Random Musing: Airlines Still Failing & Upscale Outlet

Northwest Tries To Save $100 Million A Year
Northwest said it would try to save $100 million a year through "cost reductions, productivity improvements and revenue enhancements." One part of this plan calls for 5% reduction in its domestic schedule. However, Northwest said it said it would not seek pay cuts. Northwest currently has $3 billion in cash at the end of 2007 as cushion against future losses.

Emerging Risk Event: Employing Failed Strategy To Reduce Costs. One would think that Northwest, having come out of bankruptcy, would have looked at what Southwest was doing right and try to emulate its efficiency. After all, bankruptcy is a great place to streamline workforce and get concessions out of the unions. Instead, Northwest is going to try the same cost cutting strategy that didn’t work for them, United, Delta, American, and other major carriers: cut costs, reduce domestic schedules, and added fuel surcharges (another way to say fare increase without the stigma) to their profitable international routes. I guess these airline company executives haven’t learned anything from their mistakes.

Required Corrective Action: Drastic times call for drastic actions, such as:

• Increase the fuel surcharge on domestic flights by $50 each way
  
• Charge $30 for each checked bag, after the first checked bag
  
• Charge $20 surcharge if the total weight of a passenger’s carry-on items is more than 40 pounds. (Who in their right mind would carry more than 40 pounds on-board?)
  
• Cut back on the beverage service choices to just three soft drinks, water, coffee, and two beers (no alcohol on flights shorter than 2 hours; yea, it's tough but if you need to drink alcohol on short flights, then you have bigger problems.)
  
• Stop offering snacks. This was a way to cover for the previously offered meals but it really does nothing but make a mess, cost money, and gets people missing meals again

Then use some of the money saved to provide the following services:

• Provide free gourmet, bagged meals to passengers at the gate, say at a price of $10 per passenger, including a bottle of water. Passengers can eat at the gate or carry it onto the plane.
  
• Offer free movies again. Each plane carries the video equipment already. So, given them some generic news channel or PG rated movie. Even on flight less than 2 hours.
  
• Provide free newspapers on board. Tribune Company and Metro International offer free dailies. So, why not work with them to provide free newspapers to your passengers?
  
• Install computer stations at the gates and offer 20 minutes of free web access to each checked in passengers. All a passenger has to do is enter in the ID number from their boarding ticket and they are surfing the web
  
• Provide passenger education on the reason for the changes and how, overall, it benefits them

By offering added value service that other airline carriers do not offer, Northwest can differentiate itself from the competition. While passengers may stifle at the drastic changes, once they understand that the tradeoffs benefit most passengers since most of us road warriors know how to pack. Those blockheads who decide to lug a large duffel bag or an oversized roller bag as their carry-on will pay the price, as they should. In the long run, we will have faster on-boarding and off-boarding time as well as a peace of mind knowing that some idiot is not destroying your bag by trying to cram an oversized bag right next it.

Will Northwest take the courageous path? I doubt it. Most likely they will cut more service and piss more passengers off. It must be a corporate mentality that I will never understand.
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SkyBus, the “Wal-Mart of Air Travel” Died A Quick Death
Just shy of its first year anniversary, SkyBus died ignobly today. The ‘pioneer’ of air travel that experimented with al a carte pricing and selling advertising on its planes just didn’t calculate that they needed PROFIT to stay alive. It's one thing to say that you want to be like Wal-Mart but just saying it doesn’t make it so. One thing that people forget when they try to emulate Wal-Mart’s business model is the sheer size of their purchasing power. Attempting to undercut on price while flying only 74 flights to 15 cities does not make you a Wal-Mart. (Here is Wal-Mart’s fact sheet)

Perhaps, if all the U.S. airline companies merged together and started to under cut the international carriers, then one can begin to make a comparison to Wal-Mart. Until then, you are not even Sears.
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Beer Version Of the March Madness: Hook & Ladder Backdraft Brown, the beer that I was rooting for beat out Raven Lager to win the second annual Beer March Madness. Way to go guys! Now, I am really jealous of the guys living in Baltimore. They get to enjoy the champion and the runner up at most pubs.
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An Economic Oxymoron: Upscale Outlets
These retailers can come up with ingenious ways of marketing their brand. Millions of shoppers have been going miles out of their way to outlet centers featuring upscale brands. Companies like Chelsea Premium Outlet, Prime Outlets and Tanger Outlet Centers turned this into a moneymaker with outlet malls throughout the U.S. Initially these outlet malls bought damaged (often labeled as ‘irregular’) or unsold merchandises from manufacturers and department stores, respectively. To avoid competing directly with department stores, these outlets were often located at the outskirts of a city or in a secondary city close to a major one. However, as their business model became more lucrative, brand names began making clothing lines just for the outlets. Now, these bargain basement irregular retailers have moved to the first floor and are competing directly with the department stores and major discount stores.

So, what’s the oxymoron? It’s this: How can it be ‘upscale’ if it at an outlet?

Also, just because you stick on a brand name logo on inferior products, doesn’t make it so. Look at the history of Izod Lacoste, LA Gear, Bonjour Jeans, etc. They started with good product, built up a brand name, and then started cutting on quality, eventually going into history or coming back a shadow of their former self.

Another oxymoron: If a brand name makes products exclusively to be sold at an outlet mall, then is it really an upscale product?

Tommy Hilfiger, Geoffrey Beene, and Saks Off 5th Avenue are few of the brand names that have different clothing lines specially designed and marketed for the outlet centers. So, if you buy a Geoffrey Beene shirt for $15, does it mean that you bought the same quality shirt that retails for $52.50 at Macy’s? I think not. If you are not convinced, take your outlet shirt and go to Macy’s and compare the stitching and fabric. The same goes for Hilfiger shirts. At least Saks comes right out and states that their ‘Off 5th“ is a discount brand.

Now, outlets have great bargains, especially at the very high end; however, you are buying off-season items. But who cares? A lot of the very high end products really do not have a season. So, hop on a bus or drive to your nearest outlet mall and join millions of fellow shoppers hoping to pick up a bargain. Whether or not these are a true brand name quality product or not doesn’t really matter if you like what you bought. However, if you do want to opt to buy truly brand name products at off-season prices, go to the original, Filene’s Basement or if you are ever in New York City, come to Century 21.

Have a Great Weekend!
Regards,
Ed Kim
riskyops.blogspot.com
DISCLOSURE: The author makes frequent visits to Century 21
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More Indications Of Bush’s Mismanagement Of The U.S. Economy

Fact Tidbit: George W. Bush is the first U.S. President with an M.B.A. Ironic, isn’t it?

Payrolls shrank by 80,000, more than forecast
Employers in the U.S. cut the most workers in five years last month, signaling that the economic contraction is deepening and that the Federal Reserve will continue to lower interest rates, according to Bloomberg.

For my readers, you would have already known that this is the next step in the recession. It appears that we are facing a similar pattern of the 1990-91 recession where the unemployment numbers are steadily declining in random sectors. With almost stealthy decline in employment, the numbers will be almost imperceptible. Therefore the risk.

If you are have a job, then this is the time to hunker down; batten the hatches; and keep yourself busy, engaged in your work. Any thoughts about moving jobs should be only contemplated if you REALLY hate what you are doing. Even then, talk with a friend first. As more people are being laid off or without a job due to companies going under, it will be a tough job market in 2008.

81% Disapproval Of Country’s Direction
According to NY Times, Americans are more dissatisfied with the country’s direction than at any time since early 1990’s. In the New York Times/CBS News poll, 81% of those polled said they believed “things have pretty seriously gotten off on the wrong track,” up from 69% a year ago and from 35% in early 2002.

This result should not surprise my readers since I have been writing about this from the beginning. As the poll revealed a near unanimous consensus on the state of the country and the economy, then why isn’t there more call for review of government malfeasance? We have a federal government that is willing trample on our constitutional rights from illegal wiretapping (and here), unreasonable seizure (and here), usurping laws, non-competitive bids for government contracts, lax regulatory oversight (and here for FEMA, here for Transportation Dept., here for TSA, here for DHS), federal agency not doing their job, and a federal agency acting outside of its authority. All the while, Mr. Bush is AWOL, again. This time, he is supposedly in Europe, trying to secure his legacy.

Well, his legacy has been made. As he declared “Mission Accomplished” before, he continues to declare that things are not as bad as they seem and the federal government is working to resolve the issues. We disagree. If what Bush says is true, then I can beat Tiger Woods in golf with one arm tied behind my back.

Why isn’t Mr. Bush talking with the residents of Texas who are upset with the seizure of their land to build a border fence? How about meeting with the people in New Orleans who are still waiting for the revitalization? How about talking about the FEMA trailers that are making people sick? How about meeting with Iraq War veterans who have suffered head trauma and are trying to piece their lives back after sacrificing themselves for our country? How about proper medical treatment and financial support for these heroes? How about addressing the increased suicides among returning Iraq war veterans and other veteran’s issues? Where is the Supreme Court on these matters of constitutional right violations?

Paying For A College Education Got Tougher
Never mind the fact that the Ivy league colleges admission got tougher. Now, the worry is if there will be sufficient financial aid for students. With tightening credit, students are the one who will feel it the most, as about two-dozen lenders have dropped out of student loan program. Fortunately, some colleges are now offering low or no tuition (and here). Hopefully this trend continues.

Conclusion
The bad news continue to mount up daily. It has become so commonplace that investors are becoming numb to bad news. How else can you account for the mini rally in the stock market with so much bad news?

It must be the new logic: bad is good and good is bad. While investors are acting quite irrational, stay out of their way. More bad news will come out, taking out those ‘smart’ investors who think that it is the bottom of the market. Value investors, hold on to your cash and do your due diligence because there will be good times ahead again; but not just yet.

Have a Great Weekend!

Regards,
Ed Kim
Practical Risk Management
riskyops.blogspot.com
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Consequences Of The Risks Identified, So Far

High Fuel Cost Forces ATA Into History
NY times reported on ATA filing for bankruptcy, canceling all of its flights and laying off almost all of its 2,200 employees. Put ATA alongside TWA, Pan Am, and others. They are done.

My analysis on the airline companies clearly indicated that more airline companies would be going out of business unless they start taking radical actions to overcome the high fuel prices:
http://riskyops.blogspot.com/2008/03/risk-of-rising-fuel-cost-to-airline.html

Fed Still Trying To Manipulate The Market
NY Federal Reserve Bank President Tim Geithner said policy makers and the financial industry was right to “act forcefully'' to stem the credit crisis, according to a Bloomberg report. From CNBC: “The Federal Reserve moved to assist a Wall Street investment bank [Bear Stearns] on the brink of bankruptcy to prevent a failure that could have dealt serious consequences to the U.S. economy, Federal Reserve Chairman Ben Bernanke said.”

Whatever actions the Fed take, forceful or otherwise, to prevent the current crisis will not correct the crisis. Rather, it may prolong the crisis: http://riskyops.blogspot.com/2008/04/risk-of-too-much-federal-government.html

Consumer Debt Delinquencies Still Rising
Consumers fell behind on car, credit card, and home-equity loans in the fourth quarter, the highest level in 15 years, according to an American Bankers Association survey. I think that the consumer debt delinquency rates will continue to rise throughout 2008, peaking around 1Q 2009. Here is my analysis on this issue: http://riskyops.blogspot.com/2008/03/risk-of-growing-consumer-debt-when-will.html

U.S. homeowner bail-out hits resistance
A recent Rasmussen Reports survey indicates that 53% of Americans believe that the government should not help out homeowners who borrowed more than they could afford (29% believe that the government should help out and 17% were unsure). For government helping banks that made bad loans, opposition was even stronger with those against outnumbering those in favor four to one. I am firmly in the 53% group, as my views are clear on this: http://riskyops.blogspot.com/2008/04/risk-of-too-much-federal-government.html

Gas Futures Surge
Gasoline futures prices rose sharply Wednesday. This was in reaction to the Energy Department report that noted an unexpected jump in gasoline demand. According to USAToday, gas prices returned to record levels and appeared to go higher.

With the summer driving months coming up, the demand for gasoline will rise (also here). This has been the trend and even with record high gasoline prices, people will still drive because they need to drive for work. Additionally, more people have been driving on vacation rather than flying, as a way to save on the cost of their vacation. Therefore, the demand for gasoline will not diminish, which means much higher gas prices. It would seem that my call for $4 per gallon of gasoline by 4Q 2008 might have been conservative as the consensus is now indicating $4 per gallon by the start of the summer driving season.

Truckers’ Protest Disrupting Traffic
Reuter reported on the sporadic but widespread protest and traffic slowdown by independent truckers on Tuesday. The independent truckers’ claim of rising fuel cost eating into their profit to the point where it is difficult for them to pay their bills. I have noted that the truckers are vital to the U.S. economy as they move 70% of all goods by value in the U.S.

Truckers’ protest is just starting. The diesel prices have increased nearly 50% so far but it will continue to increase. Expect more truckers’ protests, especially on major travel days. Truckers really have nothing much to lose at this point since their earnings are being squeezed by rising fuel cost. If the truckers start going out of business, then it will have a severe negative affect on the U.S. economy, as they are the transportation backbone of America.

Conclusion
All the news out there is clearly indicating that this recession is not your typical slight dip, contrary to what the Fed is saying. Drastic times take drastic measures. Perhaps the Bear Stearns bailout was the correct drastic measure, but there is a need for the U.S. to take more drastic measures to come out this economic malaise. However, we should learn from the Swedish depression in 1990-92 and not begin to act Socialistic in our measures.


Regards,
Ed Kim
riskyops.blogspot.com
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Risks And Rewards(?) Of The U.S. – Mexico Border Fence

Background: President Bush signed a bill authorizing the construction of fencing along nearly 700 miles of the U.S.-Mexico border. The bill calls for at least two layers of reinforced fencing and other security measures. Where fencing is not practical, the other measures, including cameras, lighting, sensors and surveillance, may be employed.
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NY Times reported today on Department Of Homeland Defense’s (DHS) use of its authority to circumvent environmental reviews so that the 700-mile border fence between U.S. and Mexico can be completed on time. Now, before we start (or continue) to judge DHS, remember that it is simply exercising its waiver authority granted it under the Real ID Act of 2005, section 102. This law gave DHS wide latitude to brush aside other laws, such as the Clean Water Act, National Historic Preservation Act and the Antiquities Act, if they interfere with the building of the border fence:

“SEC. 102. WAIVER OF LAWS NECESSARY FOR IMPROVEMENT OF BARRIERS AT BORDERS.
Section 102(c) of the Illegal Immigration Reform and Immigrant Responsibility Act of 1996 (8 U.S.C. 1103 note) is amended to read as follows:
`(c) Waiver-
`(1) IN GENERAL- Notwithstanding any other provision of law, the Secretary of Homeland Security shall have the authority to waive, and shall waive, all laws such Secretary, in such Secretary's sole discretion, determines necessary to ensure expeditious construction of the barriers and roads under this section.
`(2) NO JUDICIAL REVIEW- Notwithstanding any other provision of law (statutory or nonstatutory), no court, administrative agency, or other entity shall have jurisdiction--
`(A) to hear any cause or claim arising from any action undertaken, or any decision made, by the Secretary of Homeland Security pursuant to paragraph (1); or
`(B) to order compensatory, declaratory, injunctive, equitable, or any other relief for damage alleged to arise from any such action or decision’.”

Risks Of The Border Fence
Risk of violating individual’s and state’s constitutional rights: The sweeping power granted to Mr. Chertoff to build the fence will trample on the 4th and the 10th amendments, rights against unreasonable seizures and power of the state, respectively. This is going to be an issue as some of the land in Texas that DHS requires to build its fence is located on private property.

Risk of providing false sense of security: Building a 700-mile long fence, in of itself, will not stem the tide of illegal immigrants coming into the U.S. It is simply economic of supply and demand. We have jobs that pay much higher rates than Mexico and they have workers who want to work. Studies have been done that confirms just that[i]. Moreover, the border is approximately 2,000-miles long, which leaves two-thirds of the border unfenced. Guess where desperate illegal immigrants will try to cross into the U.S. Right, where they think the security is the weakest.

Risk of more illegal immigrants dying during the border crossing: Now that most ideal places for attempted border crossing are going to be sealed off, people desperately trying to gain entry into the U.S. will now try to cross over inhospitable desert portion of New Mexico and Texas. The gangs that are responsible for taking the immigrants across the border do not care if these immigrants die along the way.

Risk of diverting funds from better deterrent measures: The total cost of the 700-mile fence, according to Congressional Research Services, ranges between $16.4 million to $70 million per mile, over the 25-year life cycle of the fence. This includes the total cost of monitoring, maintenance, and replacement, as needed over the 25-year period. So, for $11.5 billion to $49 billion over 25-years, we will have a false sense of security along one-third of the border. This fund could be better used to hire 10,000 border patrol agents that the Intelligence Reform and Terrorism Prevention Act of 2004 calls for (Title V, Subtitle B, section 5202).

An average border patrol salary ranges from $40,494 to $61,000 per year, depending on the tenure. Using the average of $50,747 per person, the total cost of hiring 10,000 border patrol comes to $507 million a year. Over a 25-year period, this comes out to $12.7 billion. So, we could have hired 10,000 border patrol agents that could monitor the entire 2,000-mile border at about the same cost of the 700-mile fence.

Risk of illogical and unethical fencing: An interesting article from the Texas Observer notes that the border fence that is going up in Texas seems to have an aversion to golf courses or resorts. According to the story, the border fence, which is going through backyards or even through their house of private citizens, it bypasses a nearby golf course (River Bend Resort) and Sharyland Plantation, which is owned by the Hunts, a close friend of President Bush.

Rewards of the Border Fence
To everything there are two sides; not necessary even, but two sides. Here are the benefits of the 700-mile border fence, in my opinion:

• Refocuses attention on the need for a stronger border security measure
  
• Provides jobs to companies to build the fence: Boeing is the main contractor with DRS Technologies Inc., Kollsman Inc., L-3 Communications Inc., Perot Systems Corp., and a unit of Unisys Corp. helping out.

Things to think about

• If we are concerned about terrorists entering the U.S., then why aren’t we putting fences up along our Canadian border?
  
• Who is deciding the location of the U.S.-Mexican border fence? Is it Greg Giddens at SBI? Loren Flossman, person in charge of tactical infrastructure for SBI?
  
• What does SBI (Secure Border Initiative project) really do?
  
• Why is DHS paying $30 billion for SBI, when it should be using the money to hire border patrols?
  
• why isn’t the $30 billion contract to Boeing a part of the cost of building the border fence[ii]?
  
• Since the Congressional Oversight Committee in February 2007 noted that DHS had outsourced most of the oversight responsibility to Boeing, does this mean that it is Boeing that really has the sweeping authority to override laws to build the fence?
  
• Will any of the subcontractors used by Boeing to build the fence use illegal aliens like the Golden State Fence Company?
  
• Is Boeing acting as our border patrol? In reading Boeing’s project 28 briefing, it seems that way.
  
• If DHS is really concerned about our safety, then why is their 2008 budget for port, rail and transit, bus and truck security is only $405 million, a fraction of the $30 billion contract to build border fences?
  
• Is this a type of fencing and border security that we are paying for? (Courtesy of Wikipedia)

Perhaps someone can make some sense out of the governmental logic.

Regards,
Ed Kim
riskyops.blogspot.com
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[i] Brettell and Hollifield 2000; Cornelius et al. 2004; Massey et al. 1993; Todaro's (1976)

[ii] http://bibdaily.com/pdfs/CRS_border_fence_june2007.pdf (page 27, footnote 85)

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Risk Of Too Much Federal Government Intervention

Amended to include the chart Figure 13

With the advancement of the Foreclosure Bill through the Senate, the Federal Government is closer to being a socialistic entity. While I agree that the Federal Government should be working to ensure that our constitutional rights are maintained, I disagree when the Federal Government decides to put on its socialistic glasses when looking to solve economic issues like the current spike in foreclosures.

According to CNNMoney, more than 900,000 homeowners are facing foreclosure, or about 2.04% of all mortgages. Yes, it is a historic high but is it worth congressional actions? USAToday reports that the bill contains such measures as:

• “…letting states issue $10 billion in tax-exempt bonds to refinance subprime loans and permitting home builders and other money-losing businesses to reclaim previously paid taxes.”
  
• ”…provide $4 billion to states to buy up and refurbish foreclosed homes...”
  
• ”…award $15,000 tax credits to people who buy and move into foreclosed homes.”

These measures will not help the economy at all. After all, this is not the first time that we have been through the mortgage rough patches. According to a 1998 FDIC study, conventional foreclosure rates in 1998 (figure 13, below) exceeded 1% of all mortgage loans and approximately 80% of all loans that were 90-days or more delinquent. A subsequent study on foreclosure rates by the Chicago Federal Reserve reveals that national foreclosure rates exceeded 1% again following the dot-com bubble crash. As of 2Q 2007, the national foreclosure rate was 1.25% with Ohio topping the list at 3.6%.

In previous mortgage crises, the Federal Government did not take drastic measures of handing out thousands of dollars to the public. During 1998-91, the U.S. took direct action of taking over insolvent S&L and banks and working out the mortgage mess. During 1997-98, the growing economy helped to absorb some of the fallouts from foreclosure.

Federal Government Is Rewarding Wrong Behavior
So what is different now? I think the difference now is the Federal Government’s view on the economic slowdown. It appears that the Federal Government is so bent on trying to salvage the economy from a necessary recession that it has taken very drastic actions and now find itself in too deep to back off. First, it began innocuously with lowering of the fed fund rates from 5.25% in 2Q 2007 to 2.25%, currently, then began taking more drastic actions, including offering tax rebates up to $1,200 directly to John Q. Public, increasing the FNMA and FHLMC conforming loan limits up to $729,750 in certain high-cost states, revising the overnight borrowing parameters to allow acceptance of junky collateral. As the economy continued to slow down, the Fed applied even more severe actions of lending directly to the brokerage firms for up to 28 days, providing emergency loans to investment banks directly, and then performing the forced marriage of Bear with JPMorgan.

Now, having come too far and having firmly set people’s expectations for government bail outs when they – the business and public – have made the blockheaded choices and are asked to pay the consequences. This is a Pavlov’s dog gone wild.

Will These Measures Help The Economy?
Now with the masses firmly hooked on bailouts, there is no end in sight. After having pledged to pump $150 billion directly into the economy through federal tax rebate, it now is forced to rescue homeowners to avoid urban blight.

Based on the reactions of the various stimulus plans thus enacted or planned, it appears that the U.S. economy is faring no better than if it was simply left to its own devices. After directly lending tens of billions (and agreeing to lend up to $200 billion, if required), agreeing to rebate $150 billion in federal taxes to the taxpayers, and reducing the fed rate to 2.25%, what do we have?

We have an economy that is still on the verge of stalling; market that is back to its levels a year ago; traders trying to figure out if today’s market recovery is for real (and hoping that it is real); unemployment numbers rising; dollar devalued against major currency; prices of consumer goods rising; and growing unrest from truckers, a vital lifeblood of the U.S. economy.

So, it is conclusive that all that liquidity injection and government intervention really didn’t do a whole lot of good.

Risks Due To The Federal Government Interventions

• Increased risk of taxpayers having to pay for losses arising from the Federal Reserve Term Securities Lending
  
• Increased risk of the Federal Government having to provide more bailouts as the number of foreclosures increases
  
• Increased risk of prolonging the current recession
  
• Increased risk of stagnant economy with increasing consumer good prices (stagflation)
  
• Increased risk of higher unemployment, lower wages, and slowing consumer spending, leading to a depression

Conclusion
In the current election year, the only candidate that seems to understand the fact that the U.S. needs to bite the bullet and take its hits is John McCain. His position of being against the mortgage bailout is a tough but pragmatic decision. After all, the borrowers were not that dumb to think that they could always sell the house for a profit if the mortgage payment resets. Housing is not an investment. For those who have sought profit by flipping or sought to live the “American Dream” but super sized, too bad.

You were given full disclosure of the consequences but you chose to ignore it – it was all there under the “Acknowledgement And Agreement” section of the mortgage application, the part where all borrowers swear to tell the truth and know that it is a federal crime to lie on the application; the good faith estimate; and the Truth In Lending Form (Reg. Z), which tells you when the mortgage payment will reset and the new mortgage payment amount.

There are even instructional videos on the web showing you how things are done. And now these same folks are pointing their fingers at the banks for having lax lending standards. Tough. Two wrongs do not make a right.

The banks are getting their punishment. The mortgage brokers that dealt in these liar mortgages should be punished as well. Will they? Perhaps. However, right now the homeowners who are pleading for help are claiming ignorance and the government is buying it by working feverishly on another bailout scheme. Perhaps it is time to tell the Federal Government that ignorance of the law by the borrowers does not give them the right to now plead for assistance. They folks, either being too dumb, too greedy, or both, had plenty of information going in. As my mom always said: “You will sleep in the bed you’d made.” I don’t think the Federal Government agrees with that.

May You Sleep Soundly

Regards,
Ed Kim
riskyops.blogspot.com
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Risk Of President Bush's Ethanol Fuel Program To Common Sense

In his April 2006 Four-Part Plan to Confront High Gasoline Prices, Mr. Bush calls for investment in oil alternatives to dramatically reduce our demand for gasoline. One of his arguments for this was:

“America Is Addicted To Oil, And An Increasing Amount Of The Oil We Need Comes From Foreign Countries. Some of the nations we rely on for oil have unstable governments or agendas hostile to the United States. These countries know we need their oil, and that reduces our influence. We must not allow America to be put at risk by the unfriendly leaders of foreign countries.”

OK, it is true America is addicted to oil. Let’s face the facts: America is addicted to consumption. Period. Be it oil, food, or other consumables, we are one large nation of consumers. President’s proposal consists mainly of the Advanced Energy Initiative (AEI), which calls for reducing gasoline consumption while strengthening our economy, our energy supply, and our national security (OK, let’s buy this contoured argument on national security for a while) through four major initiatives:

• increasing use of ethanol (from corn and cellulose)
  
• Biodiesel fuel
  
• improving hybrid vehicles (electric/gas)
  
• and develop hydrogen technology

On the surface these are noble ideas of weaning America away from oil but are they effective and realistic? Let’s find out. In this article, let’s examine the first of the four parts of AEI, the ethanol from corn and cellulose. So, with that in mind, let’s examine if President Bush’s proposal makes economic sense.

U.S. Cannot Achieve The E85 Fuel Program Goal
President Bush’s goal is E85, or 85% ethanol, in every gallon of auto fuel. As of July 2007, U.S. consumed 388.6 million gallons of gasoline per day, according to Energy Information Administration (EIA). It takes 1 bushel of corn to make 2.5 gallons of ethanol. Therefore, it will take 56,735.6 million bushels of corn to produce enough ethanol to make enough 85% blended auto fuel to meet the consumption level as at July 2007.

(Side notes: 40% of gasoline used in the U.S. already has approximately 10% ethanol. California is at about 6%, increasing to 10% by 2010.)

In 2007, U.S. produced approximately 14,379.72 million bushels of corn, or enough to meet 25.3% of corn required to produce sufficient ethanol to meet the July 2007 consumption. However, converting all of the corn grown in the U.S. is not feasible since corn is vital to our caloric consumption, directly as corn-based products or indirectly as corn-fed poultry, pork, or beef.

This means that we will have to import the ethanol needed to meet our current gasoline consumption. According to EIA, we are already importing ethanol, mostly from Brazil. In the first five months of 2006, we imported 106.6 thousand barrels of ethanol. Lucky for us that Brazil is a friendly country, so far. However, there is a problem with Brazilian supply of ethanol: they are wholly seasonal so the supply, and price, will fluctuate. Not a very comforting feeling. After all, the 1973 gasoline shortage was due to OPEC stopping their shipment of oil to the U.S. You’d think that we would have learned our lesson then.

Like OPEC in 1973, Brazil can stop their shipment of ethanol to the U.S. Remember: a key point in President Bush’s argument for AEI is national security. Specifically, reducing unfriendly nations having undue influence over the U.S. and, thereby, putting us at risk. Risk of what was not stated but an educated person would conclude that the risk is potential for a foreign country that has the ability to affect our supply of fuel and cripple our economy.

I think when President Bush made this statement, he probably had two countries in mind: Iran and Venezuela. Going back on point: Brazil can stop their shipment of ethanol to the U.S. and can do so when we are very vulnerable. How? Look at Brazil’s recent history. Brazil is linked to Venezuela, a country that taunts President Bush and one of the countries that exports oil to the U.S.:

2007 – Brazil and Venezuela builds new jointly owned oil refinery and establish closer trading relations
2004 – Brazil and Venezuela establishes a “Strategic Alliance” to cooperate on defense, energy projects, and oil.
2001 – Brazil and Venezuela announces commercial cooperation.

Given that Brazil is being influenced by Venezuela, there is a potential for Brazil to stop or slow their exports of ethanol to the U.S. So, even if we go full throttle on ethanol as an alternative fuel to gasoline, there is a potential that we are simply replacing oil with ethanol in our dependency on foreign fuel imports.

How Much Corn Do We Need To Achieve E85 Self-sufficiency?
In 2007, total U.S. production of corn was approximately 14,379.72, grown on 81 million acres. Taking the entire 2007 corn production to make ethanol, the U.S. only able to produce approximately 25.3% of daily consumption of fuel as of July 2007. To be able to achieve 100% self-sufficiency with E85, U.S. needs to grow 56,735.6 million bushels of corn. This means that we would have to expand our farmland by a 394% to approximately 319.6 million acres to grow enough corn. The only problem is that there isn’t enough farmland to do this. Moreover, if we were to start expanding corn plantings, this will have severe negative repercussion on the price of other grains as well as drive farmland prices to mania levels.

U.S. has a total land area of approximately 2.3 billion acres. As of 2002, the top three land uses were forest with 651 million acres (28.8%); grassland, pasture and range with 587 million acres (25.9%); and farmland with 442 million acres (19.5%). Remaining 25.8% of the land uses are urban, roadways, and other infrastructures. Diverting additional 238.6 million acres of farmland to corn planting equals to approximately 10.4% of the land in the U.S. Moreover, since corn is best grown in the plains, we will have limited options: replace current crops to corn or tear down urban infrastructure and go back to being an agrarian society. Both options are not realistic.

Can We Not Rely On Cellulose For Ethanol Production?
What about ethanol produced from cellulose? According to government’s own study, they hope to have the capacity to produce 250 million gallons of cellulose-based ethanol by 2013. Too little; too late. Also, this figure is only a projection based on best-case scenario. Current estimates for cellulose based ethanol process indicates that it takes about 100 million acres of land to grow sufficient switchgrass to produce enough cellulous ethanol to offset approximately 25% of our current oil consumption.

Increase Use Of Ethanol (from Corn and Cellulose) And Biodiesel
Professors David Pimentel and Tad W. Patzek performed an in-depth study in 2005 to assess the economic viability of using ethanol and biodiesel as alternative fuel to gasoline. Their findings were very clear:

• “Energy outputs from ethanol produced using corn, switchgrass, and wood biomass were each less than the respective fossil energy inputs.
  
• The same was true for producing biodiesel using soybeans and sunflower.
  
• Findings in terms of energy outputs compared with the energy inputs were:
  
  • Ethanol production using corn grain required 29% more fossil energy than the ethanol fuel produced.
    
  • Ethanol production using switchgrass required 50% more fossil energy than the ethanol fuel produced.
    
  • Ethanol production using wood biomass required 57% more fossil energy than the ethanol fuel produced.
    
  • Biodiesel production using soybean required 27% more fossil energy than the biodiesel fuel produced
    
  • Biodiesel production using sunflower required 118% more fossil energy than the biodiesel fuel produced.”

So, using ethanol and biodiesel as alternative fuel to gasoline is not going to get us off foreign oil and the study clearly shows that we may need the current level of oil imports just to make the alternative fuels, unless we want to start burning billions of tons of coals like China.

Common Sense Interpretation Of Bush-speak Reveals The Errors
Bush-speak: AEI will strengthen our economy and energy supply.
Common Sense Interpretation from Energy Information Administration’s Energy and Economic Impacts of Alternative Fuel Source:

• “…biofuel production generates large supplemental streams of bulky co-products with limited marketability.”
  
• ”biodiesel and ethanol cannot be blended at petroleum refineries and batched through existing pipelines…railroad cars and tanker trucks made from biofuel-compatible materials must be used to transport…biofuels to market.”
  
• ”…limited rail and truck capacity has complicated the delivery of ethanol and contributed to regional ethanol supply shortages and price spikes, as occurred between April and June 2006.”
  
• ”The necessary infrastructure for collecting, processing, and distributing large volumes of biofuels would have to be expanded or, in many cases, created. Without substantial infrastructure investment, it would be difficult or impossible for producers to avoid bottlenecks in the transportation and delivery of biofuels to market.”
  
• ”…biofuels production to reach approximately 65 billion gallons by 2025, could require more than 25 billion gallons of corn-based ethanol and 25 billion gallons of cellulosic ethanol, a technology that is not commercially available at present.”
  
• ”It could also require a roughly 8-fold increase in ethanol imports…”
  
• ”…domestic corn and soybean prices could increase dramatically from current levels, significantly increasing domestic prices for food and feed...”
  
• ”Moreover, the competition for arable land that would result from increased corn production at the levels needed…could significantly raise all food and feed prices in the United States.”
  
• ” It is not clear that sufficient land resources would be available for large-scale expansion of corn and soybean cultivation, given the intense competition with conventional agricultural products for arable land.”
  
• ” Surging demand for biofuel feedstocks under the RFS policy would exert upward price pressure on corn and soybean commodities and influence the markets for food, feed, industrial feedstocks, and exports.”
  
• ” Ten pounds of crude glycerol is generated as a co-product for every 100 pounds of biodiesel, and the glycerol generated from 300 to 600 million gallons of biodiesel production per year would be equal to nearly one-half of the current glycerol market in North America, causing a substantial oversupply and depressing prices.”
  
• ” While it is expected that both technologies—advanced biomass generation and cellulosic ethanol production—will be feasible, their actual costs, performance, and first dates of commercial availabilities are uncertain, because no such commercial plants exist at present.”
  
• By all metrics, the proposed increase in ethanol as a substitute to fossil fuel will reduce the GDP, increase inflation, lower disposable income, reduce industrial output, and reduce consumption.

Summation Of The Risks

• Risk of increasing commodities prices
  
• Risk of increasing the volatility commodities prices
  
• Risk of increasing the inflationary rate of food and animal feedstock
  
• Risk of increasing our dependency on imports of fuel
  
• Risk of increasing biomass waste that needs to be disposed of properly
  
• Risk of substantially inflating farmland prices
  
• Risk of reducing economic growth
  
• Risk of sporadic fuel shortage from inadequate transportation system to bring ethanol to the users
  
• Risk of turning our breadbasket into an industrial ethanol production sprawl
  
• Risk of causing another “Dust Bowl” since corn does not root deeply and drains nutrients from the soil

Conclusion
I am fully for developing and using alternative fuel sources. So, don’t take this as a knock on AEI initiative. Rather, I am appalled by the lack of strategic planning by the current administration on all matters of domestic and foreign policies. Due to the lack of strategic planning, we are now at the point of having created inflationary pressures on food prices and farmland prices without any material benefit.

So to console myself, I look forward to an episode of Invention Nation (IN) on the Science Channel. At least, these guys at IN are trying to do something practical about alternative energy sources.

Regards,
Ed Kim
riskyops.blogspot.com
DISCLOSURE: The author holds long positions in oil refineries at this time.
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Risk Of Paulson’s Proposal Of Merging Regulators

According to Bloomberg, Treasury Secretary Hank Paulson will announce his proposal to overhaul the federal regulatory framework, during his planned speech on Monday at 10 AM. While Paulson’s recommendations desire to streamline the regulation o f financial institutions, including investment banks, the recommendations pose several risks of creating more problems than solving.

Risk Of Adding To The Bureaucracy
One of the recommendations is to turn the President's Working Group on Financial Markets, president’s advisory body since 1987, into a government-chartered interagency organization that will coordinate financial regulatory policies. The problem with this short-term proposal is that it will add to another layer to the government bureaucracy. A simple executive order, with congressional approval, to empower the advisory group to coordinate the financial regulations and then hand off the regulations to the respective super-agency to implement should be sufficient.

The FFIEC already exists to ensure uniformity of regulatory application, so it may create a confusing overlap of responsibility. By turning the President's Working Group on Financial Markets into a government-chartered interagency organization, there is a heightened risk of creating another bloated governmental agency, a la Homeland Defense and a possibility of interagency struggle for dominance.

Risk Of Diluting SEC’s Current Authority
NY Times states this risk very clearly:

“The blueprint also suggests several areas where the S.E.C. should take a lighter approach to its oversight. Among them are allowing stock exchanges greater leeway to regulate themselves and streamlining the approval of new products, even allowing automatic approval of securities products that are being traded in foreign markets.”

This is not acceptable given the current market condition and events, all of which indicate that SEC oversight should be increased.

How does one rationalize a self-regulated stock market that can easily introduce more risks into the market? The honor system is noble but current events fully indicate that the loosely regulated institutions have been able to heavily influence the stock market through the derivate market. By proposing dilution of SEC’s current authority, it will increase the risk of more market volatility and potential for further influence by institutions using highly leveraged derivative trades.

Risk Of Expanding The Federal Reserve’s Authority
The proposal to grant the Federal Reserve the authority to supervise the market and to ensure stability is an idea that is filled with risks. How will the Federal Reserve be empowered to supervise the market and oversee its stability when their actions (or inactions) to affect liquidity and interest rates can move the market dramatically? It is a circular logic: The Fed currently is trying to stabilize the market by injecting or removing liquidity. However, by their actions, they change the way the market and have caused unintended consequences (see Greenspan’s bubble).

It would be better to grant SEC this responsibility rather than the Federal Reserve since the SEC already has some authority in this area. Moreover, the SEC has the review function embedded in its organization that can easily be expanded. Having the Federal Reserve monitor and supervise the investment banks only invites more bureaucracy and further dilutes the authority of the SEC.

Risk From Leaving Major Risk Gaps Intact
It is incredulous that two areas that should be regulated have been left out of Paulson’s proposal: Hedge Funds and the International Swaps and Derivatives Association (ISDA), a derivatives trade group. After all, unregulated trades in the derivative market and the use of highly leveraged derivate trades by the hedge funds are two major components of the current credit crunch. According to Wikipedia, hedge funds conduct “approximately 30% of all U.S. fixed-income security transactions, 55% of U.S. activity in derivatives with investment-grade ratings, 55% of the trading volume for emerging-market bonds, as well as 30% of equity trades. Hedge Funds dominate certain specialty markets such as trading in derivatives with high-yield ratings, and distressed debt.”

Currently, there is no regulatory agency that monitors hedge funds. The regulators steps in only when they suspect fraud is involved. Furthermore, hedge funds have able avoid regulatory scrutiny by conducting private offerings to “qualified purchasers.”

The highly opaque hedge funds and loosely supervised ISDA have had a major influence in the stock market. Knowing this, one could justly ask: “why are hedge funds and ISDA not on the proposal for regulation?” “Could it be intentional?” This is open to debate and speculation. I am certain that there will be conspiracy theorists expounding on this point ad nausea.

Proposal Leaves Out Critical Regulators
The longer-term proposals recommend combining the OCC (Office of Comptroller of the Currency) with the OTS (Office of Thrift Supervision), and combine the SEC (Securities and Exchange Commission) with the CFTC (Commodity Futures Trading Commission).

This seems to be a good move but it leaves out two important regulatory bodies: (1) The Federal Deposit Insurance Corporation (FDIC), which insures deposits, examines and supervises financial institutions, and manages failed banks; and (2) The National Credit Union Administration (NCUA), which charters and supervises federal credit unions. FDIC and NCUA should be included in with the combination of the OCC (charters, regulates, and supervises all national banks) and OTS (supervises savings associations and their holding companies) since their functions are similar and somewhat overlapping.

If the Treasury is really serious about streamlining financial market supervision, why leave out these two out? Especially the FDIC. This is another one of those things with the proposal that raises more questions.

Risk Of Partisan Dilution Of The Proposal’s Benefits
Even with its gaps and unanswered questions, the Treasury proposal is a step in the right direction. However, like all grand plans in Washington, D.C., this one will most likely get bogged down in partisan bickering and backroom compromised legislation that will sap all of the benefits out of it – a whole lot of wheeling and dealing with a healthy participation by special interest groups. The end result would be a motley work of legislations that may mildly modify supervision of the money center banks and investment banks while leaving hedge funds and ISDA out altogether.

Paulson’s proposal will have a difficult time getting congressional approval as Democrats are seeking legislation on an even tighter supervision of Wall Street, including hedge funds and credit derivatives.

Conclusion
Finally, it may be sometime before congress can pass a compromise to approve some of the proposal’s recommendations. Given their process, or lack thereof, it is highly unlikely that anything will be done in 2008 or even in 2009. Since we are in an election year, there is also the risk that the incoming President may decide to veto any overhaul of the current regulatory framework. Stay tuned.

Regards,
Ed Kim
riskyops.blogspot.com
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