The Oil Nexus

Yes, commenting on oil when the price has gone ballistic is a perfect set-up for looking dead stupid. But that’s never stopped me before…..

Now, the first thing to say about oil is that oil price spikes are dreadful for stocks. I’ve got a model that uses the six-month change in oil prices and the six-month change in US mortgage rates to predict stock sell-offs. As a model, it’s near pitch-perfect back through the 1960s – the only thing about it – you need some patience – you’ve got to keep your positions in place for at least three months to make it work. Right now, the model is screaming sell, even with stocks back to their March lows.

The process at work is that the oil spike sucks the air out of the US consumers’ lungs. Sales falter, consumer inventories build, producers cut production, utilisation and profits fall back. That’s what’s in store in the US this autumn. That’s part of the reason I think stocks break to new lows in the coming weeks.

My call on oil is simple; the fundamental pressure is for higher oil prices. And it will stay that way as long as the Fed maintains negative real rates.

Now the problem, as I see it, is that the Fed is dealing with oil, and to a lesser extent food, as a shock, rather than something endogenous to the current system. I think they have that wrong.

Don Kohn’s recent speech likely sums up the thinking; in an environment with a negative price shock – oil in the 1990s springs to mind – the Fed can keep rates lower than they would have done otherwise, unemployment and inflation are also lower. No worries. In the current price shock, Kohn says, we see a shift in the Phillips curve – so inflation is higher, unemployment is higher, and rates higher than they would be otherwise.

Well, yes, that’s correct in theory. Except that the rates aren’t higher. So the Fed’s hope is that they can ‘wait out’ these higher oil prices, and when prices stop rising, then, well, inflation will collapse and all will be good again. Indeed it would. Even I’d get bullish on risk. But the Fed has been hoping for this for four years. It’s not exactly global macro leadership. My guess, the Fed doesn’t get what it wants, unless it is prepared to take some pain.

The Fed in the 1990s was an inflation capper – always keeping rates a little too high through a downturn until energy prices and inflation expectations fell off. Each cycle, inflation peaked and troughed lower than the cycle before. It was the most benign possible environment for risk.

Now the Fed is an inflation booster. Each cycle it lets inflation expectations fray a little more than in the cycle before.

What we’re left with is a Fed just as worried that it sees further structural pressure on the banking system as it is about inflation. By leaving real rates negative it is encouraging oil consumption. Not just in the US but globally.

Now, you might well argue that the deflationary forces at work in the global banking system will destroy oil demand. Indeed, lots of people have argued just that all year. But that misses a big issue. And that is that the credit crisis did not happen on its own. It is itself a victim of crowding out.

Basically, the spending at the oil producers has lagged oil prices by 12-18 months for the past five years. It meant that there was excess capital available to depress yields and spur the credit boom from 2003-2007. All good.

But the oil producer’s spending is catching up now, as ambitions for infrastructure spending and capital deepening have built. If we combine that with the fact that utilisation rates in the BRICs are all at 20-year highs, it spells a very different environment.

There are three aspects to the crowding out. The first is financial. As the oil producers ramp up spending in the face of high global utilisation rates – it crowds out financial investment globally. Spare cash goes into physical assets, pushing up costs, rather than into bonds and credit. Yields rise (compared to where they would have been). Profits fade. And if the previous period had been one where credit had multiplied aggressively, then the deleveraging phase can be particularly acute.

The second type of crowding out is of Western consumption. This is the type my model picks up – higher oil prices take spending power away from the Western consumer.

And the third type of crowding out is of Western production. As the oil producers build out their infrastructure and capital base, costs rise and profits fall in the west for the same activity. The hurdle rate for an investment goes up (with rates), and the payoff goes down (with higher costs and lower growth). The willingness and ability to invest in production in the West is reduced.

So what we’ve got, in the end, is some oil demand destruction in the West, but active demand creation among the oil producers. They’re tiny, you say? Well, yes, they account for less than 10% of world GDP. But they now account for 60% of global oil demand growth.

Nowhere, in this environment, do we have absolute, all encompassing oil demand destruction. In my view, demand is growing not shrinking. That won’t stop the oil market rising.

And if you then look at supply, there is little positive there. Oil supply is flat from May 2005, despite the extraordinary rise in prices. We have structural declines in place in the North Sea, in Cantarrell in Mexico, and in Burgan in Kuwait. Russian production is in decline. And there is a growing sense that the oil states are not unhappy with this state of affairs. With 70% of production globally in government hands, there is an increasing disconnect between higher prices and the motivation to raise supply.

Which brings me back to square one – the Fed has to raise rates – and induce disinflation in emerging markets – if it is to break oil. Otherwise, it is just engaged in wishful thinking. My bet; that wishful thinking will go unrewarded.

My plays on this are net short equities, but long Patterson, the US natural gas driller, Petrobras, the Brazilian major, and Vallourec – the specialist steels producer.