The Oil Price Bubble
As many oil experts have stated in the pages of The Daily Reckoning in recent weeks, the price of oil is in a bubble. While this realization doesn’t help much when you’re fueling up your car, it does help to put the epic rise in prices in perspective. Frank Shostak explores…
There are many factors behind the sharp increase in the oil price, but one is usually overlooked: it’s a bubble. Where bubbles appear in the market (think of housing and tech stocks, to name two in recent memory), you will find the hidden hand of monetary policy at work. This is an underlying issue that helps explain the price. Recognizing this also helps us make a better judgment concerning the future of the oil price as it relates to overall economic wellbeing.
According to the Fed’s minutes of its April 29-30 monetary policy meeting, U.S. central bank policy makers have turned more pessimistic on the growth of the economy. The Fed is now forecasting that economic growth is likely to hover between 0.3% and 1.2% in 2008 – down from the 1.3% to 2% range, which was the Fed’s previous forecast.
The main reason for the lowering of the forecast is a sharp increase in commodity prices and in particular the price of oil, which Fed officials fear could ignite inflation expectations and lift the underlying rate of inflation. On Friday, May 23, the price of oil closed at around $132/barrel. The yearly rate of growth of the price of oil jumped to 106.3% from 72.9% in April. According to the University of Michigan’s consumer survey inflation expectations one year ahead jumped to 5.2% in May from 4.8% in April and 3.3% in May last year.
It is usually assumed that rising inflation undermines consumer’s real disposable income, which in turn weakens consumer spending. Since spending is the major component of real GDP, real economic growth is obviously going to come under pressure, so it is held. By this logic, if the price of oil were to continue to climb further, then at no time would Fed officials be forced to lower their forecast to negative growth.
Fed officials follow the Keynesian framework of thinking. In this framework, spending by one individual creates income for another individual. Hence the more people spend, the more income is generated. (What causes economic growth is consumer spending, so it is held.) Also, note that the source of a possible recession in this way of thinking is various shocks, such as an oil-price shock, that disrupts consumers’ ability to spend.
Most commentators are of the view that the presently observed sharp increases in the price of oil are on account of supply problems. Existing oil fields are becoming depleted as time goes by while not enough new oil fields are being discovered. Some other commentators blame the supply issue on US government restrictions on extracting oil from various areas in the United States for environmental reasons. Without diminishing the importance of the supply factors, we suggest that another factor that must be considered is the contribution of the U.S. central bank’s policies to the recent sharp increases in the price of oil.
What makes it possible to generate the goods and services that people require to support their lives and well being is the capital infrastructure of the economy and not spending by consumers as popular economics suggests. It is the enhancement and the expansion of the infrastructure that permits an increase in the production of goods and services.
An improvement in the infrastructure makes economic growth possible. The key factor that enables the improvement of the infrastructure is the flow of real savings that funds the enhancement of the infrastructure, i.e., enables the production of various tools and machinery also called capital goods. (With better tools and machinery, a better quality and a greater quantity of goods and services can be now produced.)
In a free unhampered market economy, the established infrastructure is in accordance with the tendency towards the harmony between various activities. On this Murray Rothbard, paraphrasing Ludwig Lachmann, wrote,
"Capital is an intricate, delicate, interweaving structure of capital goods. All of the delicate strands of this structure have to fit, and fit precisely, or else malinvestment occurs. The free market is almost an automatic mechanism for such fitting; … the free market, with its price system and profit-and-loss criteria, adjusts the output and variety of the different strands of production, preventing any one from getting long out of alignment."
This harmony gets disrupted by the monetary policies of the central bank. An artificial lowering of interest rates by the Fed and the subsequent increase in the rate of growth of money supply gives rise to various nonproductive activities – bubble activities.
We define a bubble as the outcome of activities that have emerged on the back of the loose monetary policy of the central bank. In the absence of monetary pumping, these activities would not have emerged.
As a result, the economy’s infrastructure gets distorted. Various projects are undertaken that, prior to the artificial lowering of interest rates and increased monetary pumping, would not be considered.
The increase in money supply, which supports various new projects, sets the foundation for additional demand for various commodities, including oil. More money is channeled toward commodities and oil. Since the price of a good is the amount of money paid per unit of the good, this means that the prices of commodities and oil are now going up.
Once the central bank tightens its monetary stance, the diminished flow of money weakens the expansion in the bubble activities – an economic bust is emerging.
Observe that bubble activities are supported by means of loose monetary policy, which diverts real funding to them from wealth-generating activities. Once the money rate of growth slows down, this slows the diversion of real wealth, i.e., slows down the support for nonproductive activities. As a result, the demand for various goods and services that emerged on the back of nonproductive activities comes under downward pressure. Consequently, the prices of these goods, such as various commodities and oil, follow suit.
Following this line of thinking, we can suggest that there is a high likelihood that the massive increase in the price of oil that we are currently observing is the manifestation of a severe misallocation of resources – a large increase in nonproductive activities. It is these activities that have laid the foundation for the oil-market bubble, which has become manifest in the explosive increase in the price of oil.
The root of the problem here is the Fed’s very loose monetary policy between January 2001 and June 2004. The federal funds rate target was lowered from 6.5% to 1%, while the money rate of growth had risen strongly. Between Q3 2001 to Q4 2004, the average yearly rate of growth of our monetary measure, TMS, stood at 7.5%. This should be contrasted with the rate of growth of 2% in Q2 2001 and 0.8% in Q4 2000. The easy monetary stance has given rise to various malinvestments, which we have labeled here as bubble activities.
From June 2004 to September 2007, the Fed had been pursuing a tighter monetary policy. The federal funds rate target was raised from 1% to 5.25%. In response to this, the yearly rate of growth of our monetary measure TMS fell from 7.1% in Q4 2004 to 0.4% in Q1 this year. Because of this sharp fall in the growth momentum of money supply, various nonproductive activities are currently coming under pressure. This in turn should start hurting the prices of various commodities, including oil.
Regrettably, the loose monetary stance that the Fed has adopted since September of last year (the federal funds rate was lowered from 5.25% to 2%), after a time lag, is likely to arrest the removal of various bubble activities and lay the foundation for the increased presence of these activities.
Obviously if the pool of real savings is shrinking – i.e., the flow of real savings is no longer sufficient to support various existing and new activities – economic growth will come to a halt and commodity prices will come under downward pressure, notwithstanding the Fed’s aggressive lowering of interest rates since September of last year.
Now, it is not only the Fed’s policies that must be blamed for sharp increases in the price of oil but also the policies of other countries such as China. Massive monetary pumping in China and the various structures that emerged on the back of monetary pumping there have contributed to the exaggerated increase in demand for various commodities, including oil.
For the time being, the pace of China’s nominal economic activity continues to push ahead. We have estimated that the yearly rate of growth of nominal economic activity stood at 38% in Q1 against 36% in the previous quarter. This, coupled with an upcoming effect of the loose Fed’s stance since September 2007, is likely to mitigate the downward pressure on the price of oil, all other things being equal.
We suggest that there is a high likelihood that the massive increase in the price of oil is the manifestation of a severe misallocation of resources. The loose monetary policy of the Fed from January 2001 to June 2004 is the likely key factor behind this misallocation. (The federal funds rate was lowered from 6% to 1%.) The tighter Fed stance from June 2004 to September 2007 should undermine the existence of various nonproductive activities and in turn reduce upward pressures on the price of oil.
Regrettably, the loose monetary stance that the Fed has adopted since September of last year, coupled with still very buoyant Chinese economic activity, is likely to counter any downward pressure on the price of oil. The Fed’s current policy of fighting an emerging economic slump is, in fact, a policy of deepening the misallocation of resources, thereby promoting higher prices for oil. If our thesis regarding the oil market bubble is valid, then it is the Fed’s policies that must be blamed for the erosion in consumers’ living standards and not the rising price of oil.
for The Daily Reckoning
June 4, 2008
Bubble or not, the price of oil isn’t going down anytime soon – and many think $150 a gallon is just around the corner.
Frank Shostak is an adjunct scholar of the Mises Institute and a frequent contributor to Mises.org. He is chief economist of M.F. Global.
Yesterday, we were full of doubts…
But today, we’re not so sure…
Ah, that’s the trouble with growing older. You lose your dreams and youth. You lose your bearings too. We had lunch in the House of Lords yesterday, with our old friend Lord Rees-Mogg, who turns 80 next month. But more on that in a moment…let’s first turn to the financial news.
Today’s big headline concerns Fed chief Ben Bernanke. According the Financial Times, he broke with long standing tradition in order to express himself on the dollar yesterday. Alas, the fall of the greenback has "contributed to the unwelcome rise in import prices and consumer-price inflation," he said to an international banker’s forum.
The headman at the Fed may want a stronger dollar…or a weaker one; it’s usually not his place to say so. That’s what the Treasury Secretary is for. Henry Paulson, of course, says the same thing; the United States wants a strong dollar. But nobody believes him. Investors seemed to take Mr. Bernanke more seriously.
Stock market investors sold shares and drove the Dow down 101 points. Over in the oil market, the black goo sank $3.45. And gold, too, was sold on the news…it sank $11 to $885.
But let’s think about this. What could the Fed do to protect the dollar? Easy…it could raise interest rates. But if the Fed wanted to protect the dollar, why has it waited so long? The greenback has lost about half its value since 2000, why didn’t it try to protect it sooner?
Ah, dear reader…the plot has become a bit confused. Let’s see if we can remember it.
In the 15-year period known as the "Great Moderation" central banks could increase their supplies of money 2, 3, 5 times as fast as GDP growth. Normally, this would cause inflation. But it didn’t, because globalized markets…along with a few other key trends…we’re holding consumer prices down. So, the inflationary money went into asset bubbles…dotcoms, houses, and the financial industry.
But after the housing/finance bubble popped last year, consumer prices rose – even while the world economy softened. All of a sudden, the world seemed to be spinning in the wrong direction. Instead of holding down prices in the United States and Europe, China was increasing them. China’s domestic inflation is running at more than 8%. And she’s exporting her inflation to the rest of the world. Import prices from China into the United States are now rising at 4% per year…after falling about 1% each year during most of the 21st century. As for imports from the rest of Asia, they were falling in price as recently as the first half of ’07. Now, they’re going up by 4.3% per year.
And even as demand for basic commodities slows in the developed world, demand from the emerging markets makes them more expensive. Ai yi yi…globalization is no longer a force for good…but a force for evil! Now, earnings and housing prices fall in the United States, for example – while Americans are forced to compete with Asians for food, fuel and jobs too.
House prices in America are still falling. Foreclosures continue to rise – especially in places such as Las Vegas, which has the distinction of being the "mortgage fraud capital of the world." And now comes word that people are not only abandoning their houses – but their pets too. Yes, the Society for the Prevention of Cruelty to Animals says that owners are leaving their dogs and cats behind. And pet food banks, operated by the SPCA, are said to have people lined up down the block to get free food for their pets.
Meanwhile, Winnebago says it has had to put its Iowa plant in neutral. The company makes luxury land barges, which have been a big hit with Americans for many years, allowing retirees to take to the open road whenever the mood strikes them. Problem is, motor homes are expensive to buy…and now, with gasoline over $4 a gallon, extremely expensive to operate. In real terms, gasoline is higher than it has ever been in the United States…considerably higher than the $3 it hit (in today’s money) in 1981.
On Wall Street, after Bear Stearns fainted, the other financial firms took smelling salts. But some of them are beginning to look a little woozy, nevertheless. Lehman Bros. is said to be looking for $3 to $4 billion in new capital. The company has nine times as much in level 2 and level 3 assets as it has in tangible equity. And it’s not the worst. Merrill Lynch’s level 2 and level 3 assets equal 2,565% of its tangible equity.
And dear readers, be aware: "There’s another Bear Stearns out there," say our friends over at The Motley Fool. "You may already own it. And just as with Bear Stearns, chances are you won’t see the collapse coming until it’s too late."
Colleague Dan Amoss, over at Strategic Short Report, has pinpointed the next Bear Stearns – and warns that there is another credit crisis ready to jam the pipeline.
"Right now," he tells us, "this company is desperately scrambling to dump more of its weak, illiquid assets…while laying off employees by the thousands…in a desperate bid to ‘fix’ its Wall Street profile, keep its ‘shameful secret’ under wraps, and protect its stock."
But that won’t work, Dan continues. "Buried deep in this firm’s mysterious ‘Level 3’ assets, where banks have regularly hid their riskiest mortgage-backed securities, this one company already has one very large multibillion-dollar real-estate-based asset that – just by itself – could be worth nearly 30% less than it was when this firm bought it.
"When this firm is forced to beef up earnings by selling this one asset, you’re already looking at billions in write-down losses right there. And that’s just where the unraveling begins."
Of course, we can’t tell you what the name of the firm is here – but Dan will in his new special report…along with advice on how to pile up as much as 200% gains, as this firm pays the piper for its massive mistakes.
The feds’ response to this situation – so far – has been to cut rates, bail out financial firms, and hand out money (rebate checks). This inflation (along with robust demand from the emerging markets) has made itself felt, mainly, where the feds didn’t want it – in oil, gold and commodity prices.
But now, commodities are looking toppy. Oil seems to be slipping. Gold too. And the feds are talking about reversing direction – raising rates in order to protect the dollar!
Has something important changed? Well, yes…and no. More tomorrow…
*** Hillary seems to have come to the end of the road.
"Clinton’s White House dream draws to an end," says the Guardian.
Too bad. She was such a wonderful reminder of what politics is all about – empty, fraudulent, jingoistic, ready to say anything to anybody if she thought it would get her back in the White House.
But it is an historic moment for America, says the press. Rather than choose a white woman to represent them, the Democrats have chosen a black man. You’d think history would have better things to talk about.
*** The older you get, the more doubtful you become. If you’ve had your eyes open you’ve seen countless plans, predictions, and programs go awry. Plan A is almost always replaced by Plan B…and then Plan C. And you’ve discovered that the people who are most sure about things are those who turn out to be the biggest numbskulls.
"I don’t know," said our old friend Lord Rees-Mogg over lunch yesterday. "I think when you get older your mental faculties change, so you’re not as quick or as smart in some ways, but smarter in others."
We were about to ask: ‘In what ways do you get smarter?" But the subject changed to the pudding. The dining hall in the House of Lords has to be one of the best restaurants in London. We recommend the calves liver.
Our old friend is celebrating his 80th birthday this year.
"Age may not be a great advantage when you are mountain climbing," he went on. "But it helps when you are investing. Because you’ve seen so much more than young investors. And you tend not to get too excited. Your emotional reactions are more moderate. Tempered by time and experience. You’re not as likely to make big mistakes because of an excess of enthusiasm."
Lord Rees-Mogg may be right; but we’d rather be younger anyway.
*** As you may remember, dear reader, we put in a Country Hotline Service here at the Daily Reckoning headquarters. We offered to give advice to central bankers and heads of state – for free.
Well, we’re still waiting for the phone to ring. But if the phone ever rings, we’re ready. We can imagine the call:
Ben: "Gosh Bill, I’m in a bit of a jamb. I’ve got rising consumer prices on the one side…and a falling housing market on the other. I should raise rates to head off inflation, on the one hand, but if I do that, I risk sending the economy into a recession. Then, I’ll get blamed for everything. The Republicans will lose the White House – and blame me, of course. The economy will sink – just like Japan in the ’90s – and I’ll get blamed for that too. It isn’t fair…"
Ben: "Wait…it’s actually worse that I made it sound. Because either way I go, I’m screwed. If I cut rates, the dollar will go down and the "crude oil cowboys" are going to push the price up to $200 – and the whole world economy could go into some kind of crisis. If I raise rates, on the other hand, I’m almost certainly dooming all those marginal homeowners to bankruptcy. They all live on credit. And if the cost of credit goes up…they’re going to be squeezed hard. What’s really happening is that we’re on the downside of the credit cycle. So the cost of credit is going up…no matter what I do.
"And don’t even think about mentioning Paul Volcker. I’m sick of hearing his name. Let’s face it, he wasn’t a genius; he was just lucky to be on the right side of the credit cycle. Lending rates peaked out early in his term at the Fed…he could coast the rest of the way. I’ve got the opposite situation. Lending rates are bottoming out…just as I get started. It’s going to be uphill from here on…and I’m left holding the bag.
"Did you see what happened in the bond market recently? The 10-year note yield went over 4%…and it didn’t come back down until speculators started to bet on a rate increase.
"What can I do? Sit tight? But if I do nothing…and sit pat…I’ll get even more criticism. People will forgive you if you do the wrong thing; but they’ll never forgive you for doing nothing. Doing nothing is not an option."
DR: "Well…what we’re seeing is pretty much what you could have expected, isn’t it? Isn’t this what happens when…"
Ben: "Look…I don’t need any of your lectures…I just want to know what lever to pull on. The one marked ‘fight inflation’ or the one marked ‘fight recession’?"
DR: "Sorry, Benny…it’s not that easy."
Ben: "What do you mean? There are only two levers. I just wan to know which one to pull."
DR: "It doesn’t really matter, does it?"
Ben: "What do you mean by that?"
DR: "Just as you said; you’re in a jamb. If you raise rates, while house prices are falling and GDP is nearly flat, you’re almost surely going to have a recession. But if you cut rates, oil is going up…inflation will rise…bonds will fall, and interest rates will go up anyway. Either way, the economy goes into a slump."
Ben: "Yeah…so what do I do?"
DR: "Well…you’ve got to think about it in a whole different way. People made mistakes. They built too many houses. They paid too much for those CDOs and MBSs and all the rest of it. They bought businesses for more than they were worth. You can’t do anything about those bad mistakes…except help people correct them as soon as possible.
"You’re not doing any favors by offering more credit to a guy who is too deep in debt. And you’re not doing anything good for an economy that is living on borrowed time and borrowed money. What the whole system really needs is a correction. Why not give it one? Raise rates – a lot. That’ll send a message. That’s what Vol….never mind. Give people a reason to save again. And give the speculators a good spanking. Liquidate housing. Liquidate the banks. Liquidate the farmers. Liquidate the stock market. Liquidate the consumer. Liquidate the whole damned bunch. And while you’re at it, go on TV and tell the public the truth; that modern central banking is as fraudulent as Freudianism…and that from now on, you won’t be putting out any more funny money.
Ben: "Hold on…you know I can’t do that…
DR: "Then get out while the getting is good. Maybe you could fake a heart attack or something, and announce your retirement…that would give you some public sympathy…while you leave the next guy holding the bag."
The phone is still silent.
The Daily Reckoning