A Word on Natural Gas
(December 10, 2009)
Dear Subscribers and Readers,
As we approach the end of one of the most interesting years in financial history (1907, 1929, 1931, 1974, 1999, and 2008 notwithstanding), we have much to be thankful for. Sure, the bankers received a disproportionately high lifeline compared to the US middle class, but we have averted a more severe financial and potentially global economic collapse. The US (and much of the developed world, especially Japan) middle class has been languishing for the past decade, as real income levels have been stagnant and as both returns on stocks and real estate have disappointed (on a side note, if one is graduating next summer and has a decent job lined up, this is now one of the best times to invest in “risky” assets for the long-run).
For others, however, the first decade (which isn't officially over until the end of 2010) has been one of the best periods in wealth generation. On this note, the BRICs really stand out – especially those in the upper quartile in wealth and income levels in those countries. Sovereign wealth in these countries are also rock solid – all the more impressive given the financial collapses in Brazil and Russia in 1998! The US has played no small role, as American corporations outsourced our manufacturing and our IT base to China and India, respectively, and as US consumers imported a rising amount of commodities and finished goods over the last decade.
But Henry, where are you going with this? For the last decade, the vast majority of the middle class and even upper middle class have gotten the “short end of the stick!” Declining real wages, wealth, and higher unemployment were only the tip of the iceberg. What is more insulting – especially since it doesn't show up in the headline CPI numbers – is that we have witnessed very high inflation in certain services that we need and crave, even as we experienced deflation in sectors where technology has a high impact (such as PCs, cell phones, flat-screen TVs, Chinese-made goods, etc.). For example, the CPI in medical care rose 45% from 1999 to 2008, or an annualized 4.2%, while the CPI in college tuition rose over 80%, or an annualized 6.8%! Finally, despite the 2008 year-end collapse in energy prices, the CPI in energy rose a whopping 57% during the same time period, or an annualized 5.2%. The issues behind the rise in the cost of healthcare, higher education, and energy are complex. Ultimately, the issues all come down to supply and demand, but the drivers (and there are many) of each warrant its own individual commentary. I will come back to those issues at a later commentary. For now, I want to quickly present my view of what the US middle class lifestyle will be like in the next decade.
I am a cautious optimist at heart. Despite the many flaws in human beings and human nature (flaws which actually helped us to survive as a society over the last 10,000 years), I believe we will ultimately find solutions that will lead to decent and sustainable economic growth over the next decade. For the last 100 years, the US has jumped from innovation to innovation. Such innovations (and the commercialization of these innovations) have not only driven economic growth, but rising living standards for the vast majority of Americans. As long as the capitalist system remains intact (and innovators and venture capitalists are sufficiently incentivized), there is no reason to think that the US growth engine has stalled. Advances in alternative energy (e.g. cellulosic ethanol and biofuels), materials sciences (e.g. composite materials; the LA Metro recently purchased more fuel-efficient buses made of much-lighter composite materials), computing, broadband, stem cell research, etc, will continue to emerge over the next five to ten years. This will not only bring lower energy and food prices, but also higher living standards, longer life-spans, cleaner energy, and a safer world (particularly as less US dollars flow to the Middle East).
Of course – just like any forecast – it is subjected to both upside and downside risk. While many folks in the financial sector have benefited disproportionately (and undeservedly) from the boom over the last decade, we must be careful to not penalize the true entrepreneurs by taxing them to the point of discouragement (rent control policies in Santa Monica provides a good microcosm of what could happen to the US at large, as this and other policies have discouraged any significant housing development in the area). To that end, the UK and France's proposed policies to impose a special tax on bankers' bonuses is a very discouraging development. If they could impose a tax on a specific industry just because of high profits or compensation, what could be next? The best policy (in order less moral hazard risks or prevent future dislocations from occurring) would be to prosecute those that caused the crisis and who deserved prosecuting. To that end, the SEC's recent civil suit against three former executives at New Century Financial for overstating profits in 2006 is a highly encouraging development. But where are Chuck Prince, Stan O'Neal, and Dick Fuld? At the very least, these characters deserve another grilling session in front of Congress. For certain portions of the US middle class, even the prospects of sustainable economic growth and a general rise in living standards may not bring back the “good old days,” especially for those who worked in the financial or retail industry over the last five to ten years. But then again, this is simply the concept of Joseph Schumpeter's “creative destruction” at work.
As the eminent historian, Arnold Toynbee wrote decades ago, whether the US economy can move on to the next boom or the next stage of her progress would depend on our ability to meet our major challenges. Almost always, it is the “creative minorities” that tend to derive solutions to these challenges – while others in positions of power then follow. Obviously, our challenge is not just high energy, food, and healthcare prices – but all the accompanying problems that come with them, such as social and race inequality, the empowering of hostile (and close-to-totalitarian) States such as Russia and Iran, and the re-proliferation of poverty around the globe – factors which all tend to be destabilizing to long-term economic/productivity growth and global social harmony. The widespread adoption of cheap solar technologies and biofuels, for example, will bring decentralization to the power grid and allow every household to be a capitalist, while ensuring cheap transportation options. Should cheap energy ultimately become limitless – this will not only propel US technological/productivity growth to the “stratosphere” (think of the tens of millions of dollars that are needed annually to run and cool the fastest supercomputer in the world today) but will also go a long way to eradicating poverty in the United States and ultimately to most capitalistic countries around the world. This is the goal we should all be aiming and hoping for.
Now, I want to offer a quick word on natural gas. Earlier in the year, we were looking and waiting for an opportunity to buy natural gas, given the decline in drilling rates and the production decline in traditional wells. At the time, we did not anticipate the high productivity in shale gas wells. In late August, we (finally) got bearish on natural gas, and specifically on the natural gas ETF (UNG). At the time, it traded at $11.35, and has since declined to $9.11 a share. All gas watchers are now focusing on the weekly natural gas storage report to be released today at 10:30am EST, as the US finally experienced a short burst of cold weather last week (if this does not result in a big storage withdrawal, then watch out below). However, the fundamental problem of “too much gas” remains. Even as drilling rates have declined, domestic storage levels and natural gas production remain stubbornly high. At the same time, global LNG production continues to ramp up – suggesting that US natural gas imports could easily satisfy any “demand spikes” should US consumption recovers in the foreseeable future. This view is confirmed by the following chart showing that natural gas imports as a percentage of US consumption has declined to its lowest level since 1998 last year:
For subscribers who want to take advantage of a recovering US economy, buying UNG (especially given the significant contango and seasonal spreads) is not the way to go. At this time, I do not see any long opportunities in UNG unless it declines another 20% to 30%, and only if it takes the back end of the natural gas futures curve along with it. A mild winter, coupled with a rise in the U.S. Dollar Index, may do the trick. For now, I want our subscribers to be mindful of UNG and other commodity ETFs in general.
Henry To, CFA