Oil Prices: a signal for future inflation
Arca Macro Commentary June 4, 2018
Inflation is a monetary phenomenon arising from a more rapid increase in the quantity of money than in output. It takes time -- measured in years, not months -- for inflation to develop; it takes time for inflation to be cured.
– Milton Friedman
Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man.
– Ronald Reagan
The world has now experienced an entire decade of easy monetary policy. The Fed, ECB, BoJ, and BoE have all increased the size of their balance sheets and grown the quantity of money to unprecedented levels. However, inflation has been muted. Low inflation has given central banks the excuse to keep interest rates low to accommodate economic growth. Many have wondered why inflation has continued to stay low, after all, any student of Keynes or Friedman can tell you that low rates and high money supply are the fuel of inflationary conditions. Many economists who quote Friedman’s Five Simple Truths of Inflation only get to the first truth, that “Inflation is a monetary phenomenon arising from a more rapid increase in the quantity of money than in output.” Examining that statement, you might argue whether economic output in recent years has been high enough to offset the quantity of money. While in the US, the Fed is slowly trying to unwind its balance sheet and raise rates, that is not true of the ECB and other central banks. Where is the inflation? Was Friedman wrong?
More important than the First Truth is the Fourth Truth, which most forget about; “It takes time -- measured in years, not months -- for inflation to develop; it takes time for inflation to be cured.” Inflation does not occur immediately, rather it takes several years. As for the current economic cycle, after nearly ten years, inflation is still at 2.5%.
The Latest Oil Decline
I remember when I noticed that supply and demand for oil was out of balance. I had spent the last five years as a sovereign credit and emerging market analyst and trader, with many holdings in the Middle East and other oil producing nations. On July 13th, 2014, I took my dad to a KISS concert in Dallas for his 60th birthday. While we were waiting for the show to start, he mentioned that he was flying to Colorado the next morning, and was often traveling weekly to places like Western Pennsylvania, North Dakota, West Texas; anywhere there was oil and gas activity. I asked him if he thought oil prices were going to continue going up given how strong the market was. My dad, who has been working in the oil field since the 1970’s, said, “No. It feels like 1985. There are a lot of jobs right now and a lot of work, but eventually, 1986 is coming.” (The last major crash in oil)
He went on to say that he had recently been to Cushing, Oklahoma, which has the largest storage of oil in the US. Cushing was running out of storage space. Down in Houston, oil was being held on tankers as storage, because there was nowhere else for the oil to go.
Fracking had become more efficient, creating a surplus in supply. At the same time, refining had slowed down due to efficiency in automobile engines, reducing demand. It was only a matter of time before oil prices dropped. Later that year, oil fell to $50/barrel from its June peak of $115, and by 2016 was at $30. We have benefited from low oil and gas prices ever since.
Low oil prices have helped inflation remain low.
Gasoline, which currently makes up 2% of the average annual spend of a US citizen, would be affected if oil rises higher, and could be the catalyst to increased inflation. Recently, oil prices have increased to over $80/barrel. What has changed in the supply and demand of oil? Other than short term events, long term macro themes haven’t changed much. Fracking is still only profitable above $50/barrels (depending on where the shale is), setting a floor. Output has been reduced by 1.8mm BPD since a year ago, with Russia and Saudi Arabia cutting output, along with nations such as Venezuela encountering production issues, however, technological efficiencies have also tempered demand. Most of the recent push is due to speculation that oil will continue to rise and that inflation has finally arrived. Oil futures are often misleading as many companies are forced to hedge fuel costs and momentum traders often pile on to a one-sided trade. Given few economic reasons for higher oil prices, that trade will continue to unwind, taking oil back down to $55 to $60/barrel as the market settles in the short run.
Inflation may finally catch up with the low rate environment, despite the Fed’s recent rate increases. Issues with sovereign credit in the EU, such as Italy and Greece, along with other central banks keeping rates low will have a hand to play. Recent high oil prices, though they didn’t last, are a foreshadowing of future prices and have shown that inflation could spike quickly and violently. Other factors, such as a continued trade war, particularly US tariffs on steel and aluminum, wIll continue to push prices higher. One long term effect of higher steel prices will be higher cost to produce and move oil since most pipes are made out of steel. Given pent up inflationary pressures and tariffs, we could see oil should breech $80/barrel again by the beginning of 2019.
It is a good time to start unwinding from corporate fixed income, especially the high yield variety. Though bank loans have performed well this year, caution should be used when choosing this asset class. Floating rate mortgage backed securities are a good fixed income bet. It is also a good idea to begin to invest in inflation hedges and uncorrelated securities. TIPs, despite their name, are a terrible inflation hedge. Uncorrelated assets such as gold, commodities, and digital assets should have an allocation in portfolios.
Originally Published at: Oil Prices: a signal for future inflation