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The Pirates of Profit


When we wanted to pay the highest prices in the world, tankers turned around and came here instead.

Another good week for the end-of-oil'ers huh? We are not running out of oil, we are running out of cheap oil, there is a difference. But geologists (and energy investment bankers) are overlooking one reserve in abundant supply – innovation. Expensive oil will not end the world, it will end some bad assumptions many consumers have made. The reason doom and gloom predictions do not work as neatly as their straight lines off the cliff forecast is they are typically flawed by one underestimate - talented capitalists when motivated by a profit.

A former CIA analyst is now CEO of a startup company selling an $11,000 "intelligent energy management" appliance. The generator which sits in your home or business has internet connectivity providing it real-time utility pricing information in markets where electricity prices fluctuate (which will be the entire country by 2007). The appliance lets its owners arbitrage the grid. During peak-cost hours the generator will use its battery which was charged overnight while prices were lower. Additionally, the unit analyzes any wasted energy in the home and will allow a user to set a budget that it will not allow you to exceed.

Lights-out idea, no? Whether it works or not is not my recommendation, it is capitalism that works and since I'm new around here I thought it only fair to disclose up front my bias as a rabid free-market loving capitalist. I imagined possibilities like this when I wrote the following article in January '06 to my partners after the hurricanes last year...

Our Reflections on the Energy (or any) Crisis Whose Disaster Relief Kit is Called Capitalism

"If the present Congress errs in too much talking, how can it be otherwise in a body to which the people send 150 lawyers, whose trade it is to question everything, yield nothing, and talk by the hour?"
- Thomas Jefferson

"How is the price of oil set?" I hope somewhere in a high school economics class that question is being discussed right now. Unfortunately, it was also the opening question from one of your Congressmen that I recently heard on my Bloomberg radio, which was broadcasting the inquiries of big oil companies with alleged "windfall profits." As the executives raised their right hands to be sworn in, my quote screen next to that radio displayed the answer tick by tick, updated each second, as the price of oil fell. There are buyers and sellers that meet in an open market and when two of them agree on a number, the price is set, Mr. Congressman. Nobody calls one of the executives appearing before you and asks what they would like. If that happened, why would the same barrel have sold for only $12 just a few short years ago? I sit here trying to imagine the heads of state around the world tuning their satellite feeds to the intellectual capitol of the world only to hear, "How are oil prices set?" opening the dialogue. They go back to work while we go back to arguing. Yea…a big mystery our trade deficit.

Honey, I Gouged Myself

I happened to run into two of these alleged pirates of profit over the weekend and I thought I would share those conversations. I found these swashbucklers to be more enlightening than our Congressmen and contrary to rumors, neither of them picked my pocket nor held a nozzle to my head until I filled my wife's SUV. Far from Independence Ave. and the House of Representatives, I met the CEO of a small oil company at a park so that our two boys could play together. We talked about how tough his business had been for so long (no hearings on rebates are scheduled, I notice). He travels each month across the country spending weeks away from his family to work with customers and partners on his business. Congressional hearings may paint a picture of him spending his weekends in a dark room at the NYMEX manipulating markets with his band of burglars. The only strings he was pulling were attached to a swing holding his 1 year-old son. "If there was a windfall profit tax in this country, we would take our business to Canada and ship it down with higher prices," he explains matter of factly. We both wondered why no news story described this simple chain reaction that would lead to higher energy prices, increase our foreign energy dependence, and cost us jobs in, of all places, Louisiana and Texas. Some help huh?

If this oilman was ripping me off, why did I give his son a juice box at the park? We simply made a deal. He wanted the juice more than he wanted one of his extra bagels, and my daughter wanted a bagel more than another juice box, even though we paid a little more. Free trade was gouged only by plastic straws. This morning you may have cut a similar deal, deciding that you wanted a Latte more than you wanted to keep $4 dollars, and a barrista wanted your cash more than the caffeine. A good trade or ridiculous windfall profit? Both. You just paid about $1,800 per barrel for this energy, and probably said "thank you" after filling up.

The Forgotten Ingredient

Later that night we had dinner with a friend of my little girl. His dad runs the operations global energy trading firm, the perfect complement to my earlier discussion and to our pepperoni pizza. According to many pointing fingers, these guys are the prime suspects in the windfall conspiracy. They do not pull oil out of the ground, they do not refine it, so why should they be profiting when our country is in such trouble? His story is a good reminder of the key ingredient to free trade which is forgotten in unfair profit discussions, and that is the other side of a profit - something called a loss. His group had bought (for a trade) an entire ship full of crude oil on the open seas. Believing it to be worth more than the asking price, and believing they could more efficiently deliver the much needed supply, his group carefully calculated it to be a good deal for them. Then the pirates joined the deal. Not metaphors, real pirates! Pirates seized his shipment and their delivery was missed and profits lost. Yet no hearings were scheduled to investigate both sides of this trader's P&L. At a time when we are so correctly worried about losing our edge in so many industries, we would do well to remember our supreme niche that remains the envy of the world. For those who take risks, this is still the best place to hatch an idea where it can be protected as yours, and whose profits and potential has been unlimited.

"The best argument against democracy is a five-minute conversation with the average voter." - Winston Churchill

If hurricanes taught us anything it is the value of an organized group who can best anticipate the needs of customers. Riots erupted loudly around one group's inability to do this – supported by elections, speeches and taxes. While solutions were quickly created by many other groups' abilities to do exactly this – supported by competition, decisions and profits. The first is run by a democracy of people trained to react, the second by capitalists hardwired to anticipate. Many cannot see that profits and 'help' are not mutually exclusive; they are born from each other. Some of the energy traders you have heard of, and some you have not, gave enormous sums of money quickly and in some cases anonymously to the very areas they recognized had provided their windfall profits. One of the best in the world, and a great friend of ours, purchased several RV's and personally stocked them with food, water and medicine and immediately drove them to Louisiana and left them, for good. He never told a soul. Dividends from windfalls like these are paid much more effectively by choice, than by collection. Ironically, not only is their generosity masked, but it comes from a much smaller treasure chest than the real pirates have. The Tax Foundation has noted that the biggest energy profiteer is actually the government. Since 1977, federal and state governments have collected $1.34 trillion in gasoline taxes versus little more than $600 billion in corporate energy profits. Overlooked motives in the windfall conspiracy? You might wonder (read: understand) that high prices, lower volumes purchased and taxes depend on volume, not price. There are no ironies.

Why Windfalls Work

The price of oil is not the problem. We cannot refine enough of it based on choices we are currently making. Like any other business experiencing heavy demand for a hard to locate product, the profit margins for those few refiners have been going up. These margins have been growing for some time, but what a difference a few television crews can make. Like any other problem in a democracy, it was created by the voters. We want to live in castles three times the size of our parents' homes, drive trucks that could swallow cars, and still wonder why increased demand should result in higher prices? That Jefferson guy was pretty bright, I am told. Perhaps he was on to something in our opening quote above. Instead of distracting voters with press conferences, maybe one day we will focus on the pressing problems of infrastructure and demand, not supplies.

Just the other day, a client of ours described one of his many engineering projects (5 years of backlog and growing at this major firm) which he said amounts to "duct tape and baling wire" on a refinery to squeeze and wheeze just a little more life out of it. The plant was built in the late 1800's, originally to refine kerosene. Now we rely on it to help "run" the most "advanced" nation on the planet.

I will hazard a guess that $70 oil is not a problem, but a solution. Demand destruction is part of the answer and needs no tax, simply an open and free market, which works flawlessly if left alone. Being open-minded about our choices, castles, and trucks will take something that hurts. In the meantime, whoever wants something the most pays the highest price and supplies are shipped overnight to them. What we call flawless, others violently protest just the opposite, that greedy companies rig the outcome. To that we say - you prove our point - supplies never get sent in a perfect size. The greedy send too much, chasing that high price offered, with the result of what? Lower prices.

When we wanted to pay the highest prices in the world, tankers turned around and came here instead. Voila, we had more than we needed. I happened to be in Georgia the week after Rita and schools were closed because of $6 gasoline. Then prices fell below where they stood before the storm. No hearings needed, just a few open outcry sessions at the NYMEX, no strings attached.

The more intriguing questions, from an investment standpoint, focus on what will change from here. Where and how has it become more affordable to explore? What alternative sources of energy no longer seem as expensive? What entirely new industries will be created to fix old problems? Will the woefully under-built infrastructure be re-built instead of re-taped?

Some of the answers are the next windfalls. The rules of capitalism will last longer than those in Congress and they read: anticipating the needs of customers better than most requires taking a risk for the potential of a profit. Windfalls do not start crises, they end them.
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