METAL | Production | Processing | Trading

Industrial Production rose by 0.6% in December, matching both the revised November increase (previously 0.8%) and consensus expectations. However, when you dig just a bit below the surface, the report was weaker than expected.

Manufacturing output in reality declined 0.1%, and the November rise was revised down to 0.9% from 1.1%, while the October number was revised up to a decline of 0.1% from the previous 0.2% decline. The overall increase was due to a 5.9% surge in Utility output, which has more to due with a cold snap in December than it does with a surge in economic activity. In November, which was milder than normal, Utility output fell by 2.4%.

The third major component, Mining, saw its output rise by 0.2%, a big slowdown from the 1.9% surge in November. Since a year ago, total Industrial Production is down 2.0%, with Factory output down 1.9%, Mine output (which includes Oil and Gas) down 1.9% and Utility output down 0.8%.

Output of final products increased by 0.7% after a drop of 0.1% in November and an increase of 0.5% in October, and are down 2.6% year over year. On a year-over-year basis, there is a big disparity between the production of finished consumer goods, which are up 0.3%, and the production of finished business equipment, which is down a staggering 9.6%.

In December, however, output of finished consumer goods was up 0.6%, after being unchanged in November and up 0.6% in October, while production of business equipment bounced back with a 0.9% rise after a 0.7% decline in November and a 0.5% rise in October. Production of construction supplies tumbled 2.0% more than reversing a 1.5% rise in November, which in turn came on the heels of a 1.6% decline in October.

On a year-over-year basis, output of construction supplies is down 10.1%. Production of raw materials rose 0.8% in December, following a 1.3% rise in November and was unchanged in October. Output of materials is almost flat year over year, down just 0.1%.

The Real-Time Analysis of These Figures

Thus the overall picture is one of an economy that lost a bit of steam in December after a big surge in November. It is too early to tell if this is simply a little bit of a pause, or if the November strength was just a sugar rush due to economic stimulus efforts that will prove to be unsustainable.

The fact that overall industrial production growth matched that of November is deceptive; although to be fair, the cold snap that helped Utility output might have had a bit of an adverse effect on manufacturing output (though that effect is probably very small, certainly relative to the positive effect it had on Utility output). While the surge in Utility output will help the earnings of the major electric utilities like American Electric Power (AEP - Analyst Report) and Con Ed (ED - Analyst Report) in the fourth quarter, it is not really a sign of better overall economic health.

The Importance of Capacity Utilization

Turning now to Capacity Utilization, it tells a broadly similar story to that told by the Industrial Production numbers, but it perhaps is a bit more upbeat -- at least in regards to direction. Total capacity utilization rose to 72.0% from 71.5% in November and 71.0% in October. That 50-basis-point increase was also deceptive, in that Manufacturing capacity utilization only rose by 0.1% to 68.6%, although the November number was revised up to 68.5% from 68.4%, and the October number was revised up to 67.8% from 67.6%.

The graph below (from http://www.calculatedriskblog.com/) shows the longer-term history of capacity utilization. It is one of my favorite, and probably most underrated, economic indicators. It is effectively the analog to the unemployment rate (or to be more precise, to the employment to population ratio, or employment rate) for our physical capital in the country.

Like the employment rate, it never gets to 100%. As a general rule of thumb, 85% generally indicates that the economy is booming, and is in danger of overheating. It is a signal to the Fed that it is time to start tightening up and raise rates. Capacity utilization of 80% (the long-term average from 1972 to 2008 is 80.9%) indicates a nice healthy economy.

A rate of 75% is what you see in a nasty recession. At the bottom of this cycle (in June), we hit 68.3%. Prior to this cycle, the previous record low was 70.9%, hit in December of 1982 during the Reagan recession.

As the graph shows, capacity utilization is a very good indicator of when a recession ends, bottoming within a month or two of the official end of a recession just about every time. It is also not prone to throwing out a lot of false positives. However, as in the Industrial Production numbers, it is slightly flawed in that it includes Utility utilization, which is often influenced as much by the weather as by economic activity. Focusing on just the manufacturing capacity utilization is probably a better thing to do.

Factory utilization inched up to 68.6% from 68.5% (revised from 68.4%) in November and 67.8% in October (revised from 67.6%). So there, too, the trend is in the right direction, but the absolute level is still a horror show. The long-term average for manufacturing capacity utilization is 79.6%. However, utilities are a relatively small part of the overall picture, so the total is a reasonably good proxy.

Manufacturing utilization also bottomed out in June at 65.2%, and its previous low was also in December 1982, but at 67.9%. In December, Mine utilization rose to 85.7% from 85.5% in November. It is much closer to its long-term average of 87.6%.

Some Practical Usage & Behind the Numbers

Relative to the rest of the economy, this bodes well for the Basic Materials sector, particularly the base metal miners like Freeport McMoRan (FCX - Analyst Report), however most of them also have substantial overseas operations that are not captured by this data (particularly true of FCX, which has the massive Grasberg mine in Indonesia, as well as big mines in Arizona, which it got when it bought Phelps Dodge).

Utility utilization surged to 82.9% from 78.4% in November and 80.5% in October. Its long-term average is 86.6%. Even that understates things a bit, since over the last year, capacity has grown by 1.8% for Utilities, but has shrunk by 1.3% in Manufacturing and by 0.9% in Mining. If capacity shrinks, it is easier to utilize it fully than if it is expanding.

The numbers are also broken down by stage of production. Utilization of crude good production facilities rose to 86.1% from 85.6% and 83.9% in November and October, respectively, and we are almost back to the long-term average of 86.6%. However, permanent shutdowns of 1.4% of capacity have certainly aided in the effort to get back to normal utilization levels.

A 1.1% reduction in capacity for semi-finished goods over the last year has not done as much to get back close to normal; there utilization is only at 68.5%, although it too is heading in the right direction, up from 68.2% in November and 67.9% in October. The long-term average is 82.0% for semi-finished goods facilities.

Finished goods facilities were working at 70.2% of capacity up from 69.9% in November and 69.5% in October. That is still well below the 77.7% long-term average. Total capacity in those factories is down by 0.7% over the last year.

In Conclusion

So overall, it looks like we are still headed in the right direction, but at a slower pace in December than in November, and we are doing so from a very bad place. After all, we are just doing marginally better now than we were at the absolute worst point at any time since the end of WWII prior to this downturn.

Still, history has shown that once capacity utilization starts to turn in the right direction, it usually continues to move higher for a substantial period of time (the major exception being the double-dip when the Regan recession followed hard on the heels of the Carter downturn. However, even though the total capacity utilization number was slightly higher than the 71.8% consensus expectations, the make-up of the report makes it a slightly disappointing one.