market could be in for trouble as well. Our view, however is that the value of stocks will primarily reflect strengths and weakness in the economy - along with corporate earnings. Right now the economy is strong, corporate earnings are good, corporate liquidity is high, and dividends are rising. Remember that the trade (and budget) deficits which are creating our debt overhang, also are putting pressure on the dollar; pressure which higher interest costs are designed to alleviate (by making our treasury debt more attractive to other countries).

Because of these conditions, we have tended to favor high quality blue chip stocks in our asset allocation models. These companies in the aggregate, derive over half their earnings from overseas. So, if and as the dollar goes down, large international companies become more competitive, as U.S. goods are then priced cheaper than our competitors. Under these conditions, blue chip profit margins actually tend to rise, which is a big driver of the increased corporate profitability we've seen over the past 11 quarters.

Further, rising rates are beginning to have the effect of slowing residential real estate, which may result in more dollars shifting toward the stock market. This should grow over time, particularly if Congress maintains an 85% tax exclusion on qualified dividends.

The stock market marches to its own tune, and historically has been the best barometer of discounting what the future has in store for us. Unless and until we see interest rates rise a few notches higher,
and /or deterioration in stock price levels, we envision stocks generally rising, and believe that stocks in general will tend to outperform fixed income obligations over the near term.

However, much depends on whether and how many more rate hikes are to come. So far, the economy has been somewhat resilient to these increased costs. Also, any hint that the Fed might actually stop or even pause, raising rates should have a dramatic upside response in the stock market. This in fact occurred just a week ago, when the DOW rose 194 points in one day on just such a rumor.

Nonetheless, if rates do rise a few notches, we will be carefully evaluating both major asset classes (stocks and bonds) versus the attraction of holding higher yielding short term paper and selected inflation hedges.

Thanks again for your support. Please feel free to call us with any questions you might have.


Bill Schnieders

Jim Schnieders, CFA

Investor Login