While the events in the Middle East are encouraging from the standpoint of potentially transitioning those countries from despotic regimes to democracy, the impact on the world price of oil is problematic. The successful ouster of Mubarak in Egypt didn’t send the market into panic but the events in Libya certainly have. The possible spill over of citizen revolts into other oil producing countries has made the oil market nervous, to say the least.
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.
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