At the time, the stock market was tanking, new vehicles sales had slowed to a crawl, the auto manufacturers were begging for money before Congress, the acronym TARP had just been coined and the economy and our lives were looking bleak and uncertain.

Most lenders had announced in previous weeks that they were getting out of the leasing business, or dramatically “pulling in their horns.”  The asset backed securities market had disappeared, pulled down by the mortgage backed securities market and we were hearing unpleasant terms like “toxic assets.”  This reminded me of some earlier dark days in the auto industry when a dealer or leasing company might take particular vehicles to auction and they wouldn’t even draw a single bid, a particularly difficult position when one had a payroll due.

It was easy to understand how a bank holding a lot of “toxic assets” but little cash could become a “zombie bank,” a term invented to describe the Japanese banks after their own real estate bubble burst. That is a bank with a “strong” balance sheet but no cash to loan or to return to depositors who arrive “electronically” at the bank to make a withdrawal.  Marking these assets to market was impossible because values could not be established as no one would bid on these mortgage backed securities or their “first cousin,” auto loan backed securities. Regardless, “mark to market” it would have rendered the U.S. banking system insolvent and caused a complete meltdown.

After acknowledging that most of the major players had announced their exit from the leasing business, the collapse of available financing for fleet and daily rentals, and the dramatic drop off in overall new vehicle sales volume, Traylen and I asked, “Where will pre-owned inventory come from down the road?”

While used vehicle sales plunged from a high of about 44 million units in a single year to about 35 million units in 2009, it became apparent that once demand began to trend upward toward historical volumes, there would be an acute shortage of available inventory.

Within a few months, GM and Chrysler went through bankruptcy and Cash for Clunkers plucked another 600,000 potential pre-owned vehicles out of the system and fed them to the crusher.  The Buy Here Pay Here business was really crushed as what the government called a “clunker,” they called “inventory.”

Today, there is considerable pent up demand for pre-owned vehicles and the banking system has recovered to the point that ready financing is available again.  There are still serious issues to be resolved in the economy, not the least of which is high unemployment, but demand is building.

Other than unemployment, the biggest impediment to full economic recovery is the fact that 25% of American mortgages are in negative equity territory.  The large numbers of foreclosures have left empty and/or abandoned houses in neighborhoods across the country further depressing home values.  Few neighborhoods, regardless of affluence, are immune from this.

Economist Alan Greenspan, past chairman of the Federal Reserve Bank, recently stated that he did not believe the economy could reach full recovery momentum until the real estate market experienced at least a 10% increase in home values.  It just is not clear how long it will take for home real estate to become stabilized, let alone regain value.  On the other hand, the rebound of the stock market has restored almost 16 trillion dollars of mostly American wealth.

Against this mixed backdrop of economic news and general economic uncertainty, there is much more demand than available pre-owned inventory, which is driving wholesale pre-owned prices ever higher.  We see pent up demand in the new vehicle business by the steady increase in sales results.

New vehicle incentives have a considerable impact on pre-owned values.  If incentives lower the true transaction price of new vehicles, the value of same make/model pre-owned vehicles drop a commensurate amount.

Restraint of late on the part of auto manufacturers to refrain from over production is keeping dealer inventory levels in line with demand.  It is likely that OEM restraint on overproduction and incentives will be ongoing as they have new policies and labor agreements in place. The fact that dealer floor plan arrangements with lenders are much more restrictive than before has also helped maintain this equilibrium.  Few dealers have the liberal floor plan arrangements these days that once allowed for the massive stocking of vehicles on behalf of a manufacturer looking to “force the market” with incentives.

But now that financing for leasing has recovered, OEM captive finance arms are focusing on shorter terms to try to create additional supplies of pre-owned inventory.  Financing for the daily rental business has allowed rental companies to begin to return to more traditional replacement cycles.  The same is true for fleets.  So what is the outlook going forward and how will it impact residual values?

Experts say we will continue to experience pre-owned shortages for at least as long as 5 years.  Some niches will be more acute in this respect than others, and segment values could change with fuel prices and other issues.

But the tremendous shortfall in pre-owned inventory supply will take years to balance out as demand increases in line with economic recovery.  In talking to experts like Tom Webb, Chief Economist for Manheim Auctions, Tom Kontos, Chief Economist for Adesa Auctions, Ricky Beggs, Managing Editor and Vice President for Black Book, Rene Abdalah, Vice President of Residual Value Insurance Group, Eric Ibara, Director of Residual Value consulting at Kelly Blue Book and Traylen who is currently head of M.A.T. Consulting, the consensus is that the shortage will be with us for at least 5 years.  Residuals are expecting to stay quite strong!

However, in projecting residual values, there is a somewhat different outlook between Abdalah of RVI and Ibara of KBB and their counterparts at Automotive Leasing Guide.  Both companies are convinced that as long as fuel prices increase gradually, American consumers will adapt without drastic short term consequences.  Consumers will tend to buy the largest vehicles they can afford.

Other than “early adopters,” most consumers will only pay a technology premium for “electrics” and hybrids if the government pays it for them through tax credits or other subsidies.  When fuel prices suddenly spike, as they did in 2008, fuel economy becomes the consumer’s primary motivator. However, experience shows this is a short term circumstance.

As we have seen repeatedly, and as recently as the price spikes in 2008, high fuels prices are followed by oil gluts and extreme fuel price declines as oil producers rush oil to market to capitalize on the high market prices, creating over supply.  In 2008, the cycle began in April when the price threshold broke $4./gallon.  By the time January 2009 arrived, a gallon of regular was $1.90.

So while there may be some price spikes along the way, Ibarra and Abdalah expect the overall fuel price trend will be gradual.  As a consequence, manufacturers will have to deal with substantial Corporate Average Fuel Economy (CAFÉ) fines if consumers do not naturally purchase a product mix that lends itself to the auto manufacturer’s, and the government’s, CAFE objectives.

In the past we have seen manufacturers prefer to pay significant consumer incentives to move vehicles they need to move to avoid the CAFÉ fines.  With CAFÉ requirements at extremely high levels, it is logical to expect the focus of OEM incentives to be on fuel efficient vehicles. The CAFÉ standard for 2016 for cars is 39 mpg ad 30 mpg for trucks. This will drive down the values of like make/model pre-owned vehicles. Lessors need to consider this very real possibility looking down the road.

At the same time, manufacturers can be expected to raise the price of larger less fuel efficient vehicles and reduce incentives to try to make more gross profit per unit, while somewhat depressing volume to enhance their CAFÉ calculation.  As a consequence, Kelly Blue Book and RVI Group residual projections are higher for “heavies” than ALG’s projections while ALG’s projections are higher for smaller fuel efficient vehicles.

If a cataclysmic event takes place and oil goes to $200. plus per barrel, and stays there, all bets are off anyway.

Lenders, fleet operators, and private capital leasing companies will have to make their own overall residual setting decisions and come to their own conclusion about each size and fuel economy segment.  However, there is no doubt that overall residual values will stay historically strong in the years to come as strong demand for pre-owned vehicles overwhelms the available supply.

If you believe in global warming, you believe we need to get off of fossil fuel.  Conversely, if you believe we need to reduce the strategic value of oil, it is a different calculation.  People get these issues confused they result in similar outcomes.

Reducing our dependence on fossil fuel is generally considered the province of “Green Liberals,” “Al Gore Disciples,” “Tree Huggers,” “Global Warming Alarmists,” etc. However this is certainly not the case.  An example would be the following video made by unlikely partners, Newt Gingrich and Nancy Pelosi:

http://www.youtube.com/watch?v=qi6n_-wB154

But reducing the strategic value of oil is something everyone should be able to agree on, even for those who are skeptical that a global warming hazard even exists.  The following video was made by ex CIA head James Woolsey:

http://www.youtube.com/watch?v=3mWeyREivdk

So why are you reading this in an auto publication?  Because according to Gal Luft and Anne Korin, the authors of Turning Oil Into Salt, MORE government intervention into the auto industry is required to reach a solution.  Many of us are rolling our eyes at even the thought, but the stakes couldn’t be higher.  We ARE engaged in a war against fundamentalist Islam, and we ARE paying for both sides of the war.

Today, roughly two-thirds of the world’s oil is used for transportation, and most vehicles are able to run on nothing but traditional gasoline. As such, oil’s strategic status stems from its virtual monopoly over fuel for transportation, which underlies the global economy and our way of life.

To understand the implication of an over dependence on a strategic commodity we can look at history.  At one time, salt had a virtual monopoly on food preservation.  Wars were fought over salt.  Finally, Napoleon, whose army “traveled on its stomach,” had enough and offered a significant sum of money to the person to eliminate his army’s reliance on salt.  Within a few years, a French chef invented food “canning.” After canning, electricity, and refrigeration, salt has lost its strategic status and we no longer go to war over salt.

How can this be accomplished with oil?  According to Luft and Korin it only requires Congress to mandate that from a specific date forward, all or most vehicles sold in the U.S. must be manufactured as a “flex fuel” vehicle, capable of running on gasoline and/or a variety of alcohols and blends.

This has already been done in Brazil where 80% of new vehicles purchased in 2008 were flex fuel.  The additional cost to produce a flex fuel vehicle is about $100, which includes the cost of premium fuel system components, a fuel sensor and computer chip reprogramming.

The first Model T Fords ran on gasoline OR alcohol, so the concept is not new.  There are also a variety of alcohol fuels available.  Alcohol does not mean just ethanol, and ethanol does not mean just corn, a particularly bad fuel feed stock.  Other alcohol based fuels include methanol made from coal and ethanol from almost anything.

According to the authors, the average vehicle in the U.S. is in service for 16.7 years.  Once 15% – 20% of the total vehicles on the road are flex fuel, the market will take over.  Refueling infrastructure will develop and additional alcohol production will come to market with coal/methanol probably eclipsing corn as a feed stock, much to the chagrin of Midwestern farmers and Senator Charles Grassley.

Add in additional vehicles operating on compressed natural gas and electricity, plus additional conservation based on increased fuel efficiency, and dependency on oil could be reduced 35% in 10 years, the exact amount we currently import from OPEC.  We would also be less dependent on oil in general and all of our oil could be sourced from North America, including Mexico and Canada.

There is even a “Drill Baby Drill” component to the Luft/Korin plan, although we have some disadvantages in the USA.  It costs OPEC less than a dollar per barrel to lift their oil from the ground, while it costs us almost $10.   They have about 78% of the world’s known reserves, but only produce 40% of the world’s supply, as they work to maximize the price of each barrel they sell.  OPEC produces less now than they did in 1973.

In the meantime, we have less than 5% of known reserves but consume 25% of the world’s production.  And the lower the American price at the pump, they more we’ll consume and the more pressure we put on the world market price of oil to rise.  Unfortunately, we don’t get a discount for our volume purchases.

OPEC also has the nasty habit of flooding the world market with supply to drive down the price any time a new but more expensive technology threatens their dominant position.  This is another reason government involvement might need to be involved before flex fuel begins to make oil a less strategically important commodity.

A bill called the “Open Fuel Standard” is pending before both the House and the Senate.  The bill ensures that 50% of new vehicles sold in the U.S. with an internal combustion engine would be warranted to run on gasoline, ethanol, or methanol.  Diesel vehicles would also be warranted to run on bio-diesel.

In 2009 there were no fewer than 33 Make/Models warranted to run on up to 85% ethanol, but no warranty for methanol.    Expanding this to more models and including blends of methanol should be easy.  Brazil has done it and at one time, auto manufacturers considered using methanol as an octane booster, but chose lead instead.

There are currently 8 million flex fuel vehicles on the road out of 200 million total vehicles but we have not yet reached the critical mass necessary for the market to respond with refueling infrastructure and additional investment in alcohol production.

Some say the expansion of alcohol fuels is being held hostage by agribusiness lobbying efforts.  For some reason, we place a 54 cent per gallon tariff on imported Brazilian sugar cane ethanol.  A barrel of oil is 42 gallons.  You can do the math.

Turning Oil into Salt is must reading for auto industry professionals and for all U.S. citizens.  And it’s a quick read, making its points in only 138 pages.

Also, if you are into LinkedIn, please join our National Vehicle Leasing Association group: http://www.linkedin.com/groups?mostPopular=&gid=2130586

At the end of last week, the price of US gasoline was up $.53 per gallon from this time a year ago and US Light Sweet Crude has now once again topped $100 per barrel.

While watching the impact of oil prices on the auto industry for a period of decades, some things have become evident.  When the price of oil rises SUDDENLY, usually caused by some world event OR the anticipation of an event, there is a rush to produce and sell at the higher world market price.  This mitigates the shortage in a relatively short period of time and invariably produces a glut.

As oil prices continue rising, greed drives some members of OPEC to sell over their agreed upon allotment, creating an additional black market supply.  Sometimes Saudi Arabia and other OPEC countries try to counter this by cutting back on their own production.  Other oil producers rush available supplies to market.  In the U. S. oil patch, dormant wells are revived as the higher price makes it practical to borrow money to repair and update pumping, transfer, and storage equipment.  Small producers generally repair their equipment when the price goes up and run the equipment until it fails or needs a general overhaul when prices fall.  If the market price is still high, they will spend money on maintenance and repairs.  If not, they shut down the well and wait for the next price spike.  The bankers they do business with understand this cycle.

And while producers rush to fill the void and capitalize on the higher market price, demand weakens.  Ultimately, tanker ships and storage facilities are topped off and ships end up anchored offshore waiting to off load.  When the price falls, it takes a while to move the high priced oil through the system, resulting in prices at the pump that stay high seemingly longer than they should.  Oil companies who were sitting on low priced inventory suddenly have that inventory revalued at the new higher price, resulting in really high short term profits and a grassroots backlash at oil companies in general.

So how does this play out in the US auto industry?

Invariably, residual value predictors are again proven “wrong,” although the numbers are usually in-line with the exception of these “artificially” triggered market price spikes.

However, when spikes in oil prices occur, Dealers are susceptible to rapid and extreme value drops on pre-owned inventory that is not fuel efficient.  Similarly though, we see rapid run-ups in valuations of hybrids and economy cars.

This pricing volatility leads to stagnation of trades for trucks and SUV’s as more of the same at any price no longer provides any useful reflection of true value at the auctions.

In these situations, it is not uncommon for a dealer to take a “heavy” to an auction sale and leave without drawing a single bid.  The term “toxic asset” applies here.

If the dealer practices “mark to market” accounting, he/she will write down “heavy” inventory immediately, causing a huge loss and drawing the extreme scrutiny of the dealership’s lenders and investors.  If “mark to market” is NOT followed, inventories are drastically over stated, at least until the high priced oil moves through the system and order is restored.  The entire new and pre-owned auto market is disrupted as consumers look to trade off their “heavies” and move to something more fuel efficient.

Believe me. I’ve watched as this cycle has repeated itself at least a dozen times over the last 40 years.

Trading “heavies” during a time of high fuel prices can be a punishing experience for the consumer, as their trade has been devalued by market forces and the fuel efficient vehicle they want to buy now carries a premium.

Historically though, US consumers quickly become dissatisfied with their new fuel efficient rides about the time fuel prices drop again.  Many drivers will even go back out into the marketplace to trade their new fuel efficient vehicle in on another “heavy.”  Again, market forces have driven down the value of their trade and placed a premium on what they want to buy.  The consumer becomes frustrated and blames their plight on the dealer or the government, or both.

During periods of high fuel prices banks and lease lenders experience immediate losses on “heavy” vehicles that come off lease.  Instead of holding on to that inventory until the market stabilizes, they are usually forced by financing arrangements to liquidate off-lease inventory as soon as possible incurring massive losses.

On top of it all, the US manufacturers see an overall drop in sales volume coupled with a drastic reduction in sales of their most profitable trucks and SUV’s.

As we move into a new era where relative fuel efficiency can be achieved in ever larger vehicles, it is not clear if the historic formula will continue to replay itself in exactly the same way as before.  For example, the Hyundai Sonata achieves 34 highway/28 city MPG in basic 4 cylinder form.  A tiny MINI Cooper only achieves 37/29 MPG.

But everything is relative.  The person trading a Tahoe on a Malibu gets a vehicle that is a great combination of size and comfort while still getting excellent fuel economy.  But a Malibu isn’t a Tahoe.  It won’t tow and it won’t go off road.  And it won’t carry 7 passengers.  So expectations are that the historical model will generally replay itself this time around with possibly a few exceptions.

However, compared to what we saw in 2008, auto companies are better positioned to weather the storm from an overhead standpoint.  They aren’t encumbered by the same oppressive union work rules.  They have achieved better manufacturing flexibility and the Asset Backed Securities market isn’t on the verge of collapse.  Hopefully, everyone will keep their heads.  This has happened before, and it will happen again.

What Lies Ahead?

In the 1980′s Lee Iaccoca proposed a 25 cent per gallon fuel tax.  Conservative car guy Bob Lutz continues to call for a European style fuel tax.

Recently, New York Times columnist Tom Friedman called for an increase in fuel tax of 5 cents per month for 20 months, making the case that the buying power of the current fuel tax has been halved by inflation since the last increase in 1993.  He proposes to pay down the national debt with the money.  I presume he thinks that is a better way to go than instituting some new tax brackets at the top of the income scale.  Or perhaps he proposes to do both.

Even people like Alan Mullaly and Bill Ford have expressed the desire for a fuel tax, instituted in such a way as to provide some market predictability.  On the QT, most auto execs AND politicians will whisper the same, although they are reluctant to come out with it publicly.

No doubt the country’s politics will prevent us from getting a pure solution.  The system in use in Europe and Japan works way too well for us to adopt it.  It seems evident that the Middle East will continue to be impacted by events such as are happening in Egypt and Libya.

It is reasonable to expect that the dissatisfaction of the masses will drive change in many more oil producing countries, including Iran, Saudi Arabia, and Venezuela.  As such, I suspect the world price of oil to remain volatile for years to come with shortages caused by political events followed by gluts caused by the backlash of over production.

And just as we have witnessed again and again over the last forty years, there is great profit opportunity for those who can predict these cycles while auto manufacturers and dealers will continue suffering from the whip saw effect.

Lastly, I thought I would leave you with a little perspective. Be sure to tell me what you think about it all.

Ruggles

More Fuel for Thought

38 – That’s the number of miles per gallon (US gallons) that the average passenger car in the UK is getting according to the British Department of Transport.

22.4 – That’s how many miles per gallon (US gallons) the average passenger vehicle in the United States is getting according to the Bureau of Transportation Statistics.

9,200 – How many miles the average UK driver travels in a year.

13,000 – Number of miles driven each year by the average US driver, 40% more than in the UK.

“To put those numbers in some context, the average US driver will use 580 gallons of fuel each year, compared to 242 in the UK, 139 percent more. Even allowing for fuel that’s less than half the price ($3.88 per gallon vs. $8.52 per gallon, currently), US drivers are still poorer to the tune of nearly $200 a year.” Source: Ars Technica

No sooner did the Super Bowl end than the debate over the auto industry ads began.  And there were a bunch of them.

Chrysler’s two minute spot promoting Detroit had a lot of people buzzing.  It seems Chrysler has a new spokesman, one Marshall Mathers, who goes by the name “Eminem.”  He seems to be well known in certain circles.  I was in a cigar bar in San Francisco for the game and the ad drew a lot of attention.  My first impression was I was impressed, but mostly based on how the ad advocated on behalf of Detroit.  I thought the Chrysler 200 in the ad was a kind of an “after thought.” 

But no one in the bar knew the spokesman. I estimated the crowd to be in the 45 – 55 age group, a demographic that is much more capable of buying what Chrysler needs to sell than the age group who instantly recognizes Mr. Mathers.  Further dialogue indicated that in that 45 – 55 age group, of those that know him, most don’t like him and certainly don’t want him as any kind of a role model for their kids.

So the debate was on.  I find that younger consumers, especially those who aren’t parents yet, were particularly fond of the ad.  They also sympathize with the plight of Detroit.  Who doesn’t?

I gather that Mr. Mathers is somehow a hero of theirs.  They haven’t gotten to the point in life where they feel threatened by angry young people yelling a form of loud poetry from under the cover of a hoodie, and everything that represents.  I find that many parents with children old enough to be influenced by hip hop type entertainment tend to do what they can to protect their children for as long as they can, for better or worse. 

The other ad in the debate is now referred to as Mini-Darth. The ad was from VW and was introducing the new Passat.  The ad features a cute kid dressed as Darth Vader testing his force powers on his Dad’s new Passat, assisted by his father operating remote control functions from inside the house using his remote key fob.  Everyone in the cigar bar hooted and hollered over the VW ad driving me to conclude that it had much more universal appeal than the Chrysler ad. 

Here are YouTube links to the two ads:

Chrysler 200 – http://www.youtube.com/watch?v=SKL254Y_jtc
Mini Darth – http://www.youtube.com/watch?v=R55e-uHQna0            

Advertising costs for the Super Bowl reportedly approached 3 million per 30 seconds, making the Chrysler ad cost about 12 million dollars plus production costs. 

But the entire discussion brought me back to car ad campaigns of the past that are always discussed when the subject of advertising failures and/or counter productive advertising comes up.  In particular, Lisa Marie Presley and “Not Your Father’s Oldsmobile”. 

People who tended to like the ads weren’t Oldsmobile buyers.  It turns out the new Oldsmobiles were NOT anyone’s father’s Oldsmobile.  Dad’s Olds was much better.  The ads turned out to alienate Oldsmobile’s core constituency group, older buyers.  One certainly cannot blame Oldsmobile’s demise solely on the ad, but perhaps history speaks for itself.   

Folks who really liked the Chrysler ad have been quite passionate about it, especially as it pertains to defending Chrysler’s new spokesman.  It certainly will become clear if they will buy a Chrysler because of him.  If the 200 takes the Chrysler Sebring’s place as a ubiquitous fleet and daily rental vehicle, we will have our answer. 

Mini Darth cost about 6 million plus production costs.  Chrysler/Eminem cost about 12 million plus production costs.  Who got the most “bang for the buck?”  Time will tell.

For my own part, I can’t imagine anyone recruiting Keith Richards, my favorite rocker, to sell Toyotas or Hondas, and I can’t imagine Chrysler’s choice this time.  I remember thinking it strange to see Snoop Dog with Lee Iacocca in a Chrysler commercial a few years ago. I heard nothing but complaints about Celine Dion efforts as a spokesperson on behalf of the Chrysler Pacifica a few years back.   But as “hip hop” goes, I AM a fan of the Kia hamsters!  I think they work cheaper than Mr. Mathers, too.  And they don’t seem to have any alienation quotient.

Nevertheless, just because you don’t agree with him, or share his viewpoints, you must now realize that Eminem is as main stream as it gets.

OUTTAKES: Here are a couple of quotes I found particularly interesting from the online debate:

Don S. – I feel compelled to chime in here, Marshall or whatever his name is, is simply an angry young man, and in my humble opinion, standing on stage screaming hardly qualifies as talent. He is rude, profane, and supports through his rantings a culture that is anything but mainstream. My children are not allowed to listen to his rantings (can’t call that music, as there is no tune). As much as I try to not become my father, I allow much of what I don’t agree with as a father but Marshall is off limits.

Kyle Z. – I couldn’t help but to think about our debate while watching the Grammys last night. I know it is a program that is targeted to a very narrow age demographic with low ratings, but I was hoping you caught Eminem’s performance and acceptance of his 12th and 13th Grammy Awards. Not too bad for an “Urban Drug Dealer” that would have to attribute his success to “thuggery and drug dealing”, not his hard work, sheer talent or years of dedication.

As usual, Ruggles finds himself in the heat of the battle and gets to the bottom line.

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Best,

Jeff Cook (LinkedIn)
Editor

David Ruggles is a widely known, auto industry veteran with more than four decades’ worth of experience. His self-titled Ruggles Report is a highly acclaimed industry insider brief detailing the latest hot-button topics in automotive sales, finance and service.

In addition to the authoring the Ruggles Report, Ruggles is a contributing columnist for Ward’s Dealer Business, Auto Finance News and The Daily Post. He has a world-wide presence in onsite dealership sales training teaching sales desk training to the world’s largest privately owned Toyota dealership group in Nagano, Japan for seventeen consecutive years.

It’s safe to say that Ruggles has been around the block a time or two and has seen most everything this industry has to offer. And if by some chance he is not an expert on a particular subject matter, he’s very likely close friends with someone who is.