Forget $4 Gas – Can the US Handle $6 at the Pump?

The short answer is likely no, at least not at any time soon. That’s not to say, however, that middle east contagion fears are completely overblown.  The fact of the matter is that I believe that potential worst case scenarios are not as bad as many have come to believe long-term; but short-term, as we all know, anything is possible.

In the short run:

  • Muammar Gadhafi is a deranged lunatic, believed capable or anything from setting his nation’s oil reserves ablaze to genocide.
    • With sanctions having been imposed against Libya, their assets frozen, and the nation effectively divided in two, further escalation in violence may be imminent.
  • Saudi Arabia – given their enormous reserves, and that they have stepped up oil production to offset losses from Libya, concern of stability in Saudi escalates anytime the youth of the region so much as sneeze’s in its direction, it is understandable that the world’s eyes are focused turmoil in nearby Bahrain, Oman, and the country’s Shiite minority.
    • Bahrain and Oman will both be focal points in determining potential swings in crude, as worries of unrest spreading to Saudi grip the market
  • Algeria strikes many as a likely candidate for contagion due in large part to being situated in North Africa, near Egypt and Libya, considering it’s extremely high unemployment rate amongst the youth, and after having been run under a state of military emergency for 40 years – not to mention large oil reserves.
  • Though Egypt has been somewhat removed from our radar we must remember that they are essentially leaderless as a nation (with no president), and no elections scheduled until September of this year.
  • Iran. Appropriately one of only two ‘four-letter’ words on my list.  We know they’ve had issues, and we now know (courtesy of Rajat Gupta) that it’s easier to get information out of Goldman Sachs than it is from Iran.  Over the past two weeks rumors of Iranian warships entering the Suez tore through worldwide oil markets intra-day.  It is hard to assign credibility to any breaking news from Iran, and therefore I assign Iran as my ‘sleeper’ major headline-risk from the middle east (with Saudi being the 800 lb gorilla).

Of the above issues the most pressing is clearly that of Gadhafi in Libya, as history shows it’s difficult to assign probabilities to the potential actions of madmen – they’re literally capable of anything.  On the other hand, the President of Saudi Arabia was recently greeted with jubilation as he returned from medical treatment abroad, promptly instituting further benefits for the unemployed, and pledging to increase oil production to offset losses from other key mid-east nations.  Meanwhile, Algeria preempted many fears of further contagion by ending its 40-year old military sate of emergency – a state of control that Egypt had been under, until after their uprising.  This past week, further protests in both Tunisia and Egypt proved both successful and peaceful.

Though the future of the region as whole may be much brighter than many might believe, that doesn’t negate a few other pressing issues we’ll have to deal with.  With US forces having approached the shores of Tripoli amidst reports of Gadhafi  loyalists massing near rebel strongholds, and with substantial sums of Libyan assets having been frozen, full-scale escalation appears imminent if the US is unable to dangle their $30 Billion ‘carrot’ of seized assets and execute some sort of negotiated exile.  While any escalation would likely come in the form of a UN led security force (or at least for once a UN approved one), it will set an interesting precedent of supporting such uprising.

If Gadhafi has to go the hard way everything changes, and I mean everything.  If Gaddafi choses not to leave I believe that verifies that he is devoid of any logic or sound reason, and they since he doesn’t care about his money he therefore may no longer care about his oil reserves – if Gadhafi pulls a Saddam and starts lighting oil well on fire I don’t want to think about filling up my gas tank, let alone where crude might trade.  Longtime Gadhafi friend and Libyan ally, Hugo Chávez of Venezuela, has recently made news calling for negotiation with the Libyan madman, and has historically stood at his defense.  Rather then speculate further, suffice it to say that it is more than disconcerting having a Gadhafi supporting dictator with his own sizable oil reserves on this side of the planet.

Given the number of oil-producing nations currently, and potentially, experiencing upheaval it is not difficult to imagine crude surging to its previous highs; even if contagion does not spread further, if we were to get a meaningful and prolonged drop in production (or in the case of Egypt, transportation) of oil in most of or all of these nations, it would have a profound impact on oil prices in the short run – particularly in Brent crude, and with a disproportionate effect on the European economy as compared to the US.  Excess US supplies have been able to hold back WTI crude, and may very well continue to, but a prolonged shock could stifle recovery here as well.

Increased margin requirements at commodities exchanges (like CME) have curbed leverage that traders may use, and while in theory this should limit overall speculation, in practice, during times of heavy speculation, volatility may be heightened (particularly when requirements are altered during said speculative period) – so oil may not trade as high, but boy is it going to trade! The last time around when oil peaked we didn’t see gasoline prices above $4.00 f0r long, and that’s because oil prices didn’t stay that high for long (nor were they expected to, if you look at futures) – had oil prices even just hovered at $147  longer, gas would climbed further.

As a general rule always remember that for every $25/barrel of oil you can add $1.00 gallon at the pump.  Long story short, oil may or may not go higher than the famed $147  per barrel high in the next few months, but I can tell you that if prices stay at or near $150 per barrel for more than just a few months that we’ll see US gas at the pump surge to near $6.oo per gallon.

In the long-run:

This could be the best thing to happen to the middle east since air-conditioning.  The eventual outcome might be the best that Americans (though not necessary Dick Cheney) could have hoped for in the Middle East.  If we, as a nation, were actually trying to do anything more in Afghanistan and Iraq than playing “where’s the WMD?” then I think we waned Democracy to be contagious.  OK, yes to be fair let’s acknowledge that in a couple of instances here we have rebellions against US sponsored (or at least funded) dictators/monarchs (Egypt and Bahrain) – but if any President in US history was ever going to be able to look the Middle East in the eye and honestly say “that was then, this is now – we’re different” it’s probably the one named Barack Hussein Obama.

Oil production?

These people aren’t mad (again, with the exception of Gadhafi) – they don’t want to stop producing and selling their most valuable asset.  Understand that, if anything, you could argue that all of this turmoil is centered on dictators and monarchs who hoard, and do not distribute or utilize effectively, their vast oil wealth.  If anything I would believe that after a new government is installed, Libya will be capable of producing more oil with a competent government and improved infrastructure, for example.

The enemy of my enemy is my friend…

One thing worth noting in the negative column might be Gadhafi’s own comments this week that Osama bin Laden was to blame for the uprising in his country, and that Al Qaeda had drugged the youth of his country.  This gives me pause in the same way a parent might expect their child to spend time with the exact people they had told them not to associate with – to be spiteful.  I’d be at least mildly concerned that the youth of a country who hates their leader (Gadhafi) might be drawn to the person/group he seems to fear most, Al Qaeda. Whether or not they’re the ramblings of a lunatic, I pay some heed to the fact that someone with that much to worry about right now is having delusions about Bin Laden and his effect on the youth of Libya.

A crude reality

While I would characterize almost any continued spike in oil prices as just that, a spike, I am certain that the future of crude prices is elevated. Though we continue to improve fuel efficiency and are beginning to offer alternatives, it is not enough – and certainly not considering the forecast for increased global energy consumption. Without an energy policy the US is unlikely to make much headway and, even when we make the necessary switch to using more of our abundant natural gas resource, oil prices are likely to remain elevated.  Given global supply, geopolitical concerns, and that after shale is exploited most of our sources of crude will be more and more costly, I believe that in the next few years we may see oil below $100 per barrel for the last time in our lives.


Internet Revolution Strikes, Again: Both in the Streets, and on “The Street”

Every analyst on the street already seems to be on the bandwagon, and every pundit on TV believes we should be scared by so many analysts being in agreement: tech stocks are cheap. Many of them have been cheap for a decade – and they were cheap for a reason.  The explosive growth of bubble wasn’t a total farce, much of that growth was simply robbed from the future – countless companies experienced a decade of growth in 18 months……and then the wheels came off.

Less than 4,000 days later……

The growth of the internet bubble was unprecedented; with companies’ valuations sorry virtually overnight, despite an internet still in its infancy and no profits at many companies.  Companies like Global Crossing and JDS Uniphase spent billions laying fiber optic cable and acquiring companies for growth.  The result: so much bandwidth, a glut, that it would take us a decade to work off the capacity.  And so, much like the very stocks that led the boom, both the internet and it’s companies had grown wildly faster than people’s ability to connect to internet, to do so with a high-speed connection, and be able to stream content.  Much like the prices of these very stocks, these companies had grown the internet (in terms of supply of bandwidth) much faster than the growth in demand for bandwidth.

And on the market side, perhaps more than ever, valuations finally caught up to stocks.  Then the seemingly infallible Alan Greenspan (after all of his talk of ‘Irrational Exuberance’) killed the ‘Golden Goose,’ raising interest rates perhaps one too many times….and Enron was exposed as a fraud (and with it Arthur Anderson), Investment Banking and Research were flipped on their head……September 11, 2001…..the Dennis Kozlowski episode at Tyco….and sprinkle in some Sarbanes Oxley – the golden age of stocks had ended.

Accordingly, nearly the entirety of tech-land has languished for the better part of a decade (not withstanding standouts like Apple): value (cheap) companies like IBM spent an entire decade getting cheaper, and cheaper – with its stock price never surpassing $135 (for 10 years) all the while steadily growing its earnings and revenue (much like Intel, though it is nowhere near its’ highs).  Recently, in fact, IBM was finally able to break-out above that very $135 level – technically, this amounts to a break-out from a 10-year consolidation.  No wonder that only days aver surpassing $135 , IBM was able to trade north of $160 (likely on its way to north of $200).

What happened?  Many things have happened….though there are a few key factors that demonstrate that this is the break-out tech investors have been awaiting since the dawn of the internet age.

A dearth of bandwidth meets soaring data demand……

Fast forward 10 years, 4 iPhones, not even Google nows how many Androids, 3 prominent social media sites (Friendster, MySpace, then Facebook), two incarnations of high-speed mobile networks (3G & 4G), and a President elected by the social-media age, and we find ourselves in a brave new world.We finally have the streaming content, mobile access, and are so socially connected that we, as a people, have completely overrun the entire internet infrastructure.  Just weeks ago the last IP address available was used.  In New York City, where I live, my iPhone has been reduced to a paperweight during times of high data-traffic.

Governments around the world are in a race to provide the vast majority of their populations access to high-speed digital internet, while mobile carriers struggle to upgrade their networks to meet demand.  Right in the middle of at least the second worst financial catastrophe in modern civilization, we are witnessing the equivalent of a ‘digital’ New Deal.  With the world on the verge of what could be considered a long-term structural unemployment problem we are witnessing  the mass reconstruction and build-out of the entire information super highway – and many of the broken companies of the past boom are back again to reap the rewards.

Make no mistake there are, and will be losers.  Some companies did not (or not yet) adapt to the changes of the second coming of the digital age (we’ve all seen Cisco’s last few quarters).  In other areas there has been a changing of the guard; Apple is one of the rare exceptions that never skipped a beat over ten long years, and Google appears to be he new Microsoft, but better – by being the leading software provider to the ‘new’ hardware (mobile devices), all the while using their search business to literally ‘print’ money.

The Revolution will not be televised……

From President Obama to the recent uprisings in Tunisia and Egypt, we have also seen the power and scope of the internet revolution we are in the midst of.  This social revolution has created a kind of momentum, social, political, and technological, that cannot be stopped and the will forever change the course of history.  Every day we are more and more connected, and those who are unable or unwilling to adapt will be left behind; people, companies, and countries alike.  This was perhaps no  more evident than when [former] President Mubarak of Egypt spoke the world this past Thursday; he adamantly implored his people, the youth of Egypt, not to listen what the people on TV were saying/telling them what to do.  In that moment it was so obvious. This movement that began with a Google executive’s post on Facebook, a movement against a President/Dictator that, despite weeks of protests, was completely oblivious to the root of the riots and, to what the world had become.

This is a lesson not just to other nations that might rise up in peaceful democratic protest, but to all of us.  It’s been called a ‘tipping point,’ or wildfire, even cancer, but, like or not, the digital proliferation of humanity can no longer be stopped.  Perhaps more now, than ever in history, the people of the world, the masses, have the loudest voice.

The bottom line, is exponential……

This translates to a world where the most valuable infrastructure is digital, the most important security is cyber, and the majority of the world’s capital flows through fiber optic cables and is then transmitted through the air – and the rate of the proliferation of any and all of these digital trends is more rapid than anything in human history.  Faster than anything the ‘old world’ could muster other than perhaps cancer.  This past year social networking/group-coupon company, Groupon, grew from literally $0 in value to a valuation of over $1.4 billion – in less than 8 months! The company’s value literally grew at the speed of ‘word of mouth.’

Whether it’s the growth of the conservative ‘Tea Party’ or the youth of Egypt throwing their own ‘Cairo tea-party,’ we can literally see the proliferation of the internet revolution on the street.  If we look at IT spending, or at productivity, or at the growth in profits and revenues at tech companies, we can literally see the proliferation of the internet revolution on The Street.  And this time, they’re growing at almost the same rate.

Why the street is wrong about what the iPhone means to Verizon

For months and months we have speculated (and been right) that the iPhone would inevitably come to Verizon and end AT&T’s reign of exclusivity with the popular consumer device – the time seems to finally be upon us.  Yet, all of the naysayers are now trying to convince us that the iPhone may be more trouble than it’s worth for Verizon; that subsidizing (the cost of being able to offer that sexy $200 price-point) the iPhone will crush Verizon’s margins; that bandwidth consumed by iPhone users might cripple Verizon’s network; that iPhone might cannibalize Verizon’s more profitable Android sales; and that somehow the moment we’ve been waiting for since the launch of the first iPhone might not be all it’s cracked up to be as a user experience, or as an investment.

Now let’s take a look at why none of he above will prove to be much, if any, headwind to the Verizon/iPhone experience:

The cost of subsidizing the iPhone will cripple Verizon’s margins.

Perhaps, and perhaps you’re mad.  Verizon is a $100 billion company, a significant portion of which is the landline/Fios business (Verizon [VZ] only owns 50% of Verizon wireless) if you’re worried about iPhone having an extreme negative impact on margins please bring it on, because iPhone sales would have to be extraordinary to affect margins much in the short run – and the long-run it should be a non-issue.  And like most carriers, Verizon limits the number of times per year you can upgrade phones and pay the discounted price (like the $200 iPhone) – so everyone who upgraded to Android or a Blackberry within the last 12 months will have to pay full-price or wait; therefore you can try to believe that iPhone will cannibalize Android or hurt margins, but not both – you are not allowed. Even if Verizon’s margins are hurt but the subsidy of new phone sales (with new contracts) all of those customers will extend (or sign) their contracts, and the rest will be defecting from other carriers – so if we see growing revenues with a hit to margins at Verizon, we’d probably see a hit in revenues at other carriers.

iPhone users will completely over-run and/or cripple Verizon’s great network.

Imagine the iPhone is LeBron James and that Verizon is the NBA.  Now realize that Verizon has known that “free-agency” was coming for several years and they have ramped their network accordingly – like NBA teams clearing salary cap space to compete for LeBron – they have capacity, 4G has come online, they have further investments to the network scheduled, and if they really need more bandwidth they can always buy Sprint or T-Mobile.  Again, if the network is crippled short-run (which is when I’d be worried, because they’re still improving their network) I’d have to chalk it up to a ‘good problem to have’ because it would indicate that not just usage, but also sales were fantastic – you’re no crippling that network overnight.

Cannibalizing Android sales…….money out of one pocket and into the other, and at lower margins.

As we discussed, I believe this issue is overdone.  Will it occur?  I’m sure it would have to at some level, but realize this: while Android has been growing market share, that growth has been accelerating.  Therefore a disproportionate amount of Android devices are likely to have been purchased more recently, and accordingly these users will not be eligible for an upgrade to buy a $200 iPhone – and several Androids are priced well below iPhone, meaning they are not in competition.  The dominant expectation continues to be that many iPhone users will defect from AT&T, hold-outs at Verizon will finally buy the phone they want, and others will move to Verizon that wouldn’t, for one reason or another, move to AT&T.

But, is that it?

This may be just the tip of the iceberg. Verizon seems to be the leader in 4G; so we should expect to see 4G versions of the iPad and iPhone in the not to distant future.  I also believe that Verizon’s network is good enough that continued success could prompt Apple to release other phones (an Apple phone not called iPhone?) – perhaps even one with a keypad. Analysts have said that the iPhone going to Verizon was priced-in the stock after is recent move, but that the market hadn’t discounted all of the above concerns .  The fact of the matter is that the market has already discounted the above, and Verizon will not likely fall into the category of “victim of its own success” – at least not any time soon.

Trading Notes: I’m not here to say if Vodaphone (the other 50% owner of Verizon wireless) is a better play than VZ – that’s up to you.  I do happen to believe Spring will be bought, or possibly merge.  And if you’re wondering what I think of AT&T – if my friend (and account manager) ever quits there I will run, not walk, to the nearest Verizon.

To be fair: I am at the time of writing, and/or manage accounts that are,  long Apple, Verizon, and Sprint. Members of family own Google.