Saturday, May 3, 2008

Risks Facing The Global Economy For The Next 12 Months – Part 1

Increased Risk Of Expanding Military Conflicts In The Middle East
Due to a combination of sheer incompetence and lack of leadership demonstrated by the Bush Administration, we are nowhere near ending the Iraq War or the Afghanistan War. In fact, the current thoughts are to increase U.S. military deployment in Afghanistan as the Taliban and Al Qaida forces have been successful in reclaiming territories and been using opium trades to fund their activities. Moreover, the story of Iran funding the Shiite fighters in Iraq with weapons, training, staging bases, and cash seems to mostly true, unlike the total fiction of Saddam having WMDs, which was mostly false.

After six years of war, we have reversed our deployment drawdowns and have added more fighting forces on the ground. Just recently, we added 2,400 marines from the 24th Marine Expeditionary Unit and the 2nd Battalion, 7th Marine Regiment to fight the Talibans in Afghanistan, with potentially up to 3,200 marines being deployed there by the end of 2008.

The U.S. is in a losing was of attrition in Iraq and Afghanistan. Its Armed Forces are overstretched. Al Qaida, Taliban, and other fighters engaging the U.S. know this. It is a lesson they learned while battling the Soviet Union. These groups are able to wait out the U.S. using hit and hide tactics.

Soon or later, the next President of United States will have to draw down the number of troops, whether or not the President wants to or not. This is due to the long length of deployment of soldiers in Iraq and Afghanistan and equipments not being replaced timely. And when we do, the violence will flare back up, leading to near civil war in both Iraq and Afghanistan.

When this happens, the Middle East will be facing four areas of conflict: Palestine, Lebanon, Iraq, and Afghanistan. All thanks to our shortsighted commander-in-chief. Mission Accomplished.

Have a great weekend!

Ed Kim
Practical Risk Manager

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Failures Of The Credit Risk Rating System

Back on April 17, Financial Times reported that Standard & Poor’s rating matrix showed the average default rate on AAA corporate bonds was more than four times greater on than on AAA structured credit. This was based on analyzing rolling three-year periods between 1978 and 2007. This news should have been sufficiently evident for the rating agencies to immediately begin overhauling the rating systems and making their rating process more transparent.

However, the news on Friday indicates that the rating agencies may not have learned their lesson, as Barbara Ridpath, European head of rating services at S&P, is quoted saying: “I stand by the ratings we have issued.”

How can you stand by the ratings when your own default study indicates otherwise? This is blatant ignorance of the fact. Further evidence of the arrogance and ignorance of their failings is provided by Frederic Drevon, EMEA head of Moody’s Investors Service, who is quoted saying: “We did not make it sufficiently clear to the market as to how a rating should be used. Many investors were using ratings as a proxy for market prices, which is not an appropriate use. Ratings are an opinion of the credit risk, not the liquidity risk of a credit instrument.”

Mr. Drevon’s statement misses the mark, which is that the market will add on additional yield on the credit security, if the credit rating system cannot be trusted. This affects liquidity as the holder of the security will now not want to sell at a loss and potential buyers will not want to pay the face value.

Furthermore, if Mr. Drevon believed that the market did not fully understand how the ratings should be used, then why not proactively go out there and educate the market? Why plan on doing it now? If the rating agencies indeed did go out and educate the market, then why is the market still not using the rating correctly? I cannot buy Mr. Drevon’s argument at face value and must take a credit risk option against it.

Another evidence of the failing of the rating agencies comes from the Attorney General Richard Blumenthal of the State of Connecticut who stated, in his March 2008 statement before the house committee on financial services, that:

“The major credit rating agencies own studies show --beyond any doubt --that default rates for municipal bonds are substantially lower than identically rated corporate bonds. Moody's study shows that higher rated Aaa corporate bonds are four times more likely to default than lower rated Baa municipal bonds --a rating seven notches lower than Aaa. Indeed, a 2006 Moody's report revealed that the top five municipal bond grades, Aaa through A1, would all be rated Aaa if they were corporate bonds. These default studies make clear that Moody's employs two distinct rating scales for municipal bonds and corporate bonds. Fitch published default studies in 1999 and 2003 that showed similarly low default rates for municipal debt.”

Now the rating agencies are busy cleaning house and trying to impose a form of self-governance to keep the government from regulating them. The question that investors should be asking is why didn’t the rating agencies have strong self-governance system in place and if they did, then why did it fail?

However, from current quotes, it is evident that the self-governance and cleaning house that the rating agencies are doing right now will amount to nothing more than a few dusting of the ratings definition, replacing numerical systems with alphabetical, or vice versa. In the end, it will take a lot for the rating agencies to regain the trust of the market.

Potential Corrective Actions For the Rating Agencies
Establish a private governing body similar to FINRA to regulate and monitor the rating agencies. Funding for this monitoring entity would come from a portion of the ratings fees. This way, the rating agencies can maintain their self-governance with minimal governmental regulations.

Have an independent third party annually review the rating agencies’ rating procedure and process and make this report public. The market will then have the ability to comment on the findings, providing a check-and-balance system.

Have a great weekend!

Ed Kim
Practical Risk Manager

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Friday, May 2, 2008

Increased Risk Of Stagflation

Federal Reserve a.k.a. “Reverse-Rumpulstilskin” Now Accepting AAA ABS
The word is out that the Federal Reserve is now accepting AAA rated asset-backed securities (ABS), including ABS secured by credit cards, auto loans, and student loans. With this action, the Fed is acting like a Reverse-Rumpulstilskin, turning junk (ABS and MBS) into gold (UST). However, their efforts to provide liquidity to the market is setting the U.S. up for an increased risk of stagflation.

The Fed’s hope is to coax the banks back into lending again by making the bank’s assets more liquid. However, like Rumpulstilskin, the Fed will not get what it was hoping for. The banks are concerned about the longevity of the current downturn. The banks also know that the “AAA” ratings on the ABS and MBS bonds that they hold are not truly “AAA” material and they would be very happy to unload them in return for UST.

The banks will continue to exchange junk for UST, build up their reserves, and refuse to lend until the consumer market gets more certain. When that’s is going to happen is anyone’s guess. However, given that the smart monies are still counting on a prolonged slowdown, it is going to be a while until the banks begin lending in earnest. My guess is that the banks will sit tight on general lending until 2Q 2009.

In the interim, the Fed will continue to inject more liquidity into the system by swapping ever increasing amounts of UST for ABS and MBS. As this is happening, it is quite likely that the quality of the ABS and MBS bonds that the Fed is holding will deteriorate, leading to the Fed having to either mark down the value or asking the Treasury for more money.

Traders and speculators will then take advantage of this situation and short the dollar, as they sense that the declining quality of the bonds held by the Fed will lead to the U.S. potentially losing its “AAA” rating (if this happens, it will be down to “AAA-“ at most). As the dollar continues its fall, it will drive up the price of everything valued in dollars, which will lead to even lower consumer spending – a vicious downward spiral toward stagflation.

All the rosy projections for the second half of 2008 as being the period of recovery may come to a shocking end as investors lulled by the promises of the rainbow at the end of a storm come face to face with even a bigger storm. Brace yourselves and make sure that you are prepared for the soaking.

Ed Kim

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Thursday, May 1, 2008

Beware Of Over-Optimism

Risks Of A False Bottom
The New York Times, with its story Optimism Begins to Ease Onto Wall St, is touting a possible bottom to our current economic malaise:

“For the first time in months, analysts and executives sound upbeat again. Many of them see a broad, sustained recovery in both the economy and the financial markets coming in second half of this year, a prediction some market strategists call hopeful at best.”

The New York Times story is for those who desperately want to believe that the worst is over. Don’t fall for this trap. There are many economic signs out there all indicating that the current economic slow down is still at its initial stages: job loss figures, further reduction in housing prices, slowing consumer spending, tight credit market, and uncertainty around the value of the financial guaranties and bond ratings.

Hank Paulson Taking A Line From Yogi Berra
Hank Paulson must have been reading Yogi Berra’s encyclopedia on economic[i] because in a Bloomberg interview, he is quoted as saying: “We are closer to the end of this problem than we are to the beginning.'' Wow this is really profound. What worries me is that Hank, before joining the Bush Administration, was highly regarded Goldman Sachs banker. So, what happened? It’s anyone’s guess but I hope his symptoms would go away and soon.

GDP Grew?
The media was a buzz yesterday about the U.S. GDP. While many economists were expecting a decline, the GDP number showed a surprising 0.6% growth. Economists often say that statistics lie but in this case, it is the calculation of the GDP’s growth that is mendacious. This “growth” was due to 0.8% increase in inventories. Wall Street Journal got it right when it wrote: “But underlying data -- on consumer spending, business investment and construction -- paint a picture of a deteriorating economy, one that expanded only because of a rise in exports and a buildup of inventories.”

The Truth: “Excluding inventories, GDP shrank at a 0.2% pace, the first contraction in more than 16 years. Excluding inventories and exports, the economy contracted at a 0.4% rate after increasing 1.3% in the fourth quarter.”

Much like the ‘goodwill’ on a balance sheet, this ‘growth’ of inventories will come back to haunt the market as the value of the inventories will have to be marked down.

Analogies For The Current Economic Condition
I have heard and read so many different analogies about the economy. Choose your favorite among the finalists that I like:

1) It is like a major hurricane; we went through the front end of the hurricane and are now experiencing the calm before the back end comes.

2) It is like a man who is “doing well” while in mid-fall off a tall building.

3) It is like whole bunch of high-tech hamsters spinning in a whole bunch of high-tech wheels.

4) It is like the second Terminator, the one that can morph into different shapes.

5) It is like an 8.0-plus earthquake waiting to happen

I leave you with this one from BTO (Bachman Turner Overdrive): You ain't seen nothing yet (Note: this will open up a YouTube video)

May Your Trades Be Profitable!
Ed Kim
[i] Yogi Berra is famous for piety sayings such as:
“This is like deja vu all over again.”
“You can observe a lot just by watching.”
“A nickel ain't worth a dime anymore.”
“It ain't over till it's over.”

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Wednesday, April 30, 2008

Translation & Analysis Of Bush’s Press Conference Of Tuesday, April 29

Full text of the press conference: here

The President: Thank you. Good morning. This is a tough time for our economy. Across our country many Americans are understandably anxious about issues affecting their pocketbook, from gas and food prices to mortgage and tuition bills. They're looking to their elected leaders in Congress for action. Unfortunately, on many of these issues all they're getting is delay.

Translation: I was wrong about all that I had previously said about the economy being in good shape and my saying that “…we anticipated this and took decisive action to bolster the economy…” (G.W. Bush – March 7, 2008)
Furthermore, it isn’t my fault; it is completely Congress’ fault. Bush previously had used his authority to provide for the $168 billion tax rebate and other actions in the past. So, why is he so impotent all of a sudden?

Analysis: The U.S. Constitution requires that the President “…recommend to their [Congress] consideration such measures as he shall judge necessary and expedient; he may, on extraordinary occasions, convene both Houses, or either of them…take care that the laws be faithfully executed…”

This means that Bush should not be pointing fingers at the Congress for lack of action but rather take action using the powers accorded to the office. Or, as Harry S. Truman had said many times: “The Buck Stops Here.”

The President: I've repeatedly submitted proposals to help address these problems. Yet time after time, Congress chose to block them. One of the main reasons for high gas prices is that global oil production is not keeping up with growing demand. Members of Congress have been vocal about foreign governments increasing their oil production; yet Congress has been just as vocal in opposition to efforts to expand our production here at home.

Translation: I've repeatedly submitted the same proposals with very little details over and over again but Congress is wise to my ways and won’t let me push them around anymore. Also, even though I have a Harvard MBA degree, I do not understand simple economics of what drives the gas prices. I think it is due to global oil production…

Analysis: Mr. Bush, here is a basic primer on gas prices. As for the high gasoline prices, here is something that you can do right now, Mr. Bush, to secure a legacy and drive down high gasoline and diesel prices:

Create strategic jet fuel, gasoline, and diesel reserves and release the reserve fuels into the market whenever the prices get too high. Since gasoline can last only for up to a year (page 82), rotate the supply to ensure freshness of supply. (Diesel and jet fuel can last for a long time in storage with proper care, page 97.) This way the federal government can smooth out the sharp spikes and dips in fuel prices (sell into the market when prices are high and buy into reserves when prices are low). This will also make moot the issue of lack of gas refinery in the U.S.

The President: They repeatedly blocked environmentally safe exploration in ANWR. The Department of Energy estimates that ANWR could allow America to produce about a million additional barrels of oil every day, which translates to about 27 millions of gallons of gasoline and diesel every day. That would be about a 20-percent increase of oil -- crude oil production over U.S. levels, and it would likely mean lower gas prices. And yet such efforts to explore in ANWR have been consistently blocked.

Another reason for high gas prices is the lack of refining capacity. It's been more than 30 years since America built its last new refinery. Yet in this area, too, Congress has repeatedly blocked efforts to expand capacity and build more refineries.

Translation: Again, I have presented no concrete plan for drilling in Alaska; that’s why I can’t do anything more than gripe about the Legislative check of Executive power and blame them for the high gas prices, unjustly. It is unjust since the blame should be given out equally.

Analysis: While 1 million barrels of oil per day is about 20% of total U.S. production, we import about 10 million barrels a day.[i] Bush is correct about the lack of refining capacity. However, it is not Congress’ fault. There are the issues of NIMBY (Not In My Back Yard) environmental protest and the high cost of building a new refinery and infrastructure, as citied by the oil industry.[ii]

Again, by developing a strategic reserve of jet fuel, gasoline, and diesel, the government can smooth out price spikes and dips. This will further provide insurance against natural disasters in the gulf region, which houses all of our strategic oil reserves and refineries.[iii]

The President: As electricity prices rise, Congress continues to block provisions needed to increase domestic electricity production by expanding the use of clean, safe nuclear power. Instead, many of the same people in Congress who complain about high energy costs support legislation that would make energy even more expensive for our consumers and small businesses.

Translation: I don’t know my facts so let me just continue to bash Congress for high electricity prices as well.

Analysis: Nuclear power provides about 19.4% of the current U.S. electricity. In fact, the U.S. has the largest commercial nuclear energy program in the world, with 104 power reactors in 31 states. Moreover, U.S. Nuclear Regulatory Commission (NRC), which regulates the construction and operation of new commercial nuclear power facilities, has received a total of 23 applications covering 34 nuclear units for CY 2007 to 2010. Of this, 15 applications covering 22 units, of which three are new facilities, were received in CY 2008 alone.[iv] Additionally, there are nine combined licenses – an authorization from the NRC to construct and operate a nuclear power plant at a specific site – covering 15 units, all filed between 2007 and 2008.

The President: Congress is considering bills to raise taxes on domestic energy production, impose new and costly mandates on producers, and demand dramatic emissions cuts that would shut down coal plants, and increase reliance on expensive natural gas. That would drive up prices even further. The cost of these actions would be passed on to consumers in the form of even higher prices at the pump and even bigger electric bills.

Instead of increasing costs and increasing new roadblocks to domestic energy production, Congress needs to clear away obstacles to more affordable, more reliable energy here at home.

Translation: I meant to say “tax credit” but I keep on saying “taxes.”

Analysis: The bill that Bush is referring to is the H.R. 5351: Renewable Energy and Energy Conservation Tax Act of 2008 (analysis here and full text here). This bill, passed by the House of Representatives, is before the Senate.

Here is an unbiased analysis of the bill from Congressional Budget Office: “Among the provisions, the legislation would extend and modify existing renewable energy tax credits, create new tax credits for the production of certain renewable energy sources, and reduce a deduction from taxable income allowed for oil and gas producers. It also would shift some corporate income tax receipts from 2014 into 2013. JCT [Joint Committee on Taxation] estimates that the legislation would increase revenues by $1.5 billion over the 2009-2013 period and by $2.4 billion over the 2009-2018 period.”

The President: Americans are concerned about rising food prices. Unfortunately, Congress is considering a massive, bloated farm bill that would do little to solve the problem. The bill Congress is now considering would fail to eliminate subsidy payments to multi-millionaire farmers. America's farm economy is thriving, the value of farmland is skyrocketing, and this is the right time to reform our nation's farm policies by reducing unnecessary subsidies. It's not the time to ask American families who are already paying more in the check-out line to pay more in subsidies for wealthy farmers. Congress can reform our farm programs, and should, by passing a fiscally responsible bill that treats our farmers fairly, and does not impose new burdens on American taxpayers.

Translation: Hey, anyone who makes $500,000 or more in farming shouldn’t get any subsidy…well except for those farmers who are turning our corn into ethanol. That’s different.

Analysis: Bush is right on the Farm Bill and I agreed with him in my previous article: New York City Is Farmland. Who Knew?

Here is an unbiased analysis of the Farm Bill from Congressional Budget Office: “On balance, those changes to the unified budget would produce net costs (increases in deficits or reductions in surpluses) of $5.1 billion over the 11-year period.”

The President: Americans are concerned about making their mortgage payments and keeping their homes, and I don't blame them. Last year I called on Congress to pass legislation that would help address problems in the housing market. This includes critical legislation that would modernize the Federal Housing Administration, reform Fannie Mae and Freddie Mac, and allow state housing agencies to issue tax-free bonds to refinance sub-prime loans. Yet they failed to send a single one of these proposals to my desk. Americans should not have to wait any longer for their elected officials to pass legislation to help more families stay in their homes.

Translation: Whoops. I forgot that the Senate did pass the FHA Modernization Act of 2007 (S. 2338) and the House of Representatives passed the Expanding American Homeownership Act of 2007 (H.R. 1852). Maybe I should address the Congress to hammer out their differences?

Analysis: Congress has been working very diligently on reforming the housing legislations. In addition to the bills passed in the respective parts of the Congress, the Senate is working on “A bill to aid families and neighborhoods facing home foreclosure and address the subprime mortgage crisis” (S. 2734), introduced on March 2008.

What Bush should be doing, instead of just sitting and griping, is to use his executive powers to address the Congress to combine their two bills and provide the needed reforms to the existing housing legislations. Additionally, Bush muddied the process by having Hank Paulson address the public about the White House plan, which was light on detail but heavy on the talking points.

The President: Americans are concerned about the availability of student loans. The recent credit crunch makes it uncertain that some students will be able to get the loans they need. My administration is taking action through the Department of Education's "lender of last resort" program, which works to arrange loans for students who are unable to secure one from a lender on their own. In other words, we're helping. Congress needs to do more by passing a bill that would temporarily give the federal government greater authority to buy federal student loans. This authority would safeguard student loans without permanently expanding the government's role in their financing.

Translation: The Department of Education's "lender of last resort" program already exists and I am just taking advantage of it but spinning it as if I thought of it first.

Analysis: The Clinton Administration (Clinton Plan) had already implemented the lender of last resort for student loans with the Reauthorization of the Higher Education Act of 1998 (Page 109). Moreover, the problem with “students who are unable to secure one from a lender on their own” is a direct result of the problems with Sallie Mae, which was well known in 2002, 2003, 2004, 2005, 2006, 2007, and 1Q 2008 but nothing was done. So, why is it now the Congress’ fault?

The President: In all these issues, the American people are looking to their leaders to come together and act responsibly. I don't think this is too much to ask even in an election year. My administration will reach out to Congress. We will work to find areas of agreement so that we can deal with the economic pressures that our American taxpayers and American families are feeling. I ask Congress to do its part by sending me sensible and effective bills that I can sign, instead of issuing or sending bills that simply look like political statements. We can work together. We can help Americans weather this difficult period. We can keep our country moving forward.

Translation: Send me the bills that I like or I will not sign them.

Analysis: The American people are looking to their leaders to come together and act responsibly. However, you, Mr. Bush have so far demonstrated weak leadership. This is evident by the ratings results (Source:

I don’t know how the Bush administration is going to work together with Congress in the last few months that Bush has left but, based on what he has done so far, it may be too little too late. Mission Accomplished.

Ed Kim
[iv] (Existing nuclear plants are filing for power uprates, a license to increase power production at their existing facilities.)

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Monday, April 28, 2008

New York City Is Farmland. Who Knew?

Right now the U.S. congress is in the middle of a major legislation on a new Farm Bill, the backbone of U.S. agricultural policy for years to come. The current bill calls for $618 billion to be spent over 10 years from 2008 to 2017. Within this bill is the $52.5 billion for Direct Payment Program.

The $52.5 billion for Direct Payment Program is basically a handout, according to the San Francisco Chronicle:
“Direct payments are made regardless of crop prices, weather, or even if the land is still farmed. They are paid for no other reason than the land grew crops that were subsidized in the past. Even dead people have gotten payments.”

What is amazing is that New York City has been a recipient of the Farm Bill Direct Payment Program. In fact, during 1995 to 2006, 1,371 individuals and businesses in New York City received Farm Bill Direct Payment Program. Here is a map of the ‘farms’ in New York City to receive the handout.
Who knew?

Ed Kim

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Heighten Risks From Growing Grain Shortage

The probability of additional increases in the global grain prices is now higher than before. This is due to the forecast of potential summer drought in the Midwest by agricultural meteorologist Dr. Elwynn Taylor of Iowa State University. He is the highly regarded guru of weather forecasting for agricultural yield, especially corn. In his 2008 forecast for corn, Taylor notes that the corn yield is projected to be lower due to below average precipitation caused by the La Nina, a weather condition in the Pacific Ocean:

“The risk of below trend (150.6 BPA [bushel per acre]) US Corn Yield is 72% with La Nina and will diminish to 60% if the La Nina fades before June arrives.” [i]

Dr. Taylor has also noted two other ominous signs for a lower Midwest corn yield:
“History tells us that the average time span between major droughts in the Midwest is about 19 years," he points out. "The last major drought was 1988 -- 19 years ago."
"Out of the 17 major droughts that have occurred in the Midwest in the past 100 years, 16 were preceded by a major drought in the Southeast," says Taylor. "So, the drought in the Southeast is another bad sign."

"We have no scientific evidence to think that all three factors [La Nina, 19 year drought cycle, SE drought preceding the Midwest drought] and will gang up on us next year to create a major drought, but these are certainly all factors that will put people on edge."

If Dr. Taylor is correct, and I think he will be, then the likelihood of the current grain shortage intensifying has gotten more certain.

Another ominous sign comes from the National Agricultural Statistics Service (NASS) Crop Progress report, a service of the Agricultural Statistics Board of the U.S. Department of Agriculture. As of April 21, the NASS Crop Progress report notes a lower crop planting of corn than same period last year – 4% versus 17% – in 18 states that account for 91% of all corn planting. Rice and winter wheat were also lower than last year at 26% versus 43% in 100% of the rice growing states and 7% versus 14% in 90% of the winter wheat growing states, respectively. As for the winter wheat, the report goes on to note that the quality of the winter wheat is lower this year than last (55% of the winter wheat was of fair quality or worse versus 46% of the winter wheat last year).

Risk Events Arising From the Growing Grain Shortage
In addition to the 14 risk events that I have noted previously, expect the following risk events to unfold:

  • As drought hits the Midwest, the crop yields for corn and wheat will be lower, resulting in ever-higher prices for these grain as well as other grains that will move upward in a sympathetic move
  • Prices of products containing corn syrup, cereal, meat, dairy, and ethanol will increase rapidly
  • Shortage of corn and wheat will force the U.S. to export less abroad, further increasing the spot price of grain and exacerbating the grain shortage worldwide
  • More countries will halt exports of grain to ensure sufficient supply of grain for domestic consumption
  • Expect to see / hear news of mass migration of people trying to escape local food shortages
  • Rapid advances in and acceptance of genetically modified grains as substitutes without understanding the full consequences
  • Higher ethanol production prices will result in higher gasoline prices at the pumps
  • Gasoline, diesel, and electric prices will rise as speculators take advantage of the rising grain shortage to drive up the prices of other commodities
  • Water rights will become valuable and contested, especially in arid areas
Silver linings
Even in the most negative situation, there are positives that can be gleaned from it:
  • Americans’ food portion will be smaller due to the higher food costs. This will lead to lowering of obesity rate and other health problems associated with overeating
  • More families will turn to growing their own vegetables to make ends meet. This will increase healthier eating habits, further reducing health problems
  • As more families begin eating smaller portions, the amount of garbage will decrease. This will result in lower landfill and associated pollution
  • Americans facing strained household budgets will begin to economize, which will lead to decrease in overall consumption, including oil based products – less driving, less packaging, less eating out, etc.
  • Higher fuel costs will lead to increased carpooling and less driving, which will help to reduce traffic and lower pollution levels in many cities
  • Higher fuel cost will spark a renewed awareness in conservation not only of food but of fuel, electricity, water, and other limited resources
May Your Trades Be Profitable!

Ed Kim
====================================================================================== [i]

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