Obama's Housing Plan - A Turning Point?

My last couple of posts have dealt with what I feel is needed for the economy to turn the corner and start the path to recovery. Although I didn't initially intend to start a series of posts on economic recovery, I think that with the recent flow of news coming out of Washington and Wall St. it's appropriate to continue this series with at least one more post.


One of the key points that I've continually advocated that needs to occur for an economic recovery is stabilization of housing prices. This basic phenomenon is what I feel will impact other key areas of the markets and allow the economy to recover. Earlier this week, Pres. Obama announced a $75 billion dollar plan to help troubled homeowners with their mortgages and avoiding foreclosures. Although stabilizing housing prices is not a stated goal of the plan (it's more to help troubled borrowers), I do feel that this plan is a good first step in that direction.


What Does the Plan Do?

Let's take a high level look at the highlights of the plan:

1. Refinancing Requirements - The plan will change the requirements to refinance a home to make it easier for homeowners to refinance to today's extremely low rates. Generally, a homeowner' s mortgage must be less than 80% of the home's overall current equity in order to qualify for refinancing. However, due to the severe drop in home prices, many homeowners now owe greater than 80% of the home's current value through their mortgage. With this plan, the 80% requirement is increased to approx 105% - as long as the homeowner is current on their mortgage payments and the loan is conforming (i.e. securitized by Fannie or Freddie). This means that even if your mortgage is worth more than your home and you've been able to make your payments, you are eligible to refinance your home.
2. At Risk Homeowner Initiative - The meat of the plan really is in the stability program for at-risk homeowners. This $75 billion dollar plan is aimed to help homeowners whose mortgage payments are an excessively large percentage of their income - either due to monthly payments that have increased due to adjustable rate mortgages, or loss of income due to a layoff, injury, etc. In this plan, the borrower would work with the lender to modify the mortgage in order to reduce monthly payments to at most 38% of the borrowers monthly income. The government will then step in and subsidize the mortgage in order to reduce the payments further to 31% of income. One thing to note is that this plan is strictly voluntary for the lender and they do not have to participate. However, if they do, then the government will pay the lender $1,000 per modified loan, plus another $1,000 per year for three years if the borrower stays current on the loan. Plus, if the borrower stays current on the loan, he/she will get $1,000 in tax incentives per year for 5 years.
3. Fannie/Freddie Strengthening - Finally, the plan also provides financial assistance of $200 Billion dollars to both Fannie Mae and Freddie Mac - the government agencies that help subsidize mortgages, thereby allowing for lower interest rates. This will help provide stability to the troubled organizations allowing them to continue supporting the US housing market.

My Thoughts on the Plan

I really feel that this plan is an excellent first step in the economic recovery process. As I've repeatedly stated, housing price stabilization is the key component in the economic recovery process. This plan is the first significant and detailed step towards creating this stability. With that said, however, I think there are some significant gaps in the plans themselves. There's always the obvious question as to whether the government should be stepping in and artificially supporting the markets as it is in this case, especially this late in the process. There's no doubt this is an expensive plan (although most of it will be paid through the existing TARP funds). But at this point, in order to stop the bleeding in the economy, the government needs to backstop the slide and provide a clear message in order to restore confidence. I think this plan is a good step in that direction.

Another glaring weakness in the plan is there is no provision for the government to get its money back if the market recovers. If in the next few years, housing prices recover and homeowners end up profiting from the plan more than expected, the government will not be able to reap any of those rewards.

Finally, another gap in the plan is that many homeowners that are current on their mortgages and are not distressed borrowers will not get any sort of aid in the plan. In a sense of fairness, I believe that incentives should have been placed for these types of owners to be able to refinance their mortgages at a lower cost. Otherwise, this plan reeks of welfare to those that were either irresponsible borrowers, are had misfortune in their lives (there's no distinction in this plan for those types).


All in all, if this plan is successful, I think we'll see a quicker stabilization of housing prices than we would have seen without it. The plan is supposed to get rolling by March 4th, so I hope to see significant participation by this summer. On a macro lever, this will hopefully result in housing prices beginning to stabilize by the end of summer or early fall with a resulting significant recovery in the markets by the end of the year.


Questions/Comments/Feedback?
Please don’t hesitate to let me know of any questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!

The Standard Disclaimer:

The stuff I just wrote above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I’ve said above. This includes consulting with a financial advisor.

Housing Prices Article

So to relate back to my last post on how housing prices are an indicator of the economic recovery, take a look at this article:

http://biz.yahoo.com/ap/090212/metro_home_prices.html?.v=10

Highlights:

• Home Prices continued their decline in the 4th quarter of 2008 (when compared to Q4 2007)
• Sales are up in the hardest hit areas
• Number of foreclosure notices fell when compared to Q3 2008

What does this mean to me?

Well, I think it reaffirms my original thought that we're still a long ways away from a economic recovery. As I said before, stabilization of housing prices is key in so many ways for the economy. Since we're not seeing this yet, I don't think we're going to see any economic recovery.


But hold on, there are some signs of hope. If the number of foreclosure notices fell last quarter, it would be reasonable to assume that the number of foreclosures may also decrease. If that indeed does happen, that would be a great first step in the right direction in stabilizing housing prices. Let's hope we see this soon!

PS: Check out CNBC's documentary tonight on the economic crisis. David Faber is an awesome reporter and I'm sure it'll be very interesting! Check it out at 8 pm EST tonight!



Questions/Comments/Feedback?
Please don’t hesitate to let me know of any questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!

The Standard Disclaimer:

The stuff I just wrote above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I’ve said above. This includes consulting with a financial advisor.

Where I Think The Economy is Headed

Probably one of the most common questions in everyone's minds right now is 'Where's the light at the end of this economic tunnel?' This is a questions that is as difficult to answer as it is relevant. There are so many variables that come into play when determining the health of any economy - things like manufacturing output, employment, savings rates, etc. etc. etc. all play their part. Investors, who's job is essentially to play soothsayer in order to determine where their investments are headed, generally look at a few key economic indicators to determine where the economy is going. I'll explain a few of these and tell you my thoughts of where we're going

What Indicators Matter

If you watch CNBC for a couple of hours (not like I do that at all...not at all) you'll probably hear about some sort of 'economic indicators'. Although it is important to understand what the indicators mean, it is just as important how they relate to the health of the economy. Some are leading indicators - those that generally predict the future health of the economy. Others are lagging - those that change direction after the overall economy does. When trying to predict the direction of the economy, it is important to make sure you're making the right assumptions when using indicators.

Leading Indicators - These indicators will generally start going positive (bullish) early on when the next recovery takes place.

1. Wholesale Inventory/Sales - This number describes the overall inventory wholesalers are keeping in their warehouses. Generally, sales start dropping first and inventories soon follow as wholesalers cut back assuming sales declines will continue. The most recent inventories number was the lowest in 17 years and sales were still declining steeply
   
2. Housing Prices - Especially in this recession, housing prices and their direction, will largely dictate many other aspects of the economy. Intangible indicators like consumer sentiment, and business confidence will likely stay low if the value of homes continue declining. So far, housing prices continue to decline, albeit not as fast as they were last year.
3. The Stock Market - You might not realize it, but when trying to figure out the health of the economy, the stock market is a great leading indicator. The reason for this is because the market pretty much gives a picture of where investors think the economy is headed. They try to take into account all these indicators and make a judgement, whether it's up or down. Right now, the markets are still near the lows for his recession. However, they've been near the lows for several months now without breaking lower, indicating that investors may think the economy is at a low itself, but isn't ready to recover yet.

Lagging Indicators - These indicators will turn positive once the economic recover is well underway.

1. Employment - Companies hire and fire as a reaction to where they feel their business is headed. Generally, they want to have a pretty clear picture of the economy before hiring or firing employees. Therefore, employment figures generally trail the economic recoveries as businesses will wait to see some signs of the recovery before hiring again. Personally, I think the rate of unemployment increases is reaching a peak because of the panic layoffs that occurred late last year and early this year. I see the unemployment rate (which stands approx. 7.5% now) staying around 8% for a while until a recovery begins.
2. ISM - The Institute of Supply Management generally measures the manufacturing activity of the country. Manufacturing demand determines activity, and consumer demand determined manufacturing demand. Therefore, the ISM numbers will not increase significantly until consumer demand does.
3. Baltic Dry Index - This is a little less known, but I think still important index. It measures the international shipping rates for various dry goods, ranging from coal, to corn, to cars. I think it's an important index because, although it's a lagging indicator, it's one of the closest to being a leading one due to its elasticity. To me, it's the first lagging indicator to turn positive during a recovery. Interestingly, the index has experienced a strong rebound in the last month or so of over 10%.

Where I Think We're Headed -


With those indicators said, my thoughts on where we are in the economic cycle generally says that we're on the trailing end of the downturn. Although many of the leading indicators are still decidedly negative, they have been so for quite a while, and I expect some of them, namely housing prices to stabilize in the coming months. Properly exectuted (key word: properly) government intervention (i.e. TARP) can help speed us to the end of the downturn. However, just because we are coming to the end of the downturn, I don't think we'll be heading for an upturn soon. I think we're going to stay at these lows for at least the first half of this year, perhaps even all of it before we really start seeing some of those leading indicators recover. With that said, I believe as an investor, there are some really good opportunities to take advantage of now, namely very high quality banks, before the leading indicators start trending upwards again. The light at the end of the tunnel is there, and we can see it, it's just going to take some time to get to.

Questions/Comments/Feedback?
Please don’t hesitate to let me know of any questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!

The Standard Disclaimer:

The stuff I just wrote above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I’ve said above. This includes consulting with a financial advisor.

Reader Question - Where to Put Your Money Now

I wanted to discuss a topic some investingdecoded readers have been asking lately. The question to where to put your money now is something that's more ambiguous than ever - there's just so much uncertainty out there that it's hard to say where the market will be in 1 month, let alone 1 year. However, there are some basic principles that I feel that everyone should use when investing their money. Just because there's more uncertainty doesn't have to mean there's more complication. Following some basic rules can ensure that you're not making common mistakes that many investors make.

Always keep your outlook in mind

Whether you're a recent college graduate who has just started a new job, or a experienced professional approaching retirement, your investing strategy should always correlate to your outlook. Every investor needs to understand his/her risk profile and tolerance before buying a single stock - if you're investing your nestegg and may need the money in a relatively short timeframe (e.g. retirement is a couple of years away), you should make sure that you don't invest in areas where there's a great deal of short term volatility. On the other hand, if you're investing some of your savings and will likely not need the money soon, you're probably better off investing in something with a higher risk profile but with greater potential rewards.

Do Your Homework

Once you've established your outlook, take some time to research what you're investing in. To a certain extent, investing is always a form of gambling. But doing proper research can greatly change the odds into your favor. In future posts, I will write more about how I do my research. But for now, I'd like to say make sure you understand what you're investing in. Several hours per stock before buying it is a minimum. This includes researching analyst reports, historical events, and annual reports. With this information, you should develop a risk/reward profile and make sure it fits with your outlook.

Have an Exit Strategy

A common mistake that even I sometimes make is not having a well-defined exit strategy. Before even buying a stock you should have a good idea of when you want to sell it. Even I make this mistake often. Sometimes I just fall in love with stocks and hold them longer than I should. It's important to have the discipline to come up with an exit strategy and hold to it. You may lose some upside...but you'll lose a lot less sleep.


Those are three basic principles that I think everyone should follow. They are a little vague right now, but I'll try to elaborate further in future posts.

The next natural question that comes up is where to invest. You may have established your investment outlook and the levels of risk you can tolerate, but where can you invest and what are the risk/reward profiles like in those investments? Here are a few general investments and associated profiles:


1. Stocks - The most commonly known investment is equities - better known as stocks. These are easy to get in and out of, have a good potential return, and, for people like me, are a lot of fun.

• Pros - Near liquid investment (easily sold in case you need the cash, often in 48 hours). Potentially high return. Usually available on well-centralized markets so they're easy to buy and sell
• Cons - Usually a fairly risky investment - can easily go to 0. Stock holders are usually the last to get any money if the company declares bankruptcy. A little more difficult to find good deals since the market is so liquid. It's much harder to find good stocks than to actually buy any stocks, often resulting in mistakes among investors

2. Money Market - The most common version of a money market account is your savings account. It's a place where you put your money and expect to be able to easily access it later.

• Pros - Safe investments that are still liquid. Usually offer a return (instead of just holding the money).
  
• Cons - Returns are generally very low compared to the potential returns in the stock market or other areas.
  

3. Bonds - A slightly less common investment vehicle for small time investors like me, bonds are essentially buying debt for either the government of corporations. Bonds can be a good compromise investment between stocks and money market accounts.

• Pros - Offer a better return than money market with less risk than stocks. Bond holders have earlier claims to money than equity holders when a company goes bankrupt. Usually offer a fixed rate return
• Cons - Somewhat difficult for individual investors to directly buy bonds.
  

4. Real Estate - Pretty self-explanatory. Buy land, house, condo, etc and sell it later or rent it out.

• Pros - Historically a very well yielding investment when held for the long term (yeah, might be hard to believe right now, but it's true). Strong asset since you're buying a physical piece of property (in case you want to use it as collateral for other purchases)
• Cons - Usually high initial cost (down payment, etc.). Usually need a long time before investment returns are positive. Not easy to sell if you need the cash.
  

5. Options - Similar to futures, options are a good way to leverage your money to make more. You can buy/sell options for pretty much anything, but it's most commonly done for company stock

• Pros - Easy way to multiply gains substantially
• Cons - Very risky since the Options themselves don't have any inherent value (they're just contracts that eventually become worthless). Usually very volatile. Can be very complex.

6. Mutual Funds/ETF's - Instead of buying a specific stock/bond etc., it's common for investors to buy baskets of various types of investments. Depending on the type of basket, investors usually buy a Mutual Fund or ETF.

• Pros - Easy way to diversify your investments and reduce downward pressure due to volatility. Easily available and, although not as liquid as stocks, still easily accessible.
• Cons - Management fees take a bite out of principle whether you make money or not (usually 1-2%). Diligence required (at least the same as stock research) before buying).

7. CD - Certified Deposits, usually available at your banks, is similar to a money market, but not as easily accessible. You basically guarantee the bank that you'll keep your money there for a certain amount of time, and, in turn, the bank guarantees you a higher rate of return. The longer you promise to keep it there, the more return they will give you.

• Pros - Safe investment that has better returns than regular money market accounts.
• Cons - Money is locked away and inaccessible (without penalties) for a period of time.
  

The above are a few different examples of how you can invest your money. Most asset managers will tell you that you need a combination of them to be properly invested. Depending on you outlook, you should have more or less of some or all of those categories in your portfolio. Let me know if you need help allocating yours and we can chat!

Questions/Comments/Feedback?
Please don’t hesitate to let me know of any questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!

The Standard Disclaimer:

The stuff I just wrote above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I’ve said above. This includes consulting with a financial advisor.

Stock Discussion - WFC Revealed

There you have it folks, the results from WFC came out this morning and we had some good news! Let's take a look at the results:

As we discussed on the last post, WFC was expected to earn $.033 for the last quarter on $11.65 billion of revenue. Actually, they missed both numbers....badly. Instead, they recorded a LOSS of $.79 a share and revenue of $8.93 billion. They took billions of dollars of writedowns to account for future loan losses associated with the weak housing market as well as the acquisition of Wachovia.

So the stock was probably taken through the ringer, right? Wrong...actually, the stock was UP 30%! Why is that? Well, that's because as bad as the results were, they were the exact opposite of the results another seemingly strong bank (Bank of America) had earlier in the month. Let's break down the reasons why:

• The dividend was not cut - like I mentioned earlier, there is an expectation that the dividend will get cut substantially to beef up capital reserves. They didn't do it this quarter. It doesn't mean they won't in the future, but the fact that they don't have to do it now does give a vote of confidence.
• Aggressive Loan Loss Reserves - WFC is accounting for huge future losses over the next few quarters. But they're accounting for them now...not later. Only a strong bank would be able to do this...the conservative management team that I had mentioned in my previous post is taking it's losses early so it can have good growth later.
• No Surprise Losses - The Wachovia intergration is going as planned, and there doesn't seem to be any hidden losses outside of what WFC was planning for. Unlike the Bank of America/Merrill Lynch deal, this one looks like it will be good for WFC in the long run.

As mentioned in the article below, ""They are aggressively writing down risky assets in both the Wachovia and Wells Fargo portfolios, especially the toxic Pick-A-Pay loans that let the borrower determine how big or small the payment will be," Bart Narter, senior VP of Celent Banking Group," This aggressive strategy that management is taking is exactly why I bought this bank instead of the others and is what has kept them successful over the years.


The stock was up 30% today due to the not bad news. But I sitll think, long term, the company has a great deal of value to unlock. Deposits were up a record 31% last quarter - something I mentioned is key for banks when they are trying to grow. The expanded branch network gained from the Wachovia merger, along with weakness from competitors, is sure to help that deposite base grow even more. I'm holding on to this stock. It'll be a roller coaster, but I think it'll be a fun one!

What do you think? Is WFC a buy?

The full story can be found here:
http://www.thestreet.com/story/10460422/1/wells-fargo-takes-wachovia-losses-head-on.html

Questions/Comments/Feedback?
Please don’t hesitate to let me know of any questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!

The Standard Disclaimer:

The stuff I just wrote above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I’ve said above. This includes consulting with a financial advisor.

© 2009 Sahil Bhatia

Stock Discussion - WFC

Check out the new poll! ------------------->>>>>>>>>>>>>>>>>>

Today I want to discuss a particular stock, Wells Fargo (NYSE - WFC). I think this company is a good microcosm of the financial crisis and can provide some unique insights to the financial crisis. Another reason I want to talk about it is because I own it personally, and tomorrow is a big day for WFC because it's coming out with quarterly earnings tomorrow morning. These earnings will be immensely important for reasons I will soon discuss.


What Does WFC Do?


WFC is a major financial institution engaging in a variety of banking activities. It has some retail branches, primarily located on the west coast and some in the midwest. However, a big chunk of its business comes from the mortgage industry. In fact, it's the world's second largest mortgage lender which, at one point last year had a mortgage portfolio of over $83 Billion.


What Makes It Different from Other Banks

During the real estate boom years which lasted most of this decade, WFC maintained a significantly more conservative risk profile than many of its competitors. It did not get heavily involved in the MBS market and maintained strict lending standards that, although prevented it from making the vast sums of money during the boom years that some of its competitors did, also helped it whether the downturn much better. The chart below shows the 2 year performance of WFC compared to the general banking index. As you can see, it has, for the most part, outperformed it's competition thoroughly:




Why the Recent Price Drop - A Tale of Two Banks

As you can see, WFC's stock price has dropped percipitously in January. Although the price is consistent with the industry's performance, I just said that the company is head and shoulders above its industry, so it should perform better, right?

Well, that would be true if it weren't for one thing - in the fall of 2008, WFC acquired a major competitor that was well on its way to becoming the next Lehman Brothers. Wachovia Bank, at one point the 4th larget bank in the US, suffered greatly through the financial crisis due to its exposure to the toxic financial assets. When it's prospect looked bleak last September, both Citigroup and WFC made competing bids to buy the company. WFC eventually won the bid because it offered signficantly more money than Citi and did not really on government support unlike Citi's offer.


This midnight deal gave a huge boost to WFC's branch network and deposit base, which is now estimated at almost $1 billion dollars. However, concerns arose around the toxic assets that WFC was also acquiring and if the company performed the necessary amount of due diligence to really understand what they were buying. These concerns came to a head over the last couple of weeks when Bank of America, who recently made its own major acquisition of Merril Lynch last year, revealed huge losses ($15.3 Billion) stemming from the takeover and prompted the Charlotte, NC based bank to ask for more government TARP money. Furthermore, B of A also cut the dividend it pays to investors to just $.01.

This news spread to WFC as well since the acquisition was made under similar circumstances - last second deals at the height of the crisis. Investors are worried that WFC will come out with similar results and may need to take a huge loss associated with the Wachovia deal now that WFC has had the time to digest it a little.


Why I Own The Stock

Many of you are probably asking why I would even think about buying a bank stock in this enviornment. In fact, I've been asking this a little myself with the recent performance of WFC I bought WFC last July at about $24 a share. After rising to almost $40 during the fall, it has since fallen to its current level of about $16. Well, here's a list of why I bought the stock:

• An unmatched record of ethical and stringent lending practices - the company is famous for it and, since the company doesn't get involved in the risky stuff, it provides better rates for it's higher credit mortgages. In fact, my parents have had 2 mortgages their lives, and both have been from WFC
  
• Increased Deposits During the Recent Storm - With other banks going under, more people have been moving their money to WFC. This positions the bank strongly to lend and grow once the enviornment gets better
• Well Respected Management Team - This is somewhat related to the first point, but the management team at WFC is comprised of longtime WFC veterans that closely follow the banks philosophy - thereby reducing the chance of a drastic departure.
• Warren Buffet Believes in it - Yeah, as cliched as it may sound, Warren Buffet is the single biggest shareholder of the company with an almost 11% stake through Berkshire Hathaway. My investing philosophy closely follows his, so it is a vote of confidence.
  

With those high level points (there was quite a bit of number crunching involved, but I'd rather not bore you with those), I really feel that WFC is a good investment for the long term. This is why I didn't sell the stock when it almost hit $40...I really feel that WFC will be able to take good advantage of a recovery with is positioning itself to become a major banking player.


What to Expect Tomorrow

Tomorrow morning, WFC will come out with earnings which are expected to be at $.33 a share on revenue of $11.65 Billion. Although these numbers will be important, the market will also be closely listening to any indication as to the state of the Wachovia integration and any new losses stemming from the acuisition. If WFC can manage to dodge a bullet and hold the guidance they've previously provided on the deal, I can see the stock moving up significantly (10%+) as it will be a big sigh of relief. But I also think there's a good chance that WFC will be conservative in its results and write down all potential losses as early as possible in order to promote long term growth (this strategy is what convinced me to invest in them in the first place). Therefore, I wouldn't be surprised to see a big miss on the earnings front due to a large writedown, but promising future guidance.


We shall see what comes out of tomorrow's earnings release. Keep checking back on investingdecoded - I'll definitely share the news when it comes out.

Questions/Comments/Feedback?
Please don’t hesitate to let me know of any questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!

The Standard Disclaimer:

The stuff I just wrote above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I’ve said above. This includes consulting with a financial advisor.

© 2009 Sahil Bhatia

The Oil Game - Don't Get Too Comfortable (Part II)

Before I get started on today’s post, I wanted to mention some great feedback I received from a reader recently. This person mentioned that, although the information on my post is extremely insightful and great for anyone to read, the style of the writing can sometimes come off as a little difficult to read. As I’ve said since day 1, I value any feedback I can get for my blog. After all, the whole point of it is to make readers more aware of the investing world and relate the major events in the investing world to real-world impacts. I’d like to thank that person (You should know who you are J) and invite everyone to offer any sort of feedback, whether it be for writing style, topics, structure, anything at all. I’ll try to incorporate the feedback as best possible.

With that said, let’s go on to the conclusion for the Oil Industry….

With the last post, we learned the details of the oil industry and how it works. Forgive me for sounding like a textbook in that post, but I feel that it’s important for people to know about the industries they’re investing in. Much of what I mentioned during the post should be known by anyone buying an oil stock. Like Cramer says on ‘Mad Money’, do your homework! If you don’t understand the company you’re investing in, then it’s nothing more than gambling. Before I give my opinions on any industry, I want to make sure that people understand where I’m coming from, thereby making sure that people understand where the opinion is coming from.

We learned that the price of oil, and the corresponding fuels created from it, is largely determined by investors and traders on the futures markets. These investors take their own as well as their clients’ money, along with their understanding of the oil industry, and buy and sell futures contracts for the sole purpose of making money. There’s nothing really that special about oil in that sense. They do this with all types of commodities. But, the price that oil is trading at directly affects the price you pay at the pump. Until the summer of last year, the price of oil had gone on an unprecedented rise. A barrel of oil (the unit in which oil trades which equals about 42 gallons) rose to almost $150. This was well beyond its historical norms between $20-$40 a barrel. This resulted in a price rise at the pump, as I’m sure most of you already know, of almost $4 a gallon for regular unleaded.

Now, I really feel that there are many reasons for the rise – some justifiable, others questionable. The justifiable reasons were driven by a fundamental demand scenario – the emerging markets like China and India were experience huge growth that changed the supply/demand structure of the oil market. These countries demanded huge amounts of oil and this increased demand led to a natural increase in price. But did it justify $150 a barrel oil? I don’t think so. Instead, I really feel the justifiable price is more around $70/barrel. This price really accounts for the changed supply/demand landscape that China and India have caused. Furthermore, contrary to what many people may believe, there is no imminent shortage of oil available in the world – the current projections say we have plenty of oil for the world until at least 2030 – despite the increased demand.

You might then ask why would oil rise to $150 when the fundamentals only said $70. Well, let’s go back to the concept of the investors playing a big part in determining the final price of oil. Many of these investors are banks and hedge funds (money managers who invest billions of dollars for very rich people using extremely sophisticated investing strategies). Remember when we talked about how banks worked and the ‘L’’s – leverage and liquidity? Well, the huge amounts of leverage and liquidity available to these banks had other impacts than just housing investments. The financial instituations poured billions upon billions of dollars into the commodities markets as well. They were able to buy futures contracts at higher prices than the fundamentals dictated knowing that someone else would probably come along and buy it at an even higher price. They could ride the upward momentum in price as long as possible and still make money through it. The amount of cash the investors had caused an artificial increase in demand for the oil futures, but not necessarily for the oil itself. This demand caused a surge in prices which proliferated through the energy complex resulting in higher gas and energy prices for everyone. There was also very little decrease in the demand for energy despite the increase in prices, consumers just coughed up the extra cash to put gas in their SUV’s since even they had fairly easy access to liquidity through the housing boom. The prices acted like a ‘tax’ to the consumers that, for several years, were willing to pay.

Other than the investors, other beneficiaries of the higher oil prices were, of course, the energy companies. Due to the higher prices, the profit margins for these companies grew dramatically, making the industry one of the most profitable in the world. Also, the countries from which the oil came from became vastly richer. Of the $150 for the barrel of oil, a large proportion (my guess would be 30%+) went to the country from which the oil came from. As oil tycoon turned renewable energy promoter T. Boone Pickens said, this resulted in the largest transfer of wealth from one region of the world to another (the middle east where most oil comes from) in the history of mankind.

After the boom years were over, and banks began to lose all that capital they were able to raise, there was going to be a natural decrease in oil futures prices. This, coupled with the natural decrease in demand that comes from any recession, has caused oil prices to drop dramatically to their current level of about $35 a barrel. However, don’t get too comfortable with these prices. I still believe those futures traders have a big part to play here as well. Like I said, fundamentally, I feel that prices should be around $70/barrel in the long term. But because these investors lost so much money in other areas, they have been forced to liquidate in previously profitable areas – namely oil – to cover capital positions. Futures contracts have been glutted into the market with sheer lack of demand, causing artificially low prices.

The Bottom Line

Bottom line, once the banks stabilize and investors come back into the market in full force and more cash, I can see oil easily going back to $50-60 a barrel. Furthermore, once the economy begins to recover, I see oil going to a fundamentally sound $70/barrel over the next 2-3 years. All this results in pump prices for people to average a little less than $3/gallon for the long term.

Disagree with me? Don't keep it to yourself. Let’s start a dialogue.

Questions/Comments/Feedback?
Please don’t hesitate to let me know of any questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!

The Standard Disclaimer:

The stuff I just wrote above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I’ve said above. This includes consulting with a financial advisor.

© 2009 Sahil Bhatia