No Such Thing As Conservation

We don't believe there is such a thing as conservation of resources. Why? Leakage. Any savings in one area leaks out into spending in another area. One example is fuel efficiency on cars. My first car was a 1972 Ford Gran Torino Sport with a 351ci engine that got about 15 miles per gallon. A lot of people at the time had cars that got 10-15 miles per gallon but who cared; gas was 30 cents a gallon. Consumers allocate a certain portion of their after-tax income to transportation, so when OPEC decided to reduce our oil supply and gas prices rose threefold on two separate occasions consumers initially purchased more fuel efficient cars. But engineers soon designed more fuel efficient engines and allowed consumers to return to even larger cars (SUV's in the 80's and 90's). As such, any fuel savings "leaked" out into bigger and faster cars and trucks.

Consumers also learned you could save on gas by flying to vacation destinations rather than driving. Thank you Southwest Airlines for bringing cheap fares to anyone willing to fly. Several years ago our family did a road trip from the west, through the middle part of the country to Virginia, up to Boston and back across the top. Many people commented on how unusual that was yet these same people remember doing such trips in the 50's and 60's. Now they fly; and flying assists them in keeping the big SUV in the garage back home.

Another example of leakage: the cost of energy for home heating and air conditioning has risen. Solution: put in double and triple pane windows, use 2 by 6 framing and insulate every square inch of the top, sides and bottom. Result: costs to heat went down on smaller homes which allowed consumers to purchase McMansions with 6-10,000 square feet of floor space. Again, consumers are going to allocate a certain portion of their income to housing. If you drop interest rates and build homes with greater energy efficiency the "savings" will leak out into larger homes.

What does this mean going forward? The move to hybrid cars and alternative fuels is great but once consumers get through the adjustment period, they will just leak the savings back into larger, more powerful vehicles. It would take significantly higher energy costs along with long-term stagnant wages to change behavior in any meaningful way. Flat, and possibly rising interest rates in the face of higher fuel costs over the next 15-20 years may contribute to a change in attitude. A possible leakage is that consumers will continue the trend of moving to urban high rises and flying to vacation destinations. A value premium will be placed on vehicles that are well made and last more years driving fewer miles.

Strategy Update: after the last runup in commodity prices in June/July we transitioned the Dynamic Commodity Strategy to short/intermediate US Treasury ETF's. With a slowing economy this seems the right thing to do. But if prices keep dropping (oil has dropped from $80 to $71 per barrel) at some point we'll begin building positions back up. We think oil can drop into the upper-50's sometime before the end of the year before rising substantially on the next upswing in the world economy ('07-'08). YTD performance of Dynamic Commodity is 8.72%. PIMCO's commodity fund is up 3.69% over the same period.