Supplies probably aren’t ‘excessive’ or US companies wouldn’t import so much and futures spreads would be in contango instead of backwardation, and WTI now trading above Brent is another sign inventories are back towards the tight side.
Oil Falls Below $98 on Swelling US Crude Supplies
Oil held steady around $98 a barrel on Friday, off its recent record above $101 as rising U.S. crude and gasoline stockpiles added to evidence of slowing demand in the world’s largest consumer.
Comments people emailed me and my responses:
Bob Hart wrote:
http://www.wtrg.com/prices.htm
This graph supports your statement below:
Prices fell from a high of maybe $40 per barrel to the $10-15 range for the next two decades
Thanks!
“So, there is nothing the US can do to keep core inflation in check? Only the Saudis (and other oil producers) control US inflation?”
In this case, yes. If the Saudis keep hiking cpi goes up and an inflation begins via the various channels that connect energy with other prices. And in this case exacerbated by our pension funds.
Randall Wray wrote:
right: previous high inflations have always been: energy, food, and shelter costs. I haven’t looked at shelter costs this time around.
Haynes wrote:
Great piece. I’ve been thinking along the same lines over the last few weeks. I wish I had been a lot shorter the long end but think that trade still makes sense, especially given future deficits over the next 3-5 years. Having been born in the 1980s and not lived through oil embargos, stock market stagnation and hyper inflation, I am not exactly sure what the play is over the near-term and longer term. If you were to set up a portfolio that couldn’t be changed over the next 3 yrs / 5yrs / 10yrs what do you think the mix should be?
I like AVM’s current mortgage construction: buy FN 5’s versus tailored swap at LIBOR plus 25 basis points with a ‘free’ embedded put. Put it on and sit tight for Fed hikes. Worst case you get LIBOR plus 25.
Call your AVM salesman ASAP before the spread vanishes!!!
Do you buy TIPS / Broad based commodities indices (DJP) / Gold / Stocks / short end / long end?
‘Raw’ TIPS imply a low real rate. If the Fed decides to rais the real rate, you lose.
You could do a 10 year break even bit, especially in Japan, but I like the mortgage trade better.
Think that you could get killed owning bonds but input prices have already run so much its hard to buy commodities in a potentially declining demand environment. Do you buy stocks hoping they simply stay inline with inflation or do you just hold cash?
In the medium- and long-term the S&P will probably more than keep up with inflation, but help to get the right one and to get the right entry point.
Thanks for the help. I know you are busy but any insight would be much appreciated. thanks.
Philip wrote:
I agree entirely with the view that the 1970s was a question of energy prices, a supply-side phenomenon rather than anything else. The implications for policy are important; we might produce a problem where it does not exist if policy is predicated on the wrong interpretation of the problem.
Looks very much like the 1970’s to me.
Yes, the labor situation was different then – strong unions due to strong businesses with imperfect competition, umbrella pricing power and the like.
But it was my take then that inflation was due to energy prices, and not wage pressures. Inflation went up with oil leading throughout the 1970’s and the rate of inflation came down only when oil broke in the early 1980’s, due to a sufficiently large supply response. It was cost push all the way, and even the -2% growth of 1980 didn’t do the trick. Nor did 20%+ interest rates. Inflation came down only after Saudi Arabia, acting then as now as swing producer, watched its output fall to levels where it couldn’t cut production any more without capping wells, and was forced to hit bids in the crude spot market. Prices fell from a high of maybe $40 per barrel to the $10-15 range for the next two decades, and inflation followed oil down. And when demand for Saudi production recovered a few years ago they quickly re-assumed the role of swing producer and quietly began moving prices higher even as they denied and continue to deny they are acting as ‘price setter’ with inflation again following.
And both then and now everything is ultimately ‘made out of food and energy’ and hikes in those costs work through to everything else over time.
There are differences between then and now. A new contributor to inflation this time around are our own pension funds, who have been allocating funds to a passive commodity strategies as an ‘asset class.’ This both drives up costs and inflation directly, and adds to aggregate demand (also previously discussed at length).
Also different is that today we’ve outsourced a lot of the labor content of our gdp, so I suggest looking to import prices of high labor content goods and services as a proxy for real wages. And even prices from China, for example, have gone from falling to rising, indicating an inflation bias that corresponds to the wage increases of the 70’s.
Costs of production have been going up as indicated anecdotally by corporate data and by indicators such as the PPI and its components. These costs at first may have resulted in some margin compression, but recent earnings releases seem to confirm pricing power is back and costs are pushing up final prices, even as the US GDP growth slows.
US policies (discussed in previous posts) have contributed to a reduced desire for non residents to accumulate $US financial assets. This plays out via market forces with a $US weak enough to entice foreigners to buy US goods and services, as evidenced by double digit growth in US exports and a falling trade gap. This ‘external demand’ is providing the incremental demand that helps support US gdp, and corporate margins via rapidly rising export prices.
World demand is high enough today to support $100 crude, and push US cpi towards 5%, even with US GDP running near zero.
As long as this persists the cost push price pressures will continue.
Meanwhile, markets are pricing continued ff rate cuts as they assume the Fed will continue to put inflation on the back burner until the economy turns. While this is not a precise parallel with the 1970’s, the era’s were somewhat similar, with Chairman Miller ultimately considered too soft on inflation during economic weakness. He was replaced by Chairman Volcker who immediately hiked rates to attack the inflation issue, even as GDP went negative.
Russia exercising it’s pricing power as a swing producer as well.
Lukoil Cuts German Oil Exports by Pipeline on Pricing (Update1)
by Torrey Clark and Thom Rose
(Bloomberg) OAO Lukoil, Russia’s largest independent oil producer, may cut March shipments of crude oil to Germany by pipeline, continuing the halt ordered yesterday because of a pricing dispute.
Lukoil stopped February exports through the Druzhba pipeline and will consider cutting March sales while demanding higher prices from traders in Germany, spokesman Dmitry Dolgov said by phone today. The Moscow-based oil producer has reserved space in the pipeline for next month, he said.
“Why should we sell oil cheap?” Dolgov said. “We have found alternatives.”
German refineries tapped fuel from alternative sources last year to supply their customers when Druzhba shipments fell as Lukoil and Sunimex Handels-GmbH, the dominant oil trader, clashed over prices in July and August. PCK Raffinerie GmbH in Schwedt said the disputes haven’t affected output.
“We haven’t had any problems or production cuts,” PCK Schwedt spokesman Karl-Heinz Schwelnus said today by telephone.
Lukoil will renew attempts to sell oil directly to the refineries, Dolgov said. The company isn’t breaking any contracts by cutting shipments and the refineries are unlikely to run short of crude, he said.
“German drivers have nothing to worry about,” Dolgov said.
(an email)
> On Feb 19, 2008 10:03 AM, Mike wrote:
> Warren, note spec comments and dollar issues, a big hurdle to overcome
> if they go the other way …
> Mike
Hi Mike,
Agreed the dollar may have bottomed. Seems to have reached a level where exports are now growing at about 13% which maybe is the right number to accommodate the pressure from the non resident sector to slow it’s accumulation of $US financial assets.
However I continue to conclude the price of crude is being set by the Saudi’s/Russians acting as swing producer, and that there is sufficient demand to keep them in the driver’s seat. Quantity pumped keeps creeping up at current prices, with Saudis last reporting 9.2 million bpd output.
Crude at 98.70 now. Note crude goes up on news a refinery is down, when refineries are the only buyers of crude, so in fact it’s going up for other reasons (price setting by the swing producer?). Also, WTI is now ahead of Brent, indicating whatever was causing the sag in WTI vs Brent is over. WTI would ordinarily trade higher than Brent due to shipping charges.
Warren
It’s only been a few hours, but seems the first time since August higher oil doesn’t mean lower interest rates, and might even mean higher rates.
Up until now, higher oil prices meant a weaker economy and therefore Fed rate cuts.
I’ve been watching for a shift to higher oil prices meaning higher inflation and therefore Fed rate hikes.
Recent developments- Yellen (the biggest Fed dove) says core inflation is above her comfort zone, and that energy prices are finding their way into core inflation.
Why did she volunteer that when no one was asking? Signalling?
Why not just repeat something like ‘inflation expectations remain well contained but we remain vigilant…’ as before?
Plosser, Fisher, Lasker said much the same, but they are the hawks. It’s not news when they say it.
Maybe they all got an update from the Fed’s economics staff?
Might be revising q2,3, and 4 upwards due to the fiscal package?
They had already expected a second half return to ‘trend’ due to their interest rate cuts.
So let’s guess at what might conservatively be the current mid points of the Fed’s forecast with the new fiscal package-
0% q1, 1% q2, 2.5% q3, 3% q4?
Here’s the problem. The mainstream belief is that inflation is a function of the output gap.
If inflation is too high- above your comfort zone- you bring it down by engineering a sufficient output gap.
That means it takes a weaker economy with higher unemployment to bring down core inflation.
The first step is to try to estimate the GDP ‘speed limit’ which is the max growth rate with inflation staying within Fed comfort zones.
Well, the Q4 data point was .6% gdp growth and inflation above comfort zones. Forward looking Q1 data points are 0 growth with inflation above comfort zones and rising. Q2, Q3 and Q4 now show increasing growth which means at best inflation won’t be projected to fall, and probably continue to deteriorate.
So what is the best guess for the max GDP growth rate consistent with inflation within FOMC member comfort zones?
The hawks said slower growth might not bring down inflation. The dove said she expects slower growth to bring down inflation.
But the forecasts are now for increasing rates of growth, and current conditions are already driving up prices past the Fed’s comfort zones.
Also, the Fed forecasts for 2 years forward always presume about a 2% inflation rate.
That’s because the forecast assumes ‘appropriate monetary policy’ to meet the Fed’s objectives.
The Fed’s interest rate forecast is not released with the rest of the forecast. Built into that model’s forecast is the staff’s calculation of ‘appropriate monetary policy.’
Seems to me that with growth revised up and inflation persisting even with weak q4 and weak q1 growth the model’s ‘appropriate monetary policy’ would be expected to include sufficient rate hikes to be consistent with the 2% inflation rate 2 years down the road.
Recap-
The only way the Fed knows to bring inflation down is to manage the output gap.
You don’t wait for the economy to get strong (achieve a 0 output gap) and then hike rates. That just makes it worse and more costly to keep an appropriate monetary policy/output gap to bring inflation down.
You have to not let the output gap too close to 0.
The Fed has always known this, but since August has feared a deflationary collapse due to supply side issues in the financial sector.
The recent past and the Fed’s forecast shows that instead of the feared deflation, inflation has now climbed above their comfort zones and appears to be persisting. And even looking higher, even with near 0 growth.
And last week’s Fed speeches raised concerns about the possibility that slowing growth has not and may not bring down inflation as anticipated.
And even Yellen volunteered that energy prices are beginning to elevate core inflation measures, and inflation expectations are showing signs of moving up.
Yes, the economy is weak. Yes, there are downside risks. But the economy is strong enough to be relentlessly pushing up prices, including core, and now the forecasts for growth have all been revised up due to the fiscal package.
If the FOMC shifts from fear of a deflationary collapse to fear of a moderate recession with prices holding firm, rate cuts are no longer appropriate monetary policy.
♥
Yes, the below analysis has also been the Fed’s position, up until this week’s speeches.
It’s been about a crude/food/$ negative supply shock, supported by Saudis/Russians acting as swing producer and biofuels linking crude prices to food prices.
The fed has called the price hikes relative value stories that they don’t want turning into an inflation story. They feel they have room to cut rates as long as expectations stay well anchored, which includes wage demands but other things as well.
Yellen the dove, along with the hawks, now saying inflation expectations are showing signs of elevating, and saying energy costs are being passed through to core inflation is a departure from previous Fed rhetoric and may signal they are at or near their limits regarding ff cuts (data dependent, of course).
Also, Bernanke pushing Congress and the President to add to the deficit could also be a sign he is reaching his inflation tolerance regarding lowering the FF rate. The mainstream belief is that inflation is a function of monetary policy, not fiscal policy.
Now with the ECB perhaps throwing in the towel on inflation as well, look at how the commodities are responding. ‘Cost push inflation’ is ripping, and the perception is the CB’s around the world will act to sustain demand, including pushing for larger fiscal deficits.
Difficult to explain why so many have stagflation on the brain It is difficult to explain why so many folks still have stagflation or inflation on the brain just because wheat prices have soared to new highs. We have to distinguish between relative and absolute pricing. Not only that, but unlike the 1970s, the current ‘inflation’ backdrop is much more narrowly confined. The key is the labor market. And here we have a 4-quarter growth rate in unit labor costs of a mere 1% in 4Q (a three-year low), which compares to 4% heading into the 2001 downturn. In other words, as far as the labor market is concerned, inflation is less of a threat to the economy than it was at this same stage of the cycle seven years ago. In fact, heading into the 1990 recession, the trend in ULC was also 4% – the Fed sliced the funds rate from almost 10% to 3% that cycle, for crying out loud. In fact, scouring more than 50 years’ worth of data, at no time in the past has the year-to-year trend in unit labor costs been as low as it is today heading into an official recession. Make no mistake, deflation is going to emerge as the next major macro theme.
♥
Saudis are selling more oil at the higher prices, as they continue to function as swing producer, setting prices and letting quantity adjust.
♥
Iraqi Oil Minister Sees No Output Change from OPEC
(Reuters) Iraq’s oil minister Hussain al-Shahristani said on Thursday there was no sign of any shortage of oil in international markets and he did not expect OPEC to change its output levels at a meeting this week.
Saudis might like letting prices sag in front of meetings to stave off production increase talk.
“Quite frankly, the data we are looking at do not show any shortage of oil on the market. The prices are not really affected by any fundamental market forces,”
Right, just the Saudis (and probably Russians as well) setting price and letting the quantity they pump adjust, aka acting as swing producer.
Shahristani said ahead of the meeting on Friday of OPEC oil ministers in Vienna.
Twin themes continue – moderating demand and inflation.
So far, the Fed is directing all its efforts to the demand issue, including support for the coming fiscal package.
♥
Opec reported Saudi production was up to 9.2 million bpd.
This means demand has increased at the current posted prices probably making further price hikes are more likely than not.
Bloomberg should have updated production numbers around February 5 for confirmation.
♥
