FCX Freeport McMoRan Inc

Total Industrial Production rose 0.9% in July, which was well above the expected 0.4% increase. The report is stronger than that would indicate, since both May and June were revised up -- May from down 0.1% to up 0.2% and June from a 0.2% increase to up 0.4%. That is a solid performance, and should help put fears that we are on the cusp of a new recession (rather than just continued sluggish growth) to rest.

Relative to a year ago, total Industrial Production is up 3.7%. In normal times, that would be OK, but for coming out of a deep recession it is anemic, and is a substantial slowdown from what we were seeing last year.

Total Industrial Production includes not only the output of the nation’s factories, but of its mines and utility power plants as well. The production and consumption of electricity generally has as much to do with the weather as it does with overall economic activity. The a big part of the strength this month, came from the Utilities, and reflects hotter than normal weather, and thus more demand for air conditioning.

Manufacturing Sector

The report does not break things down by region or state, but I’m sure that the power plants in Texas and Oklahoma have been running full blast in light of consistent 100+ degree heat. Thus it is important to look at just how the manufacturing sector is doing alone.

It was up 0.6% in July, up from a 0.2% increase in both June and May. The June figure was revised up from being unchanged, and the May figure was revised up from a 0.1% increase. Year over year factory output was up 3.8%. The increase this month combined with the upward revisions still make this a very solid performance, and much better than expected, but not quite as good as the headline number would suggest. Part of the increase in factory output is probably due to the easing of supply chain constraints growing out ot the disaster in Japan.

Utilities

Utility output soared by 2.8%, up from an increase of 0.8% in June and a 0.4% rise in May. Year over year Utility output is down 0.5%. The utility number is mostly about weather, not changes in economic activity, and can be very volatile. The manufacturing only number is a better gauge of overall economic activity.

Mining & Drilling

The third sector tracked by the report is Mining (including oil and natural gas). The output of the nation’s mines rose by 1.1% in July, up from a 0.8% rise in July, and up from May’s 0.6% rise. Year over year mine output is up 6.6%.

The June number was revised up from just 0.5% while May was revised down from 0.7%. That is a very solid performance, and reflects rising domestic oil and gas production, largely due to the new shale plays (mostly in North Dakota for Oil, and in the Marcellus Shale of the Northeast for natural gas).

By Stages of Production

Output of finished goods rose by 1.0%, after a 0.1% increase in June and a 0.4% rise in May. Relative to a year ago, finished goods production is up 3.2%. Finished goods are separated into consumer goods and business equipment, and there is a real dichotomy between the two.

Consumers are trying hard to rebuild their balance sheets. That means spending less on current consumption while paying down debt and building up savings. That is a tough thing to do when you are unemployed, but the 90.8% of people who are working are doing their best to get their personal fiscal houses in order. In addition, a large part of consumer finished goods are imports, not made here in the U.S.

Things have started to turn around a bit. Output of finished consumer goods was up 1.1%, but that was after an increase of just 0.1% in June and being unchanged in May. Year over year, output of consumer goods is up just 1.3%.

Business equipment output, on the other hand, has been consistently strong, but has cooled off a bit. It rose 0.6% in July up from an increase of 0.2% in June (revised way up from a 0.7% decline) but down from a 1.4% rise in May (revised up from an increase of 1.2%). Business equipment production is up 8.5% from a year ago.

Equipment & Software

Business investment in Equipment and Software has been one of the strongest parts of the economy, contributing 0.41 points of the 1.30% total growth in the economy in the second quarter, even though it makes up just 7.33% of GDP. The upward revisions to output, particularly of final goods, adds some hope that the next revision to second quarter GDP growth might be upward, or at least offset the downward pressure from the bad international trade data we got last week.

This is also a solid start to the third quarter. While I would not expect spectacular results, this data suggests that we might see a bit of acceleration from the anemic 1.3% pace. However, it is not likely to be above the 2.0% growth rate we really need to start to bring down unemployment in any significant way.

Output of materials rose 0.9%, an acceleration from a rise of 0.7% in June (revised up from 0.5%) and being unchanged in May (revised from being unchanged). Materials output is up 4.7% year over year. The first graph (from http://www.calculatedriskblog.com/) below shows the long-term path of total industrial production (blue), and manufacturing only industrial production (red). As manufacturing output is the bulk of total output, it is not surprising that the two lines track pretty well with each other over longer periods of time.

While we are in much better shape than we were a year ago, production is still well below pre-recession levels. That is not particularly unusual a two years the end of a recession. In the Great Recession it fell much more than it had in any previous downturn. Notice, however, that the slope of both lines in this recovery is much steeper than in previous recoveries.



Capacity Utilization

The other side of the report is Capacity Utilization. This is one of the most under appreciated economic indicators out there, and one that deserves a lot more attention and ink than it usually gets. Total capacity utilization suffers from the same weather related drawback as does Industrial Production.

Total Capacity Utilization was at 77.5%, well above expectations for a rise to 77.0%. The revival of capacity utilization has been going on for over two years now. A year ago, just 75.3% of our overall capacity was being used, and that was up from a record low of 67.3% in June 2009.

The basic rule of thumb on total capacity utilization is that if it gets up above 85%, the economy is booming and in severe danger of overheating. This effectively raises a red flag at the Fed and tells them that they need to raise short term interest rates to cool the economy. It is also a signal to Congress that it is time to either cut spending or raise taxes, also to cool down the economy (Congress seldom listens to what capacity utilization is saying, but the Fed does).

Congress now wants to do what would be appropriate at capacity utilization levels of 85, when the actual level is less than 78. Capacity utilization of around 80 signals a nice healthy economy, sort of the Goldilocks level, not too hot, not too cold. The long-term average level is 80.4%.

A level of 75% is usually associated with a recession. The Great Recession was the only one on record where it fell below 70%. Thus, a 10.2 point improvement in overall capacity utilization from the lows is highly significant and very good news. On the other hand, we still have a long way to go for the economy to be considered healthy.

The second graph (also from http://www.calculatedriskblog.com/) shows the path of capacity utilization (total and manufacturing) since 1967. Note that the previous expansion was sort of on the pathetic side when it came to capacity utilization, barely getting over the long-term average at its peak, the previous two expansions both hit the 85% overheating mark (the 1990’s doing so on two separate occasions).

The apparent stall in capacity utilization we saw in recent months has been reversed/revised away. This is a major relief.

Relief, rather than exuberance, should be how we should feel about this report. It does not signal a good economy by any stretch of the imagination, but it also looks like fears that we were already falling back into recession are overblown. On the other hand, these days, industrial output makes up a much smaller share of the overall economy than it used to.


 
Factory utilization rose to 75.0% from 74.6% in June (revised up from 74.4%). May was also revised up to 74.6% from 74.4%. Factory utilization is up from 72.4% a year ago, and the cycle (and record) low of 64.4% in June 2009. That is still well below the long-term average level of 79.0%, so as with total capacity, we still have a long way to go on the factory utilization level.

Total capacity rose by 0.7% over the last year, but most of that expansion came in the Mine and Utility segments. Manufacturing capacity is up 0.2 from a year ago. Increased capacity is a headwind for increased capacity utilization, but at the current level it is a breeze, not a gale, particularly for manufacturing.

For most of the last two years we have seen year-over-year declines in capacity, but now that is turning around. While shrinking capacity makes it easier to use the remaining capacity at a higher level, it is not a good sign for the economy. It represents a permanent loss, rather than a temporary idling, of the country’s economic potential.

Mines were working at 90.3% of capacity in July, up from 89.5% in June (revised up from 88.9%) and from 88.7% (revised up from 88.6%) in May. A year ago they were operating at 86.4% and the cycle low was 79.0%. We are actually now above the long-term average of 87.4% of capacity.

When we are at or above the long-term average, minor fluctuations should not be a big macro concern. Since there is a lot of operating leverage in most mining companies, this probably means very good things for the profitability of mining firms with big U.S. operations like Freeport McMoRan (FCX) and Peabody Energy (BTU).

Mine capacity increased 1.9% year over year, making the year-over-year increase in capacity utilization even more impressive. As depreciation is more than just an accounting exercise when it comes to mining equipment, the high operating rates are also good news for the equipment makers like Joy Global (JOYG) and Caterpillar (CAT).

Utility utilization rose to 81.0% from 78.8% in June and 78.3% in May. June was revised sharply lower from 79.5%. and May was revised down from 78.8%. A year ago, Utilities were operating at 83.5%. We are far below the long-term average utilization of 86.6%.

We are actually not that far above the Great Recession low of 79.2%. Increasing utility utilization faces a headwind because our power plant capacity has actually been increasing even faster than our mine capacity, up 3.2% year over year.

Stages of Processing

By stage of processing, utilization of facilities producing crude goods (including the output of mines) rose to 88.5% from 87.8% in June (revised from 87.2%) and up from 87.1% in May (unrevised). A year ago crude good facilities were operating at 88.5% of capacity, and the cycle low was 77.6%. We are now above the long-term average of 86.4%. Considering that crude goods capacity is up by 1.5%, that is a very solid showing.

Utilization for primary, or semi-finished goods rose to 74.7% from 74.0% in May. While that is much better than the 72.8% level of a year ago, and the cycle low of 64.9%, it is a very long way from the long-term average of 81.3%. Part of the year-over-year increase is simply due to shrinking capacity, which was down 0.2%.

Utilization of facilities producing finished goods jumped to 76.3% from 75.8% in June (revised up from 75.4%) and from 75.9% in May (revised from 75.9%).  It is up from 74.0% a year ago, and a cycle low of 66.8%.  It  remains below its long term average of 77.3%, but we are getting closer.   Interestingly, our capacity to produce finished goods has actually increased by 1.4% over the last year, so the rise in utilization there is facing a fairly still headwind.  Part of that is due to Utilities, since electricity is considered a finished good.

A Good Report

Overall, this report was a good one, and better than it appears at first glance. Yes, the headline was boosted by the Utility segment, and that is as much about the weather as it is about economic activity. However, the revisions were up for almost every area, and the manufacturing only data was also strong, if not quite as strong as the headline suggests.

The fears that the Industrial sector, which has been taking the lead in the recover, was stalling seem to be put to rest. At the very least it is clear that we are not yet. We are actually starting to see increases in capacity, unlike the declines we were seeing last year, and while that hurts capacity utilization, it is a positive sign for the economy’s long-term potential.

While the economy is recovering, it is still running at levels far below its potential. The capacity utilization numbers can be thought of as sort of like the employment rate from physical capital, much like the employment to population ratio is the employment rate for human capital. Both are running well below where we want them to be.

Anti-Stimulus Policies In Effect

While additional monetary stimulus would be useful at the margin, the cost of capital is not the major issue right now, it is lack of aggregate demand. As such, additional fiscal stimulus would be much more effective in getting the economy going again. Unfortunately, the debate in DC has nothing to do with getting the economy going faster, it is all about the short-term budget deficit. This is pennywise and pound foolish in the extreme.

Getting the economy back into high gear would also start to raise tax revenues, and so the net cost of additional stimulus should be less than the advertised amount. Conversely, big cuts in spending now will slow the economy significantly, to the tune of hundreds of thousands fewer jobs being created in this year and 2012. That means fewer people with income, and hence fewer people paying income taxes.

We have been seeing anti-stimulus from the State and Local level throughout the Great Recession, and it is the total amount of fiscal stimulus that counts for the economy, not just what happens at the Federal level. De-stimulus from the lower levels of government has offset about half of the Federal Stimulus we got from the ARRA. The main stimulus from both QE2 and the tax deal will wear off at the end of 2011, but hopefully the economy will be self sustaining at that point (hopefully being the operative word).

Industrial Production and Capacity Utilization rebounded strongly while the ARRA funds were going out. With fiscal policy on the verge of turning deeply concretionary, there is a very good chance that they will start to fall again. Deep spending cuts don’t just kill jobs, they also idle physical capacity as well.

The attempt to cut spending now is deeply misguided. The U.K. has gone down that path, and the net result was that its economy fell by 0.5% in the fourth quarter, and only grew by 0.5% in the first quarter, and rise by just 0.2% in the second quarter, far below the U.S. growth rate. China took the most stimulative fiscal path after the financial meltdown, and now it is concerned about its economy overheating.

We have taken a moderately stimulative path with overall fiscal policy (stimulus at the Federal Level offset by austerity at the State and Local level) and grew by 2.3% in the fourth quarter and just 0.4% first, and rebounding ever so slightly to 1.3% growth in the second quarter. Budget cuts that end up slowing the overall growth of the economy will slow the recovery in tax revenues and will result in much less progress on cutting the deficit than is advertised.

As a general rule of thumb (aka Okin’s law), we need real GDP growth of over 2.0% to see unemployment fall significantly. We might get above that level in the second half, but not but much and not for sure. We should see some pick-up in growth in the second half, as some of the temporary headwinds, such as the surge in oil prices and the effects of the Japanese tsunami fade, but massive fiscal contraction could be a major new headwind that will keep growth sub par, and unemployment high and possibly even rising.
 
PEABODY ENERGY (BTU): Free Stock Analysis Report
 
CATERPILLAR INC (CAT): Free Stock Analysis Report
 
FREEPT MC COP-B (FCX): Free Stock Analysis Report
 
JOY GLOBAL INC (JOYG): Free Stock Analysis Report
 
Zacks Investment Research