Sorry!! The article you are trying to read is not available now.
Thank you very much;
you're only a step away from
downloading your reports.

Debunking the Oil Myth


Risk is lower, not higher, prices.

We're told to fear expensive oil, but the bigger concern should be lower – not higher – oil prices.

A significant drop in crude prices would indicate a reversal of the long-term inflationary trend in global commodity markets. Although oil isn't a perfect proxy for inflation since industry-specific dynamics play a central role in determining its price, deflation would nonetheless be reflected in a lower price for crude.

Basic economics tells us prices are set by the interplay between supply and demand, and crude is no different. On the supply side, world oil reserves are limited and American refining capabilities are severely constrained with little chance of a near-term increase in capacity.

The boom in emerging economies like China and India is commonly cited as a primary demand catalyst for dearer crude. Speculators are fingered as new players on the demand side of the equation, but the higher cost of leverage will marginalize their effect in the near term. The weak dollar has exacerbated these fundamental reasons for higher crude prices.

It's impossible to examine supply and demand independently, but supply will always trump demand in its effect on commodity prices since demand is so much harder to shift in a meaningful way.

Since 1982, China's economy has grown at a compound annual rate of 9.4%. So why didn't we care about China's economy growing 13.5% in 1994? Because in 1994 world commodity supplies were sufficient to handle the growth in global demand.

Over time however, China has grown such that on an absolute basis, its steady growth in demand for oil helped overrun supply. On the chart below, notice how only recently have crude prices (white line) caught up with China's GDP growth (orange line).

Click to enlarge image

High grain prices, booms in copper and steel, gold approaching $1,000 per ounce and higher health care costs are all evidence of worldwide, long-term inflationary pressures. Looking at the price for oil and other commodities, you could argue hyperinflation is already upon us. Such parabolic rises do not typically resolve themselves gently, as either time or price will resolve the imbalance.

During this rise in commodity prices, deflation imported from China and India in the form of cheap labor has offset inflationary pressures. It is no accident that higher inflation in the West has coincided with rising labor costs and growing inflation in the East.

So, despite weak U.S. consumer demand and the resulting contagion abroad, structural barriers to increasing the supply of key commodities means inflation will persist in the near term. Right?

Enter the unwinding of a debt bubble of historic proportions.

Writedowns on bad loans are eroding the global capital base and banks are experiencing a deflationary contraction in their ability to lend. We have already seen the famous promise of subprime containment proven false, and the American economy now looks poised for recession.

Persistent inflation plus recession equals stagflation, and yesterday we saw this forgotten economic conundrum splashed on the front pages. What many miss however, is that deflation and stagflation are not mutually exclusive events. The evidence of one does not disprove the existence of the other, stagflation is simply the transition from inflation to deflation.

Consumers without access to credit consume less, and are thus forced to buy fewer and cheaper products. Sellers of all goods will be forced to lower prices, compressing margins and reducing profitability. They in turn will cut costs by laying off workers and seeking out cheaper inputs. Deflation causes lower prices, not the other way around.

Returning to crude prices, the battleground has quite simply become long-term inflationary forces against a deflationary credit contraction. A significantly lower crude price – while likely to be cheered by the media and many in Hoofy's camp – would be proof the credit unwind has derailed the long-term structural foundation for inflation. This would not be an insignificant economic event.

A flight to repay dollar-denominated debt will push up the dollar, further pressuring crude prices. Toddo's theme of asset class deflation vs. dollar devaluation may finally cut the other way - equity investors beware.

That a homeowner willfully destroys his credit by walking away from his mortgage is evidence credit is already being spurned. Life will go on, but with far lower levels of consumption.

The Great Depression did not just ruin banks and wipe out stock market speculators, it permeated every aspect of life for an entire generation. How many of us listened with wonder as our grandparents (or parents) rationalized seemingly absurd and frugal behavior because of some transitory event 70 years in the past.

Excess credit is our generation's allegory – it's all we know. It touches every aspect of our financial lives, from buying bread to buying a house. Credit crosses socioeconomic borders, used by rich and poor alike to conduct the transactions of life. The impact of this swift evaporation of such a ubiquitous aspect of daily life cannot be downplayed; it holds an unprecedented potential to alter the way we live.
< Previous
  • 1
Next >
No positions in stocks mentioned.

The information on this website solely reflects the analysis of or opin= =3D =3D3D ion about the performance of securities and financial markets by = the wr=3D iter=3D3D s whose articles appear on the site. The views expresse= d by the wri=3D ters are=3D3D not necessarily the views of Minyanville Medi= a, Inc. or members=3D of its man=3D3D agement. Nothing contained on the web= site is intended to con=3D stitute a recom=3D3D mendation or advice address= ed to an individual investor =3D or category of inve=3D3D stors to purchase= , sell or hold any security, or to =3D take any action with re=3D3D spect t= o the prospective movement of the securit=3D ies markets or to solicit t=3D= 3D he purchase or sale of any security. Any inv=3D estment decisions must b= e made =3D3D by the reader either individually or in =3D consultation with = his or her invest=3D3D ment professional. Minyanville write=3D rs and staff= may trade or hold position=3D3D s in securities that are discuss=3D ed in = articles appearing on the website. Wr=3D3D iters of articles are requir=3D = ed to disclose whether they have a position in =3D3D any stock or fund disc= us=3D sed in an article, but are not permitted to disclos=3D3D e the size o= r direct=3D ion of the position. Nothing on this website is intende=3D3D d = to solicit bus=3D iness of any kind for a writer's business or fund. Mi= ny=3D3D anville mana=3D gement and staff as well as contributing writers wi= ll not respo=3D3D nd to em=3D ails or other communications requesting inves= tment advice.

Copyright 2011 Minyanville Media, Inc. All Rights Reserved.


Busy? Subscribe to our free newsletter!