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Oil and Inflation

"You'd never know there was a crisis on Wall Street. Like the rest of America, the investment community thinks the high price of energy is just temporary. Prices are not going to come down. In fact, they are going to continue to soar."
Stephen Leeb, editor of Personal Finance

Crude oil prices are at 10-year highs with natural gas prices setting a record high, on expectations that the Organization of Petroleum Exporting Countries' September 10th meeting will fail to halt market turmoil. OPEC intends a third production increase, but analysts believe that it will not be enough to satisfy demand and will be too late to prevent shortages later in the year.

"The amount they intend to increase production will not be enough to make a difference," said John Kilduff, senior vice president of energy risk management at Fimat USA Inc. "The situation is dire."

Oil prices have more than tripled since February 1999, due to a combination of OPEC's limits on production and U.S. oil inventories running at 24-year lows. Home heating oil prices have doubled since the winter of 1999, as U.S. heating oil stocks have dried-up by 39% over the same period. Additionally, natural gas prices are forecast to go through the roof this winter.

Are these higher oil prices hurting the economy? The government says no, but analysts see a different conclusion.

"We remain concerned that rising energy prices will spill over into non-energy prices, raising core consumer price inflation and the need for higher interest rates," Gail Dudack, chief investment strategist for UBS Warburg told Reuters.

In addition to higher oil prices, consumers are faced with an interest-rate environment that is no longer as favorable, now that the Federal Reserve has pushed up the cost of borrowing by 1.75 percentage points – to a nine-year high. Higher interest rates and oil prices are a bad mix that may slam the economy.

"Certainly, higher interest rates, higher energy costs and slower job growth suggest that the economy cannot keep up its previous pace," says Allen Sinai, chief global economist for Primark Decision Economics Inc.

But the government doesn't attach much significance to higher oil prices increasing inflation.

"I know, the government insists there isn't much inflation," wrote John Cruddle in his NYPost.com article. "That's always what they say when politicians are worried about their jobs. And politicians may have convinced the Federal Reserve for now that inflation is under control. But these latest government figures prove that it is not."

Cruddle went on to explain, "The Labor Department is still reporting consumer inflation of 3.5% since last year, which is an entirely unacceptable level when the Commerce Department is reporting that incomes are rising slowly. In July, personal income and disposable income rose just 0.3 percent each. Take it back a few months and income is up only 2.4% over the last five months."

Ned Riley, chief investment strategist for State Street Global Advisors, notes that "most economists have too short of a memory -- or they don't have one because they did not live through it -- but the last period of hyper-inflation in 1974 was started by rising energy prices, which crept into all other goods and services."

Stratfor.com, an intelligence-consulting firm in Austin, TX, issued an outstanding analysis of why oil prices will remain high well into the winter. According to Stratfor.com, OPEC's proposed production increase of 500,000 barrels of oil per day will not bring significant relief to the market for the following reasons:

  • Iran is producing near full capacity and has nothing to gain from the increase in production.

  • Venezuela has been opposed to the production increases in the past.

  • Oil demand in Asia alone grew by nearly 600,000 barrels per day in the first half of this year.

  • Even if OPEC increase production by one million barrels per day, it won't reach the market until late November, after winter demand has spiked.

Now the Government Notices

It has taken less than two years for President Clinton to recognize that oil prices have tripled. Oil prices have moved from a 12-year low of less than $11 a barrel in December 1998 to a 10-year high of $35 a barrel. It must be an election year.

Associated Press reported the President Clinton fears the high cost of oil could lead to a recession in the roaring U.S. economy or elsewhere in the world.

"I told him I was very concerned that the price of oil is too high, not just for America but for the world," Clinton said after meeting with Saudi Arabia's Crown Prince Abdullah at the U.N. Millennium Summit.

President Clinton finally takes notice of the situation as it nears a crisis level.

"We really have the makings of an energy crisis here, for this winter," said Kilduff, citing "bad news for natural gas, oil and heating oil."

But President Clinton is still overlooking the fact that inflationary pressures in the U.S. economy are rising.

A recent article in the Boston Globe, listed several examples alerting us that big chunks of the economy appear to be bursting at the seams, with demand outrunning supply and prices climbing at a scary rate:

  • The price of oil has doubled to a 10-year high in less than two years.

  • Natural gas prices are twice as high as they were a year and a half ago.

  • California customers have seen their electricity bills triple. Boston customers will see rate hikes of 12% this fall.

  • The price of air travel has climbed 9.5% over the past year.

  • In Boston, the cost of renting an apartment has increased 9 percent in the past year and for two-bedroom apartments, more than 80 percent over the past five years.

The article addressed a critical question: Are these isolated examples or are they forerunners of a more general inflation problem that comes when you push an economy beyond its limits?

"I don't think they are isolated," answered Nicholas Perna, an economic consultant. He added that he isn't forecasting a big rise in prices, but he suggests that most economists and investors may be overly optimistic in their inflation projections for the next year.


September 11, 2000

Blanchard Economic Research
http://www.blanchardonline.com