Oil, Innovation and Risk

I was very impressed by Kenneth Rogoff's essay today in various papers about the larger implications of the BP disaster in the Gulf of Mexico. He had the foresight to question Brazil's ability to handle its oil reserves safely. This includes both the known and obtainable reserves and the now famous "pre-sal" (i.e., even deeper and harder to obtain) reserves that President Lula is touting as one of the great successes of his administration.

The economics of the pre-sal oil aside, can Petrobras and its drilling contractor partners really handle the technological problems and risks that are involved in bringing this oil to market. We know that Petrobras is currently undercapitalized - because it is in the market seeking new capitalization. One of the lessons of the BP experience is that attempts to manage risky assets such as deepwater oil without sufficient capital to fund controls systems and pay for their monitoring courts disaster.  Can Petrobras really assuage public concern about these risks? As Rogoff puts it in his article, "Will Brazil really risk its spectacular coastline, now that everyone has been reminded of what can happen?"

The other point that Rogoff emphasizes is regulation of the manner in which the technological innovations are applied to obtain the resources. Clearly in the case of BP, the Minerals Management Service of the US Department of Energy was not managing in any way that would suggest that it understood the risks involved with the technology nor with BP's management of the Deepwater Horizon platform.

I also find Rogoff's linkage of the BP disaster with the regulatory and financial technological meltdown that enabled the current economic recession compelling. Both disasters involved applications of poorly understood, highly risky new technologies (drilling technology and well shut down procedures in one and new financial instruments in the other) and lack of sufficient government regulation to protect society as a whole.

This article is very much worth reading.

More Fuel on Bubble Fire

In yesterday's post, I made the point that the building materials industry would have problems meeting all the various needs for materials in the next five years due to the pressure of major infrastructure projects such as the Olympics and World Cup along with the increase in demand for housing.

Today's Estado de São Paulo leads with a story about the lack of manpower in industry, lending some support to my position. The story shows the shortfalls in a range of industries, including construction, steel, woodworkers and even the automobile industry that was reducing work force numbers until last year's reduction in the IPI tax.

One of the points that national industry leaders such as Jorge Gerdau make is that the education system is failing to provide enough trained young workers to meet the needs of the growing economy. It will be impossible in the long run to fix the Brazilian economy without first providing the educational opportunities to prepare young Brazilians for the skilled jobs that lead to enjoyment of a higher quality of life.

The logic works quite simply: insufficient skilled workers leads to insufficient supply of building materials (especially complicated components of housing systems), which in turn leads to increased prices for scarce housing units.

The government's populist impulse emphasizes making financing available for housing through the Caixa Econômica, without assuring the people they are trying to please that there will be sufficient units at a fair price to occupy.

Housing Bubble in São Paulo?

The world economic crisis got its start due to housing speculation. My BBS colleague Ricardo Torres and I have been considering what is going on in the local housing market here in São Paulo. Here are some of our thoughts.

Housing markets in major world capitals are living through a depressed period resulting from the crash and recession that started in 2007. Prices of residences in New York, London, Paris and other major world cities have tumbled and are proving very slow to recover. This contrasts sharply with the stock and other capital markets in these centers, which recovered rather rapidly (until 2 weeks ago).

In São Paulo and other Brazilian cities, the housing market has been expanding during this same period and so far continues its growth as demand rises and supply is slower to respond. However, as with all economic trends, at some point, a serious correction will come.

Housing prices go up and down for a variety of reasons related to demand factors such as the availability of financing and increases in family income, others related to the perception of housing as an investment and still others related to ability of the housing industry to supply product.

Demand factors first. For the first time, Brazil has developed a viable housing finance system, parallel to the housing finance system in use in North America and Europe. Consumers can take out loans secured by the residence they occupy in large numbers for the first time in Brazilian history. The legal impediments that previously reduced the ability of a lender to foreclose on a property have largely been removed. This has opened significant lines of credit, especially through the Caixa Econômica, that is enabling Brazilians to buy residences with borrowed funds with reasonable payments. This is particularly opening opportunities for the emerging and rapidly expanding Classe C market and increasing demand throughout São Paulo and other urban centers.

Second, there is a high degree of confidence in the Brazilian economy, both within and outside the country. Brazil did suffer a recession in 2008, but it was much more the marolinha that President Lula predicted than the tsunami that most analysts feared. Family income has continued to grow and unemployment in São Paulo is at historically low levels. This obviously creates more demand for units and for a “succession” effect. Families throughout the region want to improve their living situation. Thus, families seek both “better” neighborhoods and larger units. The pressure on prices moves them steadily and rapidly upwards. An informal survey of brokers in Jardins, Higienópolis and Morumbi indicates that, in these bairros, prices may have as much increased by 50% in the past year.

With the emergence and rapid growth of an emerging middle class ("Classe C" in local parlance) in São Paulo, the pressure to trade up increases. Previous residents of Mooca, Vila Leopoldina, Vila Romana and other similar bairros seek larger units in more prestigious neighborhoods. The owner of a sobrado in these neighborhoods happily sells to an incorporadora and opens an opportunity for families in Classe C.

Perhaps because of the demand pressures, Brazilians’ understanding of the nature of housing is changing as well. A family’s principal residence is a special type of asset. Families have tended to remain in their houses for many years focusing on creating a stable environment for the growth of their children. This period may extend for multiple generations. However, the experience in other countries is being repeated here now. We are starting to view housing not as a special kind of asset that we do not trade like a share of stock, but rather as fungible with all our other investments. We are starting to see people “flipping” housing units, rapidly buying and re-selling units to either trade up or invest a portion of the proceeds in other types of assets (stocks, fixed income investments). This is a dangerous indication that we are entering a speculative “bubble” that parallels the experience in property crashes in the United States and Europe and can only end in tears.

A further contributing factor to this bubble trend is that investors are beginning to see housing as a viable alternative investment to organized capital markets. There have always been investors who have focused on housing units and who live from the rental proceeds of these units. An increasing number of investors today in São Paulo view housing units as investments that should be bought and sold rather than held for the long-term. They look at housing units in terms of short-term appreciation in value and sell on these terms. This behavior as well contributes to a speculative mentality that will destroy wealth in the long run rather than create it.

Prices are rising as well because of limits on supply. The most obvious supply limit is land availability. Jardins and Higienópolis, for example, have little land remaining that can be developed for apartments. This makes these remaining parcels very valuable and expensive.

As well as the price of land, construction necessarily lags far behind demand. From the time a developer obtains a parcel, designs a building, obtains approvals and can initiate the sale of units, a period of 1 to 3 years can elapse. Then, there is typically a two-year construction period before the units can be occupied. This time lag, in itself, creates pressure on prices. Thus, the delay between the time that consumers perceive the value of a neighborhood until the time that developers can deliver units puts an increased price pressure on the existing units that goes beyond the scarcity factor. This too represents a speculative pressure on prices.

Finally, the situation of new housing construction is only going to get worse over the next decade. TheWorld Cup, the Olympics and the PAC II (President Lula's development program, Mark II) are all predicted to create severe shortages in construction materials. The ability of the building materials industry expects to double in size between now and 2016. However, this increased demand for materials for these special programs and for infrastructure development will put further price pressures on residential construction. This has already been reflected in significant increases in the IPCC, the construction price inflation index.

We believe that the current housing situation in São Paulo, and possibly in other capitals, shows signs of a speculative bubble due to these pressures. And, like all bubbles, it will burst at some point. At that point, who will reap the whirlwind?

Can Brazil Remain Immune to a New Crash?

I don't mean to imply there will be a new crash like that of last year. However, the Dubai situation, the continuing US problem with unemployment and mortgage defaults suggest that even with the late 2008 government stimulus measures, there is much uncertainty to come.

We have been mercifully immune to these problems in Brazil. The steady hand on the tiller of economic affairs that has enabled Brazil to impose a stronger set of controls on the banking and exchange rate system up to now has returned Brazil to positive economic growth and lower unemployment. However, as I've indicated elsewhere, this positive state of affairs has been based on a grand compromise that has seen the overtly socialist PT (Labor Party) of President Lula embrace the inflation and interest rate control policies of his predecessor, Fernando Henrique Cardoso, by maintaining high primary budget surpluses and interest rates in order to keep inflation in check and enable economic growth.

However, in the run-up to next year's presidential elections, this compromise is showing its age and beginning to come apart.

In his drive to elect his chosen successor and establish his place in history, President Lula is increasingly trying to establish a virtual socialist government. He is expanding government hiring almost without control. One has to wonder what all these new public servants will be doing other than being grateful to the PT for their high salaries (public jobs pay higher in most categories than private sector jobs), lifetime tenures and full pensions. He is even attempting, with some success, to extend the grasp of his appointments into companies, such as the mining giant Vale de Rio Doce, by threatening to reintegrate them as state owned companies if they don't follow the government's directions on hiring.

Who is going to pay for all this public employment is obvious.

However, the largest concern is that with his focus on the election, he leaves his government increasingly open to the strivings of the "desenvolvimentista" group in and out of government. This set of politicians and academics wants the government to lower interest rates more rapidly and open the credit markets more substantially in a set policies that more recalls the supply-side credo of Reagan Republicans than any reasonably socialist economic policy.

Credit markets in Brazil are already a point of serious concern as housing, automobiles and appliances are being offered with ridiculously long terms according to Brazilian standards. 60 months to pay for a car means that the loan will not be paid off before the car is junk (If you know the streets and roads of Brazil, you will know what I'm referring to.)

If there is another hiccup in international markets that affects employment here, what will happen to all these loans? The thought scares many.

In my next post, I will put some numbers on these concerns to move them beyond the normal level of blog alarmism.