Will Oil Inflation Destroy America?

by: Andrew Butter

The good news is that the Saudis are saying $70 to $80 is “Fair." The bad news is they may change their minds, and with oil knocking at the door of $90 and some OPEC malcontents muttering $100, they are starting to look a bit wobbly. Or even if they are steadfast, perhaps they won’t be able to pump enough oil to contain prices?

In 1985 OPEC was holding back 11 million barrels a day of capacity. In 1995 that had dwindled to 2 million a day, and today no one is sure. The leverage to keep oil prices down is a function of how much ammo you have.

In which case oil might start to get priced not at an estimate of the correct amount of blood to suck out of the world economy without causing serious harm (Parasite Economics), but instead at the cost to go out and bring 25 million barrels a day or so of “new oil" online ... like next week.

So how about if oil goes back up to $147 and stays there?

This is an analysis of the Fair Price of oil going back to 1970, before the first oil shock. The red line (the fundamental or in valuation-speak the Other-Than-Market-Value), is an estimate of the price at which the world economy does not suffer.

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Click to enlarge

The logic behind that line is here.

Let’s pretend for a moment that line is about right, the next thing that’s interesting is what happens when there is disequilibrium, or in other words when the actual price of oil is markedly different from the fundamental.

Expressing that as a percentage (actual-oil-price divided by the fundamental), and comparing it with a measure of economic well-being, for example, CPI in America:

Here is a comparison with two versions: CPI-U which is the official figure (red line) and the Shadow Stats estimate (blue line):

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Click to enlarge

Best-fit, year-on year 62% of changes in CPI-U can be predicted by oil mis-pricing that lagged one year (so this year’s CPI-U is roughly predicted by last year’s oil mis-pricing). Plot against the average of CPI-U and Shadow-Stats and the correlation improves.

Sure, oil is clearly not the only driver, although eyeballing the chart suggests that a mechanism might be (1) oil gets mis-priced up, (2) CPI goes up, (3) the Fed “tightens” and CPI goes down (along with the economy), (4) oil goes down, or (5) everyone breathes a sigh of relief. And when oil is mis-priced low, that’s a time of milk and honey, where the “Inflation Targeting” of the Fed can do no wrong.

My view on the Shadow Stats numbers is that they are overblown, and the big mistake that the Bureau of Labor made was in relation to Owner’s Equivalent of Rent. But apart from that the numbers are pretty sound, so the big disconnect started in about 2000.

But that’s just detail. What hits me in the face about that chart is:

1: The price of oil or the mis-pricing of oil reference what the buyers can afford to pay; it is a better determinate of CPI-U or whatever, than monetary policy.

2: If the Saudis can’t “contain” the price of oil, and the threat of peak oil, which even the IEA now concedes is a reality, starts to provide a logic for those countries that have any oil left to keep it in the ground on the assumption that it will be worth a lot more next year, then prices will go up.

And don’t put too much faith in corn ethanol as a savior. The reality is that you need more (imported) oil to make that stuff than you need to make regular gasoline.

If oil prices keep going up and start knocking on $150, then according to that chart CPI (however you measure it) will go up.

In that case, regardless of Ben’s brave words about being able to cut off inflation in a heartbeat; there will be nothing the Fed can do about that, outside of pushing up the base rate to throttle-down the economy.

America is unique in the world in that it needs twice the oil to generate one unit of GDP as anywhere else. And now that the financial engineers who kept the smoke and mirrors show on the road for so long are out of business, if oil does start to blow, could that signal the end of an era?

For the past 15 years, any discussion about peak oil has been countered with the argument: "Don't worry, someone will pull a rabbit out of the hat."

If so, the only question that remains is, will 2011 be the Year of the Rabbit in more ways than one?

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.