WRFest 3Apr08(World Econ): Oil, Commodities, Inflation, Doller...Oh My
Again thru the pause that refreshes we end up with a two-week collection of more international economic news. This time on major factors that are driving the entire world economy and underlie much of the symptoms and dysfunctions we reviewed in the last post on worldwide re-coupling and faultlines. In a sense, given the slowdown's widening, disruptive pricing pressures, etc. the Big Three ought to be no surprise: OIL, Inflation and Currency. You can almost just skim the readings and take our points plus what you need to keep in mind. But let's review and try to summarize the bidding a bit.
With Oil, and commodities, we're facing a long-term structural imbalance in supply and demand where growth in marginal production is not keeping up with growth in marginal demand for many reasons. By this time we should all be aware of a couple of things. The international oil markets are one vast fungible pool to which all participants are subject and the only large sources of swing production and reserves are in the ME, basically Saudia Arabia. The growth on the margin is largely due to the rapidly growing demand in China and India. In fact we're now getting to the point where emerging markets consumption is beginning to exceed that of the US. As if this weren't bad enough we're now stumbling into several other structural weaknesses. In case you didn't know it most of the world's reserves are NOT controlled by the major integrated oil companies - in fact they are minor players. Instead those reserves are controlled by governments and national oil companies. Which means they're subject to political influences. The result of which is that long-term profit-making is not the sole criteria which has in turn led to serious under-investment and under-development in new oil because of political factors. Much of this we've covered before so this is a sort of reminder but....of the major new sources of oil, e.g. Russia, et.al. existing fields are aging rapidly with rapidly falling output due to a lack of investment. And new fields aren't being developed at anything like the pace required. Sadly and badly oil is available at an economically affordable price but is not available for political reasons.
This results in feedback to commodity prices as well as the same mechanisms driving them up directly. Net net there is a major cost-side push on worldwide inflation. When Greenspan in his memoirs warned us that we were crossing the Rubicon from a regime of secular decline in prices to one of secular rise he was right, prescient and the chickens are home much earlier than anticipated. The only mitigating factor will be that the slowdown might decrease demand, let's hope it's not at the expense of socio-political collapse however !
One other reason for rising inflation and rising oil prices is dollar depreciation as the gap between US interest rates, based on an anti-recession strategy, and European rates, based on an anti-inflation strategy, is large and growing. A natural result of this is, of course, downward pressure on the dollar. Now there's a fundamental accounting identity in national income accounting which says S-I = Net Exports. When we dissave so that S-I < 0 then necessarily Net Exports < 0. That in turn requires financing, which we've been able to do because foreigners have wanted to continue to hold dollars and US investments. Since we're buying more from abroad than we're selling there's a constant flow of exported dollars which means that more dollars are held by foreigners who want to re-cycle them. In other words more and more dollars are being held for less and less foreign currancy; i.e. the relative price of the dollar to foreign currancies goes down and can only be offset by raising interest rates. OUCH again.
Until we reverse a decade's worth of dissaving that down pressure will continue. Think about that for a minute in light of the Housing ATM, which floated on pool of leveraged foreign liquidity which will have to be drained and dried, which held up consumer spending and therefore the economy. We're not only facing secular inflation pressures but secular downtrends in consumption demand. OUCH should be the world, I mean word, you're looking for. We'd say something more in basic Anglo-Saxon but this is a family blog and profanity seems to pale in comparison to what's going to happen.
A further complication of these various down pressures on the dollar is that US investments are getting shellacked for foreigners (this is the reverse of a weak dollar holding up export demand and foreign profits of course). That jeopardizes the dollar's status as the world's reserve currency and weakens significantly the demand for US investments. So not only does the Fed find itself on the horns of a dilemma with regard to maintaining or raising rates to constrain inflation when that inflation is not due to traditional excess demand internal pressures. Two huge further pressures for raising rates are building up. Now the dollar will be a major world currency for many years to come but it's role and importance are going to be re-thought, re-balanced and re-structured. All of which means that increasingly dollar defense will require higher rates. AND we will no longer be able to count on our status as a reserve currency to pursue a totally isolated monetary policy but will have to give increased attention to worldwide currency pressures. Which amounts to a third major structural shift which'll create yet another secular trend.
Happy reading. Hopefully you're not reading this right after a good meal.
OIL & Commodities
Emerging Market Oil Consumption Exceeds U.S. for First Time as Prices Rise Traffic jams in Beijing and humming air conditioners in Dubai are replacing U.S. highways and suburbs as the driver of global oil prices. China, India, Russia and the Middle East for the first time will consume more crude oil than the U.S., burning 20.67 million barrels a day this year, an increase of 4.4 percent, according to the International Energy Agency in Paris. U.S. demand will contract 2 percent to 20.38 million barrels daily, the IEA says. Economic growth of more than 8 percent in China and India, coupled with increasing car ownership among the countries' combined populations of 2.45 billion people, will more than compensate for falling U.S. demand. Oil use worldwide will increase 2 percent this year because of growth in emerging markets, the Paris-based IEA says. Oil will average $120 a barrel for all of 2008, compared with almost $98 in the first quarter of the year, and reach $150 ``by the end of the decade,'' Rubin said. Emerging Markets' Oil Thirst Likely to Exceed U.S.
Why oil could hit $180 a barrel Just when crude is becoming more costly to extract and process, producers in three key countries are short of cash. And without that money, recent finds won't do much good. In the short term -- say, the next two years or so -- we're looking at bad news about global oil supply that could take the price of a barrel of crude to $180.Needless to say, today's $3.50-a-gallon gasoline would look cheap if oil prices hit $180 a barrel. At that price for a barrel of oil, gasoline would cost somewhere north of $5.50 a gallon. The good news is that's about the price, experts now say, that would send global consumption tumbling and oil prices into retreat, as drivers scrambled to find ways to conserve.Of course, experts once thought $3-a-gallon gasoline would lead to a drop in consumption. The latest forecast from the International Energy Agency calls for global oil demand of 87.2 million barrels a day this year. That would be an increase in consumption of 1.3 million barrels a day from 2007 -- despite a U.S. economic slowdown and soaring oil prices. So why do I think oil prices will keep climbing for two more years at least? A terrible coincidence of geology and geopolitics. Just when oil is getting more expensive to produce, the oil industries in three key countries -- Mexico, Russia and Nigeria -- find themselves short of cash. And without that cash, oil production in these countries, and global oil production in general, is headed into a decline.
- Jubak’s Journal: Where will oil come from? The Saudis say oil production will rise to 12.5 million barrels a day by 2009, but that they don’t see any reason to invest billions to go beyond that, notes MSN Money’s Jim Jubak. Is it because the Saudis don’t want to increase production -- or can't? And why should we care?
- Saudis Face Hurdle in New Drilling Next year, Saudi Arabia will turn the spigots on the largest oil field to come online anywhere in the world since the late 1970s. But even in the oil-rich Middle East nation, the age of cheap and easily pumped oil is over.
- Jubak’s Journal: Why Russia still matters Oil prices hit a new high on word that production in Russia fell 1% in the first quarter. Why was that so bad? Because the world was betting Russian production would increase, says MSN Money’s Jim Jubak. Now, if Russia doesn't invest in new production, oil prices will go even higher.
Why This Oil Shock is the Big One The surge in oil prices is adding to the threat of a contraction in economic activity in the coming months. Oil is up almost $30 a barrel in just four months, trading Friday as high as $119.50 a barrel.Demand in China continues to fuel demand, along with flare-ups in oil-exporting nations and a weaker dollar. But U.S. demand, after rising for years, is not a key contributor, Alliance Bernstein economist Joseph Carson says today in a note to clients. Domestic oil demand has dropped 1.6% over the last year as the economy weakens. He calls a price increase due to non-domestic factors “an exogenous shock, similar to to the supply shortages of the mid-1970s, early 1980s and briefly in the early 1990s.” With the price shock of 2007-08, spending on energy as a share of wage income has shot up above 6%, topping the 1974-75 and 1990-91 shocks to be the worst since the 1980-81 runup. Comparing the additional cost of energy to income growth (especially sluggish in recent years), the current shock is far worse than any of the three prior ones, Mr. Carson says. The figures “suggest that energy costs will crowd out other spending components because income growth is being stifled by weakness in payroll employment,” he writes. “Moreover, relatively thin saving flows offer consumers little cushion against the rising oil prices.” Weak retail sales — from cars to appliances to clothing — are clear signs of the effect. Mr. Carson had believed the surge in exports, due to the weak dollar, could offset the housing slump as well as a “short and modest pullback in consumer demand” and keep the U.S. economy out of a recession. “That view must be re-examined in light of the unexpected jolt from higher oil prices,” he says.
Wall Street Grain Hoarding Brings Farmers Near Ruin, Losses to Food Makers Commodity-index funds control a record 4.51 billion bushels of corn, wheat and soybeans through Chicago Board of Trade futures, equal to half the amount held in U.S. silos on March 1. The holdings jumped 29 percent in the past year as investors bought grain contracts seeking better returns than stocks or bonds. The buying sent crop prices and volatility to records and boosted the cost for growers and processors to manage risk. Commodity investors control more U.S. crops than ever before, competing with governments and consumers for dwindling food supplies. Demand is rising with population and income gains in Asia, while record energy costs boost biofuels consumption, sending grain inventories to the lowest levels in two decades. Investments in grain and livestock futures have more than doubled to about $65 billion from $25 billion in November, according to consultant AgResource Co. in Chicago. The buying of crop futures alone is about half the combined value of the corn, soybeans and wheat grown in the U.S., the world's largest exporter of all three commodities. The U.S. Department of Agriculture valued the 2007 harvest at a record $92.5 billion.
Rice prices soar The staple grain's cost is soaring, but MSN Money’s Jim Jubak points out that it's going to be hard to raise supply to meet demand. Malaysia, for instance, may have to choose between producing more food, saving the rainforest or producing biodiesel to reduce fossil fuel consumption.
INFLATION
Japan's Inflation: Bad Timing Japan's policy makers, dogged for years by falling prices, had long yearned for a little bit of inflation. But now that the global tide of inflation has finally reached Japan, nobody is cheering. The reason: Prices are rising for the wrong reasons. A little bit of inflation can be a sign of strong demand in a healthy economy; if consumers and businesses are prepared to pay more for goods and services, the providers of these can charge more, and prices rise. But the price increases since last year are caused by higher prices of food, commodities and energy on global markets that are driving prices up world-wide. As the prices of imported materials are higher, manufacturers have to charge more for the products in order to make ends meet. Japan Factory Production Fell 3.1% in March From Record on U.S. Slowdown
Caterpillar Prices Take Off as Runaway Rice Has Consumers Hissing `I' Word ``We're seeing a marked increase in inflation pressure everywhere,'' says Harvard University professor Kenneth Rogoff, who was formerly chief economist at the International Monetary Fund. Rogoff says the threat may be the greatest since the 1980s. Driven by rising demand for food, fuel and commodities, especially in China, India and Russia, inflation is accelerating in every corner of the world. Merrill Lynch & Co. predicts a 4.2 percent global rate this year, the highest since 5.2 percent in 1999 and almost a percentage point more than it forecast at the start of 2008. As businesses boost prices and workers demand more pay to meet higher bills, signs of so-called second-round inflation are emerging. Kroger Co., the biggest U.S. grocery chain, is charging more after General Mills Inc. and Kraft Foods Inc. increased prices because of their rising milk and wheat costs. Concern that spiraling inflation will further infect the world may be overblown, says Stanley Fischer, governor of the Bank of Israel. A U.S. recession would curb global demand, easing prices. Cheap labor in developing countries will keep some costs in check. ``I suspect we'll see more of the great moderation,'' said Fischer, referring to prices that began cooling in the 1980s.
Why we're stuck with insane prices Forget supply and demand. We're now seeing scarcity economics at work -- what happens when buyers fear they won't get what they need at any price. If you think prices have become insane, you're right. But insanity rules markets for everything from oil to rice right now. In fact, insanity is the new "normal." For example, why should oil sell for $119 a barrel, a whopping $55 a barrel, or 86%, higher than it did last April? It's like the United States is suddenly out of oil, right? March crude oil reserves in the U.S. were actually 2.4 million barrels higher than reserves in February and only a trifling 3.4% lower than reserves in March 2007… Or copper, which is setting record highs just about every day and has climbed in price by 30% so far this year. Or aluminum -- up 28% this year. Or wheat. Or corn. Or, well, you name it. But the global economy is now playing by different rules, the rules of economic scarcity, and the rules of scarcity say the normal relationship between supply and demand and prices doesn't hold. Yes, prices are insane. But this kind of price insanity is exactly how a scarcity economy works. Scarcity markets play by different rules. In fact, scarcity markets exist because buyers believe the normal rules of supply and demand have broken down. Buyers in a scarcity market don't believe higher prices will depress demand or increase supply enough to allow supply to meet demand. In such a market, prices are driven by fear that there will not be enough supply at any price.
Dollar & the Currency Wars
Asia Getting Fed Up With Bernanke's Rate Cuts: William Pesek While the Fed hinted it may be ready to pause, the amount of monetary stimulus in the pipeline is a growing threat to Asia. One immediate side effect is rising currencies, which poses challenges for Asia's export-dependent economies. The bigger issue is that easy money is fueling global inflation. Yet the Fed's cuts are adding ever more liquidity to global markets. While bad weather and the increased use of biofuels explain part of the run-up in food prices, rising oil costs are as a much a consequence of liquidity as demand. Central bankers in Asia could be excused for feeling a bit, well, fed up by sliding U.S. rates. Their concern is over ``hot money'' flows of the kind that wreaked havoc in Asia a decade ago. Investors who had poured in amid rapid growth fled even faster at the first sign of trouble. Large amounts of the liquidity created by the Fed are heading Asia's way to tap its rapid economic growth.
Dollar Reserve Status Is Tale of Fading Glory: Michael R. Sesit Reserve currency status is like your health: Abuse it, and you risk losing it. With the dollar's 45 percent decline against the euro during the past six years and its 37 percent drop on a trade-weighted basis, there is a growing concern that the greenback's six-decade reign as the world's most important currency may be ending. It's not. The dollar is the world's reserve currency, and absent some unexpected exogenous shock, will probably remain so for some time. Nonetheless, the dollar's premier status is under threat, especially as a store of wealth, by both foreign governments and private investors. Also, companies are using it less as a currency in which to invoice and settle international trade transactions. Why care? Reserve currency status allows the U.S. government to borrow in its own currency, lets the U.S. run large trade deficits, and helps the government and American companies to fund themselves at low interest rates. It makes it easier for U.S. companies to do business and increases the international demand for U.S. assets. Moreover, as the specie of choice, the dollar is blessed with seigniorage, the interest-free loan America receives from the hundreds of billions of dollars held overseas and hoarded as misfortune insurance. Although the composition of official central-bank foreign- exchange holdings receives the lion's share of attention when people talk about reserves, it is the private sector's trade in goods and services that plays a dominant role in determining a currency's international status.
Dollar Slide Drives Burgeoning U.S. Deficit as Japanese Desert Treasuries Add another ailment to the U.S. misery index of soaring gasoline and wheat costs and falling home values: a federal deficit that is burgeoning as foreign investors led by the Japanese recoil from the slumping dollar. The Japanese, who own $586.6 billion, or 12 percent of U.S. government debt, had their worst quarter in Treasuries this decade, losing 7 percent in the first three months of the year as the dollar fell to the lowest since 1995 versus the yen, Merrill Lynch & Co. indexes show. Dai-ichi Mutual Life Insurance Co., Meiji Yasuda Life Insurance Co. and Sumitomo Life Insurance Co., three of the nation's four-biggest insurers, would rather accept the world's lowest bond yields in Japan than buy U.S. debt. After raising their holdings by $9.2 billion to $620.6 billion between March and July 2007, Japanese investors trimmed that stake by $34 billion through February, the Treasury said April 15. America relies on foreign investors, who own more than half the U.S. government debt outstanding, to finance a deficit that New York-based Goldman Sachs Group Inc. predicts will expand to a record $500 billion for the year ending Sept. 30, after a $163 billion gap last year. Without their support, long-term interest rates would be 0.9 percentage point higher, a 2006 Federal Reserve study found. Asian investors outside Japan are also pulling back. Money managers in China, the second-biggest overseas holder of Treasuries, with $486.9 billion, and South Korea say they favor debt in Europe, equities or commodities. Beijing-based ICBC Credit Suisse Asset Management Co., controlled by China's biggest bank, said last week Treasuries are ``not attractive'' because of currency risks. South Korea's $220 billion National Pension Service in Seoul said yields on the debt have lost their ``charm.'' U.S. borrowing costs will rise in the ``longer term'' because central banks may slowly cut their holdings of dollars to about 30 percent of their reserves in 15 years, from less than 60 percent now, said Kenneth Rogoff, a former chief economist at the International Monetary Fund in Washington.