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Chinese Oil Torture

The proximate cause for today's $1.63 leap in Crude to all-time highs of $63.94 (although not, we are reminded by CNBC, the all-time high in inflationadjusted terms, or adjusted for the volume of REIT sales, or some other such irrelevant measure) was assuredly the threat to U.S. interests in Saudi Arabia that resulted in the temporary emptying of our embassy there. That spike in energy helped push yields up again (2.4bps in the 10y, to 4.414%) and led to outperformance by the TIPS curve, especially by the front half of it: Jan-07 thru Apr-10 BEIs widened 3-5bps.

But far worse threats previously had pushed oil up quite a bit; remember all the talk, last year, about the $5 or $10 or $15 "risk premium" embedded in oil prices? Analysts couldn't understand how the oil fundamentals could possibly justify $45 or $50 oil.

The reason this is confusing is that oil analysts tend to think of supply and demand curves as quasi-linear, and they tend to think of them only in dollars. I'm not critiquing that approach: in most cases, it's a perfectly reasonable simplification, because historically we have operated on supply and demand curves that looked normal, like those in Figure 1.

As time passed, supply gradually increased (S became S'), and demand gradually increased (D became D'), so that the equilibrium price didn't move a whole lot (by comparison to today, that is). Shocks in supply, in which S' moved sharply to the upper left as for example in the OPEC embargoes of the 1970s, led to sharply higher prices in the short run as the demand curve turns out to be very short-term inelastic (that is, changes in prices don't change consumption very much in the short-term). While this was very painful to people like me who were alive in the Seventies and had to wait in gas lines in the scorching Texas sun, it was a wonderful thing for econometricians, who have lots of data with which to play and estimate the shortterm and long-term price elasticities of demand for oil.

However, supply was always a bit trickier because the primary sources of supply haven't been ours in decades, and moreover the price is set by a cartel whose membership consists of countries that are socialist, communist, and/or autocratic - in other words, people who don't necessarily think like capitalists all the time. But treating supply as a more or less linear function was a reasonable approximation, and so oscillations in price could be explained reasonably well by oscillations in demand, such as those caused by global expansions and recessions.

The problem is that it is becoming increasingly apparent that we have reached an inelastic part of the supply curve (in the real world, such things do happen!), as in Figure 2. The same demand bump (D to D' in this case) that used to cause a small rise in price, now causes a large rise price (instead, D'' to D''').

I'm not the first person to point it out, of course, and I won't be the last. There is a second salient point about Figure 2 that bears observation - although I didn't draw S' because the graph was getting too busy, the fact is that the supply curve isn't moving rightward as rapidly as it used to (some observers think we're about topping in terms of quantity supplied at any given price - Hubbert's Peak, that is; I don't hold such a view but it is clear we are at the point where incremental additions to supply require very large investment.

So, while an abatement of the terrorist threat may, in the short run, lower prices; and while a U.S. recession in 2006 might move us from D''' back to D'' and lower prices precipitously at some point in the next year or two (incidentally triggering panic about deflation as those declines pass through to the headline figures), the steady drip-drip-drip of additional demand from emerging economies, most especially China, is what is killing us. It also bears noting that China has the ability to lower domestic oil prices simply by letting the RMB float higher.

Indeed, as oil prices remain in the top half of the double-digits, and especially if growth begins to flag in Asia, the incentive for foreign governments to buy our dollars and debt starts to diminish. Any decline in the dollar now has salutatory effects on a country's domestic demand because of the implied decline in local-currency crude prices; at some point, if a country thinks declining oil prices can provide enough domestic stimulus to offset a portion of the U.S. demand lost through a depreciating dollar, they will buy fewer dollars. It also bears noting that while the peasants have been known to riot over gas lines, they typically do not tend to riot over a rise in the won/dollar cross.1

So now we turn to stocks: the market declined ¼% after an overnight rally attempt fizzled as real traders showed up for work. Amusingly, the modest decline was attributed to fears that the terrorist threat in Saudi Arabia might push oil prices even higher - perhaps, even, to an all-time high adjusted for the number of beekeepers in New Jersey. Let me get this straight: fears of a terrorist threat in the U.S., or in Britain, has become casus bene for a rally, and $60 oil is considered bullish by some because it helps the earnings of the oil majors...but somehow, high oil prices because of a threat in a dangerous country that is a veritable hotbed of terrorist activity - that is the reason that some white-knuckled types sold stocks?

Well, it is an easier story to sell than "well, stocks are ridiculously overvalued, so they should tend to go down more than up, especially the day before another excessive Fed tightening."

Tomorrow's Events:

Speaking of another excessive Fed tightening, it is on tap for tomorrow after the 8:30ET release of Productivity (Consensus: +2.0%) and Unit Labor Costs (Consensus: +2.9%) gives us a stirring warm-up.

I continue to be amazed at the resilience of the American economic machine in the face of multiplicatively higher energy prices and rapidlydecelerating money supply growth as a result of Fed tightening, but unless they've changed the rules higher rates and higher energy do still constitute a drag. In this case, the drag is being offset by higher housing prices, but that's not a game that will last forever and like any person riding in a balloon that gets punctured, it tends to go down faster than it went up.

The recent revisions to GDP, showing somewhat slower growth and somewhat higher inflation retrospectively, have been seized upon by some observers as a reason the Fed should tighten moreaggressively. I am equally amazed at the resilience of these forecasters, who were undeterred by observed low inflation from telling us that 3% or 4% growth would surely spell inflation; now that inflation is 0.2% or 0.4% higher - but still awfully low especially considering the pass-through effects of energy - they are equally undeterred by the fact that growth was apparently 2.5% or 3.5% (in other words, too soft to be using up much of the economic slack, which is why new job growth has been so anemic) and merely point to the inflation numbers as being alarming.

In truth, the revisions make the Fed - to the extent that they care about past data at all - less likely to accelerate their course, not more likely. Now it can be seen that they were tightening a goodly amount into an economy that was weaker than they thought; and, while past inflation was higher than they thought it was, it is still not at particularly alarming levels and nothing about the current growth dynamic suggests it should become so. Moreover, one element of the Fed's statement formulation in June was "longer-term inflation expectations remain well contained"; since that time, 10y BEIs from TIPS have risen all of 10bps and remain quite low.

I expect that the Fed will tighten 25bps, and retain the "measured" phrasing. I suspect bonds will take that as a sign for a relief rally.

Question of the Day: What British Prime Minister also won a Nobel Prize for Literature?

Answer to Prior Question: The question was, "Columbo is the name of a brand of yogurt, a television detective, and also the capital city of what southern-hemisphere country?" The answer is: Sri Lanka.

1 Here I am explicitly excluding from consideration the peasants who work on forex desks.

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