Wednesday, December 15, 2004

Gas Prices and Crude Oil Prices

Today's Wall Street Journal commented that gasoline prices were not necessarily following the path of crude oil prices, even though over half of the cost of gasoline is represented by the cost of crude oil used to produce it. The major reason was a restriction in the ability of energy firms to refine the crude oil into gasoline. The refining process is a complex and dangerous operation involving explosive chemical unit operations and very expensive equipment.

There has not been a new refinery built in the United States for nearly two decades, because NIMBY (Not In My Back Yard) groups like homeowners associations and neighborhood associations challenge almost all new plant proposals and because a protracted depression in the price of oil discouraged profitable investment in refinery plants. Refinery capacity has been increased by a process called debottlenecking, which involves identifying the choke point in a production process and increasing its capacity selectively, resulting in a much larger output from the plant with minimal (sometimes no) capital outlay. After twenty plus years of this, however, the US refinery industry will need to add new capacity by building plants soon.

Another problem afflicting the industry is environmental regulations, both in terms of product specifications and building restrictions on chemical plants. Add to that endless red tape and fears of terrorist attacks, and you can imagine the difficulty and cost of building a new plant. Regardless of this difficulty, however, as demand for new products increase, the refining industry will have to respond with additional capacity --- if not in the US, then somewhere in the world where regulation and NIMBY concerns aren't as great.

Tuesday, December 07, 2004

Downgrade of US Debt???!!!

In a Wall Street Journal Article today, there was some discussion of degrading the rating of the US Government debt from AAA to AA. Only a short time ago, there was talk of panic because people thought the US Government might pay off its debt. What a long way we have come.

If debt is downgraded (which would be the first change since 1917, when the government first earned AAA status), interest rates can be expected to increase. While the US Government can certainly pay off its dollar-denominated debt by resorting to inflation (the functional equivalent of printing money), there may be a time when the government will have to borrow in a foreign currency, most probably the Chinese Yuan or Euro. This would eventually plunge the US into a third-world like currency crisis, with unknown implications for the world economy.

While unlikely (much as paying off the federal debt was unlikely a few years ago), its now possible that the US could loose much of its status as a world economic power in only a few short decades.

Friday, December 03, 2004

Interest Rate Parity Brought Home

One of the final topics studied in most undergraduate finance courses is something called "interest rate parity." The concept is a simple one. It states that investors should earn an equal rate of interest on equal risk investments, regardless of the currency involved. In mathematical form, this means:

Forward Rate/Spot Rate = (1+kh)/(1+kf)

Where the forward rate and the spot rate are in terms of home currency per foreign currency unit, kh is the interest rate at home and kf is the interest rate in the foreign land.

Recently, exchange rates have been changing, with the dollar becoming weaker (less foreign currency is provided per dollar exchanged). To counterbalance this change, the above equation implies that interest rates at home will have to increase, since the change in currency rate is accelerating (the difference between the spot rate and the forward rate is becoming greater).

A related concept is purchase price parity. The classic example of this is the Big Mac. We assume that if a Big Mac costs $10 in the USA, then the same Big Mac must cost the equivalent of $10 in any foreign country into which it is sold. This is summarized by the equation:

Spot Rate = Price at home / Price in Foreign Land

Where the price at home would be in the home currency and the price in the foreign land would be in the foreign currency. Since the cost of a Big Mac in Europe is pretty stable, the fall of the dollar in terms of Euros purchased per Dollar implies the cost of the Big Mac will soon increase by a like amount in the United States.