The Tycoon Report

What's that cooking in the kitchen?

Last week, gasoline usage plummeted 4% on the back of $3.50 gas  prices. Some have opined that this is enough to plunge us into  recession. Maybe, but I don't think so. The Europeans have been  living with $5 gas for years, the Brits pay over $7 a gallon for  their gas, and you don't see economic activity screeching to a  halt in those countries.  

Quite frankly, we don't see the gasoline usage drop-off lasting  long, even at these elevated levels. As investors, we need to  always remember that the average American is a voracious consumer  that spends money like a drunken sailor, and God bless him for it!  Many folks have good paying jobs and still have growing equities  in their homes which they are happily tapping into to feed their  consuming ways.

As many of you already know, getting into a recession is like  baking a cake; it takes a certain recipe for one to happen.  It will take a very special combination of events to put the  US into a recession, and we want to make you aware that we see  all of the ingredients laid out on the table.

One group of people says that the Fed should postpone its rate  raises or even cut rates in light of the astronomical costs  generated by Hurricane Katrina. It was these people coupled  with short covering that drove the markets higher last week.  Others say that any rate cuts here will just drive an out of  control energy pricing spiral and create more inflationary  pressure without growth. (Anyone remember the stagflation of  the 1970's?)

Here's the hard reality of it. Higher energy prices ALWAYS  precipitate recessions. ALWAYS. The question isn't if;  it's when, how long and how bad?.

The problem with high energy prices is that the price of a  barrel of oil is hard wired into our economy. It increases  the price of everything from manufacturing to shipping, and  plastics to pipe cleaners.  

What happens when costs rise?  

Companies that make and distribute products and services  see their profit margins SHRINK. When profit margins shrink,  you either have to raise prices or cut costs to maintain  net earnings.  

What happens if companies can't pass on price increases to  their customers? The Boardroom big shots have two choices:  they can take the hit, make less money and watch their stock  price and their stock options get POUNDED, or they can cut costs  (read CUT JOBS!!). Which way do you think they're going to go?  Not a tough question. Obviously, they're going to side with their  personal wallets over the wallets of their employees.

Now multiply this out across Corporate America, and you've got a  big problem. Like Nitrogen added to Glycerin, the combination of  massive corporate layoffs (euphemistically referred to as  "Corporate Restructurings") combined with a highly leveraged  American consumer will lead to a MASSIVE EXPLOSION of defaults  on both credit card and home mortgage debt. This is a scenario  that is absolutely unavoidable should unemployment spike, and  the effect will be felt globally.

Like a child who whistles past the graveyard to fortify his  courage, we see Wall Street's confusing $64 oil one week vs.  $70 oil another week with a good thing for the US economy  perplexing to say the least. To put it another way: "da-nile"  is not just a river in Egypt.  

High energy prices are going to be a new reality for us for a  good while. There are two primary ways to drive energy prices  lower, and both take time.

Method # 1  Find and refine more oil; find and pump more natural gas. Here's  the problem. Due to the cyclical nature of energy prices, the  oil and gas guys have been burnt badly by expanding their drilling  operations during the boom times only to have energy prices plummet  as they ramp up production. As a result, they just decided not to  aggressively drill for new oil and gas!  

Even the pros, the guys who are in the industry, never imagined  that $70 oil would be a reality. Matched with China's and India's  burgeoning demand from their growing middle class, and what you  have is a perfect energy Money Cycle!! It takes years to build  and deploy large scale energy exploration and production facilities.  So strike Method One as a way to reduce energy costs.  

So what's Method Two?  

Method # 2  The other way to lower prices is to choke off demand. It's been  said that "When America sneezes, the whole world catches a cold."  That's never been truer than now in our networked global economy.  If the American economy stumbles and demand falters enough to tip  us into recession, then the global knock on effect will take down  not only oil prices but all asset classes in general. Think China's  demand will buoy oil prices? Think again. China gets about half  it's annual GDP from exports. If we have a sharp global recession,  CHINA IS DONE and done for awhile. It'll hurt us, but it will  DEVASTATE them!

Tune in for Part II next week.

"Let the game come to you"