February 6, 2008

When I first started this website, it was my intent to offer a unique perspective on the automotive industry and to broach subjects not commonly touched upon by the automotive press or the majority of the analysts who cover the industry. One of the subjects that I have been very persistent about has been fuel economy. Since I have started this site I have written and discussed this issue numerous times. Why? Personally, I believe this is the most pressing issue the auto industry will face over the next decade.

For starters there is the environmental impact with regard to emissions and the link between global warming and burning fossil fuels. There is also the political impact of countries being dependent on foreign oil. Last but not least there are the serious consequence of the world reaching maximum oil production. This will result in more political instability around the world and further escalation of fuel cost.

Petroleum industry experts and analyst have been predicting world oil consumption will soon exceed the capacity of the world’s ability to produce oil. More recent analysis indicates that may have already occurred in 2006. Although, there may be some disagreement or debate as to the exact date of peak oil, the world cannot maintain its current consumption of oil without consequences. Furthermore, this will adversely affect the automotive industry as the volatility in the price of oil increases. Right now, there are no other near term viable solutions that can replace oil. That I see is at the heart of my discussion.

According to the Department of Energy, total petroleum use in the US rose from an average of 17 million barrels per day in 1990 to 21 million barrels in 2004, an increase of 24%. In 1998, with oil at $11 per barrel, the US paid approximately $45 billion for its imported oil. Fast forward to 2007, with oil hovering around $100 per barrel, the cost to the US was approximately $400 billion. Oil constitutes the single-largest contribution to America's balance-of-payments deficit and a substantial transfer of wealth from the US economy to those of oil-producing nations.

Even the petroleum industry is beginning to come around and acknowledge the uncertainty with regard to the future of oil and the potential radical changes that may be on the horizon. Recently, Jeroen van der Veer, Chief Executive of Royal Dutch Shell plc, who also chairs the Energy and Climate Change working group of the European Round Table of Industrialists released a sobering statement on Shell’s website:

“By 2100, the world’s energy system will be radically different from today’s. Renewable energy like solar, wind, hydroelectricity, and biofuels will make up a large share of the energy mix, and nuclear energy, too, will have a place. Humans will have found ways of dealing with air pollution and greenhouse gas emissions. New technologies will have reduced the amount of energy needed to power buildings and vehicles.

Indeed, the distant future looks bright, but much depends on how we get there. There are two possible routes. Let’s call the first scenario Scramble. Like an off-road rally through a mountainous desert, it promises excitement and fierce competition. However, the unintended consequence of “more haste” will often be “less speed,” and many will crash along the way.

Regardless of which route we choose, the world’s current predicament limits our room to maneuver. We are experiencing a step-change in the growth rate of energy demand due to rising population and economic development. After 2015, easily accessible supplies of oil and gas probably will no longer keep up with demand.”

Why is all of this important? Because the very future of the automotive industry is at stake if they do not begin to rethink their business model and move quickly to move the automobile beyond petroleum dependent powertrains. If in the near future there was more then a temporary shortage of oil, the automotive industry as we know it could collapse when fuel prices soared. I hate to sound like an alarmist but I find the lack of serious public discussion on this issue more alarming.

The rise in fuel cost over the past two or three years has already had a significant impact on the public as they have shifted their purchases from the truck based SUV to more fuel efficient cars. This has also had a significant negative impact on the bottom line of US vehicle manufacturers. In 1999 Ford sold more than 428,000 mid-sized Explorer SUVs. In 2007, sales of the Explorer dropped to just under 140,000 vehicles. In that same period, Toyota went from selling just over 5,000 hybrid Prius’ to just fewer than 200,000. This shift in buyers preferences resulted from only about $1/gallon increase in the cost of fuel.

What happens when there is real increase in the cost of fuel because of a more permanent disruption to the supply. I just do not see a sense of urgency beyond the usual rhetoric. Do not get me wrong, as I have seen the recent emphasis on fuel economy from industry. Yet, I see only reaction and not a proactive discussion. The US automakers and pundits are just not facing the real issues:

"Gas prices would have to be $13 a gallon in today's world for consumers to demand a fleet where half the vehicles achieved better than 35 miles per gallon," Chrysler LLC economist Paul Traub said after addressing the Society of Automotive Analysts this month.

"Americans still want to go to Wally World on the weekends, and we don't want to leave our grandmas and dogs at home," he said. That means automakers must make vehicles that can still carry seven passengers and haul a boat, but meet more stringent fuel economy standards. Chrysler estimates such technology would cost $6,000 to $7,000 per vehicle, Traub said, a sentiment echoed by General Motors Corp. Vice Chairman Bob Lutz.”

“In a highly competitive market, car companies are unlikely to be able to pass that cost on to the consumer, said Erich Merkle, vice president of forecasting at IRN Inc., who tracks vehicle sales trends. "If the consumer isn't demanding those massive leaps forward, but automakers are forced to produce it, the automakers will have to absorb those costs," he said.

And GM's Vice Chairman Robert Lutz has recently said the following at a speech at the 2008 Automotive News World Congress:

“People still have need for trucks in this country. People still buy them for work. People still want them to haul boats and horse trailers. Everyone is not going to suddenly switch into Smart Cars, or Saturn Astras, or tiny little pickups, unless they suddenly decide to haul tiny little horse trailers carrying tiny little horses.

For example… look at the differences in automotive purchase behavior between Europeans and Americans, which is basically dictated by the price of gasoline.

Here are two cars basically off the same architecture. One sells here for around $13,000 and frankly, it’s not breaking any sales records, even at that price. The other sells for more than $30,000 and it’s Europe’s second-largest selling car.

Why is that? Well, it’s because Europeans, at their fuel prices, are willing to pay premium prices for premium small cars that deliver terrific fuel economy.

That is not the case here in America, land of the big truck and big horse.

Nor will it magically become the case once the fleet we offer for sale hits a 35-mile-per-gallon average. It will only be the case if gas prices rise sharply to levels near what they’re paying in Europe.”

I find most of the above statements just absurd as the issue is not the market or the customer but the fundamental ingredient the industry needs.

My thoughts on this subject are not based on the answers I have but the many questions I feel have to be vetted in the public arena.

What would happen if the price of gas would hit $13/gallon? Could the automotive industry retool plants to produce small cars? That is a 2 – 4 year proposition. Demand for vehicles would drop off a precipice. Are some of the smaller companies even viable if industry demand retracts back to 1991 levels in the US at 12 million vehicles? What happens to that excess capacity when compared to the recent 17 million sales per year? What manufacturers can survive is there really is a sharp decline in global vehicle demand?

If manufacturers develop new technologies that cost $6,000 to $7,000 per vehicle, a manufacturer cannot absorb that investment and function as a viable company. As a result, demand will have to decrease as increases in prices push vehicles out of reach. This also assume companies have the technologies available to implement in their fleet quickly. This could very well require a 4-8 year lead-time.

What about alternative bio-fuels? Given enough time, the bio fuel infrastructure should be in place but what happens if it is not? What happens if peak oil is reached before the fuel making capabilities are in place?

In many ways this is a speculative discussion but the questions that need to be answered are very real. I can only hope there is a serious discussion soon, where industry confronts its near term worst nightmare. An industry with limited oil!

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December 29, 2007

Automotive News is reporting (see attached pdf) that Hyundai Motor Company's (Hyundai) chairman, Chung Mong Koo, stated that the company will increase its capital spending by 57 percent in 2008 to $11.7 billion dollars. Hyundai primarily markets product through its Hyundai and Kia brands.

To put this into perspective I will compare Hyundai's planned investment with the capital spending of the two largest automobile companies. Toyota invested $14 billion in the 2006 fiscal year, which ended in March 2007. Struggling General Motors spent approximately $8.7 billion in its 2006 fiscal year, ending in December 2006.

With this significant increase in planned investment in its global operations, Hyundai should continue to rise in importance as a automobile company. In 1998, Hyundai was ranked 16th in production and as of 2006 ranked 6th (Table 1).

At a December 2007 Conference, Hyundai management outlined the state of company and their expectations going forward. Their strategy continues to be growth in emerging markets, increased plant productivity, improved quality and increase the breadth of the product portfolio.

Hyundai, is no longer the fringe manufacturer that once imported the plebian Excel into the US back in 1986, but evolved rapidly into a full-line, global producer of quality products. Brand perception, important for sales growth has improved with the quality of the product. According to the 2007 JD Power and Associates, Automotive Performance Execution and Layout and Initial Quality Studies, Hyundai now ranks with the industry average and continue to improve.

More importantly has been the strides Hyundai has made in long term vehicle reliability. As recent as 2003, Hyundai ranked at the bottom of the JD Power, Vehicle Dependability Study, and now measures close to the industry average.

Not only has the quality of its product improved on the objective measures, but also those which are highly subjective (styling) and not easily quantified, except through observing their appeal by increasing sales. The company will soon release the Genesis rear-wheel drive luxury vehicle, intended to take on Toyota's Lexus at a fraction of the price.

However, exponential growth could become a burden on the organization. Though, it appears Hyundai has used Toyota as a business model for global expansion it also may suffer the same growing pains if internal controls are not effective in identifying problems early. Hyundai could suffer quality issues and production inefficiencies if they do not properly balance their expanding operations with experienced management. Also, stretching human technical resources could lead to costly warranty claims and recalls; creating ill will with their customers.

I am highly impressed with Hyundai and its managements over the past decade. In a couple of product cycles, the company went from being a small South Korean manufacturer, producing mediocre products to becoming a world-class global vehicle manufacturer. I just need to caveat, that continued growth could have a negative cost if management over-extends the company. The recent recalls at Toyota show that to be true even at a company known for efficiency and excellence.

For reference Hyundais' 2006 Annual Report

Note: JD Power results attached.

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December 21, 2007

In an interview with the Wall Street Journal, Chrysler CEO Robert Nardelli stated he was asked if Chrysler was bankrupt. He went on to say "Technically, no. Operationally, yes. The only thing that keeps us from going into bankruptcy is the $10 billion investors entrusted us with."

Add to that Chrysler is expected to lose $1.6 billion for 2007, with the company originally expecting to turn a profit in 2008.

Nardelli also expects to raise additional capital by selling assets.

The facts of the matter are, $10 billion dollars is not a lot of money and may not be enough to restructure Chrysler.

Chrysler requires about $5-7 billion of that on hand at any time to keep the business operational. That is dedicated capital used to pay employees, pay for parts and raw materials to build vehicles.

Chrysler also invests in future product and their capital expenditures probably range $3-5 billion a year.

Since, Chrysler is a private company I cannot be sure of their true financial picture.

Nardelli expects to raise capital by selling assets. Personally, I have to question what assets Chrysler has that can quickly be sold to raise money. I also question how much money will that actually bring in. I can argue they may raise a few hundred million to a billion dollars. This is not a significant amount of money.

To put this into perspective, General Motors (GM) has spent $20 - 30 billion dollars over the past few years to restructure their operations through selling significant assets.

Chrysler does not have the depth of assets in their corporate portfolio as GM once did. Even GM is running very thin on assets to sell. They have just concluded another transaction to raise funds by selling their heavy truck operation.

Which leads me to believe that Chrysler will have trouble raising capital by selling assets because their is little to sell. As I have written about before, Cerberus may have to sell their assets to fund Chrysler's future.

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January 9, 2008

On December 19, 2007, the President signed a comprehensive and significant energy bill that will require a substantial rethinking of US vehicle fleet over the next decade. The goal of the legislation is to help reduce America's dependence on foreign oil by:

• Increasing the supply of alternative fuel sources by setting a mandatory Renewable Fuel Standard requiring fuel producers to use at least 36 billion gallons of biofuel in 2022.

• Reducing U.S. demand for oil by setting a national fuel economy standard of 35 miles per gallon by 2020 – which will increase fuel economy standards by 40 percent and save billions of gallons of fuel.

Over the years, the auto industry has been resistive to any significant upgrades to the CAFE requirements. Their arguments in the past have been, fuel economy does not sell, American’s want big vehicles, we sell what the public wants, etc.

With the new energy bill, both the American consumer and the automotive industry will have to accept transformational systemic changes in transportation as this sector reduces its dependence on oil and offers choices to power the fleet.

Ninety-six percent of the energy for vehicle transportation comes from oil (Figure 1). Currently, the rest is ethanol, or other biofuel. The focus of energy independence lies with the automobile and transportation because no other sector of the economy is as heavily dependent and consumes so much.

 Figure 1: US Vehicle Fuel Source

Let me compare the energy source for the power generating industry (Figure 2). Oil use produces only 2 percent of the electricity in the US. If the US is going to become less dependent on foreign oil, the first step is to reduce the public reliance on oil for their transportation needs. At this time the most viable solution and the most efficient is to put the car on the electrical power grid. This is what the Energy Independence and Security Act of 2007 intends to do over the coming decades.

 Figure 2: US Electricity Producty by Fuel Source

The Act will transfer over time the primary source of power for the automobile from gas/diesel derived from oil to coal, nuclear, hydroelectric, solar power generated by the power companies and when applicable for the application biofuels.

This far reaching law, will result in a fleet composed of electric, hybrid electric, plug-in hybrids and fuel cells vehicle. As the requirements are phased-in, the current credits manufacturers receive for vehicles designed to run on alternative fuels will expire and all vehicles that continue to use an internal combustion motor (primary or hybrid power) will be required to be capable of running on biofuels. The aim is, the public will have an energy choices to fuel their vehicle that are only currently available in limited numbers.

The new CAFE requirements will be based on a continuous scale and vehicle foot print. This means small cars will be required to achieve fuel economy well above the 35 mpg corporate average and is a similar strategy used for the current light truck standard regulation as of 2006. Also, if a car and truck have the same size foot print, both will be required to achieve the same fuel economy.

In the mean time the Secretary of Transportation was authorized to begin to increase the current CAFE requirement for cars and trucks and transition the industry starting in 2011 to 35 mpg by 2020. New fuel requirements begin sooner rather than later.

Ultimately commercial work medium and heavy-duty trucks will be required to improve their energy economy after the National Academy of Science completes their technology assessment report on improve fuel economy for these classes of vehicles. Currently, these types of vehicles are not regulated. A new category is defined for work trucks with a gross vehicle weight rating over 8,500 pounds.

The new law focused on the automobile industry because transportation consumes a significant majority of the oil imported into the country. Though, the environmental impact of putting the car on the power grid may be up for debate because the US is heavily reliant on coal as an energy source for electricity. Coal is well known for producing a significant amount of CO₂ as a product of combustion. However, overtime I suspect this law is just the first step in creating a more environmentally friendly transportation infrastructure that is not reliant on oil.

Research grants into advanced technologies relevant to the law as well as for consumer information programs on alternative fueled vehicles are also allocated in the Act. Substantial money will be allocated for battery, fuel cell and hybrid research programs. There are also incentives for loan guarantees for investment into US production facilities. Many of these same programs also apply to research and investment into biofuels.

I do believe the automobile as we now know it will not exist in 15 - 20 years. It may perform the same task, but the underlying motive principle will be light-years more advanced than today.

This will require a tremendous advance in the application of new, novel and expensive powertrains. I do question how some companies will be able to afford to develop the technology necessary to meet this challenge. I even wonder if vehicles will become so expensive the vehicle market in the US will shrink, putting further pressure on smaller companies and niche brands.

In summary the V-8 and the V6 engine may soon be dead for passenger vehicles. Pickup trucks may be relegated back to their original intent as work trucks and not the life style vehicle they have become for many. The next generation of consumers may well be counting fuel cells stacks and not pistons as a measure of performance and efficiency.

After researching the new Energy Independence and Security Act of 2007, the car of tomorrow will soon be here today. This time the automakers have no choice. Make no mistake; the bill signed in December is comprehensive, significant and transformational. Energy independence will also take time and commitment. Referring to this law as a CAFE increase is an understatement.

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