BUD BREWER

One Man's Opinion

THE MAGIC OF THE MARKET’S INVISIBLE HAND

February 18, 2016: Adam Smith’s cogent description of the force that generates equilibrium in free markets has been at work in the energy industry over the past 18 months.  The price of oil has adjusted in response to these forces as Saudi Arabia, the leading and most dominant

Who is afraid of the Frackers

producer of oil in the OPEC nations, has led that body in an attempt to affect the price of oil.  This worked well until the recovery from the vast deposits of oil in North American Shale oil sands became economic.  At that moment, OPEC’s ability to control the price of crude by simply reducing their level of production thereby riding the long term growth of consumer and industrial demand for the commodity, which has been about 1% per year, began to fail.  The problem in their strategy is that at a certain time or period, the equilibrium price for crude is sufficiently above the cost to generate new supply, so that the ability to control that supply side of equilibrium artificially breaks down and with it goes the price.

Now if you were the Saudis, what would you do to counteract this problem?  Understand that the largest repository of “sweet” crude oil lies beneath the sand in Saudi Arabia.  Their cost of lifting it is probably one tenth or less of the cost to recover oil from the Arctic or deep water drilling offshore.  Fracking technology in North American deposits of shale several hundreds of feet below ground has been developed sufficiently to enable those producers to sell their oil recovered at prices $20-$50 above their cost to produce.  As a result North American oil production has risen sharply to a point where it has changed the balance of power held by OPEC and in particular, the Saudis.  Acting as they had for the past several decades, you would expect that they would tweak their production schedules slightly and maintain the equilibrium price at a level that would keep it on trend.  But with this huge increase in supply being generated from Shale and new offshore drilling, any reduction in supply from OPEC would only serve to sharply reduce their revenue and yet have little or no supporting effect on the price.  So the Saudis adopted a new strategy.  They have elected to continue production at levels which would when combined with this new level of Global supply cause the equilibrium price to crash.  And so it has from $115 per barrel to $26 per barrel.

So what is the effect of this collapse having on the world’s sources of Oil?  Measured by the declining number of new rigs or bankruptcy or potential bankruptcy of Shale producer companies, their strategy appears to be working.  Historically during any period in which rig count has declined, the price of crude has risen.  We may therefore be in that period now in which by merely continuing production at levels well above then current supply side of equilibrium, the Saudis have potentially put the shale oil industry out of business.  The economic impact of this has both positive and negative impact upon the American economy.  Consumers have about $200+ additional to spend each month, the price of oil derivative products, tires, nylon etc. along with many drugs in the prescription business have seen their costs reduced and their profits thereby increased as the margins rose reflecting after the fact price-cost adjustments of end product.  But the negative effect upon the oil producers, the oil service industry and the drilling companies and especially the alternative energy industries has made a lot of people lose their jobs as companies cut back or even went out of business.  For many of the large producers, temporarily this only affected their profits slightly because of the increase in margins experienced in their refineries divisions.  End prices of gasoline have not reflected the rate of decline in crude oil at the same pace because of lagging adjustment by merchants in the retail price.

The battle for equilibrium

We must keep in mind that the Saudis are experiencing a very sharp decline in revenues that fund the huge cost of their personal and general expenses budgeted for entitlements and infrastructural expenses.  From the end of 2014 to today, this shortfall has required that they dip into their reserves by almost $1trillion and they can only continue to do this without additional sources of capital (debt) for a limited time or they will probably face a collapse in their economies.  This would likely cause a revolt perhaps even a takeover by ISIS.  The strategy of flooding the market with oil has achieved its objective and given the risk of sustaining this negative economic effect upon their people and the political risk of ISIS, within the next year, we will probably see a willingness of OPEC to actually begin to reduce production thereby, if timed correctly, it will once again allow them to force the price for equilibrium to begin to rise again on the ashes of the U.S. Shale oil industry.

I believe that this prospect has enormous potential for the investor to exploit but it will take careful analysis and patience to learn what and where to invest.  Certain companies who will benefit are now selling 40-50% below their recent highs and with given prospects for increasing end prices,  rising earnings can be once again projected and positions can be taken where the price looks reasonable.  This analysis does not ignore the prospects for lower costs of alternative energy particular the solar based ones that are experiencing such rapid change in both effectiveness and efficiency let alone costs, but it is likely to be a decade or more to be able to exploit those changes.  In the meantime, we are at a period of opportunity for some companies who can take advantage of what is likely to happen in the Global markets during the next two to three years.

One Man’s Opinion- Bud Brewer

SEC Goes Political on CEO Pay

August 12, 2015: In an interesting article in the WSJ, Theya Knight writes about the recent ruling by the SEC that mandates a Public Corporation  disclose the ratio between its CEO compensation and the median or average compensation of its work force. But by mandating this information from companies like Walmart, Macy’s, MacDonald’s or the big box stores, the SEC is trying to embarrass companies about income inequality, but the agency is likely to be the one blushing

The SEC, drawing on concepts in its founding 1934 legislation, states on its website that its mission is to “protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.” Some disclosure rules—those that provide investors with material information that assists them in making decisions—seem justified under that mission statement.
There are two main arguments in favor of forcing companies to calculate and disclose this pay ratio. The first is that the ratio will help investors evaluate management by providing additional information about whether the CEO’s compensation is appropriate. The second is that the ratio will help address income inequality by telling the public—in the words of a form letter to the SEC in favor of the rule—“which corporations are fueling the yawning gap between rich and poor.” Neither argument is convincing.

So the question is: Should the SEC require public companies to disclose the ratio of CEO pay to that of the median or average employee salary? Will this enable shareholders to make better judgments regarding the market valu of the Corporation or efficiency in operations? enable shareholders to make a better determination of the Company’s market value or is it relative to judging valuation? Is it even material given the fact that Corporations are already required to disclose the CEO’, compensation. . Daniel M. Gallagher, a Republican, said “the new rule “hijacks” the SEC for political purposes”. Commissioner Luis A. Aguilar, a Democrat who voted for the requirement, admitted last week that it is “controversial.”. No wonder!. The rule is unrelated to the SEC’s mission, imposes significant costs on public companies and will do little to achieve its intended goals.

A company’s pay ratio is not material information. For one thing, executive pay is already included in companies’ disclosures to the SEC. For another, the ratio has no bearing on whether the CEO’s pay is appropriate. The value of a CEO’s contribution to a company can be measured by several metrics—the extent to which the company’s market share or value has increased, for example—none of which include how much more the CEO makes than the median employee.  Nor does the ratio provide insight into corporate culture and governance. It will be difficult to compare two companies’ ratios, because the calculations will vary widely by industry and business model. A technology company that employs many highly educated, and therefore highly compensated, engineers will tend to have a low number. A retail giant, which employs thousands of part-time cashiers, will tend to have a high number. The difference between the two simply reflects the difference in market wages between a software engineer and a cashier.

The argument that the disclosure will pressure companies to narrow the pay gap between executives and workers is irrelevant: Such matters are unrelated to the SEC’s mission, and the agency’s move to stretch its power beyond its intended scope is a dangerous precedent. Forcing companies to disclose pay ratios is unlikely to have the intended effect. Let’s suppose a company does report a wide gap in pay, which activists then try to use to embarrass it. What are the options? Assuming the company is paying a market rate for the CEO, if it cuts that compensation there is a risk the CEO will go elsewhere. More likely is that the company will try to goose the ratio from the other direction, by figuring out how to shed its lowest-paid employees. It might lay off full-time permanent staff, and replace them with a raft of contractors and “temps” provided by staffing companies, which are explicitly not included in the calculation of the ratio.  In this scenario, the CEO loses no pay, and the wage gap remains untouched. But the most vulnerable workers are shunted into contract positions with no job security. Further, the company suffers because it must pay a middleman to supply the temporary staff, and it loses whatever psychological benefit inures from employees “belonging” to the company instead of being merely contractors. Then there are the direct costs of implementing the rule: an estimated $1.3 billion up front, according to the SEC’s own calculations, for all listed companies to gather and crunch the relevant data, plus an estimated $526 million a year afterward.

The SEC might have written a slightly less terrible rule—for example, by excluding all temporary and part-time employees from the calculation—but the ultimate fault lies with Congress for the provision in Dodd-Frank that mandated disclosure of this ratio in the first place. It is difficult to think of another SEC rule with so little redeeming value and yet such potentially negative effect upon the middle and lower class workers.

One Man’s Opinion – Bud Brewer

Minimum Wage vs Econ 101

March 4, 2013: Robert Barone is a frequent writer in the Gannett chain of newspapers. He has a Ph.D. in economics from Georgetown University. He wrote an article the other day about the Minimum Wage laws which should be read by those who are concerned about why there are so many people unemployed in today’s economy. The Professor’s statements should remind our legislators that interdicting the natural relationships between economic variables in a free market economy are likely to create unexpected consequences. For some reason, those economic advisors that serve President Obama’s Administration just don’t seem to remember the teachings of Econ 101, a basic undergraduate course taken by every person with a business degree. What we learned taking that first year course in economics was that “free markets clear where demand and supply intersect, however if artificial constraints are imposed and raise the price of the goods or services, the demand for them (in this case, labor) falls.

Reading it I was reminded of the times as a young school boy that I was able to solicit an after school job at a grocery store, a “Five & Dime” store, a restaurant and a Nursery so I could just have some spending money of my own. It wasn’t that my parents weren’t generous responding to my pleas for certain necessities but having a job was so much fun and made me feel good too. I would go into a business and ask if there were a job available for an energetic young boy who was dependable and honest. Frequently, I would receive a negative answer when the manager would say he couldn’t afford to hire anyone at that time. But I was prepared because I knew some of the other clerks who were complaining about having to work overtime or on Saturdays or Sundays. So I would ask, “Well Sir just how much could you afford to pay to have someone stock the shelves, sweep to aisles and clean up the storeroom”. The owner would toss off a figure that was 10 cents (25%) per hour below that which he was paying his clerks thinking I would be unwilling to work at that wage. But I accepted and told him he wouldn’t be disappointed in my work. I learned a lot about life during my afternoons and Saturdays at the Garman’s Five and Dime Store earning $0.40 per hour. I found some no small amount of joy being on time, working hard and efficiently taking care of my responsibility. I actually had the feeling that my boss was embarrassed when he handed me my weekly paycheck (actually we received cash). As I remember, I received $7.25 in a small brown envelope each Saturday when we were finished for the day. I learned a lot in conversations with co-workers and became good friends with several of them. Now as I observe the way politicians talk about minimum wage, I hear them use terms like income disparity, making money on the backs of the poor, the unfairness of trying to raise a family while living below the poverty line when they describe the plight of an individual who is working for a minimum wage of only $7.25 per hour. A remark is often added like, “how can a person support their family on that measly amount of income”. This sets the stage for the big lie that convinces many people, some ignorant of economic laws and others who feel guilty as a result of having much higher earning value.

But what are those economic principles that are so badly distorted or misunderstood by so many people. Here is the simple truth of how the value of labor is determined in a free market economy. Labor, capital and raw materials are inputs in the productive process. To an employer, especially a business that employs low-skilled labor, raising the minimum wage is like adding a tax to an input just as if the raw materials were taxed. What if the government passed a law that said the minimum price of a gallon of gasoline is $5.75 or $1.75 above the current price of $4.00? There certainly would be people who would not be impacted (the 1 percent crowd), but for most the higher price would significantly impact discretionary spending and economic growth would be negatively affected, as most consumers would cut back on auto travel.

Just as the tax on gasoline would impact the demand for it, so too, raising the minimum wage significantly would impact those businesses that rely on low-skilled labor. If it really is beneficial to raise the minimum wage from $7.25 to $9.00 an hour, why stop there? Why not raise it to $100 an hour?

“Absurd you say. Of course, such an idea is absurd. Much of the employed population would be laid off as employers couldn’t afford to keep employees whose hourly production doesn’t yield a margin before wages and benefits of $100. So why is this different from raising it to $9.00 an hour? For one reason, most folks already earn more than $9.00 an hour, so massive Layoffs won’t occur. But there are some employers who either will lay off the lower wage worker or simply will not hire them if those workers produce less than the required $9.00 per hour margin needed by the business. While the impact of the $9.00 an hour minimum wage won’t be as obvious as the leap to a minimum of $100 an hour, there still is an impact.

Those who get $1.75 an hour raise from the current 7.24 to $9.00, clearly benefit. But the least educated and least skilled likely are victims. Who are these? Generally, young people in their “teens”.

According to a February 15th Wall Street Journal editorial titled “The Minority Unemployment Act”, 85% of academic studies find negative consequences on low-skilled workers – usually teenagers – from mandated minimum wage increases. The studies include a recent one by William Dunkelberg, Chief economist for the National Foundation of Independent Businesses. Dunkelberg found that 600,000 teen jobs disappeared in the six months following the July 2009 minimum wage increase (to $7.25 an hour), a period in which gross domestic product was rising. In the previous six months, when the GDP was rapidly was contracting, Dunkelberg said that only half that many teen jobs disappeared.

It is clear that those keeping their minimum wage jobs benefit from the higher wage rate but it also means that those who would have gotten jobs at the lower wage rate remain unemployed. this, in effect, is a redistribution of income within the segment of the labor force having the lowest level of skills and education, and it puts the burden of the higher wages earned by those keeping minimum wage jobs directly on those who cannot now find employment at the higher minimum wage.

In economic jargon: Those making the incremental difference in the minimum wage are being subsidized by those who cannot find employment at these higher wage levels, but who are laid off instead of it being spread among all.

Those, of course, who do benefit think this is a good idea. Those who can’t find jobs simply aren’t aware that it is the rise in the minimum wage that is the issue, as there generally is no direct recognized measurement of this phenomenon. As a result, populist sentiment could very well think this is a good idea. But from the standpoint of trying to reduce the unemployment rate, especially for teens, this is a bad idea. For the past 150 years, students have learned this in Economics 101, but for at least the last half of that 150 year period, sound economic theory has been ignored by our policymakers and legislators.

In the end, raising the cost of labor, albeit at the low end, will, like all taxes, fees, rules and regulations on businesses, especially small businesses and those relying on low skilled labor, reduce output and constrain economic growth at a time when the American economy can ill afford it.

One Man’s Opinion—Bud Brewer

GOLD AS AN INVESTMENT

Is Gold a good investment? Over the 50 years of my investment experience, the potential for price appreciation of gold has always come into consideration by investors when the dollar is experiencing devaluation either through inflation or through excessive monetary policies of the Federal Reserve. From 1970 when President Nixon took us off the gold standard until 1980 when Ronald Reagan was elected and Federal Reserve Bank Chairman Volker (more…)

Markets Escaped Armageddon, What Now?

August 17,2007. When I was a kid, one of the simple type games we used to play while sitting around the kitchen table after dinner was a card game I called “building a house” Each player would stand one or more playing cards on their side and in turn place them against or on top of each other so that a structure would be built as high as possible before one or the other players made it fall as they put their last card in place. This “House of Cards” syndrome and its inherent risk of collapse has some anological comparison to how the financial structure of economic systems function here in the United States and around the world. While far more sophisticated, the money, banking and credit system overseen by our Federal Reserve Bank and Central Banks in other parts of the globe nevertheless has tiny elements that could bring into focus the possibility of and fear for financial implosion that is much similar to the House of Cards game we played.

Now having said that, lets see if we can gain some perspective of what the “norm” is or should be for constructive administration of monetary policies and the oversight of financial institutions operating in free markets around the world. The health of the U.S. economy is typically measured by the percentage change and direction of its Gross Domestic Product. This GDP is an amalgamation of output in manufacturing and services that are purchased by the individual, institutional and government consumers. The money a producer or provider receives for this output may be made up of a small portion of currency but for the most part it is represented by a preponderance of dollar bank credits. The willingness of a producer to accept dollar bank credits in exchange for their output is based on their expectation that they will be able to turn around and pay their obligations by transferring these bank credits to other producers or service providers. The difference between dollar credits earned by institutions or individuals from their output or work and the amount of their consumption purchases becomes savings. These savings are generally held by banks as an obligation payable to or FBO the saver and for which the bank will add additional dollar credits representing compensation to them for the use of that dollar credit. In many cases, these credits are exchanged for equity or debt ownership in securities, real estate and in some cases, commodities. The structure that provides the tract on which all these transfers of credits take place is governed by State and Federal Banking regulations and by the Federal Reserve turning the money spigot on or off depending on whether or not they see the need to ease the ability for individuals and institutions to obtain temporary loans for their discretionary purchase of consumer items or longer term loans for the payment of mortgages or other fixed obligations.

This entire system depends on the degree of confidence consumers have in the ability or desirability to exchange their dollar credits for some other asset. As long as the credits are moving in the system, the economy and the producers of goods and services are selling their product and exchanging value for value. The problem comes and it did come in this summer’s near collapse of the financial system when the mortgage banker increasingly came to discover that it became more and more difficult to sell mortgages he was generating and that his source of bank credits needed to hold and create mortgages was drying up. The financial system was freezing up. It is sort of like the human body having plenty of blood (currency) but the heart has stopped pumping it to the circulatory system.

One critical form of the “blood” in this system is the financial obligation called Commercial Paper. When banks or institutions cannot sell and investors eschew the purchase of these short term (30-90 day) obligations, it is like the heart stopping its beating. The reason for this near disaster is the growing fear that the underlying values being used to price these and other longer term paper liabilities are over stated. This fear leads to investors selling down collateralized financial obligations (Mortgages, Commercial Paper, etc) and brings to a virtual halt the liquidity of fixed income markets leading to the suspension of funding for private acquisition deals or leverage buyouts.

It was early this morning that the Federal Reserve, having concluded that they needed to step in and try to stem the tide, decided to reduce the discount rate by 50 basis points. This act, which is intended to make it possible for banks and mortgage companies to sell some of the paper they hold and provide an alternative for the realization of funds to procure working capital or monies to fund other approved mortgage commitments brought an explosion of buying into the security markets and reversed a great deal of the apprehension Traders and Hedge Fund managers were feeling about going into the weekend heavily unbalanced in their risks. This, along with a multi billion infusion of money into the system by a purchase of Treasury and re-purchase agreements, seemed to generate a strong sense of stability to the money markets around the world.

Although the Fed’s action brought a sense of calm to the markets and was most appreciated by the investment community, the experience of the past 30 days brings into focus the impropriety of lending money to creditors who’s collateral is illiquid and/or probably overvalued to the extent that the loan amount is greater than the fair market value of assets securing it. These type loans will no longer have a secondary market nor will the issuer be able to combine them into a security and sell them at par value. The mortgage broker will now have to limit the amount they lend to borrowers to a figure that investors can be comfortable with, perhaps only as much as 80% of appraised value. This will be good for the financial markets but it will certainly have a negative affect upon the price and volume of real estate transactions.

The ultimate negative impact upon the world as well as the domestic economies will be caused by the reduction of and maybe by substantial amounts, the ability of consumers to monetize the excess equity in their primary and secondary residences. This impact will be felt in household purchases and ultimately in the earnings of many if not all consumer companies. With this negative impact upon our economy and those that serve our appetite for imports our economy may be less robust in the coming year.

One Man’s Opinion — Bud Brewer