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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.
Energy Storm
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.
Disaster
Markets
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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