Falling Oil Prices are Inflationary
Crude oil futures for March delivery on the New York Mercantile Exchange this week plummeted to a fresh 19-month low as the bear market in energy continues. Prices on Tuesday morning moved below $52 a barrel. The talk that OPEC members were going to hold an emergency cartel meeting had little lasting impact. From a technical perspective, more serious chart damage was inflicted in the crude oil futures market this week, as prices dropped well below what was key technical support at the $55-a-barrel level. Crude oil prices have been trending lower since mid-July, when the futures were trading above $80 a barrel in the farther-out contracts, including a contract high of $81.24 in February Nymex crude. My friends who are not working in the financial services industrie have not complained about “rigged energy markets” in quite a while. Why is it that? Collapsing oil prices in an environment of continuously rising energy demand smell of manipulation, don’t they? Elections are over, so we can’t blame the (incumbent) politicians for spending our tax dollars on manipulating the energy markets. Is Detroit secretly buying up tankers full of oil to dump it on the open market so that they can sell more Sport Utility Vehicles? You and I know that in a world where everybody competes with everybody else, no conspiracy can be kept secret for more than 5 minutes (unless of course it deals with extra-terrestrians, since they leave no sane witnesses behind) because somebody would take the opposite side of the conspirational trade and then blow the cover of the conspirators. If I knew about Detroit’s plot to revitalise the SUV market, I would love to mortgage my house, buy every oil futures contract in sight and then call Maria Bartiromo at CNBC. At the minimum margin requirement, I would double my money on a 10% move in the nearby futures contract. But I digress. Since there is no manipulation going on, let us examine the E.I.A.s supply/demand estimates.
You can see that demand spikes each year during the Northern hemisphere’s winter months. Except that this year was warmer than usual so that demand was not as strong as expected. The result is the current collapse in prices, which probably caught quite a few speculators by surprise. The two charts below show demand estimates issued by the U.S. Energy Information Adminstration for Asia and for Europe and the U.S. You can see that the estimates for Europe and the U.S. show barely any increases for the next two years. Whether that is correct is debatable but the point is that seasonal fluctuations are not apparent. The Asian countries (ex China), however, show big seasonal fluctions with demand peaks occurring during the 4th and 1st quarters each year. These seasonalities show declining demand into May of each year and could argue for one more cleansing decline in oil prices during the next three months. That should then have eliminated even the staunchest bull in the sector and prepare the energy markets for a continuation of the multi decade bull market in the second half of this year.
What I find most interesting though is that nobody talks about the consequences, yet. A 33% decline in oil prices should put money in consumers pockets, which they most likely are going to spend. Personal consumption increased at a relatively slow 2.8% rate in the third quarter and by 2.6% in the second quarter, slower than the 3.6% average rate of gain seen over the past fifteen years. So, perhaps now the energy price drop will help bring spending back to 3.6%. Many are already forecasting a gain that strong for last quarter and in the current quarter. Growth of more than 3% changes the dynamic of the labor markets, with companies needing more workers and equipment to handle the increased demand. The increased income this brings is what sustains the economic expansion but also stretches the economy’s resources, which in turn might push up inflation. And that is my point, today. By the time that oil prices reach their final low probably in May or June it is entirely possible that consumption, retail sales, capacity utilization and perhaps even the CPI show a worrysome increase in inflationary expectations which might prompt the Fed to act and raise rates a notch or two. The Bank of England’s Monetary Committee surprised markets last week with just that kind of a surprise move. There are plenty of signs of ample liquidity these days, and the money supply can be added to the list as well. The growth in M2 has even been accelerating of late, with the growth rate at about 10% over the past four months, an acceleration from the 4% gain seen in the year prior to the four-month run. With hawkish rethoric emanating from many Fed Governors, with liquidity making every money manager drunk and with capacity utilization already stretched, it would not take much to convince Bernanke that discretion is the better part of valor. The risk of a rate hike gets greater as employment data, in particular, get stronger, a phenomenon that is defying many economists' expectations. Wage inflation is what economists call "sticky," and it can have much more impact than energy price-driven inflation.
That indeed would probably turn out to be the one surprise that markets would not anticipate and that would certainly put an end to the partying around town. This scenario, however, will probably not develop before springtime. Until then, enjoy the ride.