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Residual Values To Remain High – Even In Face Of High Gas Prices

I have been privileged to discuss residual values and the pre-owned market with a number of industry experts over the years.  An idea that was born in a late 2008 discussion over a beer with Matt Traylen, then Chief Economist for Automotive Leasing Guide, has since become full blown reality.

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.


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Turning Oil Into Salt – A Review

Turning Oil into Salt, a review of the new book by Gal Luft and Anne Korin

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:


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:


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.

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