The "R" Word

LA At Night, Wikipedia

With the S&P 500 falling one hundred points off its September high, a growing number of economists are warming up to the idea of a US based recession. The other more optimistic portion continues to place faith in an esoteric soft landing where the economy becomes sluggish, nearly stagnant, while remaining free from the grasp of an actual recession. Although this is an enticing idea in theory, emerging circumstances deem it highly unlikely. What is more realistic is the likelihood of the US's first consumer lead recession in nearly two decades.

The primary risk for our economy is the imploding housing market. Since its peak in early 2006, home builders, lenders and those directly connected to the market have felt the pain. This has lead to housing starts falling by 47% and home prices by 8% (inflation adjusted). Compared to the nearly 100% (adjusted) price appreciation seen from 2006-1997, it would appear as though the housing market has much farther to fall before we witness a true correction. Given the magnitude of unsold homes and tremendous backlog of residential construction, it becomes apparent that construction investments and prices must fall further to become rebalanced for supply.

For the housing market to affect the overall economy, its retraction must influence consumers' spending habits. Consumers spending patterns are affected by employment, financial wealth and housing wealth, just to name a few. According to The Economist, consumers are more influenced by changes in housing wealth; although it normally takes longer to materialize. "A $100 fall in financial wealth is traditionally associated with a $3-5 decline in spending. An equivalent fall in housing wealth, it seems, eventually reduces spending by between $4-9." When we take note of the wealth amassed within America's residential housing, a 10% reduction over the next few years will eventually equate to a sizable reduction in consumer spending.

This delay might be a result of the perceived value of a home by consumers. According to The Economist, "house prices are often sticky as homeowners are slow to acknowledge their houses are now worth less." Unlike the modern equities markets which reflect price changes rapidly, the price of a home is slower to react to supply and demand imbalances. Ultimately, this leaves us with a growing number of consumers realizing their housing wealth is decreasing. Even worse off are the speculators, laden with debt and dependent on continuous residential price appreciation. With the housing market in ruin, these flippers are left with mortgage calls, absentee buyers and properties they can't afford. While the housing sector has noticeably begun to unravel, its eventual effect on consumer spending habits has yet to be witnessed. Given that 70% of GDP is comprised by the consumer, a serious reduction in their spending will have profound economic reverberations.

Plants, Plastics and Profits?

Image Taken From www2.unil.ch

There is a growing consensus to develop alternatives for plastics, in order to alleviate our dependency on fossil fuels and decrease our ecological footprint. If we can manufacture plastics from non-petroleum feedstock we will cut our dependency on oil and decrease our production of waste streams in one fell swoop. This is easier said than done; with current petroleum prices this is certainly not an effortless economical endeavor. However, with on-going research and potentially higher feedstock prices, the dynamics of this pendulum could shift.

Enter Metabolix Inc. (MBLX), a freshly IPO'ed biotechnology company developing alternatives to petrochemical-based plastics. In the 1980s, Metabolix's founders Oliver Peoples and Anthony Sinskey demonstrated an enzyme's ability to integrate into microscopic biofactories capable of manufacturing useful polymers such as Polyhydroxyalkanoatesas. PHA, as they are commonly referred to are "linear polyesters produced in nature by bacterial fermentation of sugar and lipids." In a controlled environment these biofactories, through photosynthesis, combine carbon dioxide,water and sunlight to create a biodegradable, renewable alternative to petro-plastic. The potential adaptations for this technology are indeed vast. Their use could range from disposable
eating utensils to orthopedic sutures and fasteners.

In 2007, Metabolix received attention after they re-announced a 50-50 joined venture to build the world's first plastic biorefinery in Clinton, Iowa. The venture, under the name Telles after the Roman goddess of the earth, is scheduled for completion in the 3rd or 4th quarter of 2008 and targeted to produce 110 million pounds of plastic resin per year. Telles plans on distributing the resin for $2.50/pound, which compares to 70 cents on the dollar for traditional plastic.

While these prices reflect a cost bias in favor of traditional plastics, the company believes customers striving for a greener persona will pay the premium. Additionally, "analysts at Jefferies & Co. see Metabolix carving out a niche in the market for disposable plastics, which is roughly 20% of the entire plastics market."

Where there is a need there is a way, and Metabolix is not alone in its undertaking to alter plastic consumption habits. Companies such as DuPont (DD), BASF (BASFY), and agricultural giant Cargill are all in the process of developing bio-based plastic resins. Most interestingly however, are the developments at a microcap company, by the name of Cereplast Inc.(CERP).

Cereplast was founded in 2001 and is engaged in the development and commercialization of bio-based resins in the United States, Europe, and Asia. Earlier this month, the company reported record revenues of $1.6 million, a 258% increase year over year. The company attributed this predominantly to the commercial launch of Cereplast Compostables. While these earnings are encouraging, the company is still in the red and continues to issue shares as a means to finance operations. Total outstanding shares for the third quarter were 258.2 compared to 200.4 million during 2006.

Cereplast's line-up consists of two proprietary products: Cereplast Compostables and Cereplast Hybrid Resins. The Compostables are slightly self-explanatory. They consist of certifiable, biodegradable plastic alternatives derived from starch-based feedstock such as potatoes, corn and wheat. The Hybrid resin is identical, except they are a neatly package 50-50 mixture of starches and petroleum. Unlike the Compostables, the Hybrids do not meet biodegradable and compostable standards in the United States and Europe. However, according to the company’s website, they are "cost competitive with traditional petroleum-based plastic resins."

The company seems to be poised for growth and has the approval by several industry leaders, including a notable, multi-year supply contract with Alcoa-Kama, a subsidiary of Alcoa (AA). Furthermore, the company claims that more than "65 prospective customers are evaluating more than 100 different potential product applications" for both the Hybrid and Compostable bioresins.

Both Metabolix and Cereplast could prove to be speculative companies worth watching in the wake of 90-dollar oil. Furthermore, with the U.S. consuming 7.5 billion barrels of oil a year and about 254 million barrels dedicated to plastics and chemical production it could prove wise to protect our planet and pocketbooks by developing these increasingly cost effective, biodegradable alternatives.

Flexable Oil

Shaybah Oil Field, Saudi Arabia - New York Times

In the realm of commodities, oil is extremely unique. Unlike the precious metals or pork bellies, oil provides us with cost effective transportation, thermal energy to heat our homes, and a matrix for the creation of seemingly endless consumer products. Succinctly put, it provides our economy with the necessary lubrication to transition each day smoothly into the next. Due to this dependence, it appears that the average consumer and ExxonMobil(XOM) will remained joined at the hip. Why then, with brent crude trading in the $90 range haven't the markets thirst for oil been slaked, or the consumers appetite to spend been squelched?

In physics, elasticity is defined as the physical ability to return to an initial form or state following deformation. For economics, elasticity can be understood with a similar methodology. Price elasticity is the responsiveness of quantity demanded or supplied with respect to price changes. In other words, how likely is demand or supply for a good or service going to respond following a deformation in price.

For items such as normal and inferior goods, price fluctuations correlate to a reflected increase or decrease in the quantity demanded by consumers. These goods, such as computers and cars are considered elastic as the quantity demanded changes substantially with these pricing gyrations.

Inversely, goods such as cigarettes are largely considered inelastic. Graphically configured, inelastic demand for cigarettes would appear as a nearly vertical line on a demand curve i.e. as price increase, demand remains relatively unchanged. Some argue that this inelastic nature is skewed as nicotine is a physically addictive substance requiring progressively greater concentrations by the user which supports demand regardless of underlining price. Additionally, cigarettes remain inelastic because no readily apparent substitute exist. This further prevents consumers from switching products in response to price changes.

Computers, cigarettes and consumer staples make sense, but what about oil? How can the price of oil increase 500% in a decade without dramatically stifling demand? Odiously to some extend, oil must be inelastic. However, to accurately determine the effect of price on demand for oil, price must be correlated with time. Throughout recent history, oil has demonstrated instances of inelasticity and bouts of elasticity as during the 1970s-80s oil shocks. The importance here is not so much price, but price with respect to time.

Oil as Elastic

"From 1980 to 1981, the price of oil went from $11 to $35 per barrel. World oil consumption fell from a 1979 high of 51 million barrels per day to less than 45 million in 1985." Prices rose rapidly, and demand was squelched. During this move consumers were shocked by a 1 year, >100% price undulation. Consumers were unable to adjust personal lifestyles rapidly enough to compensate for the price increase. Additionally, suppliers were unable to subsidize refining capacity with alternative sources such as biofuels or new oil streams.

As a result of the 1980-81 shock, demand was suppressed. The elasticity of oil can also work in reverse as we saw during the 1990s. Decreased consumption in the 1980s and an increased in non-OPEC production from 15 million barrels in 1977 to 24 million in 1985 resulted in price stability in the range of $18-20. This depression of price encouraged many Americans to purchase gas-greedy SUVs during the 1990s economic expansion.

Oil as Inelastic

Even with a greater than 500% increase from 1996 to 2007, oil is still relatively cheap. According to economist Nigel Gault at Global Insight, "at $3 a gallon, it costs Americans only about 4 percent of their disposable income." With these prices, the consumer is capable of absorbing the price differential. More so, the consumer has had sufficient time to adjust life styles accordingly. Until now oil's upward accent has had limited effects on the average consumer. During the third quarter the economy logged its best performance in over a year and a half as the gross domestic product expanded 3.9%. This slow but deliberate progression has allowed consumers to buy more energy efficient cars, upgrade home heating systems and yes, even car pool. We are paying more for gas than we were a year ago, but we are able to do so with out significantly altering our spending patterns.

There however could be an inflection point. Eventually, either through price shocks, the emergence of alternatives or even a recession, demand for oil could decrease. Until that point, demand and prices remain high as the EIA expects consumption to grow by 14 million barrels per day from 2004 to 2015.

I am reminded of an experience just last week, where I actually had to wait at the pump for biodiesel. This scenario had never happened to me, and in retrospect it dawned on me. All of these consumers are waiting for biodiesel; not to be green, or to support our farmers, but simply because it is now selling at a discount to petrodiesel.

Biofuels and Avation?

Refueling in Flight, New York Times

As of last Monday, the race is officially on to test fly the world’s first commercial airliner powered by biofuels. Yes, you read the aforementioned sentence correctly. The ever creative and bipedal primate known as homo sapien is at it again. This time, we will attempt to fly an aircraft powered with refined plant matter 30,000 feet into the air. In theory, these turbines, traditionally run on jet fuel, can burn most types of compressed fuel such as diesel, hydrogen and methane. The moment of Zen however, won't be achieved until we take these theories and apply them practically.

During a press conference on Monday, Virgin Chairman, Sir Richard Branson announced intentions to test fly a Boeing (BA) 747 fueled by biofuels his Virgin Group was currently developing. Branson, a stanch activist for global warming, formed Virgin Fuels in late 2006 by investing US$400 million over three years for renewable energy initiatives.
Virgin and its development partners, Boeing and General Electric (GE) have targeted the test flight for early next year.

However, Branson is not alone. In September of this year, Air New Zealand announced an agreement with Boeing and Rolls-Royce Group Plc to test-fly their own commercial aircraft. The consortium intends to mix kerosene and an unspecified bio-fuel in order to power one of the four engines. The flight is set for late 2008 or early 2009, according to the BBC.

Seemingly unbeknown to flashy Bronson or the environmentally friendly Air New Zealand, a rather microscopic startup company by the name of Green Flight International and its equally tiny partner Biodiesel Solutions achieved notoriety when they successfully completed an "experimental test flight in an L-29 aircraft powered by B100," or 100% bio-diesel.

The two pilots, Carol Sugars and Douglas Rodante flew the Czechoslovakia jet out of Reno, Nevada, gradually blending ever increasing concentrations of bio-diesel until 100% utilization. According to the press release the green flight attained performance levels comparable to those achieved with traditional jet fuel and reached an altitude of 17,000 feet!

Green Flight International was founded in 2006 by Rodante, "to serve as a platform for future development in the use of renewable fuels in aviation and other sectors." Furthermore, the company anticipates the announcement of additional "record-breaking" events shortly.

These developments within the private sector come after record oil prices and announcements by the United States Air force to "certify the entire fleet by 2010 with a 50-50 mix," or even mixture of petroleum and synthetic fuel. According to the New York Times, the Air Force burned "3.2 billion gallons of aviation fuel in fiscal 2005, or 52.5 percent of all fossil fuel used by the government." These dynamics have made aviation an increasingly costly undertaking. Since securing safe and cost-effective sources of energy is of strategic importance to our national security, it has now become attractive to explore alternative resources for our jet fuel consumption, even if commercial use is some years away.

Disclosure: The author has no position in any of the aforementioned companies.

The Google Glow

On Thursday, a consortium led by Google(GOOG) launched an initiative to create a list of standards which would encourage open source programmers to develop software for Google's social networking site Orkut.com. In addition to Orkut, Google’s platform, OpenSocial, is said to be compatible across all of the member’s websites, including Friendster, LinkedIn, hi5, Plaxo, and Ning. The move is believed to be in response to a similar initiative by Facebook last spring, which lead to the development of 5,000 smaller programs capable of integration into individual users’ pages. Popular programs such as RockYou and iLike provide users additional customization within their individual page. Essentially, you get a "Subway sandwich" effect: Your site built with your specifications, hold the onions.

Since News Corp’s(NWS) $480 million dollar acquisition of Myspace in 2005, significant attention has been given to these social networking sites. Google’s own Orkut has a loyal following in Brazil and Asia, but has yet to generate much interest from American net-workers. Google hopes the addition of these smaller programs will have a remunerative effect on the site. As of August 2007 Google estimated a following of 67,000,000 users strong.

Driven by curiosity, I attempted to set up my own account with Orkut to see what type of social networking could be had in the greater Seattle metropolitan area. Using my Gmail account I was able to gain access to the site almost instantaneously. Due to time constraints, I was only able to perform a limited survey of the site. A user search for ‘Seattle, WA’ produced an abundance of single, 20-something males utilizing catch phrases and obnoxious quips such as, “single and ready to mingle” to spark interest from visitors. Comparing this to my previous experiences on Myspace and Facebook, it was apparent that Google’s site needed some new life. Jokes aside, Orkut sits at the tenth largest traffic-ranking spot on a global level. Additional, Vic Gundotra an executive at Google believes this enhancement rich software will perpetuate Internet traffic, enhance advertising, and in turn benefit Google.

Google's initiative comes a week after Microsoft announced a $240 million, 1.6% investment in Facebook. According to the New York Times, the deal values Facebook at an absurd $15 billion. Given that the company is projected to bring in $150 million in revenues this year, it becomes transparent that Microsoft might have paid a 'slight' premium. Although comparable to Orkut’s 67,000,000, Facebook's 50 million user base boosts an additional 200,000 members daily.

While this move shows desperation on the part of Microsoft, it reaffirms the importance of these social networking sites. For Orkut to gain additional market share in the US, it will need to distinguish itself among the competition. Google’s ability to differentiate itself from the competition has been its strong point. From strengthening its search algorithms and incorporating digital satellite imagery into mapping, Google was able to distinguish itself from established leaders such as Yahoo.com (YHOO) and Mapquest. By greatly enhancing existing services and products, Google was able to establish significant brand equity for themselves. For Google, the problem with Orkut may not be with its interface, accessibility nor design, but more so with its defunct, quasi association with Google. Perhaps the time has come for an Orkut name change?

Aramco Insider: Oil Structural Ceiling Reached

Production curve as predicted by depletion analysts

Many speculators, myself included, love to analyze Peak Oil or the plateauing and decline of global oil production. The problem however, with determining global Peak Oil has long been convoluted due to the inherent elusively of Saudi Arabia. Unlike the publicly traded oil conglomerates such as Exxon Mobil(XOM), BP plc(BP) or Total(TOT), Saudi Aramco isn't bound by full disclosure. Since Saudi Arabia has the world's largest proven reserves and Saudi Aramco is the world's largest oil producer, the theoretical peaking of Saudi Arabia could indicate the world’s peak.

For those unfamiliar with Peak Oil, it is the inevitable peaking of any given oil well, or the point of maximum production and subsequent decline. This theory was first presented in 1956 by an American geophysist, Marrion King Hubbert. His theory was initially scoffed at, but has since received notoriety as he accurately predicted the United States' 1970 peak.

Despite King's genius, experts are still divided on the validity of a global peak. Some argue that improved technology and greater exploration can prevent it, but the undeniable fact remains that the world's most technologically advanced nation, the United States has been unable to prevent it's own peak. With this premises it seems unlikely that the less developed world will be exempt from a similar fate. Still other, more optimistic critics argue that oil is somehow a renewable resource.

This week during an interview, former head of exploration and production at Saudi Aramco, Sadad al-Huseini disclosed that, "oil production had reached a structural ceiling and that the technical floor for the oil price will rise by $12 annually for the next 4 to 5 years as new fields become increasingly costly to exploit." According to al-Huseini, "the technical floor - the basic cost of producing oil excluding factors such as geopolitical risk and hedge fund speculation - is currently about $70 per barrel, meaning the minimum oil price could hit $106 in 2010 and $130 by 2012. Actual crude prices, including financial market factors, could be as much as $125 by as early as 2010."

This disclosure by Sadad al-Huseini is important for many reasons. First, it marks a rare instance of blatancy from a Saudi oil insider. Second, it presents additional validity to the theory of global Peak Oil. Finally, this omission aligns with other renown advocates like Matthew Simmons. With Peak Oil, hindsight truly is 20/20. We won't know our actual peak until we see it in the rear view mirror...



Listen to the interview with Sadad al-Huseini

(Problems noted with Quick Time)

After a Hiatus, the Diesel Commuter is Back

2006 Jetta TDI

No longer are the Prius and it's eco friendly associates the only fuel-efficient vehicles on America's streets and interstates. Long a major staple of European transportation, the compact diesel commuter is making inroads to a highway near you. Traditionally, diesels have been synonymous with large trunks and smelly, noisy Mercedes Benz. Unlike most stereotypes, this association has proven remarkably accurate. When fuel prices soared in the past, automobiles such as the Volkswagen Rabbit, and General Motors's(GM) Oldsmobile and ever iconic Cadillac models, were seen efficiently cruising commuters to and from their destinations. While these relics are now largely retired and or scraped, there is a new breed of quiet, super efficient, cleaner burning diesels emerging.

Volkswagen(VOW.DE), a trendsetter and respected innovator of diesel technology, has seen great success with its highly acclaimed Turbo Diesel Injected(TDI) engine. Originally appearing in 1989, within the Audi 100, this reliable and fuel-efficient engine recreated the idea of a diesel commuter car. Furthermore, it destroys the negative connotations and stereotypes associated with diesels of the past. I should note here, that I am writing from real world experience, as I personally own one of these cleaner burning TDIs.

Unfortunately, these stylish, spacious and fuel-efficient vehicles have been discontinued until 2008 due to tightening emission standards. Currently, only 45 states have approved the sale of these vehicles, but VW has announced that the TDI will return in 2008; freshly minted with improved emission and compliant with all 50 states’ requirements.

The Engine

The primary reason consumers have chosen diesels over the standard gasoline engine is due to superior fuel economy. Case in point, my 2006 TDI Jetta(manual) achieves 40 and 50 mpg compared to the 21 and 29 mpg attained by VW's 2.0L gasoline counterpart. This is achieved by two methods. First, the inherent British Thermal Unit(BTU) content of diesel is much greater than that of gasoline. Essentially, this means there is more energy content per unit measured. Secondly, diesel combust fuel in a much different manner. Unlike gasoline, diesel engines compress air within their cylinders. Once the point of maximum pressure is achieved, fuel is injected and instantly combusts with the highly compressed air. Since these engines are higher pressure systems, they must be built to endure the additional stress. This is the reason we are still privy to 30-year-old VW rabbits and seemingly paleolithic diesel Mercedes Benz.

Emissions

Like all hydrocarbon combustors, these contemporary diesels produce carbon dioxide and associated smog creating pollutants. However, due to the superior fuel economy inherent to these diesels, on a direct mile-to-mile comparison they emit much less carbon dioxide. If this is true, then why are existing diesels only permitted to be sold in 45 of the 50 states?

As diesel burns it creates particulate matter(PM) such as soot and aerosols as well as nitrogen oxides(NOx), which cause the formation of ozone and other fine particles. Due to stringent EPA emission regulations(PDF) from the 1980s, the tolerable level of these byproducts has greatly decrease and it set to decrease further again with 2007-2010 legislation. The dynamic however changes if diesel commuters use biodiesel in their engines. According to the National Renewable Energy Laboratory(PDF), use of B100(100% biodiesel) cuts NOx by 10% and PM by 48%. Furthermore, diesel engines and their superior fuel efficiency contribute fractionally to carbon dioxide, the major gas attributed to global warming.

The Industry

Unfortunately for General Motors(GM) and Ford(F), it appears as though the US automakers are once again behind the curve. According to CNN, neither Ford nor GM have plans to sell SUV or diesel passenger cars again in the US. The companies claim, the endeavor "wouldn't be cost-effective, because existing diesel cars sold in Europe aren't sold within the US and the current US market is too small for additional development." As for the rest of the industry, everyone from Honda, Volkswagen, Mercedes Benz to BMW are either selling or planning on selling diesel passenger cars and SUVs. Even the often-marginalized Korean auto firm Hyundai has plans to introduce an SUV to the US by 2010.

For GM this inability to adapt is all to reminiscent of its hybrid debacle. Since 2003, Toyota's(TM) Prius has set record year over year sales. At the same time, GM continued to endorse it's higher margin vehicles such as trucks and Hummers. Now, 7 years since the first Prius rolled off the lot, GM finally has its own hybrid lineup. Unfortunately for GM, their plans to introduce hybrids might be futile because while marketing my say 'hybrid', consumers may hear 'Prius'. GM's plan to avoid the diesel car market could prove to be yet another disappointing milestone in this manufacturer's withering legacy. We will have to wait to see if and when GM responds its competitors inevitable success within this new market. The moral of this story? Recognize a shifting paradigm before it drives over you.

Disclosure: The author has no position in any of the aforementioned companies.