I had to write a general economic overview for a valuation of ConocoPhillips in one of my business courses. I will reproduce it here so everyone can take a look at what I'm basing most of my opinions off of.
General Economic Overview – This Time It’s Different
For the last two years the world economy, especially the United States, has been in the depths of the largest recession since the 1930s Great Depression. Surprisingly, the last quarter of 2009 provided some hope to the economy. The U.S. economy grew at a 5.7% rate in the fourth quarter, according to the Commerce Department. The fourth quarter also saw a better than expected number from capital expenditures. This was the second quarter in a row that the U.S. has posted economic growth. Economists believe that economic growth should slow down to around 3% in the coming quarters as government stimulus is withdrawn. However, for the full year of 2009 the U.S. economy contracted by 2.4%. This was the largest decline in the last 50 years. The recent GDP report is good, but there are still very good reasons to remain cautious.
When the economy tanked in late 2008 and early 2009 companies cut inventories dramatically. Inventories actually fell below sales, so a buildup in inventories was needed. In fact, over 60% of the fourth quarters GDP number was made up of inventory rebuilding. This is a good thing, but the growth can only continue if sales grow as well. In the fourth quarter sales actually contracted from 2.3% in the third quarter to only 1.7% in the fourth quarter. Unemployment also rose by nearly 500,000 jobs in the fourth quarter. That is hardly consistent with a 5.7% growth rate. This looks like a classic case of a statistical recovery. Not one driven by real strengthening of the fundamentals.
This Time It’s Different
Mainstream forecasts for GDP growth for 2010 are quite good. Most are north of 4%, which is great based on evidence of past recoveries. However, this recovery is quite different and the upcoming downfall will shock most people who have been led to believe over the past 50 years that a government can print and spend its way to riches. We are now running deficits in the trillions. Increased deficits and rising debt-to-GDP ratios are a long term losing battle. We are simply putting off a crisis that will be much worse. You cannot borrow your way out of a debt crisis.
In previous recoveries the economy has been led by consumer spending and a recovery in the housing market. However, bubbles typically don’t recovery for decades. The last U.S. housing bubble was few years ago, so I don’t expect the housing market to lead the way out of this recession. What about the consumer? Many economists believe the consumer will spend us into a sustainable recovery like they did in the early 1980s. This is not the case. Household debt was on 46% of GDP in 1983. Today it is nearly 96% of GDP. The consumer simply can’t afford to take on more debt. Also, if the economy is truly recovering we need to see banks lending to the private sector. The opposite is occurring. In December of 2009 total loans at commercial banks decreased 7.7%.
So what’s really happening? Debt has never been this high before. In the 1930s debt-to-GDP looked really high, but this was because GDP was falling. Today GDP is near an all-time high, but debt is even higher. For the past 30 years debt has been increasing faster than GDP at an ever increasing rate. This creates the illusion of real growth.
We are dependent on debt. In the United States we consume more than we produce. Jobs are fleeing the country and production capacity is moving away. Government debt is also nearing all time highs when compared to GDP. This can lead to only two scenarios. Either the U.S. government defaults, which is unthinkable, or our tax burden goes up. Debt is not always so bad. We used to use debt to create factories and invest in productive capacity. However, in the last decade household debt has been used to invest in TVs and five bedroom cookie cutter houses. What does all of this mean? Credit deflation is a definite possibility. This would lead to further economic contraction and a slump in prices, hurting ConocoPhillips and other integrated oil companies. Some economists think that the Federal Reserve can stop deflation by expanding the money supply, just as it has done many times in the past. I’m not so sure.
This chart by the Federal Reserve Bank of St. Louis shows that total bank credit is actually deflating. Notice that it has been in a steady rise since the mid-1970s with no noticeable contractions until now. Without government spending in the economy this chart must go exponentially higher for each unit of GDP increase every year in the future. That means we must borrow exponentially more every year to support GDP growth. Why? This is because when we borrow banks create money. For this borrowed money to be paid back as principal + interest, the interest portion needs to be created by even more borrowing. There is no such thing as perpetual borrowing. Sooner or later it ends and we will have to experience a significant decline in GDP growth. A decline in GDP growth will drastically affect my valuation of ConocoPhillips
The chart above from the Federal Reserve Board of Governors shows that bank credit is actually deflating for the first time in the last three decades. This recession is clearly different than the ones we have faced in the past. The Federal Reserve is trying to fight this deflation in a massive way. The Fed is essentially printing money and buying the banks bad assets to prevent insolvent banks from being having a liquidity crunch. If it was not doing this the chart above would be much worse. However, the new money is not making its way into the economy through loans and therefore is not contributing to inflation. The next chart shows the increase in the St. Louis Adjusted Monetary base.
If the money supply is increasing so rapidly, where is all that money going to? It is going to the banks to repair their balance sheets. What are the banks doing with the money? They are not lending it. They are parking it in their reserve accounts right back at the Federal Reserve Bank. The chart below shows the increase in excess reserves of depository institutions with the Federal Reserve. Banks are simply afraid to lend. It is a debt crisis that precipitated a crisis of confidence. This is why you cannot simply print and spend your way out of a debt crisis.
Summary of Economic Overview
ConocoPhillips needs prices and demand to rise to succeed in its industry. I simply do not see this happening right now. For price inflation to happen consumers must have too much money chasing too few products. Right now we have the opposite. We have wage reductions, high debt levels, and excess capacity producing too many products. The supply exceeds demand and when this happens prices will not rise. This continued debt deleveraging will be the basis for my valuation of ConocoPhillips.
