Urgent Message January 5, 2000 November 24, 1999 November 15, 1999 October 25, 1999 September 23, 1999 October 7, 1999 October 19, 1999 October 21, 1999

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Whistling in the graveyard. The Tune? "Oil prices don't matter." February 2, 2000

Those of us who depend heavily on the stock market for our livelihood are comforted by the consoling words of pundits who seek to reassure us that rising oil prices, up 300% since the start of 1999, do not necessarily mean rising inflation in the US. The reason? Oil makes up a much smaller part of the new US economy than in the 1970s when OPEC's monopoly pricing hammered the US with rising import prices and energy costs. Not to worry, say the experts. Now we have an Information economy. Oil is less important. The perfection of the New Economy is demonstrated in the most recent CPI and PPI figures.

July 1999 Aug 1999 Sept 1999 Oct 1999 Nov 1999 Dec 1999 Consumer Price Index(1) 0.3 0.3 0.4 0.2 0.1 0.2 Producer Price Index(2) 0.2 0.5 0.1 -0.1 0.2 0.3

(1) All items, U.S. city average, all urban consumers, 1982-84=100, 1-month percent change, seasonally adjusted (2) Finished goods, 1982=100, 1-month percent change, seasonally adjusted US Bureau of Labor Statistics data (January 28, 2000) Why, then, has the Fed embarked on a program of interest rate hikes when inflation is so clearly in check, when the New Economy is obviously running with such efficiency that not even a three fold increase in the price of oil in less than a year moves the inflation needle off the Extra Low mark.

As attractive as these figures are, the US Import Price Index tells a more ominous story.

July 1999 Aug 1999 Sept 1999 Oct 1999 Nov 1999 Dec 1999 Import Price Index 1.6 3.2 3.9 3.9 5.1 7.0

All imports, 12-month percent change, not seasonally adjusted US Bureau of Labor Statistics data (January 28, 2000) If we dig deeper into the sharp Import Price Index increase we find that most of this rise in import prices comes from imported oil.

If you lived through the inflationary 1970s in the US you recall that rising oil prices was the primary cause. High oil prices effected all industries, businesses, and wage earners. Can high oil prices have a similar impact on the so-called New Economy? The answer, unfortunately, is: yes. The paradox of the New Economy is that fewer tons of remnants of millions of years old dead plants are needed than before, but the Old Economy used far less from overseas.

When the pundits say that oil doesn't matter, do they mean the US is less dependent on imported oil than it was the last time OPEC ramped prices in the 1970s? Let's take a look.

Millions of Barrels. Source: US Energy Information Administration

In fact the US economy imported 646% more oil in 1998 than it did when OPEC made the scene in 1973. Maybe the pundits mean the US is importing less oil relative to real GDP, so that while we're importing more oil, this represents a smaller portion of economic output.

Source: US Bureau of Labor Statistics

That claim doesn't seem to hold water either. While oil imports rose 646% between 1973 and 1998, real GDP grew by only 200%. From a real GDP growth perspective, oil imports are more than three times as important now than when OPEC manipulated oil prices up in the 1970s.

One factor does support the contention that the US economy is less oil dependent now than in 1973. Even though oil imports are rising, this is primarily because domestic production has slowed due to falling prices. The US is indeed consuming less oil now relative to GDP than in 1973.

Source: US Energy Information Administration

US oil consumption has risen only 27% between 1973 and 1998 while real GDP grew 200%.

In 1973, 1.5 barrels of oil were consumed to create one dollar of GDP while in 1998 only 0.7 barrels were needed. This does support the argument that the new US economy needs a lot less oil than the old. However, in 1973, 0.14 barrels of imported oil delivered a dollar of real GDP whereas in 1998 0.36 barrels of oil were needed. While around half as much oil is needed to run the economy now than when OPEC last raised prices, nearly three times as much imported oil is needed.

If reliance on oil imports has risen so much more quickly than real GDP since 1973, how is that the US economy is less vulnerable to OPEC's price hikes prices now than it was then? The answer is that it isn't. The pundits are wrong.

In the 1970s oil price-induced inflation was eliminated only by Fed Chairman Paul Volker's interest rate shock treatments to the US economy. This produced a period of stagflation. GDP fell as inflation continued to rise. Unemployment rose to levels not seen since The Great Depression yet prices continued to rise rather than fall, contradicting the dogma of economics textbooks before that time that claimed deflation as an inevitable price effect of falling demand. This was a period of economic and monetary trauma that caused the world to question the efficacy of the US central bank. Safe to guess that the Fed is likely to want to avoid a repeat. If the price of oil merely stays where it is, around $30 per barrel, the Fed must raise rates significantly or the US will likely suffer a repeat inflation event. The inflationary impact of rising oil import costs does explain why the Fed is planning to raise interest rates when the CPI is lower than at any time in the past thirty years.

How likely is oil to stay at or above $30 a barrel?

Oil probably has a better chance at staying at or above $30 than in 1973. OPEC has a more diverse composition, representing a broad range of geographic interests rather than primarily middle east nations, and is a far more economically sophisticated organization than it was 25 years ago. The current OPEC membership conrtols a larger portion of oil production than in the 1970s. And of course, as we've demonstrated, with a three fold greater depenence on imported oil now than in the 1970s, OPEC has the US over a barrel, so to speak. The group may choose to increase supply to keep the price under $30, but then maybe not. If $30 oil is good then isn't $60 oil better? Depending on price elasticity, of course.

If the price of oil stays high long enough, domestic prodution that is not profitable at oil priced below $30 will come on line to compete with imported oil, and new conservation technologies that reduce demand will become cost-effective. In the mean time, a period of rising inflation and rising commodity prices is a reasonable expectation. On the other hand, the current rise in oil prices may signal the start of a secular trend.

An excellent analysis Secular Trends in Financial Markets written in 1996 by Global Financial Data states:

"...different factors drive the supply and demand for stocks, bonds and commodities. Stocks are primarily driven by earnings expectations which depend upon the business cycle. Bonds depend primarily upon nominal interest rates which are driven by inflation and by default risk. The long-term world bull market in bonds from 1865 until 1900 was driven by reduced risks to bondholders, and the current bull market in bonds has been driven by falling inflation rates. These structural adjustments can take decades. Because it can take years to bring into production new sources of oil, gold, or other commodities, raw material prices can remain stable for years, then jump in price suddenly. For these reasons, secular cycles in stocks, bond and commodities behave differently."

If you read the whole piece it becomes abundantly clear from the analysis that the beginning of an inflationary trend such as is indicated by the rising price of oil may mark the start of a bull market in commodities and a bear market in both stocks and bonds.

If a $30 oil price or higher is maintained and the Fed does not agressively raise rates, inflation can be expected to rise as a function of the rate of increase in import prices and in proportion to the ratio of imports to GDP. This cannot help the current account deficit, and will put further pressure on the dollar. Lucky for the US, Europe and Asia are even more oil price sensitive than the US, so the effect on the dollar will likely net out in the dollar's favor. In any event, domestic inflation will rise or interest rates will rise or, worst case, both will rise.

Look on the bright side. Inflation isn't all bad. It benefits those who have a lot of debt, little savings, and own hard assets, especially real estate. In other words, the average American in the year 2000.

No article on the the threat of inflation is complete without an acknowledgment of the possibility that the current euphoria is justified, that we have indeed achieved economic nirvana. Perhaps we have. Or perhaps...

Outlook & Independent August 7, 1929 "IN MANY WAYS this has been the most remarkably cheerful summer in recent financial history. The stock market speaks for itself. After the serious decline in May, prices of the leading securities have been marching steadily upward... This prosperity might be disquieting if it were accompanied by any of the symptoms of inflation."

-- RLW (rlw6883@ipa.net), February 12, 2000

Answers

RLW,

Thanks for the post.

Theres a type of software out there that will actually lift a exact copy of a page and allow you to post it elsewhere.

If I remember correctly its called Outlook Express and its Really Cool! Robert Magnus used it on one of my threads a while back.

I'm going to be heading out shortly and I think I'll stop at Comp USA and check on it.

Thanks Again,

-- Zdude (zdude777@hotmail.com), February 12, 2000.

Sorry Robert I meant to type Mangus not Magnus.

-- Zdude (zdude777@hotmail.com), February 12, 2000.

Excellent post RLW! I would add one caveat. There is a a delicate balance to be set in order to avoid price implosion. Simply put, it is correct to say that OPEC must not allow oil prices ot rise to high lest they risk marginal production resuming to create another overproduction crisis. Once the elephant gets moving, she's pretty hard to stop or make sharp turns.

However, the pundits seem to feel that this level is 22-25 dollars per barrel. I think they are wrong. I think the Sauds believe the correct price to be 27-30 dollars per barrel minimum.

Thanks again for your excellent post.

-- Gordon (g_gecko_69@hotmail.com), February 12, 2000.

Good commentary, however the increase in oil price over the post year has been slightly less than 200%, not 300%.

-- Dave (dannco@hotmail.com), February 12, 2000.

Please note that conditions can exist wherein real estate will not benefit from inflation. An example of such a condition is when LOTS of real estate has mortgages and other debt so high as to not be supportable by persons affected by the falling economy. They then default and walk out from under 125% type loans. Then the lenders have problems in that mass house selling in a depressionary state with inflation will only serve to lower prices. Then as real estate prices rapidly deflate due to a glut on the market (sort of like bubble.com), the regular real estate market will be depressed, and so on.

Problems escalate when banks or other lenders call due your mortagage or rather that part which represents the difference between the loan amount and the new (much lower) price of the house. This is how people lost property in the depression. The banks now will want the 40 or 50 thousand dollars difference between the price of the house and the loan amount.

One strategy is, if the conditions are right, lots of houses and nothing moving in your area, and you have the cash, you can 'renegotiate' your loan by threatening to walk from it. They freak. Got enough bad debt as it is. You then say, 'well if you are willing to talk 10 cents on the dollar....."

Know a guy who bought damn near a whole town that way between 1932 and 1939. Nice fellow too. Gold miner and wine maker. This was down in S Ca. near Sonora. Got himself killed in alaska years later as an innocent drunken bysitter in a fight in a 'house' near the pipeline. To bad. Hell of a guy. Restless though.

anyway....

-- old bald guy (old.bald.guy@cloud.hidden.whereabouts.unknown), February 12, 2000.

I especially love the quote from 1929: That speaks volumes.

-- Susie (Susie0884@aol.com), February 12, 2000.