Deficits, Dollars, and the Price of Energy

The latest revision to the forecasted federal deficit has implications beyond the sustainability of current government spending. Reading a pair of high-profile, skeptical assessments of Peak Oil in the context of a $9 trillion deficit projection for the next decade, it occurred to me that the most serious risk of higher oil prices in the near future might not be flagging production or surging demand but the further depreciation of the US dollar. The quickest route back to $4 gasoline could run through Washington, DC, rather than Riyadh or Beijing, and that might not be as helpful for renewable energy as its advocates might guess.

The main worry I've heard expressed about the size of the federal deficit has focused on the risk of inflation. However, high deficits carry another risk that could have a much more direct effect on energy prices, which in turn could help re-ignite inflation. The problem is acute because it goes well beyond the one-time impact of federal stimulus efforts, which have apparently ballooned this year's deficit to $1.6 trillion. Fundamentally, there is a persistent and growing gap between government revenue and expenses, exacerbated by high unemployment and lower income--and thus lower tax collection--particularly from the top quintile of earners who have consistently been paying 86% of the federal income tax. Unless that gap can be brought back into line with recent history, the government will soon face a difficult choice. Financing a steady stream of trillion-dollar annual deficits will require either interest rates high enough to attract investment from all over the world--and thus high enough to stifle a nascent recovery--or the monetization of the debt by means of the Federal Reserve printing even more money than recently. The latter course, which seems likely to be more politically palatable, despite Dr. Bernanke's reappointment, would inevitably weaken the dollar and lead in fairly short order to higher energy prices.

We got a taste of this effect in 2007, when oil prices and the dollar moved in opposite directions in an oil-dollar price loop that looked more than merely coincidental. A weaker dollar encourages producers to raise prices, or to consider pricing their output in a stronger, more stable currency. Meanwhile, non-US consumers experience stable or falling energy prices that encourage demand growth, which eventually leads to higher prices in all currencies. Either way, US consumers would see higher prices for petroleum products, though it's not clear how much further demand could fall in the near term, with US oil consumption already running 10% below 2007's, on a comparable year-to-date basis.

The dollar has already weakened by about 10% against the Euro and 5% vs. the Japanese Yen since March, as the resolution of the financial crisis and early signs of a global recovery have eased the fears that prompted a classic flight to dollar safety. This shift merely returns the exchange rate to roughly its level of pre-crisis 2008. Oil prices have risen by around 40% over the same interval, though how much of that is due to a weaker dollar is far from clear. However, from today's $70/bbl level, another 25% drop in the value of the dollar could return us to the threshold of $100 oil.

Higher oil prices due to a weaker dollar would not necessarily be beneficial for biofuels and other alternatives to oil, either. If we learned anything from the oil price spike of 2006-'08, it was that higher oil prices don't automatically make alternative energy more competitive. If only oil prices were moving, it might be helpful, but the only way to achieve that is through taxation, not inflation or currency depreciation. Just as oil functions in a global market, so too the components of the main alternative energy technologies have become global, with wind turbines and solar panels sourced globally and in high demand in many regions. So too for the steel and other basic materials for constructing such installations, as well as the grains and oilseeds turned into ethanol and biodiesel. A weaker dollar wouldn't just mean higher oil prices, but higher prices at least for all of the new energy sources to which we are turning in our effort to address climate change and bolster our energy security.

At an average price for 2008 of $93/bbl, oil made up just 15% of the value of the goods and services we imported last year, and a weaker dollar would see the prices of a host of other things--cars, electronics, call-center assistance, for example--go up, as well, fueling inflation and further depressing our standard of living. That scenario is hardly inevitable. A sea change on the part of the American public could convince the Congress and administration that we are finally prepared to pay for the government we have been demanding, or to see government services fall to a level commensurate with the level of taxation we appear willing to bear. Or the Fed could start raising interest rates to defend the dollar, in spite of the consequences for economic growth and unemployment. I'm pretty sure which choice I'd vote for.

Rebound or Dead Cat?

US light sweet crude oil closed above $50 per barrel yesterday for the first time since late November. The financial press appears to attribute this mainly to the weakening of the dollar and inflationary expectations triggered by the Federal Reserve's decision to purchase over a trillion dollars of securities, in a bid to reduce longer-term interest rates. Although I don't discount these concerns, a review of oil's fundamentals suggests there are other factors at work, as well. The recovery in oil prices from the mid-$30s has involved more than a one-day rally, nearly a dollar of which had abated as of this morning. It is hardly the kind of rebound we might expect once the recession eases, but if it is sustained it should remind consumers that the current price relief on petroleum products is temporary, while sending producers a positive signal on the need for continued resource development.

Yesterday's weekly statistics from the Energy Information Agency showed that US inventories of crude oil and its two main fuel products, gasoline and distillate (diesel/heating oil), continue to build. But while distillate demand remains very weak, reflecting the decline in goods movement that accompanies a slowdown in economic activity, calculated gasoline demand has returned to within a percent or so of its year-ago level. Gasoline imports are running at a million barrels per day. All of this provides refiners some welcome headroom for their traditional spring-time switch into maximum-gasoline mode, after having optimized on distillate production during the winter. If demand were still as weak as it was a few months ago with gasoline inventories this high, any rally in oil prices would quickly extinguish itself.

Weakness in the dollar relative to other key currencies can also drive crude prices higher. This effect contributed to the extraordinary spike in oil prices from mid-2007 to mid-2008. But many of the factors that fed the resulting "oil-dollar price loop" look too anemic now to create a sustaining pattern of this type, amid the global recession and credit crunch. A slight decline in the Euro or Yen price of oil seems unlikely to stimulate much demand. Unless the dollar continued to weaken progressively, turning its recent 8% slide against the Euro into something more serious, it's hard to see this sustaining higher oil prices against the fundamentals.

The notion of oil as an inflation hedge is another matter. Traders aren't the only ones who get the jitters at the thought of the US government printing money to buy its way out of our current problems. However, inflation worries seem premature when deflation remains a serious risk. The latest report on seasonally-adjusted US consumer prices showed "core inflation"--excluding food and energy--rising at a sub-2% clip, while the three-month and twelve-month averages for the prices of all items are still in negative territory. The whole point of the stimulus bill was to soak up the enormous slack capacity in the economy, and until that begins to bite, the idea of too much money chasing too few goods seems a remote prospect. Nor did oil work out very well as an inflation hedge last summer, when the CPI was growing at more than 5% per year.

And that brings me back to oil's fundamentals. The fact that the market didn't swoon when OPEC met and decided to defer further cuts suggests that they have reduced output sufficiently--and are living up to their lower quotas well enough--to create an environment in which events such as the Fed's move can be seen as bullish. It wasn't long ago that it seemed nothing could drive up oil prices for more than a day or two. At the same time, oil's recent moves haven't flattened out the remarkable degree of "contango" that I observed in December. Oil futures for delivery twelve months from now are $10/bbl higher than the front-month price. That suggests the market is still weighed down by high inventories and tight credit, impeding the obvious arbitrage opportunity such wide spreads create. A more dramatic rebound in oil prices must still wait for the global economy to begin to turn around and draw down that overhang. In the meantime, though, the 50% appreciation of oil from its low on February 12th looks like rather more than the proverbial bounce of a dead cat.

Oil and Asset Classes

An article in yesterday's Financial Times raised some provocative questions about the future status of commodities as an attractive asset class for institutions and other investors seeking to diversify their risks and improve their returns. Anyone who believes that the extraordinarily high oil prices we experienced this summer were influenced by commodity speculation should regard the response of portfolio managers to this proposition as quite significant for the future path of oil prices, which have recently plummeted in line with other assets. And because that drop has been overshadowed by a global stock market crash, we haven't had a chance to work out all its implications, other than its short-term benefits for consumers.

As of this morning's session, oil prices were down nearly 45% from their peak of $145 per barrel in July. The largest part of that decline is attributable to the dramatic reversal of long-term demand trends in the US and EU, and a slowing of demand growth in developing Asia. However, non-fundamental factors have also played a role: Liquidations by hedge funds and other institutions needing to cover redemptions and margin calls, along with a healthy dollop of fear and flight to safety, helped drive oil to a $77.70/bbl close last Friday, the lowest since September 2007. This is almost certainly an over-correction, and the steep "contango" in the market reflects that likelihood, with prices for delivery in 2010 and beyond in the mid-to-high $80s. Those are still dramatically less than just a few months ago.

What does all this mean for the price of oil in the years ahead? That question ought to be of great interest to struggling automakers, among others. If you are scrambling to build highly-efficient cars in response to the $4 per gallon pump prices that effectively ended the SUV fad, falling prices are a big potential problem. Gas prices starting with a "2" are popping up in some markets, and if current oil prices and refining margins hold, they should be ubiquitous in November, with the possible exception of California. Could that prompt another shift in car-buying patterns, slowing demand for smaller, thriftier cars, and for alternative fuel or flexible fuel vehicles?

At the same time, the $700 billion oil wealth transfer statistic cited by T. Boone Pickens and endlessly repeated by politicians and pundits now looks wildly off: At current prices, the tab for net US oil and petroleum imports in 2009 could end up below $350 billion. That's still a huge amount of money, but it cuts by half the payoff available from drastic changes in our energy economy.

Future oil prices will be determined mainly by the fundamentals of supply and demand, including the durability of demand growth in Asia and the Middle East and OPEC's discipline in cutting output and making the cuts stick. Although commodity index investors could amplify the resulting price changes, as they probably did earlier this year, their impact is likely to be on a smaller scale. A rebounding dollar reduces the potential rewards, while global de-leveraging dries up the fuel for such investments. I'm just not sure where oil prices go from here--lower or much higher, again. But unless the deficits from massive government financial interventions trigger a new wave of inflation, making oil and other commodities look more attractive to a much broader array of investors, the controversy over oil-price speculation that raged for much of this year is starting to look like another casualty of the financial crisis.

Record Gasoline Prices Ahead?

Average retail gasoline prices have eased a little, recently. Weaker winter demand, perhaps further depressed be a slowing economy, has been reflected in steadily rising gasoline inventories, which are now above even their seasonal norms. Regular unleaded is back under $3.00/gallon across much of the country, but before we get complacent about that, it's worth recalling that street prices were closer to $2 than $3 at this time last year, when crude oil was in the mid-$50s, rather than the $92/barrel that West Texas Intermediate has averaged for the last two months. Unless the economy derails all of the normal seasonal patterns, or oil prices suddenly head south, we stand a very good chance of breaking last year's all-time record weekly average price of $3.22/gallon, set last May. That could make gas prices even more of a political football than they already are, as the presidential nominating process culminates this summer.

Although its patterns are often obscured by the volatility of crude oil prices, gasoline has historically been a seasonally-influenced commodity. Its price typically dips after Labor Day, as driving slows, then recovers in the spring, as annual refinery maintenance on the big cracking and reforming process units shrink the inventories that have accumulated during winter (see chart below.) By the time the summer driving season gets into full swing after the Fourth of July, gasoline prices have often already peaked for the year, barring some surprise affecting oil prices or refinery operations.

From "This Week in Petroleum," January 30, 2008, Energy Information Agency, US DOE.

The price difference between gasoline and crude oil on the futures exchange--the so-called "crack spread"--is right where it was for the last three Januaries, at around $6-7 per barrel. However, over the last three years that same relationship has averaged $21/bbl. in the second quarter. If 2008 followed a similar pattern, gas prices could pick up another 35 cents per gallon from current levels, and we'd break $3.30/gal. nationally, with many places over $3.50/gal. for unleaded regular. This is all speculative, of course, but it's worth recalling that the long-time record of $1.35/gal. from early 1981 was broken, in inflation-adjusted terms, following Hurricanes Katrina and Rita in 2005, when prices spiked to $3.07/gal. And I wouldn't look to ethanol for any relief, this year, as corn prices continue to rise and refiners bid up supplies in the scramble to meet the higher Renewable Fuel Standard that just went into effect.

With crude oil again at levels comparable to what we experienced at the peak of the first energy crisis, and the US having outstripped its domestic refining capacity to the tune of over a million barrels per day of gasoline, it would be more surprising if we didn't continue setting new price records for gasoline, year after year, until we finally get a handle on our consumption. Persistent $3 gasoline has had a noticeable affect on demand growth. Unfortunately for consumers, we might get an opportunity to find out what $3.50 will do.

The Greenspan Effect

I was struck by a comment on energy from former Federal Reserve Chairman Alan Greenspan last week. As quoted in the weekend Wall Street Journal, he said, "The notion of core pricing is fading in importance as: One, food prices driven by increased long-term demand for meat and milk rise with the growth of China and other developing countries, and as; Two, global oil supply peaks lower and sooner than has been contemplated earlier." You could write a dissertation for a Ph.D. in economics based on that sentence. In one thought, Mr. Greenspan suggests that measuring inflation without factoring in energy price increases is an outdated notion, and that high energy prices are likely here to stay. The absolute accuracy of such an assertion may matter less than the market's response to an utterance from someone with such impeccable credibility.

I don't know if it says more about Mr. Greenspan's extraordinarily long tenure as at the helm of the Fed, or the qualities of his successor, that many continue to regard him as the preeminent voice on the economy and seek out his views regularly. I don't remember quite the same thing occurring after Mr. Greenspan replaced Paul Volcker, whom many credit with eradicating the high inflation of the 1970s. In any case, Mr. Greenspan still has the knack for encapsulating vast economic trends in a few words, and those words can move markets.

For as long as I can remember, observers of the economy have focused on core inflation, excluding food and energy prices, as the key measure of price stability. Until recently, the logic of factoring out volatile energy prices was solid, because oil prices always seemed to revert to a long-term average price in the low- to mid-$20s. Since 2003, however, that rationale has broken down. Over the last five years the key indicator of oil prices, West Texas Intermediate crude oil traded on the New York Mercantile Exchange, has gone up by about 30% per annum--with very large spikes and dips around that trend. Substituting the DOE's record of US refiner crude oil acquisition prices, a broader indicator of the raw material cost of fuels, suggests that oil inflation has been running at 25%. Natural gas isn't far behind, with roughly an 18% inflation rate on wellhead prices since 2003. Mr. Greenspan's remarks recognize that you can't double energy costs every three or four years without swamping many of the other economic factors that the Fed and economists monitor. And as I noted the other day, the alternative energy supplies being promoted by US energy policy are unlikely to provide any price relief.

Mr. Greenspan apparently doesn't envy the task his successor now faces: simultaneously trying to stave off a recession, defend the value of the dollar, and protect against the reappearance of serious inflation, driven by the very factors that the core inflation rate ignores. This may not fit the classical definition of a liquidity trap, but it could be the practical equivalent of one, if the Fed can't reduce interest rates much further--or even if the market merely believes that to be true, validated by voices such as Mr. Greenspan's.

What does that mean for all of us non-economists? Well, for starters, it shifts the burden of averting a recession away from interest rates and toward tax cuts and other fiscal policies--hardly the flavor of the week in a Congress seeking new revenue to offset the cost of new programs and shrink the federal deficit. At the same time, Mr. Greenspan's endorsement of the idea of an approaching peak in global oil output will tend to keep energy prices high by supporting higher long-dated futures prices. That compounds the Fed's problem and could also lead to higher valuations for oil equities (some of which are in my personal portfolio.) To the degree that this all comes down to market expectations about the future, I can't think of a more credible influence on those perceptions than the former Fed chief.

$100 or Bust?

While I was traveling yesterday, oil prices set another record. From $86/barrel, the idea of breaking $100 before the end of the year doesn't seem nearly as implausible as did a few months ago. Happily, I'm not in the business of predicting oil prices--we're already beyond where I'd have expected prices to top out. However, I am in the business of considering the implications of future scenarios, and at this point I think it's more interesting to consider what $100 oil might mean, rather than guessing when and whether we'll see it.

First, $100/bbl would finally vault us past the previous inflation-adjusted peak price from the early 1980s, at least for the light, sweet crude priced by the NYMEX WTI and ICE Brent contracts. Even though the US economy is much less sensitive to oil price increases than it was in the 1970s-80s, since it has become much more efficient, there must be some point at which higher oil prices--even if they're partly driven by a weaker US dollar--start to slow the economy, either by stimulating producer-price inflation or because they are the equivalent of a tax on consumption. $100 might not constitute a magic level at which those effects would suddenly kick in, but it would represent a doubling of nominal prices in three years and a quadrupling in five years. That's approaching "oil shock" territory, even though the process has been a lot more gradual than the shocks of the '70s.

What it would mean for gasoline prices depends on refining margins, which have weakened significantly from their stratospheric heights earlier this year. If refining margins in the fourth quarter of 2007 remain comparable to those in 4Q06, then we could expect a US average pump price of around $3.20/gallon for unleaded regular, versus $2.77 today. (If margins spiked again, it might go as high as $3.60/gal.) That ought to be enough to elevate fuel economy in car-buyers' priorities and put a big dent in the recent resurgence in the sales of large SUVs, while giving hybrids and crossovers a bigger boost. However, I doubt it would be enough to change fuel consumption dramatically, because so many elements of our driving patterns are tied to our lifestyle choices.

Lurking behind these implications is the larger question of the psychological impact of reaching the $100 mark. We've come so far in the last few years, I'm not sure another $15/bbl would make much difference. Consumers complain about high gas prices, and demand is growing more slowly than it was previously, but the sea change that promoters of alternative energy and higher efficiency have been hoping for remains elusive. Has the gradual climb from $25 to $40, $50, $65, $70, and then recent sprint past $80/bbl numbed us and obliterated our memory of just how unthinkable all this seemed not very long ago? Could $100 shatter our complacency, or would it be just another turn of the dial on the boiling frog? I can see it going either way, with very different results in each case: two complex scenarios, instead of the simple one we started with. One sets up radical energy change, while the other preserves the current evolution, gradually adding new sources to our traditional ones. The latter sounds much less glamorous, but it would also be a lot less disruptive and a lot more predictable.

Nearing the Old High?

Whenever the price of crude oil breaks its previous record in nominal prices, we see comparisons to the all-time high of the early 1980s, adjusted for inflation. When it passed $80 the other day, I saw several such comparisons. Only one problem: they differed by more than a dollar per barrel among them. That's more than a rounding error, considering that price data are given to the penny, and the GDP deflator commonly used for such calculations goes out three figures beyond the decimal point--five when you realize it's quoted as a percentage. What could be causing these disparities, and what is the true, inflation-adjusted oil price high? That turns out to be a decidedly non-trivial question, and there's really no single correct answer. The best I can come up with is around $91/barrel, which is much lower than recent estimates over $100/barrel that probably rely on the consumer price index.

Explaining why this isn't nearly as simple as it looks requires a bit of background on the different grades of oil, how the market works now versus how it worked in the early 1980s, and what we mean by inflation adjustment. This isn't intended as an economic dissertation, however, so I'm going to paint it in broad strokes:

Start with oil, itself. There are probably more different types, or grades, of it than there are rock bands with funny names. The grade the media generally refer to is West Texas Intermediate (WTI), a generic mix of light, sweet domestic crude oil streams (plus a few specified import grades) with sulfur content below 0.42% and API gravity (a measure of density) between 37 and 42 degrees. While it has been the primary benchmark crude oil type for the US and the world for a very long time, it's not particularly representative of what most refineries actually run, though it was more representative 25 years ago.

Now consider the market. Today, the WTI price usually refers to the settlement price for the front-month futures contract on the New York Mercantile Exchange. Unfortunately for anyone trying to compare current and historical oil prices, the NYMEX only started trading crude oil in 1983, a couple of years after the price had peaked. To compare WTI before 1983, you must look at "first purchaser" wellhead prices. The best publicly-available proxy for those that I could find is "posted prices", which are not actual transaction prices, but price schedules published by companies soliciting offers to sell them oil. To complicate matters further, actual transactions typically occur at a premium to postings, referred to as "P-plus". For example, "XYZ agrees to buy 10,000 barrels per day of WTI at Cushing, OK for the month of June 1987 for P-plus 50 cents." As quaint as that sounds in an era of real-time electronic trading, I understand that a fair amount of crude is still transacted on a P-plus basis, for various reasons.

Next consider what we mean by inflation. How relevant is the commonly-used consumer price index to the wholesale price of a primary industrial commodity? Not very, even if oil isn't just any commodity. I'm a lot more comfortable using the GDP deflator, which is a very broad measure of the impact of inflation on nominal prices across the entire economy. It might be equally legitimate to argue for using some other index, such as nominal GDP per capita or relative share of GDP.

The highest posted price for WTI during the first energy crisis was $39.50/barrel from April-July 1980. (While there's better data available for imported crude oil in the same period, trying to equate that to current WTI requires all kinds of additional assumptions, and I'd prefer to avoid those.) Applying the ratio of GDP deflators to the posted price yields $87.92 in 1Q2007 dollars. If we assume that actual transactions in the peak month of 1980 were probably done at P-plus $1.00--about as much as the market would take before competitive forces pushed the postings up--then we get to $90.14. But that's still a wellhead price, so we'd need to add something for gathering, handling and transportation to arrive at a figure that equates to NYMEX WTI at Cushing, OK. Call it a buck, and we're at $91 and change.

If I've done my sums properly, we're closer to the all-time high oil price than some analysts are suggesting. The puzzle, of course, is how prices can be this high for this long without putting the economy into a deep recession, such as we saw in the previous energy crisis. Part of the answer is found by translating that July 1980 oil price based on its relative share of the 1980s GDP, compared to today's, rather than using the deflator. On that basis, oil at $80 still has a long way to go to match its equivalent of $187/barrel in 1980.

Update, 11/7/07: The Washington Post described similar difficulties in coming up with an inflation-adjusted all-time high, reporting different results from three groups, the IEA, CERA, and the Energy Information Agency of the US DOE. The EIA's figure comes closest to mine at $93.48. They applied the same GDP deflator, though they used a different starting point, the average monthly refiner acquisition price in Jan. 1981. CERA used WTI postings, as I did, but inflated at the CPI to arrive at $99.04.