Roiled Oil There has been a lot of rumbling of late on the trading floors of the world’s commodity exchanges. Oil prices have been on the rise, a happening that always brings frantic hand-waving and screaming to the market even in the era of high-tech everything. As the cost per barrel of crude topped $30, alarm bells went off in the heads of consumers all around the globe (and warm smiles lit the faces in several parts of Texas).
As has been the case for several years now, the basics of supply and demand support a price in the mid-$20s. While volatile forces on all sides frequently pull prices above or below this level (often for extended periods), they always manage to return. In my opinion, the reason has to do with game theory, the complex mathematical examination of how we react to (and with) one another in competitive situations (a field notably impacted by the work of a youthful John Nash of A Beautiful Mind fame). In essence, lower prices drive the folks in and out of the cartel to actually cooperate in lowering production (the dynamics and inherently unstable nature of cartels is another fascinating mathematical process worth a non-technical look at some point). At higher prices, consumers start buying less and suppliers start cheating on their quotas.
In any case, the present frenzy is driven almost exclusively by the threat of war in the Middle East, to some extent because of ongoing conflicts but mostly because of the current discussions of an invasion of Iraq. Demand is down to some extent due to a relatively weak international economy and reduced consumption of jet fuel. Nonetheless, the prospect creates uncertainty about the future oil supply situation, and markets react to uncertainty by pricing it. At present, it is evidently worth about $3-$4 per barrel.
Assuming that the war speculation ends soon, oil prices will settle back into the mid-$20s. That’s the easy one. The more difficult question is, of course, what happens if we indeed go to war? Market analysts and media pundits alike consistently remind us that prices went above $40 per barrel during the Gulf War in the early 1990s. They always forget to mention that they only stayed there for a day or so. Once it was recognized that there would be ample supplies, the invasion actually lessened the uncertainty.
The situation is certainly different now, but this little history lesson is instructive. Given the facts that (1) there are many more players in the market now who want nothing more than to expand their share, (2) it is highly improbable (though not impossible) that a group of significant producers would shut off the spigot in support of Iraq (or opposition to us), and (3) we are extremely adept at not bombing oil production or the mechanisms to get it to market. I strongly suspect that a war would not keep oil prices up very long. On the other hand, the greater number of factors at work in this instance could well keep the spike in place for more than a day.
This issue is very important to the economy. While some Texans certainly obtain enormous windfalls from sustained price increases, they really do have notable affects on overall business conditions. While we tend to focus on the price at the pump, oil also heats, cools, flies, paints, clothes, cures, packages, and does a thousand other things in our daily lives. A sustained price hike or heightened instability will definitely impact our domestic recovery and that of other nations whom we depend upon to buy the things we make.
All of this to say that a lingering period of abnormally high oil prices is by no means the most probable outcome to the current market environment irrespective of whether we invade Iraq. On the other hand, it is clearly a scenario that is too critical to be ignored.
Dogs and Ducks Although it would be sheer folly to predict the stock market at present, the major indices have definitely moved up from their lows of a few weeks back. Another significant corporate scandal (or a war) could send things reeling, but otherwise we may (at least for a little while) get back to fretting over economic indicators, Federal Reserve whims, tax policy, and all of the other things that usually stress investors.
The most obvious reason for this turnabout is the “signoff” by hundreds of corporate chieftains on their financial reports (the recent corporate accountability bill signed into law likely helped some as well). There were no major surprises, a few minor restatements, and some requests for the automatic extension. Because restoring credibility is all about psychological response to a situation the likes of which we haven’t seen before, we can only speculate about what folks are thinking.
From what I can tell, comfort was taken not only from the disclosures themselves, but also from the minor adjustments and those that needed a little extra time. The idea was that (1) the vast majority of the numbers were fine; (2) changes were minor, reasonable, and of little consequence; and (3) everybody was really trying to get it right. The scandals now appeared more like aberrations and less like a pattern permeating the entire universe of public companies. It’s too early to say if this view will hold, but it is a refreshing change.
It’s easy to see how some could yield to the enormous temptations and allure of cooking the books. The market sets expectations, and those who meet or exceed them receive incredible financial rewards and superstar status. Those who don’t generally fall into oblivion. To make matters worse, the market is a very fickle master. It is only a slight exaggeration to say that the dot-com collapse occurred when the goal of “revenue, revenue, revenue” was quite suddenly abandoned for one of “profits, profits, profits.”
In such an environment, if the market wants ducks and you have a dog, you might find an almost irresistible urge to put feathers on your dog and call it a duck. (That little pearl of wisdom about those who would try to fool you is courtesy of my granddad.) If a desire for dogs subsequently emerges, the less scrupulous of the lot would pull the feathers off the dog and put some hair on their ducks.
This process obviously leads to some mad dogs and ducks, and even the best of dogs can’t quack and is not a very appetizing a l’orange. The key point is that an overly zealous desire to achieve growth and profit targets as they arch ever upward in a red hot market can ultimately lead to disaster. To make matters worse, the process becomes a self-reinforcing spiral. Each time a bar is cleared, it is set higher for the next quarter. The requirements increase dramatically, and the costs of failure escalate in tandem.
Based on what we know now, it appears that the overwhelming majority of firms did not fall prey to this dog and duck deception. Assuming this pattern holds (and I think it will), market integrity will likely return to what passes for normalcy in short order. If not, all bets are off. In the meantime (absent a war), keep the dogs at bay, get your ducks in a row, and buy quality.
The Forum I have recently been to two forums. One was a patch of historic ground in Rome, once ruled by the Caesars. The other was the President’s Economic Forum in Waco on Tuesday. I have been to the one in Rome before; it is always impressive. I can’t say I was surprised, but it is definitely worth many return visits.
The one in Waco was similar in many ways to a dozen others I have been a part of over the years (it was nice to have it only 4 exits down Interstate 35 from my office), but did offer a couple of pleasant surprises.
I enjoy these events on one level. They offer a chance to see old friends and colleagues, and the food is generally pretty decent (although nothing tops the continuous feast at the G7 Summit back in 1990). This particular one was different from the norm in several ways.
First, these sessions frequently boil down to geeks like me talking to each other. That was decidedly not the case in Waco. I participated in the panel on Economic Growth and Job Creation, and three of my fellow economists from around the country who are no strangers to these events (Mike Boskin, Marty Feldstein, and Allen Sinai) were also part of the mix. But the group of 20 or so also included CEOs of major corporations, trade association heads, union leaders, real estate folks, and small business owners. Other sessions were equally diverse.
Second, it was a much larger group than usual. There were about 250 people representing forty states. It was structured in a manner that allowed a fair amount of time to interact with each other and the Washington crowd.
Third, it was attended by a broad group from the Administration, including the President, the Vice President, all of the cabinet members who deal with economic issues, and several other senior members of the White House staff. These folks were also accessible to everyone much more so than usual (due in part to a large security pre-screening effort that most participants were probably unaware of).
The leadership of the Democratic Party called the event a joke, a show, and a photo-op for the President. Frankly, I didn’t find it that way. On the other hand, it probably didn’t merit the effusive praise offered up by the Republicans. Clearly, the media opportunities were carefully crafted to be politically correct and reflect well on the Administration. The same can be said of every event for every candidate for every significant office in the country, irrespective of party affiliation. It is also fair to say that most, but not all, of the people there generally supported the President and his agenda and some, but not all, were significant campaign contributors.
I must also say, however, that there was considerable diversity of interests and opinions. I am to some extent living proof of that point. I have been fiercely independent, high profile, and outspoken for the better part of a quarter-century. I have praised things I liked about the President’s actions, and I have pointedly criticized those I felt were wrong. While it is true that the Democratic Congressional leadership was not there, neither were the Republicans. This Forum was not about people inside the Beltway talking among themselves; that happens every day. It was designed for folks facing a variety of challenges and opportunities to communicate with the Administration at the highest levels—and they did. As one who looks at data and models all the time, consistently talks to key political and business leaders, and also visits with thousands of folks on the stump every month, I can assure you it is the last of these activities that is the most informative.
I mentioned a couple of surprises at the outset. One was the relatively consistent views of a diverse group of people. Economists, workers, educators, small business owners, investors, retirees, corporate CEOs, and union representatives alike recognized the need for corporate accountability, affordable healthcare, and rational regulation. The other was that there was a genuine, uncensored opportunity to communicate with those in a position to make a difference. Earthshaking—I wouldn’t think so. Productive and informative—without a doubt!
Dips and Dots When I was growing up, a “double-dip” was a good thing. It was the two enormous scoops of strawberry ice cream I enjoyed (for a dime, by the way) at the local drugstore soda fountain every Wednesday afternoon when my dad cashed his weekly payroll check. Alas, what a difference a few decades make.
In the parlance of modern financial markets, a different kind of “double-dip” is gaining increasing credence, and it is nowhere near as tasty. There is concern that the economy, having gone down and back up, will go down again before it gains significant momentum. This outcome can clearly be avoided and probably will be, but it is nonetheless a source of legitimate discussion. What ultimately happens depends on how we connect the dots. That’s right. The dips depend on the dots. Hang with me.
Generally speaking, the stock market and the economy move together. The correlation is certainly not perfect, but it is pretty tight—and with good reason. Fundamentally, when you strip away all the daily noise, stock prices reflect the present evaluation of the future prospects of firms (appropriately discounted for risk). This relationship may diverge from time to time, but ultimately the dots are always reconnected.
Because of the current crisis in corporate credibility spawned by numerous accounting scandals, things are completely discombobulated. The economic numbers have been fairly strong for several months, yet all of the major market indices and a vast majority of blue chip equity prices have plummeted by double-digit percentages (irrespective of whether they met their earnings targets).
As I have noted in prior editions and will not belabor here, the availability and reliability of information lies at the very core of the market. The point for this week is simply that the dots will indeed be connected again; it never fails. The only question is “how?”
There are essentially two ways to join them together. The preferable one is to create confidence in corporate performance, thus allowing the market to properly value and price growth prospects. If that happens, stocks will do very well. We are the most productive and efficient country on the planet and the opening of new global trading opportunities will only accelerate the potential for success. Progress is being made in that regard. New legislation has been enacted (not the strongest, but a good start); the “prep walks” of professional executives in designer suits and shoes and matching handcuffs make good theatre; and the need to vouch for financial statements by senior management is dragging a lot of skeletons out of the closet and creating an added incentive to get the numbers right (to say the least). At the same time, the market itself is meting out harsh punishment to those who would cheat.
The other way to connect the dots is less pleasant. A continuing credibility crisis and poor stock performance limits access to capital by major firms. The result is a lack of investment and a dampening effect on short and long-term prospects. The loss of wealth in individual portfolios also discourages the purchase of big-ticket consumer items. Such actions can become self-reinforcing and generate a second dip. A few recent statistics suggest that some of this type of response may be surfacing, thus leading to all the talk around Wall Street and more than a few kitchen tables.
Through effective leadership and market discipline, the dots can be connected in the right way. If that happens (and it should), growth will continue. Otherwise, we could be greeted with a second dip which bears no resemblance to strawberry ice cream (even the fat-free variety I’m forced to consume now). But make no mistake about it; the dots will be connected.
Rules of the Game The primary role of government in a market economy is to create and maintain a stable framework in which firms can compete. When the rules are predictable and certain, consumers benefit and corporate decisions can be made with confidence. When they are not, serious dislocations can occur. This basic premise can easily be applied to the newly competitive electricity market in Texas.
In 1995, the Legislature passed laws and the Texas Public Utility Commission (PUC) adopted rules that allowed competition in the electric industry’s wholesale market. These rules have remained constant, and the generating companies have responded to this stability and certainty by constructing 16,200 megawatts of capacity—more than doubling the need expected through 2004. As a result, Texas has a comfortable supply of electricity. By contrast, years of uncertainty in the California market have discouraged development, and the state has only about one-fourth of its projected needs for new capacity.
In 1999, the Legislature adopted the Texas Electric Choice Act, opening the market to retail competition as of January 1, 2002. Again, the law and PUC rules were carefully thought out, and provided the certainty needed for many new competitors to enter the electric market. Although the market is still in its infancy and has had a few growing pains, dozens of new competitors are vying for consumers’ business, and the consumer is better off through having choice and lower prices. I quantified these savings and benefits a few months back, and they already had stimulated the Texas economy to the tune of over $700 million in spending and 5,000 jobs.
Unfortunately, the PUC recently acted to remove some certainty and stability from this emerging market, a practice which could have adverse consequences. In 2001, the PUC adopted a “Price to Beat” rule which would assure small consumers a lower price in the electric market and assure room in the market for robust competition. The rule—adopted after a lengthy (some would say excruciating) hearing process, including full participation by all parties—is intended to ensure that competition develops in the Texas electric market and to prevent conditions that developed in California.
In adopting the rule, the Commissioners concluded that flexibility to adjust the Price to Beat to accommodate rising gas fuel prices would be essential to creating and preserving competition—and they were right! As in any market, if big competitors are forced to hold their prices low during the time of rising production costs, new and smaller competitors cannot enter the market.
Recently, rising natural gas prices prompted many of the traditional electricity providers to apply to the PUC for an increase in the Price to Beat. They complied strictly with the Price to Beat rule, and the State’s Office of Administrative Hearings judge recommended approval. Unfortunately, the PUC chose to disregard its own rule. Rather than continue to assure stability and certainty to the new electric market, the Commissioners sent the request back for additional study, thereby indefinitely delaying a decision and putting providers in the position of being unable to adjust for the effects of market price changes.
This action plunged the market into uncertainty and threatens the very viability of retail electric competition. Because of the delay, the large traditional providers are being forced to sustain artificially low prices and the smaller non-traditional energy firms cannot compete effectively.
As in any market, if the electricity market is to survive and offer benefits to consumers in Texas, rules must be established and followed to give the market participants and customers needed certainty and stability. The current stock market situation clearly reminds us what uncertainty can do to public confidence.
The PUC needs to help stabilize the market by staying with the rules it established. Understandably, the PUC is concerned that consumers will see higher prices if the Price to Beat is increased. By keeping prices artificially lower in the short-run for uneconomic reasons, however, competitors are discouraged from entering, and prices are thus higher in the long-run. It is easy to forget that, in the regulated market, prices increased and decreased with changes in the fuel costs, without providing customers with choice. In fact, it is precisely this practice of forcing retail prices to remain consistent as costs rose which created much of the crisis in California.
It is unfortunate for consumers that fuel prices went up, but they did. We can’t afford to allow the normal functioning of one market to disrupt the basic framework of another. Simply stated, let’s play by the rules.