(Peak) Oil Day for the Chicago Tribune

The Chicago Tribune on Sunday April 17 did a double whammy on the housing bubble and higher oil prices in the Business section. The section was practically devoted to rising oil prices and their effects as well as the housing bubble. They had some nice graphs at the back of the business section where they continued various stories. The series of 7 graphs at the back pages (14 and 15) was effective at the getting the point across.

http://www.chicagotribune.com/business/chi-0504170314apr17,1,2688966.story?coll=chi-business-hed

Consumers hold key to limiting loss

By James P. Miller
Tribune staff reporter
Published April 17, 2005

Although rising energy costs are never welcome in the manufacturing sector, the effect of a surge in such prices can vary from bad to not so bad.

The key variable? To a surprising extent, the amount of profit damage high-priced energy causes to the manufacturing sector depends on how things are going in the rest of the economy.

“If manufacturers are able to pass through the higher energy prices, earnings won’t be hurt” too badly, says William Strauss, a Federal Reserve Bank of Chicago economist who specializes in manufacturing issues.

“But these are competitive times,” he noted. “The question is, how much gets passed through?”

Goods producers can accommodate higher energy costs; in other words, as long as demand from consumers remains solid.

Ultimately, the biggest impact manufacturers feel from high energy costs comes from consumers’ loss of spendable income: If a household pays an extra $100 monthly for gas, the family’s income is reduced just as if it had been hit by a pay cut or a major tax hike.

But if the economy is so weak that customers refuse to accept price hikes, then producers end up absorbing most of the higher cost–and their profit margins suffer.

Figuring out if or when that will happen keeps lots of economists busy. Just Friday, when the federal government reported manufacturing output declined by 0.1 percent in March, the National Association of Manufacturers laid the blame on “soaring prices for natural gas and oil.”

“Modern manufacturing is heavily dependent on energy,” said association economist Chi Nguyen, and the slippage in March output “makes it abundantly clear that we are paying a high price for the lack of a comprehensive energy policy.”

Despite the trade group’s concerns, in a number of manufacturing sectors higher energy costs don’t seem to be doing much damage.

For the petrochemicals industry, where petroleum is almost the sole raw material, input prices are up–but the petrochemical business is strong and moving toward a cyclical profit peak expected to arrive either this year or in 2006, according to industry experts.

In fact, a number of industries continue to reap the benefits of a strengthening U.S. economy.

“Some of our costs are going up and we, like everyone else in the industry, are trying to pass the costs along,” says a spokesman for Warrenville-based truckmaker Navistar International Corp.

“Sometimes we’re successful” in passing along the cost increases, he says, “and sometimes we’re not.”

Navistar’s exposure to higher energy costs lies at both ends of the supply chain: Not only are the company’s energy costs up, but its principal customers are trucking companies–who are now getting socked by higher prices for diesel fuel.

“Obviously, higher fuel costs are going to impact all our customers,” says spokesman Roy Wiley, “but we’ve seen no let-up in demand.”

Navistar, like other makers of heavy and medium-weight trucks, endured a long cyclical slump but has seen a flood of new orders over the past year, and is producing at maximum capacity.

A stronger U.S. economy has America’s factories producing more goods, and that in turn means the nation’s truck fleets are busier hauling raw materials to those production plants, and carrying away finished products to end markets.

USG Corp., the Chicago-based wallboard producer, is a big buyer of natural gas, and earnings in recent years have been hit hard by the tripling in the fuel’s price since 2002. Gas prices remain high, but other factors have changed in USG’s market.

For years, USG’s results suffered from low industry prices, caused by a glut of wallboard capacity from new production that came online in 2001. Recently, that excess capacity has at last been absorbed. With wallboard prices now sharply higher, USG has been enjoying a profit resurgence even though natural gas remains very expensive.

Earnings have strengthened, acknowledges a USG spokesman, “but they’d be even better if natural gas didn’t cost so much.”

Oil’s wide effect

In recent months higher petroleum prices have driven up the price of all kinds of building products–like cement, plastic pipe, asphalt and linoleum flooring–but to date the housing market has been so hot that builders and home buyers have been willing to absorb the higher costs.

Higher energy costs have also pinched profits at aluminum producer Alcoa, and at steelmakers such as United States Steel, but higher global prices for such industrial inputs have helped offset the energy shock.

In a sense, energy costs are comparable to an increase in raw-materials costs.

When Caterpillar Inc.’s steel suppliers began raising prices more than a year ago, the Peoria manufacturing giant’s profit margins initially narrowed. The heavy-equipment industry was only beginning to emerge from a cyclical downturn, and Caterpillar didn’t want to lose business to rivals by bumping up prices for its earthmovers and diesel engines when something close to a buyer’s market was in effect.

But now, with the industry in a full-blown boom that has producers struggling to keep up with demand, Caterpillar has raised its prices significantly, and is facing pressure from Wall Street to maximize profits by raising prices even more.

Sooner or later, the system is self-correcting, although the process can be disruptive. As price hikes trigger more price hikes, higher costs cascade through the nation’s economy until eventually consumers balk and cut back spending.

When manufacturers and service providers respond to slowing demand by laying off workers, the economy cools and prices stabilize.

And if consumers don’t put the brakes on, government inflation-fighters are always ready to step in and raise interest rates until the economy slows enough to chill prices.

World impact

From that perspective, high energy costs can be seen as a function of a strong economy. But now the U.S. and western Europe are having to share a growing portion of the globe’s energy resources with China, India and other fast-growing Asian economies; a slump in U.S. consumption might not yield the quick drop in oil prices that it has historically provided.

“The American economy thrives on inexpensive fuel for transportation, distribution and manufacturing,” notes author Tom Mast, in a just-released book on energy issues entitled “Over a Barrel.” Removal of the “crutch” of cheap energy, he said, will remove America’s ability to compensate for high-cost labor by employing energy-intensive machinery; in the long term that promises to “make competing with low-cost-labor countries like China and India more difficult,” Mast contends.

Although price hikes are increasingly rumbling through the U.S. manufacturing sector, consumers haven’t yet felt the full impact of rising energy and raw-material costs. But increasingly, they will.

The standard rule of thumb, says the Federal Reserve Bank of Chicago’s Strauss, is that “for every $10 rise in the price of oil, you see a one-quarter of a percentage-point reduction in the gross domestic product” in the first year, and a smaller effect the following year.

But if oil prices later stabilize at the higher level, he noted, the initial economic impact will be a one-time phenomenon and the economy–and the manufacturing sector–can resume growth.

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jpmiller@tribune.com

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http://www.chicagotribune.com/business/chi-0504170316apr17,1,3475400.story?coll=chi-business-hed

‘A HURT ON US’
Like an oozing tax, price rise infiltrates all sectors
Cabs, buses, vacationers and shippers

By Mark Skertic
Tribune staff reporter
Published April 17, 2005

The financial pinch of higher gas prices is not only felt at the gas pump.

Food costs more at the grocery store, and it’s pricier to deliver something bought on the Internet. Vacation budgets are squeezed a bit more, and commuters re-evaluate the cheapest way to get to work.

“Gas prices are putting a hurt on us, that’s for sure,” said Mark Anderson, general manager of Coach USA’s operations in northwest Indiana. The upscale buses take passengers to O’Hare and Midway airports.

“With fuel prices and the Illinois Tollway rates up, we raised prices $1 a head,” Anderson said. “It’s still pretty economical [$21 one way or $32 round trip to either airport from Gary], but you’ve got to pass along some of the increase.”

Rising gas prices was one of the factors cab drivers cited recently when they successfully asked the Chicago City Council to approve fare increases. The new fares, including a 20-cents-a-mile boost, go into effect this summer.

Consumers also are paying more for goods that are trucked across the state or flown across the country, because shipping giants FedEx and UPS both add fuel surcharges to the cost of handling customers’ packages.

It’s a fair way to pass along charges that reflect the real impact of higher fuel prices, said UPS spokeswoman Susan Rosenberg. The amount fluctuates, and different charges are levied for air and ground service. One is based on a jet-fuel price index, and the other is tied to the cost of diesel fuel.

The effort to shave fuel costs has affected everything from how routes are configured to how vehicles are loaded, she said.

“There’s the communications that prompt our drivers with handheld computers, telling them that there’s five packages at a stop,” she said. “It used to be that maybe one got missed in the back of the vehicle, so then you’d be doubling back.”

Setting up efficient routes and eliminating the need to go back to stops because something was missed can save an estimated 14 million gallons of fuel annually, Rosenberg said.

Fuel conservation efforts are under way in other industries too. Airline pilots are being trained in ways to cut fuel consumption, and computers now analyze the best places to fill up planes.

While the price of a gallon of jet fuel is always a consideration, factors such as local fuel taxes and the weather are also taken into account, said Mary Frances Fagan, a spokeswoman for American Airlines.

“The computer is able to look at all the costs associated with buying fuel at one airport as opposed to another, and help us make the appropriate decision,” she said.

With the price of jet fuel now 50 percent higher than it was a year ago, passengers are being asked to help cover some of the increased costs. In recent weeks, a succession of ticket price increases has raised the cost of a one-way plane ticket by $60 on some commercial carriers.

The prospect of more expensive airline tickets and higher gas prices will affect the vacation plans of many families this summer. Destinations that can be reached in just a few hours’ drive could benefit.

“People want to be closer to home. That’s what we’ve seen,” said Jerry Huffman of the Wisconsin Department of Tourism. “We’re not panicked about gas prices, because our average tourist spends only about 7 percent of their vacation budget on gas.”

Wisconsin tourism surveys show about a quarter of the state’s vacation visitors come from the metropolitan Chicago area. The Wisconsin Dells, Milwaukee and rural areas in the southern part of the state are among those places that are expected to attract more visitors this year, he said.

The prospect of paying more for gas is not enough to change some plans. Demand for sport-utility vehicles remains strong, said Tom Libby, senior director of industry analysis for the Power Information Network, an affiliate of J.D. Power & Associates.

“For consumers to make major changes in their purchases, gas prices would have to go up a lot more and then stay there for an extended period of time,” he said.

It’s unlikely that there will be any significant change in the types of vehicles people want unless gas spiked to about $5 a gallon, Libby said.

“What we’re seeing is shifts within segments, but not across segments,” he said.

Instead of buying the larger SUVs, such as the Ford Expedition or Chevrolet Tahoe, some are opting for smaller vehicles such as the Ford Escape or Toyota Highlander, he said.

Even demand for the Hummer–a $50,000 SUV on steroids that gulps fuel and gets eight miles to the gallon–has softened only slightly, Libby said. A new, smaller version, called the H3, is expected to reinvigorate the brand, he said.

Libby isn’t the only one who feels consumers are reluctant to give up their bigger cars just because a jump in the price of gas could cost them several hundred dollars more each year.

Jeff Ellington, owner of Abel RV in Bartlett, says demand at his business has remained strong, even though the campers burn through fuel quickly.

“This is something people have saved up for,” Ellington said. “It’s something they’ve waited for for a long time. They’re going to do it. It doesn’t matter what gas prices are.”

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mskertic@tribune.com

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http://www.chicagotribune.com/business/chi-0504170196apr17,1,6096846.story?coll=chi-business-hed

OUTLOOK
OUTLOOK

William Sluis
Published April 17, 2005

HOUSING STARTS

Lean wallets pinch gains

As home prices ratchet higher, creating fears of a bubble, American workers are in a squeeze. Not only are they pouring record numbers of dollars into fuel tanks, but incomes are growing slowly, if at all. Result: Wallets are looking leaner for consumers trying to make ever-larger mortgage payments.

Doubters about the real estate market say that double-digit price increases cannot go on indefinitely, that too many homes already are out of reach.

That brings us to Tuesday’s report of March housing starts. In February they rose unexpectedly by 0.5 percent, to 2.195 million units annually, a 21-year high. Analysts expect a slight pullback.

Chicago economist Diane Swonk is in the camp that says a price bubble is unlikely. Nationally, homes will rise in value by 6.5 percent this year and another 4 percent in 2006, she said.

Although sales will slacken a bit this year, they will remain near record levels, said Swonk, of Mesirow Financial.

“Construction will hold up even better, aided by projects already in the pipeline and tight inventories of new and existing homes,” she said. “This is shaping up to be another phenomenal year for housing.”

INFLATION INDEXES

Energy costs boost prices

Is it possible that the Federal Reserve, on a nine-month campaign to tighten credit, could soften its stance?

Some analysts thought so after last week’s release of central bank minutes that were deemed less than hawkish. Fears of inflation appear to be receding.

Economist Lynn Reaser is looking for a shocking gain of 0.6 percent in Tuesday’s report of the March producer price index and a rise of 0.5 percent in Wednesday’s consumer price index.

But Reaser, of Bank of America’s Investment Strategies Group in Boston, says inflation worries will soon subside, because most of the concerns stem from energy. Excluding energy, the gain in each monthly inflation index would be only 0.2 percent.

“Corporations have limited pricing power and we already have seen a severe drop in the cost of oil,” she said. “That means price pressures inevitably will simmer down.”

EQUITIES

Searching for leadership

A mystery in the stock market is why the drop in petroleum prices hasn’t set off much of a rally. Oil has fallen more than 13 percent from its peak, yet Wall Street is in a state of torpor.

Chicago investment manager Marshall Front says the stock market is in search of new leadership, as energy and materials companies suffer through an overdue price correction.

“There is a growing perception that growth is slowing, at least slightly, and that is making some investors nervous,” said Front, of Front Barnett Associates.

As steel companies and others involved in producing the basics of the economy head lower, he sees opportunities for investors in pharmaceuticals and other health-care stocks.

In addition, Front said, “if there is a realization that the Fed is at the end of its rate-raising cycle, it would create an upward shift for the financials.”

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wsluis@tribune.com
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http://www.chicagotribune.com/business/chi-0504170271apr17,1,3737544.story?coll=chi-business-hed
Pop goes a market?
There’s only one sure way to avoid investment bubbles: Show your heels

By John Lux
Published April 17, 2005

Bubble, bubble, who’s got the bubble? Is it real estate? Commodities? Equities in general? Or none of the above?

Most investors are painfully aware that bubbles burst, and they can hurt. Five years ago lots of investors were burned when stock markets, led by the Nasdaq, went into a tailspin. People who dreamed of a comfortable retirement financed by endless gains in the market got a wake-up call, and many haven’t recovered yet.

Once-burned, twice-shy investors began moving money out of stocks but now are worried that the investments they chose are bubble-prone, too.

Werner F.M. De Bondt, director of the Richard H. Driehaus Behavioral Finance Center at DePaul University in Chicago, says the fault lies not in the markets, but in investors .

“People think life is too short and they deserve to be part of a society that becomes richer and richer,” he said.

The facts of investing life belie the entitlement mentality. Economists say the worth of an investment must be judged not by escalating prices paid for it, but by the investment’s earnings capacity.

Jeremy J. Siegel, a professor of finance at the Wharton School of the University of Pennsylvania, writes that a bubble is created when the rising price of an asset is not related to its true value but is fed by “momentum investors,” who buy only with the idea of selling to other investors at a higher price.

And it’s a fool’s game to try to guess when the bubble will burst. De Bondt said, “There are bubbles all the time. But you can only say it was a bubble after a dramatic collapse in the market, or an industry, or even a particular stock. Nobody can really predict.”

Robert H. Parks, professor of finance at Pace University’s Lubin School of Business in New York, sees bubbles everywhere today–stocks, bonds, hedge funds, real estate–and says America’s monetary and fiscal policies are at fault.

There is already a lot of money available for investment from Baby Boomers racing toward their looming retirements, and Parks thinks the last thing the country needs is easy money.Because the Federal Reserve has been too timid in raising rates, Parks said, “speculators are borrowing short and lending long,” meaning that money borrowed at low short-term interest rates is being re-lent at somewhat higher long-term rates. One example: A banker borrows short by issuing a one-month certificate of deposit. She then turns around and lends long by issuing a five-year auto loan.

“This works only if interest rates are coming down,” Parks said. “That’s about to come to an end. If you borrow short and lend long just before interest rates surge, you go bankrupt.”

Parks is especially worried about all the money going into real estate. The National Association of Realtors says that 23 percent of all homes sold in 2004 were bought strictly as investments, with another 13 percent sold as second homes, also a form of investment for many people.

“Real estate is a tempting investment,” De Bondt said, “because people think they understand real estate. It’s not like the stock market, where new prices are recorded every day. People have a false idea that there is less volatility, and this lures people in.”

People see real estate as an inflation hedge, De Bondt said, and it is–but only in the long run. Many of our parents did very well, he said, because they held onto the house for many years and capitalized on America’s greatest middle-class subsidy: deductions for mortgage interest and real estate taxes, and generous capital gains exemptions when they finally were sold.

Hal Young, a certified public accountant and a partner with Frank & Co. in McLean, Va., sees big problems on the horizon for individual real estate investors. In a nutshell, buyers are paying more for properties and getting less in rent when they lease them.

“In Washington, D.C., for example, current owners are converting rentals to condos, and current renters who can are buying,” Young said. Because mortgages are easy to get, lots of renters are buying, and there are fewer people who want to rent. “So prices go up for sales, but not for the rents,” and the investor can’t make the purchase pay.

Historically, Young said, to make an investment worthwhile, real estate investors have looked for a 9 percent or 10 percent rate of return on invested capital. But because of high prices and low rents, many condos now bring only a 5 percent or 6 percent rate of return.

Even worse, Young said, is the outlook for second homes investors hope to rent out.

“I see people buying property in the Outer Banks of North Carolina,” Young said, “which has a May to September rental season. So run the numbers and you can’t come anywhere near the right cash flow. You’ll be carrying it from October to March. Cash flow can kill you.”

The run-up in housing prices is a prime example of the greater fool theory, Young said: Even if you paid too much you’ll make money on any investment if you find a buyer who’s a greater fool than you are.

Is there any way to keep from getting caught in a bubble?

Parks thinks that now’s the time to show the markets your heels.

“Last week, I shifted every penny I have to money-market funds,” he said. “The hope is to retain what I have.”

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Identifying real vs. inflated value

Werner F.M. De Bondt, director of the Richard H. Driehaus Behavioral Finance Center at DePaul University in Chicago, has identified three stages in the development of an equity bubble.

1. Some objective news justifies a higher valuation for a sector or a certain stock. This could be the introduction of new technology, or a need for increased supplies of a particular commodity. (While most often real, sometimes–De Bondt cites the run-up in Krispy Kreme–the innovation is imaginary.)

2. Professional market watchers start seeing patterns that extend the good news further and recommend that their clients buy in. But this is often wishful thinking and there are no real patterns.

3. The rest of us see the way the market is moving and jump on the bandwagon.

But De Bondt says it’s foolish to try to catch up: “The fact is that people are betting on yesterday’s winners.”

– John Lux

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jlux@tribune.com