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Wednesday, April 16, 2008 11:07 AM

Why Do Oil Prices Keep Rising?

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Inflationistas are crowing over the price of crude hitting $113 a barrel and the March Producer Price Index as well.

Indeed the PPI soared last month, primarily on account of energy and food.

Before seasonal adjustment, the Producer Price Index for Finished Goods climbed 1.9 percent in March to 175.4 (1982 = 100). From March 2007 to March 2008, finished goods prices rose 6.9 percent. Over the same period, the index for finished energy goods increased 20.4 percent, prices for finished consumer foods moved up 5.8 percent, and the index for finished goods less foods and energy advanced 2.7 percent.

Gasoline and diesel prices are soaring as well.

Gasoline Prices 2008-04-14

click on chart for sharper image
Chart courtesy of the Department of Energy.

Gasoline prices are about 6 cents higher than last week, and 51 cents higher than a year ago. Diesel prices are 10 cents higher than last week and $1.18 higher than a year ago.

Higher diesel prices we behind a proposal by independent truckers to participate in a "National Shut-Down" on April 1. I wrote about Trucker Dan's proposed strike on March 24, in Open Letter To All Truckers. The shutdown was a big flop as I expected.

Other than isolated incidents of truckers deliberately driving slow and blocking traffic nothing happened. Is blocking traffic on freeways supposed to win sympathy? In the end, truckers had loads to deliver and they delivered them. If they failed to do so, it might be the last load they would get. Who wants to do business with an unreliable trucker?

Gasoline Consumption Declines

In a sign of economic stress, gasoline usage is declining. This Week In Petroleum is asking Where Have All the Drivers Gone?

Does it seem like there are fewer cars on the highway this year? The recent trend in motor gasoline consumption would appear to indicate so. Gasoline consumption has been declining for at least six months. Households may be thinking twice about jumping in the family car as a slowing economy and rising prices are stressing pocketbooks from Maine to Hawaii.

During the first half of 2007, motor gasoline consumption was up by 0.9 percent compared with the same period the previous year. But, during the second half of 2007, gasoline consumption declined by 0.1 percent from the year before. In fact, fourth-quarter consumption fell by 0.4 percent. The drop in gasoline consumption, the first since the recession of 2000, should come as no surprise with the slowing economy and soaring gasoline prices. The first quarter of 2008 continued to show an even sharper decline in consumption of 0.6 percent compared to the same period in 2007.
Inquiring minds might be asking: If U.S. consumption is down why are prices rising? Here are the answers.
  • The dollar is falling
  • Global demand is still rising
  • Peak Oil
  • Speculation
Russia Supply Jitters

The latest peak oil news shows Russian Oil Slump Stirs Supply Jitters.
Russian oil production, for years a vital source of new supplies for world markets, is showing signs of a slump, adding to uncertainties that have helped push oil prices to record highs.

Russian output fell for the first time in a decade in the first three months of this year, according to the International Energy Agency, which represents industrialized oil-consuming countries. It said Russian production averaged about 10 million barrels a day, a 1% drop from the first-quarter of 2007.

Declining production from the world's largest oil producer and one of its largest exporters puts further pressures on an already strained market and adds to the potential for higher prices for a global economy coping with a slowdown.

The economic downturn in the U.S., by far the world's largest oil consumer, has taken some steam out of oil demand. But fast-growing Asia and other places are still adding to demand, and many analysts worry that a global supply pinch later this year could send prices higher.
Problems On Our Doorstep

The oil fields in Saudi Arabia are in decline. So is the second largest oil field in the world, Cantarell, in Mexico. One year ago, Rigzone reported Mexico Tries To Save Big, Fading Oil Field.
Cantarell, which currently produces one of every 50 barrels of oil on the world market, is fading so fast analysts believe Mexico may become an oil importer in eight years. That would batter Mexico's economy, which depends on oil exports to fund 40% of its government spending.

Benjamin Melo, manager of the Akal C platform, tries to assess the future by looking out across the field: "This has been a generous field. And there is still a lot of oil down there. But it won't last forever."
Supply Demand Issues Do Not Constitute Inflation

This is a simple supply demand issue. Supply drops, demand rises, prices rise. And this has nothing to do with inflation. Someone who gets it is "Genesis" on the Market Ticker Forum.
On the one hand we have their house price collapsing back to intrinsic value (which must happen) and at the same time we have the "bubble kids" shifting their bets into the commodity market fueling insane PPI and CPI increases, which means you're paying more for everything you need to survive, from food and fuel to copper pipe for that house you'd like to build.

And since fuel is in literally everything, there is no escape. Oil is a primary component in plastics, for example. Go walk around your house and tell me how much of what you have in that home would not be there were it not for some form of plastic!

In addition oil is food. The obvious part, of course, is the transportation of the food to your local store, but it doesn't stop there. Natural gas is the primary component in fertilizer (ammonia) and of course tractors need diesel fuel to operate.

There are some who claim that this is a matter of "inflation."

If you define "inflation" as "price change", yes. But that's not the true definition of inflation - inflation is first and always a monetary phenomenon. Unfortunately the bad news is that because this is not being caused by monetary inflation there is no monetary solution.
Treasury Bubble?

Peak Oil is not a monetary phenomenon so all this ranting we hear about bubbles in treasuries based on oil and food prices is misplaced. The Fed is not printing so that inflationary claim can be tossed out the window.

Swapping is not printing, although it could cause printing down the road. See Fed's Swap-O-Rama Gets Crazier and Fed Is Not King Midas for more about what the Fed is doing and still others want the Fed to do.

In the meantime, writeoffs are continuing at a staggering pace. More writeoffs are coming still. There will bank failures. The Fed is even gearing up for them. Commercial real estate is poised to plunge. There are Record Home Price Drop In Southern California. Walking away will be The Next Mortgage Crisis.

And there is an entire wave of foreclosures coming because Lenders Swamped By Foreclosures Let Homeowners Stay.
Banks are so overwhelmed by the U.S. housing crisis they've started to look the other way when homeowners stop paying their mortgages. Lenders who allow owners to stay in their homes are distorting the record foreclosure rate and delaying the worst of the housing decline, said Mark Zandi, chief economist at Moody's Economy.com, a unit of New York-based Moody's Corp. These borrowers will eventually push the number of delinquencies even higher and send more homes onto an already glutted market.

"Some people stay in their houses until someone comes to kick them out," said Angel Gutierrez, owner of Dallas-based Metro Lending, which buys distressed mortgage debt. "Sometimes no one comes to kick them out."
Think that's marked to market?

There is not a thing above that is remotely inflationary. I am sticking with what I said in Now Presenting: Deflation!

It's time to stop pretending. Deflation is here and it is now. Anyone who sees stagflation or inflation out of what's happening now is missing the boat.

People point to rising M3 or MZM. But they fail to note that the biggest rise in M3 is institutional money market funds. Why are those rising? Because businesses are tapping credit lines while they still can and parking it in money markets. Is this inflationary? Hardly. Those who propose it is show a lack of understanding about what is really happening.

What about bank credit? Supposedly bank credit is still rising. At least that's what the chart shows. But marked to market is bank credit really rising? No chance.

Is Peak Oil Causing Inflation?

The answer is clearly no. Peak oil can never cause inflation in and of itself. Inflation is an increase in money supply and credit. Peak oil cannot cause that to happen. Rising oil prices in general, for any reason cannot cause inflation either. However, rising oil prices could be a result of inflation. But given that the U.S. is in deflation right here right now, the recent rise in oil prices cannot be attributed to inflation, at least in the U.S.

Rising oil prices can be attributed to rising inflation in China, rising worldwide demand, and peak oil. That is a nasty brew and there is no way for the Fed or the ECB to control it.

Suppose oil production in a large Saudi Arabia oil field halted tomorrow. Oil just ran out unexpectedly and oil surged to $300. Would the correct response be to hike interest rates to combat inflation?

The idea of course is preposterous. Every central bank in the world would be rapidly cutting rates because economic activity would drop off a cliff. Instead of shutting down that oil field overnight, imagine it shuts down over time. Just like is happening. Oil prices rise. Is the response from central bankers supposed to be to keep hiking?

That simple example should show why setting interest rate policy based on the price of oil is absurd. However, central bankers are certainly guilty of spawning bubble blowing policies that have led to the mess we are in.

And as I said in the Fed Uncertainty Principle "I don't know, you don't know, and the Fed does not know what to do. This is part of the "Fed Uncertainty Principle" and a key reason why the Fed should be abolished."

Perhaps there is a bubble of some sort in bonds, but if so, the price of oil sure does not prove it. Only by getting rid of the Fed and checking the resultant answer would one know for sure.

Why Is Gold Rising?

People keep asking me why gold is going up. The answer is that it should be going up. Money (and gold is money), tends to increase in value in deflationary times. It doesn't have to but it tends to. So why, isn't the dollar going up? Because it is not backed by gold. Credit is being repudiated and there is a flight to real money (gold), and other hard assets.

Can there be another leg down in gold? Of course. Deflation is likely to remove leverage everywhere, and that includes hedge funds and other speculators hiding out in commodities and gold. The only unknown is from what level that happens. It could happen now, or it could happen from a higher level. I am open to either possibility.

A Weak Dollar Is Masking Deflation!

Right now what we have is deflation with a weak dollar. That weak dollar, in conjunction with peak oil, has caught nearly everyone off guard to the point they are screaming about oil prices and bond bubbles, while missing the far more important deflationary forces of foreclosures, bankruptcies, and massive writedowns in credit.

The combination of a weak dollar, peak oil, job losses, falling home prices, walk aways, and global wage arbitrage is the checkmate scenario for the Fed. Bernanke will find it impossible to inflate out of this mess.

Mike "Mish" Shedlock
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