Jay Alix Now Takes Credit for GM Bailout

Editor’s Note: Lots of people–including President Obama–have trumpeted their role in the success of the government-backed turnaround plan that saved General Motors, the most important industrial company in the history of the United States. But on the fifth anniversary of the crisis, Forbes presents an exclusive, unprecedented look at what really happened during GM’s darkest days, how a tiny band of corporate outsiders and turnaround experts convened in Detroit and hatched a radical plan that ultimately set the foundation for the salvation of the company.

Author Jay Alix, one of the most respected experts on corporate bankruptcy in America, was the architect of that plan, and now, for the first time, he reveals How General Motors Was Really Saved.

Ruggles Writes: Alix IS highly respected, or at least he has been. The country of Japan once paid him huge dollars to analyze their own economic system. But I am reading this article with a grain of sale. It seems to me to be somewhat self serving for a Johnny Come Lately to come in 5 years after the fact to take a large measure of credit. I'll try to follow up this post with documentation either for or against.

Steve Rattner mentions Alix Partners only once, on page 197 of his book "Overhaul." Regarding resentment of Team Auto's bankruptcy specialist Harry Wilson, who rubbed many at GM the wrong way, Rattner writes in the book:

"To hear Harry and his even younger aides imply that the company was slow, inept, and out of date was insulting, to put it mildly. "Who does this little prick think he is?" they would sometimes mutter after a meeting with Harry. But not everyone connected with GM responded this way. Longtime advisers from such firms as Morgan Stanley, Alix Partners, and Evercore generally nodded in agreement with Team Auto's requests and "prescriptions," which often echoed their own past recomendations to their reluctant client."

I had been told by numerous sources that Wagoner threatened to fire any GM employee who even whispered the word bankruptcy. Here's Alix saying the Section 363 sales was his idea, presented to Wagoner on December 8, 2008, days before the Bush Administration extended the bridge loans that allowed GM to survive until the Obama Administration came in to inherit the mess. It IS clear, however, that there had been many steps taken by Wagoner and his executive team leading up to the bankruptcy that helped facilitate the unprecedented 40 day walk through Chapter 11 bankruptcy court. Regardless, after presiding over about $80 billion in losses, Wagoner left GM in March 2009 with a substantial "Golden Parachute." Sources differ on whether he was fired by the President, Larry Summers, or Steve Rattner, or just offered to step down and had his offer accepted. His record at GM was mixed at best.

Forbes: October 2013

By Jay Alix

....

In the popular version of the company’s turnaround story, as GM teetered toward liquidation in 2009, an Obama-appointed SWAT team, led by financier Steven Rattner, swept in and hatched a radical plan: Through a novel use of the bankruptcy code they would save the company by segregating and spinning out its valuable assets, while Washington furnished billions in taxpayer funds to make sure the company was viable.

...

GM’s extraordinary turnaround began long before Wagoner went to Washington in search of a massive loan to keep GM alive. My involvement in that story began in GM’s darkest days, five years ago on Sunday, Nov. 23, 2008, when I visited Wagoner at his home....

“Filing bankruptcy may be inevitable, Rick. But it doesn’t have to be a company-killing bankruptcy,” I said. “I think we can create a unique strategy that allows GM to survive bankruptcy.” .... I proposed that GM split into two very separate parts before filing: “NewCo,” a new company with a clean balance sheet, taking on GM’s best brands and operations; and “OldCo,” the leftover GM with most of the liabilities. ...we would use Bankruptcy Code Section 363, which allows a company to sell assets under a court-approved sale. Typically, 363 is used to sell specific assets, from a chair and desk to a factory or division, but not the entire stand-alone company. Under this strategy GM could postpone filing a plan of reorganization and a disclosure statement, which consume months and fuel a blizzard of litigation while market share and enterprise value bleed away.

... I volunteered to help GM on a pro bono basis. But what I could never anticipate was how deep and strong the opposition to my plan would ultimately be.

On Tuesday, Dec. 2, I pulled into GM’s Detroit headquarters at 7 a.m. after most of the company’s executives had already arrived for work. I was given a small cubicle and conference room on the 38th floor, a spacious but empty place that held GM’s corporate boardroom and a warren of cubicles reserved for visiting executives and board members.

Spending 18 hours a day digging through the numbers in GM’s filings, I began working in greater detail on the outlines of the plan and making some assumptions on what assets should be transferred to NewCo and what would stay in OldCo, which I dubbed Motors Liquidation. There were thousands of crucial questions that had to be asked and answered with management: Which brands and factories would survive? Which ones would the company have to give up? What would be the endgame strategy? What would be the enterprise value of NewCo? The liquidation value of OldCo?

...three alternative plans. First, they hoped to avoid bankruptcy altogether, believing the government would provide enough funding to bring GM through the crisis. At least two cabinet members in the Bush Administration and others had provided assurances to Rick and board members that government help would be forthcoming.

Second was a “prepackaged” bankruptcy plan being developed by general counsel Robert Osborne with Harvey R. Miller, the dean of the bankruptcy bar and senior partner at Weil, Gotshal & Manges. Under this plan, GM would prepare a reorganization in cooperation with its bond creditors that would take effect once the company went into a Chapter 11 bankruptcy. The goal of a so-called prepack is to shorten and simplify the bankruptcy process....

And third was the NewCo plan, based on years of experience at AlixPartners, where we had a major role in 50 of the 180 largest bankruptcies over $1 billion in the past 15 years. GM had also retained Martin Bienenstock, the restructuring and corporate governance leader from Dewey & LeBoeuf, to help develop the NewCo plan as well....

From my perspective Wagoner had been unfairly treated by many politicians and the media. Since taking over as CEO in 2000, working closely with Fritz and vice chairman Bob Lutz, Rick orchestrated large, dramatic changes at the company. They closed GM’s quality, productivity and fuel-economy gaps with the world’s best automakers, winning numerous car and truck awards. They built a highly profitable business in China, the world’s biggest potential car market. They reduced the company’s workforce by 143,000 employees, to 243,000. They reached a historic agreement with the UAW that cut in half hourly pay for new employees and significantly scaled back the traditional retiree benefit packages that had been crippling the company, while also funding over $100 billion in unfunded retiree obligations. And he was able to accomplish all these changes without causing massive disruptions among GM’s dealers or major strikes with the unions.

Ultimately, those structural changes positioned the company not only to survive but also to bring about the extraordinary turnaround. But now, with the economy and the company in free fall, all of that hard work seemed to be forgotten.

....

“Rick, do not resign ... until we get the three things...

“We have to get government funding of $40 billion to $50 billion. Plus, we need an agreement with the government and GM’s board to do the NewCo plan. And we must put a qualified successor in place. It must be Fritz and not some government guy. It’s going to be painful for you, but you’ve got to stay on the horse until we get all three.”

When we gathered for a telephonic board meeting on Dec. 15, the mood was urgent, the tension high. Only two weeks after arriving at GM I was about to present the plan to the board of directors in a conference room outside Wagoner’s office. Also on the phone were the company’s lawyers and investment bankers.

... we were just two weeks away from running out of cash.

Miller [and] ... Other attorneys chimed in, claiming the plan oversimplified the situation and there would be major problems with it. Yet another added that this would not be viewed well by the court and doubted any judge would allow it. Collectively, they characterized it as a long shot, discouraging the directors .... Unbeknownst to me [inside counsel] had previously proposed the idea to GM’s board, naively believing GM could complete a prepack bankruptcy in 30 days....

... Kent Kresa, the former CEO of Northrop Grumman and a GM board member since 2003 [spoke:]

“I understand this has some risk attached to it, but we’re in a very risky state right now,” he said. “And I understand it may even be unusual and unprecedented. But it’s certainly creative, and quite frankly, it’s the most innovative idea we’ve heard so far that has real potential in it. I think it deserves further consideration and development.”

Rick then addressed another lawyer on the call, Martin Bienenstock.

“Well, I’ve actually studied the problem, too, and there’s a way for this to work,” said Bienenstock. “Almost all bankruptcies are unique and the Code does allow for the transfer of assets. I can’t imagine a judge taking on this problem and not wanting to solve it. We’ve done a preliminary analysis, and it’s not as crazy as it sounds. It’s unique and compelling.”

“Okay, we’ve heard both sides of it,” Rick said after others spoke, smartly bringing the debate to a reasonable close. “I suggest we continue working to develop both the prepack plan and the NewCo option, while seeking the funding to avoid Chapter 11 if at all possible.”

The meeting adjourned without a vote....the next weeks I worked closely with Bienenstock, assistant general counsel Mike Millikin, Al Koch of AlixPartners and GM senior vice president John Smith on the NewCo plan. We huddled dozens of times with Wagoner and Henderson to work out which brands GM would ultimately have to give up (Hummer, Saturn, Saab and Pontiac) and which ones it would keep (Chevrolet, Cadillac, GMC and Buick). Informed debate and deep analysis of structural costs led to decisions about projects, factories, brands and countries.

On Sunday afternoon, Mar. 29, Wagoner called me. It was a call I had hoped would never come–but here it was. ...

Wagoner told me Henderson would be named CEO. “What about the bankruptcy?” I asked. “They’re enamored with the 363 NewCo plan. They seem bound and determined to make us file Chapter 11 and do NewCo. … This is really tough,” he said.

“I’m so sorry,” I said, pausing, “but … you got the money. They’re doing the NewCo plan, and Fritz is your successor. … You’ve succeeded. You got the three things.” ....

.... The strategy I pitched to Wagoner in his living room four and a half months earlier was the plan chosen by Team Auto in a meeting on Apr. 3, 2009 in Washington. Treasury agreed to fully fund NewCo with equity, and thus it became the chosen path to save the company.

[...and more on subsequent events]

Mike Smitka: As per Ruggles, this is fascinating, though as Ruggles points out none of the various insider accounts mention Alix as the source of the idea, though (I checked) contemporary news accounts do credit him and the others he mentions as outside advisors to GM. My suspicion is that the Task Force had staff who independently considered §363 – a quick news database search found lots of references in fall 2008 to §363 bankruptcies of this sort, including a panel at a bankruptcy lawyer conference labeling it a "hot topic". Similarly, on 20 February 2009 the WSJ blog [Deal Journal] posted of a Heidi N Moore interview with Mark Roe of Harvard Law School suggesting it as the obvious approach. In any case, both their performance in public and Rattner's account of interactions in private cast doubt on the ability of GM's finance operation to pull together details, and the sub-text I read in the Alix story is that until the very end GM's board remained fixated on unrealistic scenarios. Alix however focuses on Wagoner and does not point out that most of the board was replaced. But the latter deserves a post of its own, moribund boards of moribund companies. Chrysler under Iaccoca, GM under Roger Smith, Nissan for the 20 years prior to its acquisition by Renault...there are all too many examples.

Transparency and the Retail Auto Business

The new buzz word in the Auto Industry these days is “Transparency.” Auto manufacturers have fallen in  love with the word, as have vendors looking to charge Dealers money to bring "Transparency" to their customers. To some, the word is euphemism for “One Price,” where every buyer pays the same profit margin.  This has been proven to be an abject failure. The demise of the Ford Collection is the prime example.  We could revisit the Saturn debacle, but why? How many times does the lesson have to be learned. Does anyone actually think Saturn was a success story?

There are still Dealers using “One Price” as a strategy of Negotiation, but “One Price” ONLY works when there is more demand than supply. Most Dealer’s fantasy is to wake up one day and find out that his nearest competitors have all gone to a “One Price” strategy.

To many consumers, "Transparency" means being able to bypass the dealer and buy direct from the manufacturer so everyone pays the same margin and there is no middle man profit.  After all, they aren't aware there really is no middle man profit, on average, after payment of middle man expenses. For some reason, they are oblivious to the fact that those expenses still exist if the factory owns the car dealership.

Ever notice how it is the Silicon Valley types who want to change our business? Ever notice that they have never sold cars on commission or owned a Dealership before they set out to give Consumers what they think they want. These people are experts at running focus groups, although they don’t know the right questions to ask or how to interpret Consumer answers.

So lets set out to thoroughly discuss the issue of “Transparency” as it regards the Car Business.

“In economics, a market is transparent if much is known by many about:

1. What products, services or capital assets are available.
2. What price.
3. Where.

There are two types of price transparency: 1) I know what price will be charged to me, and 2) I know what price will be charged to you. The two types of price transparency have different implications for differential pricing.

A high degree of market transparency can result in disintermediation due to the buyer's increased knowledge of supply pricing.

In economics, disintermediation is the removal of intermediaries in a supply chain, or "cutting out the middleman". Instead of going through traditional distribution channels, which had some type of intermediate (such as a distributor, wholesaler, broker, or agent), companies may now deal with every customer directly, for example via the Internet. One important factor is a drop in the cost of servicing customers directly.

This can also happen in other industries where distributors or resellers operate and the manufacturer wants to increase profit margins, therefore eliminating intermediaries to increase their margins. (In the case of the Auto Industry, the “intermediaries would the franchised new vehicle Dealers.)

“Disintermediation” initiated by consumers is often the result of high market transparency, in that buyers are aware of supply prices direct from the manufacturer. Buyers bypass the middlemen (wholesalers and retailers) to buy directly from the manufacturer, and pay less. (Buyers can also pay MORE because the manufacturer controls the market. Competition between Dealers is what maintains the price equilibrium Consumers aren’t smart or knowledgeable enough to appreciate.)

Price transparency can, however, lead to higher prices, if it makes sellers reluctant to give steep discounts to certain buyers, or if it facilitates collusion.” Excerpts from WIKI

In legal terms, and in the context of the Auto Business, “Transparency” means fully disclosing all information mandated by all applicable laws in exactly the way the law demands these disclosures take place. There is NO legal mandate that the Consumer has to be happy with the transaction. We have always known that a “Good Deal” is largely a state of mind.]

Definition of “NEGOTIATE,” Merriam Webster:

1. to confer with another so as to arrive at the settlement of some matter.
2. to deal with (some matter or affair that requires ability for its successful handling):
3. manage to arrange for or bring about through conference, discussion, and compromise “

More WIKI Excerpts

A brief historical reference of Transparency Regulation in the context of the Auto Business:

New vehicles did NOT have a stated and posted price until 1958, when a law sponsored by Senator Mike Monroney of Oklahoma was passed. Trucks did not have a priced Monroney label until much later. “The window sticker was named after Almer Stillwell "Mike" Monroney, United States Senator from Oklahoma. Monroney sponsored the Automobile Information Disclosure Act of 1958, which mandated disclosure of information on new automobiles.”

Even if the Consumer is prepared to pay the Auto Dealer’s asking price, the value of any trade in has always been a matter for Negotiation. There is no single wholesale value for any Pre-Owned vehicle. A vehicle is worth whatever a wholesale Buyer will pay at auction in a competitive bid situation on a given day. Typically, Retail Buyer’s want Retail for their trade, thinking the Dealer should sell their trade at Retail just to get their money back, for the privilege of selling a new vehicle.

Even in the most simple purchase situations, where a Dealer states his/her price and the Buyer accepts and makes the purchase, this is still technically a “Negotiation.” The stating of a price is a first pass of Negotiation. Regulation, beginning with the government mandated Monroney label, has forced Dealers to state their price instead of merely entertaining offers on sales. The Monroney law came into being after WW II, when Auto Dealers, who hadn’t had new vehicles to sell for years, were in a short supply, low demand situation. And they took advantage. After all, they had just been through a period of no supply and high demand and had previously experienced high supply and low demand during the Great Depression. Consumers were offended, preferring only to experience a market driven by higher supply than demand.

As a practical matter, it makes no sense for a Dealer to debate “transparency” with Consumers OR with those who have never had the experience of making a livelihood by selling vehicles or with those with a major investment in an Auto Dealership. They have no standing on the issue. In the Auto Business it becomes clear quickly that without substantial gross profit, one doesn’t eat very well. The Sales Person’s welfare or the Dealer making a profit are NOT concerns of most Consumers. Consumers typically have no understanding of what a Dealer’s Cost of Sales might be. They don’t typically care. But for some reason many Consumers think they have the right to know a Dealer’s cost structure. These same Consumers seldom ask cost and margin questions of other retailers. At the least they don’t want to pay more than other Buyers of the same product. That’s no surprise. Neither do I. But if I buy from a “One Price” Dealer there is NO ASSURANCE that others aren’t buying for less than I do. After all, there are always competitive Dealers who are happy to work from their “One Price” competitor’s Best Price.

All car buyers negotiate in some fashion and to some degree. Car buyers typically think they are entitled to be quoted a price to take to competitive Auto Dealers. The first Dealer either accommodates, or doesn’t. If the Buyer doesn’t like a Dealer’s Negotiation Strategy, they are free to find one that gives them what they want. In other words, the market works in the Buyer’s favor. The Car Buyer can find another Dealer more quickly than the Dealer can find another Buyer. Consumers are NOT held to the same laws and ethics that Dealers are obligated to. So the Consumer holds all of the advantages, EXCEPT, in most cases, the Dealer has more experience Negotiating car deals and possesses more accurate information. Providing equal information to a Car Buyer would, in theory, create an efficient market that could commoditize new vehicles. This could theoretically eliminate Dealers. But then who would take the trades? Who would arrange the financing? And who would teach Consumers how to interpret all of the information?

In Business, it is also clear that if a Negotiation takes place, and neither party gets their “feathers ruffled,” someone left money on the table.

So what do Car Buyers really want? They want a guarantee that they will WIN the Negotiation. They want a guarantee that the Dealer will quote them a price that they can validate in their own mind by using what the first Dealer provided to shop other competitive Dealers. This has not changed in my 43 years in the Auto Business. Only the method of delivery of the information has changed, as well as they ease with which a Consumer can shop. If a Dealer doesn’t play along, they are vilified, not only by Consumers, but OFTEN by 3rd Party Vendors who appeal to Consumers and who also depend on Auto Dealers for revenue. But the Market works. If Consumers are unhappy with one Dealer, they can go to the next. They can also make use of information provided by the Vendors, although these Vendors are at risk if they also depend on Dealers for revenue.

As it involves the varying definitions of “Negotiation,” many Car Buyers would prefer to have the Dealer disclose the triple net cost of their product, and then “Negotiate” the “Margin.”

So how does one sell New Vehicles in this environment? Most Dealers attempt to provide Consumers with a “Perception of Transparency” as a Negotiating strategy, since TRUE Transparency would prevent making a Gross Profit high enough to pay overhead expenses. We currently do not have true Transparency and we are still seeing considerable margin compression.

The Consumer has the ability to shop until they find an Auto Dealer Negotiation strategy they like. Some give up and buy because they were worn down, lost patience, and gave in. Others depend on the Dealer to arrange financing which may be more important to them than the price of the vehicle.

Despite the massive amount of regulation that has been imposed on the Retail Auto Business, the current Market Driven system has sold up to 17 million vehicles in a year. Some might say the system has served us well over the years despite the fact that many Consumers are aggravated by the process. To those Consumers, I say, “Keep shopping until you find the Dealership shopping experience that gives you what you want.” Let the Market work.

Dealers are not typically completely “Transparent” with their own Sales People and Managers. Why should they be? It is human nature for Sellers to give away potential profit in an effort to make a sale. The cost structure of a new vehicle is so complicated that even Dealership management staff has a hard time understanding it. In many cases, the true cost structure is not determined until a Dealer receives a check based on the achievement of objective over a period of months. With all of the possible incentives, including “Conquest Incentives, “Realator Incentives, Plumber Incentives, Glass Company Incentives, First Time Buyer Incentives, Fleet Incentives, Special Bid Incentives, College Grad Incentives, Employee Purchases, various “Private Offers,” Returned Military Incentives, and many more, plus variations of the above. Trying to provide all of this information, including teaching Consumers the elements of the wholesale market would be overwhelming to most. It would be akin to drinking from a fire hose. There is a considerable learning curve when training new Sales People. Consumers aren’t typically going to understand it all when they are only buying a vehicle every few years.

New hires entering the Auto Business as Sales People bring their perceptions as a Consumer to their new job. Like me 43 years ago, most were convinced in the beginning that selling cars would be easy. All one would have to do is to quote the lowest price and make up the loss of margin in additional volume. What a revelation us veterans of the business had when we found out that Consumers had no loyalty. There has never been such a thing as the “best price,” despite the fact that Consumers typically think there is. As an early “price quoter” I was the one who spent the time, gave a detailed product presentation and demo drive, only to find many of my prospects, who had promised to “Be Back,” had bought from a competitor who had beaten my “Best Price” by a small margin. Occasionally, deals are lost because one appraiser might see more value in a trade in than another.

To be clear, some Auto Dealer attempts at negotiation are more “artful” than others, and crude attempts at Negotiation generally fail. The Consumer isn’t harmed, except for some wasted time. They are certainly given “grist for the mill” in their complaints about “Negotiation.” They are free to keep shopping for that Dealer who gives them what they seek. But then some Consumers are never satisfied.

I recall a time when my boss, the Dealer himself, quoted me a price that involved a $1K mistake in my Customer’s favor. I presented this price to my Customer who then railed about us being crooks, cheats, and liars. After shopping our quoted price the Customer later slunk back into our Dealership to take try to take advantage of the mistaken quote. And because we didn’t honor the price from two days earlier, we were crooks, cheats, and robbers all over again. A good deal is as much perception as reality.

Let’s discuss “Transparency” as a practical matter in the modern Internet driven Auto Market. The most demanding Consumers are the ones who have 720 and higher credit scores. They know they have good credit and can buy what they want. They are the ones who are most analytical and the most demanding of information to shop with. They are the ones who feel most entitled to be able to determine the “Best Price” from the convenience of their office chair using the Internet, entertain competitive quotes from Dealers all vying for their business, and to make a purchase decision without spending a lot of time or going through a more traditional process of negotiation. They will typically visit a dealership for a demo drive and to gather additional information, then retreat to their computer to use the Internet to “Negotiate” the price as they try, often successfully, to get Dealers into a bidding war with each other. The fact is, this niche of Buyers make a LOT MORE NOISE than their numbers would indicate. This group makes up LESS THAN 30% of Consumers. And of that 30%, at least 5% of those have a debt payment to income ratio that does NOT guarantee them financing. All other Car Buyers have a legitimate concern that they might not gain credit approval for a Car Loan at optimum terms and interest rates. AND without the help of Dealers and their market power, many of these could NOT gain a car loan on their own. Does anyone with common sense believe that the Retail Auto Industry should turn itself upside down over 25% percent of Consumers who represent less than 15% of total Vehicle Sales Gross Profit?

In this current environment Manufacturers are coercing Dealers into ever higher overheads through ridiculous “Image Programs.” What happens if margin compression makes the selling of vehicles unprofitable to Auto Dealers? A quick look at history will give an indication. When I entered the auto business in 1970, the Markup on large vehicles was 22.5 percent, plus a 2 – 2.5% “Hold Back” that was paid to the Dealer every quarter or at year end. Imports typically had no “Hold Back” in those days. Deals were transacted OVER “Invoice,” the amount the Manufacturer drafts the Dealer’s floor plan account when the vehicle leaves the assembly plant, sometimes before. There was little “Trunk Money,” money rebated to the dealer based on “Stair Step” programs and other incentives based on achievement of an assigned objective. In other words, “Invoice” had meaning. Today “Invoice” has little meaning. Consumers routinely take delivery of a new vehicle for LESS than the Dealer has to pay off at his/her lender. The “Markup over invoice today is less than 10%. Manufacturers have raised the MSRP to accommodate both the cost of rebates and subventions, but also the “Trunk Money.” In 1970 F&I revenue represented a relatively small portion of Gross Profit on a per deal basis. Today the per deal F&I gross profit runs from $1K to $1.5K. Labor rates in Dealer Service Departments were reasonable in 1970. Today, $100. plus per flat rate hour isn’t unusual. Are you starting to get it now?

Many Consumers think Manufacturers should cut their Franchise Dealers out of the equation. First, there are laws in place to protect those Dealers, all of whom have made substantial investments in their businesses. Secondly, the OEMs would need Ben Bernanke's printing presses running full time to ever come up with the amount of capital required to replace their Dealers. It ain't gonna happen.

The Bottom Line:

1. Consumers already have the market slanted in their favor
2. Consumers can readily shop
3. If Consumers don’t want to “Haggle,” let them find a Dealer who will give them what they want.
4. Vendors who started their businesses depending on dealers for their initial revenue, and who now turn on those dealers and demonize them in an effort to convince consumers to turn to them for “protection” from the villains, and who provide even more downward pressure on gross profits, can expect push back and a lack of cooperation from auto dealers.

TrueCar, CarFax, Cars.com, and some others have paid a price for pushing Dealers too far by providing Consumers additional tools to help them in the effort to compress margins, often depending on Dealers to support their efforts. These Companies have every right to do what they are doing and/or have done, but they are unrealistic if they expect there to be no push back from Dealers. I suspect there are some others, including Kelly Blue Book and their version of the “Bell Curve, recently abandoned by TrueCar while under fire from Dealers, who will be a target for Dealer push back.

As long as the Franchise Dealer system is in place, trades are taken, and financing not a given, there will be no completely “Transparent” and “Efficient Market” that commoditizes pricing in the Retail New Vehicle Business. Is this a surprise, or just common sense? The current system has served us well and will continue to do so.

At the recent JD Power/NADA conference held in March in New York City, noted Auto Industry analyst Maryann Keller spoke optimistically about the conventional system of selling cars in the U.S. “Over four decades, I’ve heard many arguments made against the Franchise Dealer system.” They are claims Dealers never fail to disprove time and time again.”

One myth promulgated in the 1990s, and now resurfacing with Tesla’s effort to run its own sales outlets, is that factory stores save money by reducing distribution expenses, wrongly estimated at 30% of the total cost of a car.

Put aside for a moment that the percentage itself is way off, Keller says. Ford’s ill-fated Auto Collection experiment in certain markets during the late 1990s proved that Auto Companies are good at a lot of things. Running Dealerships isn’t among them. Dealers with entrepreneurial spirit are good at doing that.

Ford ended its bad-science experiment after a couple of years of market share losses and mounting evidence that Factory Stores do not deliver a better customer experience nor reduce costs.

Franchise dealers’ cumulative investment in land, equipment and facilities easily exceeds $100 million, Keller says.

“Dealers fund 60 days of inventory and another month of inventory in transit that would otherwise fall to the Auto Maker.”

The inventory buffer allows auto makers to adjust future production levels. For a company like Ford, U.S. inventory funding equals about $15 billion at any point.

“While we are talking about myths, how about the still-repeated one that people hate Dealers so, if given the chance, they will buy a car online,” Keller says. “I almost don’t know where to start in taking this one apart.”

Not all that long ago, Silicon Valley funded and lost hundreds of millions, maybe even a billion dollars, on ill-fated ventures that promised to sell cars online.

“CarOrder.com, Greenlight.com, and CarsDirect.com (in its original configuration), among others, all promised to avoid the dealership experience,” Keller says. “A few actually did that by buying cars from Dealers, and then reselling them at lower prices to customers until they blew through their capital.”

She recalls the defunct Build to Order.com. It proposed that customers would place orders for fully customized cars while lounging in a company-owned showroom/entertainment center. “Build-to-order.com never built anything for anyone,” Keller says. Priceline.com’s experiment of trying to sell cars online was in some respects replicated later by TrueCar.com, which ran afoul of franchise laws for the same reasons Priceline

“What I learned then, and this is still true today, is that we could connect Buyers with Dealers and that the price of a vehicle was the easiest part of a deal,” Keller says. “The other elements are harder to control and often the cause of frustration for the Customer and the Dealer. People don’t like to hear that their trade isn’t worth the value they saw online or that their poor credit doesn’t qualify them for the no-down-payment, 0% loan.”

Buying a car is as complex as buying a house, Keller says. “Why should we think it should be as easy as buying a pair of shoes from Zappos with a return receipt in the box in case they don’t fit?” While much Auto Advertising has shifted from newspapers to the Internet, that transition “has not reduced Advertising expense per vehicle or made buying a car as easy as buying a book,” she says.

Another salient Keller point:

“Add up all the monthly traffic to all automotive sites, including auto makers, dealers and independent sites, and you’d get more than 100 million, possibly close to 200 million, unique visitors using the Web to get information about buying or selling a new or used car.

Except there’s one problem, if this traffic is somehow supposed to represent potential sales.” Dealers retail about two million new and used cars a month. That’s a fraction of all those automotive website visitors.”

“So just like newspaper, radio or TV advertising, Dealer spend on the Internet is likely no better targeted, once again dispelling the notion that the Internet would solve the age-old problem of knowing which 50% of a dealer’s advertising works.”

Technology is wonderful. Dealers have adapted to it. Sophisticated software helps them manage every aspect of their business. But it will not fundamentally change Auto Retailing, Keller says.

“The system of Franchised Dealers – using their own risk capital to fund their businesses and guarantee millions of dollars of inventory, promote their own brand and that of their OEM, provide the expensive tools needed in their service departments, and manage the endless headache of a workforce – will not be superseded by technology or Factory Owned Mall Stores.”

Keller predicts start ups such as Tesla, which currently runs factory-owned mall stores, ultimately will conclude “the dealer network is the best way.”

I would only add this. As long as Auto Makers understand that Dealers are their Customers and the End User is the Dealer’s Customer, things will be fine.

david ruggles

Did We Dodge a Bullet?

Ruggles, Auto Finance News

Or did we just get President Obama’s Second Choice?

Now that Larry Summers has taken himself out of the running for the position of Chairman of the Federal Reserve Bank of the United States, President Obama has appointed the current Fed Vice Chairman, Janet Yellen, to the post.   If confirmed, it would make Yellen one of the most powerful woman in the world, with her hands on the controls of the globe’s largest and most powerful economy.
From the Federal Reserve website:

“The Federal Reserve System is the central bank of the United States. It was founded by Congress in 1913 to provide the nation with a safer, more flexible, and more stable monetary and financial system. Over the years, its role in banking and the economy has expanded.

Today, the Federal Reserve's duties fall into four general areas:

• conducting the nation's monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates
• supervising and regulating banking institutions to ensure the safety and soundness of the nation's banking and financial system and to protect the credit rights of consumers
• maintaining the stability of the financial system and containing systemic risk that may arise in financial markets
• providing financial services to depository institutions, the U.S. government, and foreign official institutions, including playing a major role in operating the nation's payments system”

Why might we have “dodged a bullet?”  Larry Summers has a LOT of baggage.  Many say he is brilliant.   According to Car Czar Steve Rattner, “No one is perfect, but I score Larry’s batting average and qualifications at the top of the heap. There’s that extraordinary intelligence: the most brilliant, most analytical and most surgical brain of anyone I’ve ever encountered.”

But Summers laid an egg in his stint as President of Harvard University.  He resigned after a “no confidence” vote by the Harvard faculty after he made some less than complimentary statements about women, among other issues.  Many think Summers, along with Steve Girsky, engineered the dealer terminations during the GM and Chrysler bankruptcies.  In addition, it is well known that Summers participated in the ouster of Brooksley Born, then Chairman of the Commodities and Futures Trading Commission.  It seems Summers, Robert Rubin, Clinton era Treasury Secretary, Alan Greenspan, then Fed Chairman, and others didn’t think it was necessary to regulate derivatives, including the credit default swaps which led to the bubble, the mortgage crisis, and the economic collapse of 2008.  They thought the derivatives market would “self regulate.”  Only the most extreme ideologues still believe that.  It was looking like the President was going to have problems from his own party in any Summers confirmation hearings. So Summers withdrew his name from consideration

So what about Janet Yellen?  Who better to carry on Ben Bernanke’s policies, which have not been perfect, but have been the best available under the circumstances.  After all, the Fed tool box was empty when Bernanke inherited the Great Recession.  Interest rates were already so low there was no place to cut them to goose the economy.  Congress was handcuffed by obstructionism leaving the Fed with no best choices.  We ended up with "quantitative easing," the best of the imperfect choices remaining.  The new Fed Chairman will have to navigate difficult waters to ease off the Fed stimulus without cratering the economy or waiting too long, taking the risk fueling rampant inflation.  Yellen has been Vice Chairman of the Fed through it all and understands the challenges.

Yellen is immensely qualified.  Even though partisanship and obstructionism will make her confirmation an adventure, she is universally respected.  She graduated summa cum laude from Brown University with a degree in economics in 1967, and received her PhD. in economics from Yale University in 1971. She has no history to indicate she would be a patsy to Wall Street.  Her predictions are the envy of the Fed.  She has more Fed experience than anyone in history leading up to her appointment.  An added bonus is the fact that she is married to a Nobel winning economist, George Akerlof.  Akerlof won his Nobel for his work on “asymmetric information.”  As Bill Clinton famously said about his wife Hillary, “You get two for the price of one.”

I think the “second choice” is the “best choice.”  Let’s hope Janet Yellen’s confirmation is as smooth as possible so she can get about the business at hand.

People LOVE Their Car Dealer, But Hate Yours

Steve Finlay - WARDS June 2013

People carry on a love-hate relationship with car dealers.

They typically love their dealer, as evidenced by rating websites where grateful customers say things like:

• “He cares about his clients and is extremely helpful with any questions or issues.”
• “I have always been extremely pleased with the service and professionalism.”
• “It was honestly the BEST customer service I’ve received in my whole life.”

But many consumers dump on dealers in general. Disliking from afar is a human flaw. Disdaining faceless groups is a building block of bias.

So when the National Automobile Dealers Assn. said the traditional franchised-dealer system actually protects consumers, angry Internet users began pounding their keyboards.

“Yes, everyone I know leaves a dealership thinking, gee, that dealership is really interested in protecting me and my interests rather than their own interests,” one sarcastic wag wrote in the reader comment section of an online story mentioning NADA’s claim.

“Very disappointed to see that NADA thinks we’re a bunch of morons who will buy this line,” someone else commented. “I could respect them more if they would just come out and say they were trying to squash a competing business model.”

Another person proclaimed: “The arrogance of trying to tell us they are just watching out for our best interests is stunning.”

All this bluster is tied to electric-vehicle maker Tesla deciding to short-circuit the conventional dealer system by selling its vehicles directly to customers.

Tesla has opened small showrooms here and there where shoppers can check out the single-product Model S, then order one online from the manufacturer.

Some consumers think that’s the way to go. They see dealers as needless middlemen who hike up vehicle prices, even though one could argue prices would rise if dealers weren’t competing against each other, and a customer instead had to buy a particular vehicle from only one source: an auto maker.    

Many foes of the franchise system seem woefully uninformed about how it works. Yet, they praise Tesla founder Elon Musk for trying to “revolutionize” how cars are sold. But auto companies, not dealers, came up with the franchise system.

Auto makers did that because they deemed it better for someone else to sell and service products, especially if that someone covers the facility costs. Accordingly, dealers collectively have invested billions in their stores.

Auto makers realize their core competency is in making vehicles, not selling them. Every now and then, an auto maker will give auto retailing a shot. In the late 1990s, Ford unsuccessfully tried in certain markets, such as Tulsa, OK, and Salt Lake City, UT. It took years for the smoke to clear from that bomb.

A newspaper columnist decries the fact that if you want a Ford, you can’t march down to your local general car store to get one. No, you must buy it from a Ford dealer.

That’s because auto makers want it that way. They don’t want big-box auto stores selling different brands, side by side, under one roof. You’d find plenty of dealers willing to do that, but good luck finding a manufacturer.

Dealer associations and Tesla are battling legally and legislatively over the EV maker’s desire to sell cars directly to consumers. Meanwhile, Tesla stock looks like a bubble ready to burst.

“Elon Musk has done an amazing job of driving up Tesla’s stock price,” Bill Wolters, president of the Texas Automobile Dealers Assn., tells me. “He’s a master of P.R. What puzzles me is that he has never tried the franchise system, yet he insists it won’t work for him.”

Throughout automotive history, start-up companies selling limited-appeal products in unconventional ways have suffered high fatality rates.

I’m not saying the dealership franchise system is perfect or that it will last forever. But I bet it outlives Tesla Motors.

Outsiders Poised to Buy Car Dealerships

Oct. 15, 2013 Phil Villegas 

Reprinted from WARDS AUTO

As the auto industry surges, private-equity firms and others may drive up blue-sky values, but they face obstacles.

This is an attractive time to be a car dealer. Dealership profitability is up across the board, automaker are producing great vehicles and the upswing looks like it will last for the next few years.

Accordingly, we’re once again seeing activity brewing from outside speculators looking to enter and redefine the dealership arena. It’s similar to 2004 through 2007 when individuals and entities new to the industry vied to buy dealerships.

With interest rates low, banks eager to lend and a shortage of deals in the dealership buy-sell market, we are very much in a seller’s market.

I anticipate double-digit blue-sky multiples in the coming year, and not just in situations where the dealership being acquired is significantly under performing, but also in cases of healthy and operationally effective dealerships.

These high multiples will not be paid by the public chains, private mega dealers or even traditional dealers in acquisition mode. Rather these high prices likely will be paid by industry outsiders and private-equity firms trying to get a foothold in the industry, and in the process driving up blue-sky levels.

Because most sellers want an expedient buy-sell transaction, many will shy away from selling to those who may not easily gain automaker approval.

However, many dealers still will be enticed by the higher prices these outside speculators often are willing to pay, and may take their chances with the manufacturers.

The auto-retail sector is attractive due to exclusiveness and high yields. We find most traditional dealership acquisitions target a 20% return on investment, a rate that’s higher than other speculative investments.

These returns can be even greater if the transactions are leveraged to the manufacturer-allowed limits. Most outsiders trying to break into auto retailing typically will leverage as high as possible to maximize their return.

The largest obstacle industry outsiders and private-equity firms faced in the past, and will likely continue to face, is in obtaining automaker approval of their prospective dealership purchase.

With few exceptions, automakers are predisposed to approve franchises only for experienced dealer operators. Industry outsiders and private equity firms are problematic for a manufacturer because they’re often wanting on key operational matters.

Simply put, auto makers want the ability to deal with a dealer operator who can make a relatively fast decision on an issue at hand. They do not want a board or committee slowly and deliberately deciding a matter.

Nevertheless, outsiders inevitably will find their way to the closing table, often through a minority operating partner who on the surface appears to have full operational autonomy. In truth, operating partners have that as long as they deliver profitability that satisfies the investors’ ROI model.
Times are so good now the auto-retailing business appears easy to outside speculators, even though they may lack experience and operational resources.

Many of them see traditional dealerships as failing to operate at full potential. They think they can come in and immediately crank up revenues, cut expenses and boost profitability beyond conventional benchmarks.

While such a quick and dramatic turnaround can happen, it’s hardly the norm. Inflated confidence based on internal-model assumptions can lead many outsiders to pay above market prices for dealerships.

While some stores do better than others because of their prime locations or the popularity of the brand they represent, success with most stores rests with upper management, primarily the skills of the dealer operator.

In dealership acquisitions, many outsiders fail to give the appropriate amount of credit to the long-term impact that key managers can have on the investment. When the industry is benefitting from improved consumer confidence and sales, many outsiders take these sales for granted, failing to understand the cyclical nature of the car business.

In good times like these, many marginal operators appear better than they are. Outsiders often fail to identify true talent in a timely manner. Truth is, a lot of hacks and retreads can talk a good game yet always seem to come up short in delivering results. It may take an outsider six months to a year (or longer) to realize a dealer-operator partner is merely a faster talker in a nice suit.

Nonetheless, industry outsiders and private equity firms who understand the risks are not easily deterred from attractive high-yielding investment opportunities like auto dealerships offer.
But interest rates won’t stay low forever. And while we have seen strong sales in recent years, this trend probably will start to level off in the next couple of years as pent-up demand eases.
My guess is many outsider deals that close at irrationally high multiples ultimately will result in affected dealerships finding their way back on the market within a few years, with rational prices and shiny new facilities that automakers required the original investor to build.

Phil Villegas is a principal at Axiom Advisors, an automotive dealership consulting firm specializing in mergers, acquisitions, enterprise management and litigation support.

Can “Friction” Be Eliminated in the Buying/Selling Equation?

Ruggles in WARDS October 2013

At the recent J. D. Power event held in Las Vegas in October Scott Painter, TrueCar CEO, introduced a new theory, something most of us had never heard. According to Painter, elimination of “friction” from the car buying process could lead to a 20 million SAAR in the near term. He seems to believe that the “agony” and trepidation car buyers feel about the car buying experience costs the industry sales, as if many consumers are so fearful of the car buying process that large numbers of potential car buyers essentially hold on to their current vehicle so they don’t have to venture into a punishing game where there is a chance they might not “win.” According to Painter, there are many things that the industry would have to do to achieve the elimination of the harmful “friction.”^{Note 1}

One of those “friction” causing items, according to Painter, is the practice of OEMs offering “trunk money” to dealers,

which makes it difficult for consumers to know the true cost of a vehicle to the dealer. “Trunk money” includes any payment back to the dealer from the OEM that reduces the dealer cost of new vehicle inventory below that of invoice less hold back. Invoice and holdback information is already readily available to consumers. He seems to think that the consumer is entitled to know dealers’ bare cost information so that only the dealer gross profit margin is negotiated. Somehow he believes this would help reduce the harmful “friction.” Of course, this flies in the face of the needs of OEMs who would also like to build new vehicles at a profit, and need to be able to negotiate prices from suppliers based on volumes that sometimes have to be “forced” via various “back of invoice” incentives. This includes “stair step” programs and other incentives designed to boost volume. After all, OEMs need to achieve volume commitments made to suppliers to achieve the best pricing, as well as other economies of scale.^{Note 2}

Painter seemed to be longing for the days when TrueCar used their infamous bell curve to advise consumers of what they should pay for a new vehicle while relying on dealers for the revenue to fund that initiative. This caused extensive pushback from dealers and forced TrueCar to adopt a different business model, one more conducive to dealers being able to achieve a more acceptable gross profit on a transaction. Despite the dealer push back against TrueCar, other vendors have picked up on the “bell curve” model. Many analysts believe these self serving initiatives to reduce friction in the purchase process have not increased volume but have resulted in the same volume being done at decreased dealer gross profit.

In addition to OEMs changing their own business model and giving up their tools to balance their production, what else could be done to eliminate the harmful “friction?” Consumers don’t seem to mind a dealer making money as long as they don’t have to hear about someone else getting a better deal than they received. Isn’t the answer to that “price fixing?” If everyone pays the same margin, won’t that satisfy consumers? Perhaps TrueCar and certain other vendors, who are bent on creating a frictionless efficient market in new vehicles, should spend their time and resources lobbying the FTC so dealers won’t have to go to jail for “price fixing.” After all, isn’t the most righteous objective happy consumers, not real competition with consumers having the ability to shop? The FTC (Federal Trade Commission) holds the impression that competition at the dealer level benefits consumers. Maybe they’re wrong?^{Note 3}

Is there another business where consumers have as much information about the products they buy? Aren’t car buyers free to shop? Aren’t they free to use their own buying strategies? How can they ever be completely satisfied?

In recent times, dealerships would take cheap deals as a way of achieving increased market penetration and providing “plus business” they wouldn’t otherwise have received. These special “cheap deals” have often been funneled through a dealership’s fleet department. To achieve an acceptable average, some buyers had to pay a higher margin than others to achieve a reasonable average. But instead of “frosting on the cake,” these “cheap deals” have become more the norm as evidenced by the extreme margin compression seen on dealer’s financial statements.

It is amazing to many auto retail veterans that those who have set out to make money by reducing “friction” in the auto purchase process can be characterized by one glaring deficiency. Very few, if any of them, have any real experience dealing with real car buyers on a day to day basis. These are not people who understand customers. They don’t know the difference between what consumers say and what they really mean. Steve Finlay’s recent column, “Consumers hate dealers, love theirs” provides excellent insight on this.

Let’s do the math. We have margin compression brought about by the proliferation of dealer’s proprietary information via the Internet and vendors focused on making money for themself by reducing transactional “friction” with the resultant dealer gross profit reduction. We have margin compression on the used car side, again brought on by the Internet. We have increased margin compression on dealer rate participation through CFPB (Consumer Financial Protection Bureau) initiatives. At the same time we have OEMs working to raise dealer’s costs through their image programs. Is there anything wrong with this picture?

Notes by Smitka

Note 1: This is synoymous to a claim that the short-term price elasticity of demand is extraordinarily high – a 4% reduction in price ($1K with an average $25K price) will lead to a 25% increase in sales. Nonsense! Furthermore, big rebate programs pull forward sales – examples include cash for clunkers in the US and short-term government tax rebates, such as the "Eco-car" program in Japan.

Note 2: As someone who works on suppliers, such incentives may be tied to "take or pay" pricing with suppliers, but is more likely due to the benefits of keeping assembly plants running at a steady pace.

Note 3: I am teaching "Industrial Organization" this term, which examines topics such as collusion. As per Ruggles' rhetorical question, there's no particular reason to think the FTC is wrong. Indeed, we have an experiment in this in the initial Saturn dealership network. The evidence (papers presented at the MIT IMVP) suggest that the reason this model worked was because the car was popular (= little need to discount) and dealerships were "thin" on the ground so that it was challenging in those pre-internet days for consumers to play one dealership against another. One either of those two pieces of the equation is taken away, fixed price retailing doesn't work.

The Fundamentals of Global Oil Economics

By Gal Luft and Anne Korin

The first U.S. energy secretary, James Schlesinger, observed in 1977 that when it comes to energy, the United States has “only two modes -- complacency and panic.” Today, with the country in the middle of an oil and gas boom that could one day crown it the world’s largest oil producer, the pendulum has swung toward complacency. But 40 years ago this week, panic ruled the day, as petroleum prices quadrupled in a matter of months  and Americans endured a traumatic gasoline shortage, waiting for hours in long lines only to be greeted by signs reading “Sorry, no gas.”

The cause of these ills, Americans explained to themselves, was the Arab oil embargo -- the decision by Iran and the Arab members of the Organization of Petroleum Exporting Countries (OPEC) to cut off oil exports to the United States and its allies as punishment for their support of Israel in the 1973 Yom Kippur War. And the lessons they drew were far-reaching. The fear that, at any given moment, the United States’ oil supply could be interrupted by a foreign country convinced Washington that its entire approach to energy security should center on one goal: reducing oil imports from that volatile region.

But Americans were wrong on both counts. The embargo itself was not the root cause of the energy crisis. Contrary to popular belief, the United States has never really been dependent on the Middle East for its supply of oil -- today only nine percent of the U.S. oil supply comes from the region. At no point in history did that figure surpass 15 percent. Rather, the crux of the United States’ energy vulnerability was its inability to keep the price of oil under control, given the Arab oil kingdoms’ stranglehold on the global petroleum supply. Nonetheless, for the last four decades, Washington’s energy policy has been based on the faulty conclusion that the country could solve all its energy woes by reducing its reliance on Middle Eastern oil.

Where did this conclusion come from? By the time the six-month embargo was lifted, in March 1974, the global economy lay in ruins. In the United States, unemployment had doubled and GNP had fallen by six percent. Europe and Japan had fared no better, and struggling, newly created countries in Asia and Africa took the worst hits. Countries completely dependent on energy imports found themselves heavily in debt, and millions of unemployed poor had to migrate from the cities back to their villages.

What Americans import from the Persian Gulf is not oil but its price.

The crisis also dealt a blow to American prestige. At the height of the Cold War, the United States essentially proved that without oil it was a paper tiger. The worried secretary of state, Henry Kissinger, indicated that the United States was prepared to send military forces to the Persian Gulf to take over whatever country was needed to keep the oil flowing. Since 1973, the United States has sent forces to the Middle East time and again in the name of energy security. Moreover, the embargo created a deep sense of vulnerability from which the United States has never recovered. The country has been portrayed that way by its own leaders: in 2006, Senator Joseph Lieberman called it “a pitiful giant, like Gulliver in Lilliput, tied down and subject to the whim of smaller nations.”

The only proper response, it seemed, was to stop importing so much Middle Eastern oil. Every U.S. president since the embargo, from Richard Nixon to Barack Obama, has sought the elusive goal of “energy independence,” either by increasing domestic oil supply (Republicans) or by constraining demand through a gasoline tax and improving the standards for cars’ fuel efficiency (Democrats). Americans have been led to believe that the vulnerabilities associated with oil dependence would be alleviated if only oil imports decreased. Furthermore, they have been promised that import reduction would yield lower crude prices and thus lower prices at the pump.

Those assertions were wrong 40 years ago and they are even further off the mark today. The long race for energy self-sufficiency reflects a systematic failure to grasp the meaning of the events of 1973 -- specifically the exact role that OPEC played during this episode and over the subsequent four decades. It is time to take a fresh look at those events, to rethink the U.S. national fixation with energy self-sufficiency, and to focus on solutions that actually have a chance of getting the United States -- not to mention the rest of the world -- out of the mire.

THE EMBARGO SYNDROME

The first clue that the oil embargo did not cause the United States’ energy woes is that the real (inflation-adjusted) price of oil barely dipped when the embargo ended and did not again hit the pre-embargo lows until the late 1990s. The fundamental driver of the rise in oil prices was rather a structural shift in the oil market, which transformed it from a buyer’s to a seller’s market. From the mid-1940s to the 1970s, oil markets were dominated by the so-called Seven Sisters, investor-owned Western oil companies that controlled the global petroleum industry. They were replaced by a cartel of 12 governments.

OPEC was initially created in 1960 by five member states that were frustrated. They felt that they earned too low a share of oil revenues, and they were irritated by oil import quotas set by the United States in 1959 that lowered oil prices outside North America while keeping them high for the benefit of domestic drillers. Moreover, they were intent on changing the balance of power between themselves and the investor-owned oil companies. But the organization did not garner real power until the following decade, after the United States became a net energy importer in 1971.

OPEC’s founders understood that by consolidating control over a large portion of the world’s oil reserves and colluding to suppress oil production, they could drive prices up to a level more to their liking. In the three years prior to the embargo, OPEC members worked hard and fast to seize control over the international oil market. They taxed and nationalized their oil assets and implemented arbitrary production cuts and sharp increases in prices to offset the loss of their income caused by the decline in the value of the dollar. These measures effectively doubled the price of crude oil between 1970 and 1973.

A sense of impending doom was in the air. In an influential April 1973 Foreign Affairs article, James Akins, a White House oil expert who was appointed U.S. ambassador to Saudi Arabia a month before the embargo began, predicted an oil crisis. In the absence of adequate uses for their oil wealth, the Arabs would likely conclude that oil in the ground was just as good as money in the bank and that they should produce less rather than more, despite the blistering growth in global demand. Before the Arabs and the Israelis exchanged a single bullet, OPEC was already working hard to drive oil prices up.

Then came the actual embargo. On October 19, 1973, the Arab members of OPEC and Iran decided to stop sending oil to the U.S. market as a punishment for President Richard Nixon’s appeal to Congress to appropriate $2.2 billion in emergency aid for Israel. What mattered most, however, was not the decision to cut off exports but the cartel’s throttling down of oil production.

The oil market is like a pool into which producers pour oil and from which consumers take it out. It does not matter so much who purchases which oil from whom. If the embargo simply consisted of a ban on exports to particular countries, it would not have had much of an impact on prices, since those countries would have purchased from an alternate supplier and OPEC’s oil would have flowed elsewhere. Yet a reduction of supply in the face of the same level of demand was guaranteed to drive prices up globally -- for everyone -- not just to those countries targeted by the embargo. What really happened was that key members of OPEC took advantage of geopolitical events to shift to a lower level of supply and to send prices up to what they perceived as a more just level. In total, five million barrels per day were withdrawn from the market, and OPEC’s posted price of crude doubled yet again, from $5.12 to $11.65 per barrel.

For the last four decades, Washington’s energy policy has been based on the faulty conclusion that the country could solve all its energy woes by reducing its reliance on Middle Eastern oil.

Meanwhile, in the United States, another policy had already set the stage for the snaking gas lines and desperate drivers. The Economic Stabilization Act of 1970 gave the president control of wages, rents, and prices across the American marketplace, including the price of fuel. Whereas in 1970, the Mandatory Oil Import Quota Program had kept U.S. oil prices about 2.5 times higher than global prices, and politicians said nothing, the major price spike following OPEC’s 1973 production cuts sent the political and regulatory machinery into a spin. Politically unable to unwind fuel price controls and let the price of gasoline go up in sync with rising global oil prices, the U.S. government had made selling fuel in the United States a losing proposition for some refiners. This caused a reduction in domestic fuel supply. Demand did not drop because the government prevented prices from rising in a way that reflected market realities. The result was shortages at the pump, a spread of panic and uncertainty among buyers, and a doubling down by the government: the Emergency Petroleum Allocation Act, passed in November 1973, enabled the administration to embark on Soviet-style allocation and rationing of petroleum products.

Energy security is traditionally defined as the availability of sufficient supply at affordable prices. The collective memory of the embargo and the U.S. response to it were mostly shaped by the events that were perceived to affect availability -- the embargo and the gas lines -- rather than OPEC’s change of the supply-demand balance, which for decades has affected the affordability side of the ledger. Nixon’s response to the crisis, Project Independence, aimed at achieving energy self-sufficiency for the United States by 1980, but it ignored the real story: the cartelization of the world’s most important commodity and the new balance of power that had been established between consumers and producers.

THE ANATOMY OF A CARTEL

Analysts tend to discount OPEC’s role in the modern energy market, deriding it as a dysfunctional and irrelevant group that long ago lost its sway in setting oil prices. Watching OPEC’s conduct on a week-by-week basis, especially the internal disputes among its members, that conclusion seems plausible.^{Note 1} But looking at the cartel’s overall performance since 1973, one can appreciate the precision of Akins’ observation that for OPEC, oil in the ground is as good as oil in the bank. In the past 40 years, the world’s population has grown from four billion to seven billion, the number of vehicles in the world has quadrupled, and the Chinese economy has risen from its slumber. All these trends have caused global oil demand to spike from 55 million barrels a day in 1973 to 88 million barrels a day today.

Although the United States and other non-OPEC producers have been increasing their production, OPEC, which holds some three-quarters of the world’s conventional oil reserves and has the lowest per-barrel production costs in the world, produces today the exact amount of oil it did four decades ago: 30 million barrels a day, accounting for about a third of global supply. In other words, OPEC deliberately produces much less oil than its reported reserves would allow in order to keep prices higher than they would otherwise be. If investor-owned oil companies such as Exxon, BP, Shell, and Chevron were sitting on top of three-quarters of the world’s conventional oil reserves, they would be supplying something around three-quarters of the world’s oil. And if not, they’d be slapped with an antitrust lawsuit. Antitrust lawsuits, however, don’t work against sovereign governments, and sovereign governments are what constitute OPEC.

At the same time, the Arab OPEC members today face growing budgetary obligations as a result of the Arab Spring’s unrest.^{Note 2} They need to maintain an oil price high enough to ensure that they will have enough money to distribute to keep the masses from storming the palaces. To make matters worse, Persian Gulf countries are also among the world’s fastest-growing oil consumers -- Saudi Arabia, for example, is the sixth-largest oil consumer, using more oil than Germany, South Korea, or Canada -- which means they have less oil for export as their domestic demand grows. What OPEC terms the “fair price” or the “reasonable price” of oil -- which in practice means whatever price its members require to balance their national budgets -- will remain high in order to ensure political stability. “In 1997, I thought $20 was reasonable. In 2006, I thought $27 was reasonable,” the Saudi oil minister, Ali al Naimi, said in March this year. “Now, it is around $100 ... and I say again, ‘It is reasonable.’”

The financial obligations of OPEC members are likely to continue to inflate, and so OPEC’s response to the oil boom in the Western Hemisphere, which has the potential to drive down energy prices, will need to be corresponding to cuts in production. This has been the cartel’s modus operandi since its inception. When non-OPEC producers such as the United States or Norway increase their production, OPEC can respond by decreasing supply accordingly, keeping the overall amount of oil in the market the same. With annual revenues exceeding $1 trillion, OPEC members seem unconcerned by the pain they have inflicted on the global economy, not to mention the world’s poorest nations, with oil’s meteoric price rises.

Put simply, what Americans import from the Persian Gulf is not so much the actual black liquid as its price. As long as oil is essentially the world’s sole transport fuel, neither expanded domestic oil production nor improvements in the efficiency of cars will change this reality. Such remedies may have a positive impact on our trade balance and the environment, but they will have little bearing on the economic burden of importing oil or the price that consumers will face.

COMPETE, BABY, COMPETE

Half a century of a global transportation sector dominated by OPEC has led us to accept the cartel's price-over-volume strategy as a fait accompli. We shouldn’t. In a modern global economy defined by free trade, open markets, and antitrust laws, no cartel should be allowed to dominate any commodity, not least the most strategic one of all. That most OPEC members adhere to the World Trade Organization’s obligations and that one of them, Qatar, is even home to the WTO’s current trade negotiations round only highlight the inconsistency.

What can be done? A breakup of OPEC is unlikely, since all its members are in the same boat, and holding on to the cartel is their only way of remaining economically viable and maintaining domestic stability.

But the United States now has a unique opportunity to stabilize oil prices -- and to do so in a fairly short period. To see how, one can look to salt, the commodity that for most of human history held the same strategic importance that oil holds today. Just as oil has a virtual monopoly over transportation fuel, salt was for centuries the only means of food preservation. As a result, the pursuit of salt was a matter of war and peace and a source of real conflict. This grip was broken with the invention of competing methods of food preservation, such as canning and refrigeration. Salt’s strategic importance was eliminated not because countries stopped importing or using salt -- in fact, the United States imports and uses more salt than ever before -- but because there were other options. Oil’s strategic importance can be similarly reduced.

In every sector in which oil has faced competition from substitute commodities, it has lost market share due to its high price. For example, until 1973, most industrialized countries, and certainly the developing ones, used oil to generate electricity. As much as a quarter of U.S. electricity and 70 percent of Japan’s was generated from petroleum. But the emergence of civilian nuclear power in the 1970s, followed by the increase in the use of natural gas for power generation, effectively pushed oil out of the electricity mix. Today, in the United States, only one percent of electricity comes from petroleum, and only one percent of U.S. petroleum demand is due to electricity generation. Despite popular claims that drawing electricity from wind turbines, solar panels, and nuclear power would reduce the world’s oil dependency, today in most countries, including China, the electricity sector is decoupled from oil.

Such a transformation has yet to happen in the transportation sector, which remains as dominated by oil as it was four decades ago. Other energy commodities, such as natural gas and coal and the fuels that can be made from them, are much less costly than oil and oil-based fuels. Yet so long as cars are made and certified to run on nothing but petroleum fuels, oil will continue to be an uncontested master and will not face competition at the pump. Should cars be open to a variety of fuels, however, oil would be forced to compete for market share, and this competition would force oil prices down even as it drove the price of other energy commodities higher.

The ubiquity of the petroleum-only vehicle, despite the existence of cheaper non-petroleum fuel, is partially a result of the challenge of coordinating between fuel stations, fuel makers, and vehicle manufacturers, and partially due to entrenched regulatory advantages petroleum has accumulated over the years. These can and must change.

PITTING NATURAL GAS AGAINST OIL

The recent proliferation of fracking and horizontal drilling technologies has unleashed such substantial quantities of tight oil and natural gas in North America that it has become a cliché to proclaim an “energy revolution.” But if this development is to have any real and lasting impact on the security of the global oil supply, it will stem from unconventional natural gas production rather than from unconventional oil. Increases in domestic oil production are, after all, trivial for OPEC to counter. Low-cost natural gas is another story.

At current oil and natural gas prices, oil costs five times more than natural gas on an energy equivalent basis. But despite its low cost, less than one percent of U.S. natural gas is used to fuel automobiles. There are a number of paths to making use of natural gas in transportation. Some would allow for cheap fuel but would increase the cost of vehicles; others would be able to keep down the cost of both. For example, using compressed natural gas to power vehicles, while quite cheap on the fuel side, would make cars more expensive, since a gaseous fuel under pressure requires a much more expensive fuel tank than a liquid fuel for safety reasons. Electricity generated from natural gas could power plug-in hybrids and electric vehicles -- also somewhat costly on the vehicle side and quite cheap on the fuel side. Natural gas could also be converted to liquid fuels such as gasoline, ethanol, and methanol, all of which could used by engines capable of working on any blend of gasoline and alcohol. This last option would add roughly $100 to the cost of a vehicle.

Methanol offers a particularly appealing alternative because of its affordability (it sells today for a dollar less than a gallon of gasoline on an energy-equivalent basis), scalability, and the very low cost of enabling vehicles to use it. All that is needed to enable a car to run on methanol are a fuel sensor and a corrosion-resistant fuel line. And in fact, China has opened its transportation fuel market to methanol and has become the world’s largest producer and user of the fuel, which in China is primarily made from coal. The fuel’s economics are so attractive that illegal blending of methanol and gasoline is rampant.

Opening vehicles to fuel competition would pit cheap and abundant commodities such as natural gas and coal against one whose supply is chronically constrained by a cartel and whose price is consequently inflated. The subsequent increase in production capacity of non-petroleum fuels, and the ability to shift on the fly among different fuel sources at the pump depending on their per-mile pricing, would finally allow market competition to drive down the price of oil.

The realities of geology and the comparative marginal cost of production in different regions make it extremely unlikely that OPEC can be knocked out of its monopolist position in the global oil market. But fuel-competitive vehicles would make the cartel just another purveyor of commodities when it comes to the transportation fuel market. For this to happen, the United States first needs to realize that its current approach might bring oil self-sufficiency, but it will get the country nowhere near energy security. True energy security would not require the United States to shield itself from the rest of the world. Rather, it would require the United States to apply to the transportation fuel sector the economic principles it has always cherished: consumer choice, open markets, and vigorous competition.

Note 1: Economists look at the outcome, not the drama. On that basis, when supply and demand are such that the market is strong, OPEC has no internal conflicts – individual members can pump more if they disagree with their quota – but it is also largely irrelevant, because prices would be high anyway. When the market is weak, OPEC has demosrated time and again its inability to monitor how much oil members are actually pumping, and countries that disagree with their quota (want more money) cheat and pump more. (Indeed, I've heard an anecdote about ships repainting their bow (draft) marks so that "spies" with field glasses couldn't be sure how low they were riding in the water and hence how much oil they were carrying.)

In the face of rampant cheating, what matters is the willingness of OPEC's largest members (and above all Saudi Arabia) to cut output by more than the agreed reduction to try to offset cheating. That is in tension with preserving revenue. Unless demand is extraordinarily inelastic, if the Saudis have to cut output by 10% extra, but are 10% of global output post-cheating, that means total output would be pushed down only 1%. In order for this to be revenue-neutral, however, the price the Saudi's receive has to rise by 10%. Prices aren't that sensitive, so the Saudi's have to count the cost.

To make it even more of a challenge, Saudi Arabia as the presumed leader of OPEC accounts for only 25% of OPEC's production, and OPEC about 40% of global output.

Note 1: OPEC members hope to be around in the long run. The House of Saud seems in no hurry to leave power, and the country will outlast them. So if you care about the future, you're likely to want to leave oil in the ground. Note that this is not going to be true of purely private energy production; a CEO likely isn't thinking of being in the saddle 20 years down the road, shareholders are only moderately patient, and stock analysts and portfolio managers are evaluated on a 90 day cycle. So they pump more quickly. Only sovereign producers – such as OPEC members and Norway – can play this game.

Now the obvious counter is "put the money in the bank" or "invest in infrastructure and education and..." These countries do have their sovereign wealth funds and do squander, er, invest large amounts on "real" projects. Both parts can be corrupt – but it's hard to steal oil that's still in the ground. Plus, of course, standard portfolio management rules say "diversify" and leaving oil in the ground is one way to balance a country's overall wealth portfolio.

Data Check: Should you add inventory or build capacity?

One side effect of the government shutdown is a delay in data collection and release. If you're in business, you either track directly data such as that below, or rely on those who do. So this is what the impact looks like for this month... The Bureau of Labor Statistics (www.bls.gov) has not indicated whether some of next month's releases will be delayed as they play catch-up with collecting, verifying and analyzing data.

If you're on edge about whether or not to go ahead with a project, or to increase inventory levels, well, you might wait until you have more information. Since many others will be doing the same, this will exert a modest (but likely measurable) drag on the economy. (If a project is clearly good, as many are, then this sort of informational black hole won't affect your decision. Hopefully you don't find projects that are clearly bad landing on your desk.)

Note that the sequester affects BLS, too – if you want quality and not just timeliness, well, doing the research and improving collection takes money. Special surveys in particular are costly. That's most important if you're affected by new sectors of the economy, because that's where BLS has to redesign or at least extend their data collection.

Updated Schedule of BLS News Releases

Release	Reference Period	Previously Scheduled Release Date	Revised Release Date
Metropolitan Area Employment and Unemployment	August 2013	Wednesday, October 02, 2013	Monday, October 21, 2013
Employment Situation	September 2013	Friday, October 04, 2013	Tuesday, October 22, 2013
U.S. Import and Export Price Indexes	September 2013	Thursday, October 10, 2013	Wednesday, October 23, 2013
Job Openings and Labor Turnover Survey	August 2013	Tuesday, October 08, 2013	Thursday, October 24, 2013
Producer Price Index	September 2013	Friday, October 11, 2013	Tuesday, October 29, 2013
Consumer Price Index	September 2013	Wednesday, October 16, 2013	Wednesday, October 30, 2013
Real Earnings	September 2013	Wednesday, October 16, 2013	Wednesday, October 30, 2013
Employment Situation	October 2013	Friday, November 01, 2013	Friday, November 08, 2013
Employment Cost Index	Third Quarter 2013	Thursday, October 31, 2013	Tuesday, November 19, 2013
Usual Weekly Earnings of Wage and Salary Workers	Third Quarter 2013	Friday, October 18, 2013	Being planned
Regional and State Employment and Unemployment	September 2013	Tuesday, October 22, 2013	Being planned
Occupational Injuries and Illnesses	2012 Annual	Thursday, October 24, 2013	Being planned
Metropolitan Area Employment and Unemployment	September 2013	Wednesday, October 30, 2013	Being planned
Productivity and Costs (Prelim)	Third Quarter 2013	Wednesday, November 06, 2013	Being planned
Nonfatal Occupational Injuries & Illnesses Requiring Days Away From Work	2012 Annual	Thursday, November 07, 2013	Being planned
Job Openings and Labor Turnover Survey	September 2013	Friday, November 08, 2013	Being planned
U.S. Import and Export Price Indexes	October 2013	Wednesday, November 13, 2013	Being planned
Producer Price Index	October 2013	Thursday, November 14, 2013	Being planned
Consumer Price Index	October 2013	Friday, November 15, 2013	Being planned
Real Earnings	October 2013	Friday, November 15, 2013	Being planned
Business Employment Dynamics	First Quarter 2013	Tuesday, November 19, 2013	Being planned
Regional and State Employment and Unemployment	October 2013	Tuesday, November 19, 2013	Being planned
Metropolitan Area Employment and Unemployment	October 2013	Wednesday, November 27, 2013	Being planned
Producer Price Index	November 2013	Friday, December 13, 2013	Being planned

The PACE of supplier innovation

GM just announced that it will begin selling a dual gasoline/CNG (compressed natural gas) version of its Impala – the first Chevy in years (decades!?) to get a top rating from Consumer Reports. Now such vehicles are standard in Brazil, allowing the country to take advantage of the widespread availability of natural gas. [In Brazil, such vehicles can also use any gasohol mix, from 100% gasoline to 100% ethanol – you put whatever's cheapest into your tank.] With natural gas running as low as $1.50 per gallon equivalent in the US, that's of considerable interest to fleet operators, and perhaps someday to regular consumers. And while the article makes no mention of the specifics of who supplies GM's system, the dual fuel technology comes from a supplier, Magneti Marelli. One item of note is that it is an example of the globalization of the supply base, as this is an Italian firm but the R&D was done in Brazil. The other is that this innovation – TETRAFUEL – was a 2008 PACE winner.

The PACE supplier innovation competition is now entering its 20th year; finalists for the 2014 awards were announced Saturday morning at the Society of Automotive Engineers "Global Leadership Conference" at the Greenbrier in West Virginia.^{Note 1} I've commenced a project analyzing PACE winners. I hope that will provide a window on what I believe is a gradual shift in the nature of automotive innovation (I gave a presentation on "technology roadmaps" at the Industry Studies Association in May 2013.) Another component is to see whether we PACE judges [yes, I'm one] have done a reasonably good job in evaluating which innovations matter. Of course we can't give awards to firms that don't apply, so we don't have a complete set of innovations to work from. But my sense is that we do pretty well.

Flexible fuel systems are an example of that. What Magneti Marelli did was really clever, starting from problem solving in the Brazilian context, where ethanol is cheap [unlike in the US]. Now other suppliers have to make sure that their hoses aren't soluble in ethanol, that their fittings are robust, as it's chemically different from gasoline. MM's focus was engine controls. How does the air-fuel mixture need to adapt, or ignition timing, or ... in the presence of different mixtures? And how do you measure the fuel mix? They discovered that the information they needed was already being gathered by sensors present in the burn and emissions systems; they didn't need additional sensors in the fuel line to figure out ethanol content. TETRAFUEL took it one step further: how did engine controls need to respond to natural gas? Solvable. (Again other suppliers did the work on lines and fittings; CNG storage and handling is a mature technology.) How to switch fuels? Some clever engineering utlimately led to a low-cost system that could be fitted to existing engines.^{Note 2}

You can peruse past PACE winners on the competition's web site, along with the list of 2014 finalists that this year ranges from Korea and Japan to Sweden and Germany, with a global customer base. I'll make site visits to a few as part of the judging process. Until the announcement of the winners at a black-tie event in Detroit in April 2014, though, I won't be able to say much more.

Note 1: SAE is recovering from a near-death experience, the two-plus-century-old Greenbrier resort is also recovering nicely under the ownership of a local WV businessman.

Note 2: All the detail that I provide on PACE innovations is from public sources. We judges are very careful to adhere to non-disclosure rules, which not only includes engineering, customer and financial data from suppliers relating to their innovation, but the input of customers and other outside references on an innovation relative to alternative approaches and systems from rival suppliers.

mike smitka