Friday, August 13, 2004

Oil Shock: Are We There Yet?

For some time oil market commentators have been piping in that oil has not yet reached its inflation adjust high of $80 a barrel. However what they've neglected to mention is that we've already passed the inflation adjusted price that was the first price spike because of the oil embargo. (MSNBC)

Oil is up more than $10 a barrel since the start of the year. In real terms, adjusted for inflation, prices are still well below 1980’s peak of $80, following the Iranian revolution. But prices have surpassed those of 1974, the first oil shock, when crude averaged an inflation-adjusted $43 during the Arab oil embargo.

You know how irritating it can be when someone on a car trip get's impatient and asks, "Are we there yet???" repeatedly? Well it's been equally irritating to the oldman to read commentators write "But we aren't there yet." Well guess what buddies, we are there right now. We're in the middle of an economic oil shock right now. It has arrived and it is mean, ugly, and nasty.

Did you think the economy had turned out okay? Kiss that good bye. Did you think it was bad? It's about to get worse. Just in time for the Atlantic hurricane season and the olympics.

We broke through the psychologically important $45 per barrel level, and the price trend looks like it's going to be sustained. The long term price of oil, which already ten years out reflecting additional supply expectations was up to $35 pb we can now expect that to rise slowly but steadily upward the longer this goes on. The economy will tank and the Federal Reserve will be forced to choose between unpalatable alternatives.

If they really do stick to their guns, and I find it difficult to predict the FOMC because I find it hard to imagine such self-important old stuffed shirts, then we will have a sharp deflationary recession. The bad news is that the amount of deflation will be mild. You see, we have a structural and hemorraging foreign exchange problem.
WASHINGTON - The U.S. trade deficit widened much more than expected in June, hitting a record $55.8 billion as the biggest drop in exports in nearly three years combined with record imports, the government said on Friday.

Wall Street economists had expected the deficit to widen, but looked for a gap of just $47 billion. In its report, the Commerce Department also revised May’s trade shortfall to $46.9 billion from the previously reported $46.0 billion.

The department said exports fell 4.3 percent to $92.8 billion in June, the biggest decline since September 2001 and the weakest performance since February.

Why is this happening? Stirling Newberry explains why, in discussing the role of corporations, intellectual property, and why the equity markets are our biggest exports.
Now if you look at what the US sells abroad, it is "King Copyright". Without the export of copyright and other intellectual capital, the US is near bankrupt, we cannot afford to import the goods from abroad - primarily energy - which we cannot make or substitute for here in the US.

Our other export is - equities - that is, other nationals buy our stock. The value of stock is based, again, on the unique intellectual capital that the corporation holds.

Thus, America's economic prosperity rests on piling all control of intellectual capital into a few hands, so that the revenue extracted from that control, and the equity value of that control, can be packaged as equities and "property" and sold.

In short, Americans are selling off their rights to information to buy energy.

However our stock market is going down at the same time that oil prices are going up. What that means is that fewer foreigners are buying our equities. They buy less of our equities, and our trade deficit manifestly worsens. That's what it means for our exports to drop right now. Of course it's a vicious cycle right now, because whoever sells our equities is hedging against it by buying commodities - gold, oil, etc. That's a classic inflation hedge play.

However as all this money is flooding into commodities, it is increasing oil prices and inflation in general - also worsening our trade deficit. Which means more people begin to think about hedging against inflation, which means switching into different currencies and buying commodities. Which creates more upward pressure on both accounts on the price of oil and commodities.

It doesn't matter why it started. It doesn't matter the particular reasons the market is using as an excuse on a particular day to go up or down. The general trend will go up. Part of understanding markets means looking past superficial explanations.

As I discussed in my previous post, those are irreducible anyway because of the nature of the market participatory process. What you can analyze about markets, and this is a handy heuristic, is that understanding the biases built into a market. Markets are always forming prices from the tensions between competing feedback loops. A price stabilizes once going far enough in one direction has created enough feedback to equalize the downward and upward pressures again.

If you understand the biases that go into the market participants behaviors and if you can understand the impact of that on the feedback loops in play, you can tell which way the market will move. What about irreducibility and lack of a free lunch? What you lose when you look at the market this way, is that you lose the knowledge of when. The more certain a market move is typically the less certain it's exact timing. The best you can do is a trade-off within a general period.

You can practice so you get fast at spotting the market move early on, but that's about as far as it goes.

The market is moving now. It will continue moving up until it deteriorates demand for oil sufficiently to stabilize the price. However there are one billion plus Chinese industrializing right now. As they industrialize they massively increase their fixed-energy costs in their infrastructure.

Think of it this way. Ten years ago everyone except bigwigs rode a bike. Now the Chinese are rapidly putting a lot of cars on the road. You can drive less somewhat when the oil spikes, but once you've redesigned your entire economy and lifestyle around cars you are going to be driving them a heck of a lot more than before you started delivering everything with automobiles or commuting to work in them.

Because there's an industrial economic restructuring going on in China right now, we can expect their demand to not significantly decline in the face of higher oil prices. Which it hasn't. Because they're consuming more to merely convert their economy over. It's like trading up to a bigger house - you have bigger monthly mortgage payments. Well the fixed energy consumption of China is skyrocketing and will continue to skyrocket for the next five years or so as they industrialize and start using oil-consuming machines everywhere.


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