Oil Prices, and the Recurring Monetary Nightmare

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On June 23, 2011, less than one year ago, the Department of Energy released the final details of the planned sale of crude oil from the Strategic Petroleum Reserve (SPR). Not surprisingly, the DOE would conduct the sale of 30 million barrels of oil in one bidding process (in conjunction with foreign sales of an additional 30 million barrels), with a reference price of $112.78 per barrel. That reference price was derived from contemporary trading of the Louisiana Light Sweet Crude benchmark, referencing sea-borne crude with high energy content and low specific gravity, the highest quality oil. By all accounts the sale was conducted without incident, though there were rumors that investment banks bought most of the oil to store offshore in tankers (they certainly had enough free or near-zero cash to do it).

The price of oil did, in fact, fall significantly not long after the sale from the SPR. But the release of our strategic asset was not the cause. Worse than that, we are right back at Square One with oil prices again (this year, already in mid-March, LLS is trading north of $127 per barrel, having gained nearly $20 since the end of January alone). Back in 2008, these kinds of oil prices were considered too high to sustain economic growth, contributing a great deal to consumer retrenchment in the early stages of the Great Recession. I have little doubt that was on the minds of administration policymakers back last June, and it seems to have occurred to the same administration officials to go back to the well again (pun intended).

The CIA estimated that the US consumed or used about 19.1 million barrels a day of crude oil in 2010. The SPR draw and sale, then, had a negligible effect on the supply, so it is not really surprising that it had little effect on the overall price trend (which was already in a declining trend by the end of June 2011 due to the growing concerns of re-recession).

As you might expect, gasoline prices pretty much track oil prices, so the intended intervention in oil was really aimed at gasoline. What is odd about gasoline prices, though, is that consumption has steadily declined throughout this recovery. In November 2007, the month before the official recession began, retail gasoline sales at US refiners were about 56.5 million gallons per day (not seasonally-adjusted). By November 2009, gasoline sales were down to 47.4 million gallons a day, a 16% decline. That makes sense for a period just after the official trough of the Great Recession.

By November 2010, though, gasoline sales were still falling, registering 42.8 million gallons per day. That is conceivable since employment did not really hit its nadir until earlier in 2010, but it was still a rather large decline. There is no real answer to gasoline sales in the fourth quarter of 2011, however, despite the official recovery in both GDP and employment. By November 2011, gasoline sales absolutely collapsed to 30.3 million gallons per day. That is 29% below the end of the recession, and an unbelievable 46% less than pre-crisis. Even if we look at gasoline usage during peak months, sales are way off. June 2011 sales were still 30% below June 2007. There aren't enough Chevy Volts on the road nor imports to account for such a massive collapse.

This kind of data is not unique. We see the same pattern in electricity usage and even oil usage (though not to the same degree as gasoline). There has been an absence of recovery in these kinds of indications, and that is extremely odd since these sectors are exactly where you expect to find a recovery, especially one that has been accomplished largely through the manufacturing and transport sectors .

The price of a commodity, like that of a real good, is supposed to be a function of supply and demand. The demand side of the energy economy is getting weaker, yet prices have surged. Sure, there was a disruption in oil from the Libyan "expedition", but that small disruption is not comparable to the magnitude of the drop in demand. Absent a third factor prices should be falling, certainly not rising toward record highs for the second time in as many years.

The answer here is simply monetary debasement. Traditional economics only accounts for two parts of the price equation, essentially assuming that the means of payment (and the acceptance of payment) is largely stable and unchanged. Match these tremendous gyrations of energy prices, especially crude oil, with swings in the dollar and/or the balance sheet interventions of central banks, and there really is no mystery to the price process. The April 2011 peak in oil prices coincided with the peak and wind-down process of QE 2.0 in the US. LLS was at a "mere" $104 on December 19, 2011, two days before LTRO 1.0 (I say "mere" because that price was only $1-$2 off the yearly lows which were still, somehow, above $100 per barrel).

I think what is happening in oil, gasoline, electricity and energy is a microcosm of this recovery. In many ways this is not a recovery, certainly not in the sense that most people have of what a recovery is supposed to be. This is the speculators' recovery, as free money finds its way into (and then rushed out of) risky financial assets all over the world. Policymakers hate speculators that push up the price of oil, yet never complain when the same speculators push up the price of stocks or credit. Nor is there any question about where said speculators are finding their funding, or how much/little that funding costs and why speculators seem to have such deep pockets.

Even when measuring GDP, the Bureau of Economic Analysis reports the dollar level of economic activity, as if the amount of dollars circulating connotes economic health. In more "normal" conditions that is largely the case, more dollars does usually imply more activity, but we are nowhere near anything like normal. This is not so much a recovery as reflation.

Reflation makes perfect sense in the context of what central banks are trying to accomplish. If you are deathly afraid of deflation, then you are wholly inclined to try to create and foster the opposite. Part of this equation flows through the mathematical interpretation of risk. So much of central bank fear of deflation is wrapped up in how economics perceives the cause of deflation: hoarding. The precursor to deflation is where people or investors descend into the "bunker mentality" of a large-scale recession or dislocation, opting to accept little risk. The psychology of monetary policy thus requires (in economic orthodoxy) a managed and sustained effort of giving people a reason to accept risk. Inflation, in both its official definition and the more commonly accepted version of it, is at least a reason to engage in what can broadly be termed as risky behavior.

That was the "rationale" for the housing bubble. It was an intentional attempt to get investors, and indirectly get consumers, to accept risk coming out of the collapse of an entire asset class. The 2002-2007 period was as much a reflation as it was a recovery and normative "boom" cycle. All of the same signs were there: rising prices in both assets and commodities, weak wage growth and capital investment, and dollar debasement. The primal difference between this reflation and the previous one is that there is now no way to square the monetary circle.

In the housing bubble reflation, money circulated from the Federal Reserve to banks to consumers in the form of mortgage debt (and consumer debt to a lesser, but still important, extent). The availability of easy, cheap credit in conjunction with rising prices, especially stocks and real estate, "convinced" households to accept the financial risk of the $7 trillion in household debt accumulated from 2003-2007. At the margins of the real economy, though, that consumption flowed overseas in the import trade, forcing dollars to emerging and export economies. Those dollars were recycled back into the housing bubble as they were largely invested in GSE debt and shadow banking liabilities. That closed the loop of reflation, allowing the economy to appear to be healthy, but all the while producing malinvestment by massively misallocating real resources and growing financial imbalances. The lack of wage growth and the business preference for financial innovation over real innovation should have been the tip-off that something was amiss (in addition to the obvious and exponential growth of financial economy debt to supplement and even supplant stagnant real economy wages).

That is the Achilles heal of reflation attempts, they are largely artificial. That isn't to say they create no growth, just that what growth does come is contained to the financial economy and its immediate periphery rather than the much more important real economy. Because of these imbalances and malinvestment, they are unsustainable absent exponentially growing monetary inputs - credit production and monetary debasement. Once Japan ended its experiment with QE in 2005, coinciding with rising interest rates in the United States, and thus the willingness of the Fed to blindly fill any and all bank demand for reserves at the 1% Fed funds target, it was no coincidence that the housing bubble peaked in 2006. It all fell apart from there as the absence of expanding monetary reflation exposed every weakness and imbalance.

The playbook of economic policy has simply been replayed in years since 2008 and 2009 (it "worked" after the dot-com bubble). The current euphoria is nothing more than the third reflation of this single recovery period. Again, going back to oil prices, it is no coincidence that asset prices and commodity prices have taken to the tempo and pace of central bank expansions. During those episodes of monetary printing, prices rose and everything seemed like a real recovery except for the disappointing pace of employment and wages (and large corporations were busy buying back stock instead of expanding capacity). Once those monetary programs were turned off prices of risky assets and commodities reversed, bringing perceptions of the economy down with them.

There is no coincidence to this pattern since reflations do not lead to sustainable patterns of economic circulation. Imbalanced circulations can form, and can sustain themselves for a period, but the channels of circulating monetary largesse will always be flawed and artificial.

At the heart of this fatal flaw is the misconfiguration of risk within monetary policy. For central banks, especially the Federal Reserve, risk is risk, undifferentiated. In reality, there is a chasm between financial risk and real risk. Certainly there are positives to convincing businesses and individuals to take and accept financial risk, but if it is not matched and then surpassed by true economic risk it is a doomed effort. Convincing an army of day traders to put money at risk speculating on stocks (or real estate) in the financial economy is wholly different than getting the same number of people to start their own business or to upgrade and invest in current businesses. At some point, should asset prices and paper "wealth" rise far enough, people stop working altogether and simply live off their accumulated paper wealth, all the while extinguishing true productive wealth that labor engenders. This is not a fine line either, it is night and day, yet the Fed does not distinguish between risks, expecting that an increase in financial risk-taking is a perfect substitute for an increase in real economy risk.

That is where the reflation attempt always falls apart. It encourages financial risk at the expense of , not in conjunction with, real economic risk. Current economic thinking is that getting participants to accept financial risk will eventually lead to a broadening of participation in real risk. But history shows rather conclusively that forcing financial risk-taking actually cannibalizes real risk-taking, thus reflations feature weak growth in both wages and real capital investment. When everybody is making easy money in asset markets, no one wants to work hard building or expanding a real business that might take years to bear fruit (and will likely be a net cost over the intermediate term), the mass psychology of asset bubbles. The economy at the margins is perverted into a kind of momentum-chasing price addict, herding the majority of marginal participation away from true production where it is really needed.

Again, it appears to work and is sustainable temporarily as long as there is a path to close the monetary circulation loop. In the recovery years since 2008, there has been no way to close that loop since the credit system has been chronically malfunctioning (the lack of balance sheet capacity and higher lending standards), and the overseas trade imbalance has now been recycled into regular US treasuries (at least until late 2011). Thus the reflation attempt has been fragmented into this yearly dance where optimism reigns around Christmas and early winter, then falling apart by summertime as monetary expansion fades and recession fears "unexpectedly" re-appear.

But in this new cycle of annual mini-reflations, there is a ratcheting upward of negative imbalances such as commodity prices, so it is not a neutral proposition. The economy has become zombified. Without a full circulation pathway, commodity prices cannot be matched by incomes, and thus consumers and households end up worse off than before each respective mini-reflation cycle (LLS never fell below $100 in 2011 despite some heavy and realistic fears of a real and global economic slump). So as the economy "dies" with each commodity spike, the Fed and ECB return and revive it with even more asset prices - which only kill it again. In terms of perceptions, the economy feels like it is trapped in an inflationary cycle since more money is being paid for less and less real goods. The economy appears to be growing, but it does not function like a healthy economy where success broadens outward into all segments. But given the on-again, off-again flirtation with renewed contraction (given the scale of the decline, there should really be no parties and exhortations for sluggish employment growth) expectations become "normalized" to this cyclical trap. That does not conform to the official definition of inflation, but it is consistent with to what the vast majority of "laypeople" think of as inflation - paying more and getting less - no matter how that impoverishment is actually achieved.

Central banks are largely sticking to the expected schedule now that their balance sheet expansion has once again stopped - no signs of QE 3.0 and the ECB is emphatic about LTRO 2.0 being the final one, at least until the reflation process completes its third cycle. Then we can expect renewed talk of selling oil out of the SPR (check), "prices paid" parameters of regional surveys shooting to record highs (check), Bernanke speaking of "transitory" inflation pressures (check), stubborn and unexpected headwinds (partial check, Bernanke did speak about the slow pace of the recovery just this week), and then deafening cries and shouts from the financial economy about getting a fourth reflation cycle underway or the world will end.

Who knows, maybe this time banks will be right (it is 2012 after all) but somehow I think that as long as central banks are committed to reflation, the zombie economy will keep coming back, only to die the following year. However, if you take the perspective of the real economy over the now long-term, what appears to be a cycling period of inflation might start to look like a single period of depression, an economy trapped in artificial financial risk, unable to awaken into a healthy long-term recovery where marginal actors freely choose to accept and welcome true risk so that any economic "success" is no longer concentrated in a few sectors.



Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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