Why Do Oil Prices Keep Rising?

Inflationistas are crowing over the price of crude hitting $113 a barrel and the MarchProducer 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.

Comments

[ErnieMontague]

A technically sound look. Oil may drop $20 a barrel in the next three months, but $100 oil is here to stay.

[AmesTiedeman]

We will see 150 by 2009.

[John Egan]

Need to mention the new oil and gas find in Brazil's offshore... WIll be a considerable time before it can be drawn on though and PetroBras seems a little high right now (Possible play is RIG or other deepwater drillers - Maybe OIH for a longer term .. No rush ) ..

The other issue is that the big producers such as Chevron, XOM etc are not investing in new production.. Instead, they are buying back their shares, and they are not pushing storage right now, which presages a higher price for a gallon of gas in the near furture..

Lastly, keep an eye on Chevron in particular as Mexico's production is expected to go negative in 2010 ... California gets 1/3 of it's crude from Mexico right now ( the other 2/3 comes equally from Canada and pretty much the West Coast.. ) As an aside... Consider the issue of illegals from Mexico when the government can no longer fund their massive social programs with the petro-pesos as they have in the past .. (Wasn't Western Union the beneficiary of the 'wire money home' issues?? Can't remember ..)

The other issue coming up is China's curtailment of industrial production shortly before and during the Olympics.. ( There was a recent article on Alpha about this ) ... They intend to reduce air-quality issues during this period by slowing consumption of oil/coal etc. for the benefit of appearances for tourism.(Think air quality in L.A. in the 70's ) .. Could be a surprise coal/steel/copper/oil commodity drop ... Probably not foodstuffs though ..

Thx jegan ;-)

Thx jegan ;-)

[Sir Sid]

Great analysis sir! I enjoyed reading your article. I am glad someone else sees some of the things that I see and can put them in proper perspective. Best wishes.

[DirtSimple]

No surprise at fall in Russian production numbers ... expect that to continue as gov't control of the resource continues to replace private business enterprise.

[The FItzman]

Peak oil isn't causing inflation? The Fed is not printing money? The US is experiencing deflation? With all due respect, are you living in a cave man? This is the most absurd economic "analysis" I think I have ever read. If you invest based on the thoughts in this article, you will go broke soon as I am sure you are short on oil, long on the US dollar, and a bull on US equity markets. Good luck with that!

[Henry L]

Thanx Mish. Good to hear from a guy who can think "outside the box".
Keep up the good work. H

[Shaggieman]

Let's hope the doomsday scenarios aren't played out. If the SPR was opened periodically to CONTROL the price of crude things would run much smoother. Probably no SPR oil takers, since there's plenty of crude available, but the speculators would be gone and the price would be lower.

[paultaut]

Methinks that the Light Oil on which we base oil futures contracts has Peaked. This particular grade is the standard for most of the refineries in this country. This translates into a shut down of refining capacity and the rise in all refined products.....There just isn't enough of this grade.

Refining capacity Peaked at 95% two years ago and is now close to 80%. The sour/heavy grades are in abundance but it will take years and a declaration of a national emergency to increase refining capacity to process the heavier grades...A Green Light without restrictions must be done now to start building them.

Personally, I did not believe I would see $200 oil before 2012 but now that prospect has a 50/50 chance of occurring in 2009...Watch the refining capacity numbers closely.

[User 35132]

We need more refinerys, and get the oil out off our own coasts

[bill west]

Drilling technology has changed drastically over the last twenty years. Go talk to the drillers if you like. What has not changed is the evironmental nazis death grip on the body politic in the United States. No drilling off the coastlines, no drilling in Alaska, no new refineries to be built. The chickens have come home to roost.

Even if massive approval for exploration and refining started today it would take at least 5 to 8 years to get through the processes required now and start the oil flowing. In the meantime you have the emerging markets growing at lightning speed with the flattening of the earth taking place via the internet.

So while we sit and wring our hands fretting about $4 per gallon gas; don't worry, Europe is already paying $7 to $8 per gallon. Needless to say you won't see many Hummers or Escalades in Europe.

You can hate XOM if you like but I prefer to own it and smile everytime I fill up the suv.

Diclosures- Long XOM

[ChipSeal]

"...a declaration of a national emergency to increase refining capacity to process the heavier grades...A Green Light without restrictions must be done now to start building them."

Not until we get over climate change hysteria. It may take a little load shedding in the present to nullify the concerns of a few degrees warmer a generation or two in the future. Only when Americans see that the choice is between actual prosperity or feel good environmentalism will we be able to build power plants, transmission lines and refineries.

Too bad we couldn't find a presidential candidate that would stand up to the crazies. Sigh.

[ErnieMontague]

While I am all for drilling off shore and in Alaska, it won't "solve" anything. There is not enough oil in ANWAR to make any difference at all in our supply. It is a small field.

[bearfund]

If light crude supplies constitute a "national emergency" then the appropriate response is not to override environmental laws to drill and build more refineries. Even if one ignored the direct negative effects that policy would have, it would be years before any significant new supply hit the market. Instead, a suitable response to an "emergency" would be to ration fuel for automobiles to ensure adequate supply at tolerable prices for industry. That would begin making a real difference immediately, which is what one would want in an "emergency." It would also encourage long-term investment in the very area that all postwar policy has discouraged it: mass transit. If everyone took buses, streetcars, and subways, walked, or bicycled for all their day to day travel, oil would still be $20 a barrel, prices for other goods and services would be lower, the dollar would be stronger, and our economy would be more competitive. Oh, and the air and water would be cleaner, too, for those who care about that sort of thing; that is, those of us who breathe or drink.

Disclosure: Long STO, a money pipeline from middle American fools to my bank accounts.

[maher]

You fail to mention one of the most important factors in oil's perpetual rise: geo-political risk; It's Iran stupid. War, that is.

[LJ]

Both the money supply now experience a kind of parabolic growth. There is simply too much money in the system.

[LJ]

The money supply now experiences a kind of parabolic growth. There is simply too much money in the system. Dollar looks like a bubble waiting to burst.

[epoch]

"Instead, a suitable response to an "emergency" would be to ration fuel for automobiles to ensure adequate supply at tolerable prices for industry. If everyone took buses, streetcars, and subways, walked, or bicycled..."

Might work in a small "high density" European type country. Not in the US with the long distances we must travel. Unless your proposing controlling freedom of movement too.

[Maybe]

Maybe the profitless war, with a cost of 3 trillion, and asset writedowns, about 1 trillion, have scared away foreign investors from the dollar; which in turn means dollar weakness;which should definitely cause costs to rise! - thats inflation. It would'nt be such a bad thing, if demand and production were growing,alas, that has'nt happened since the 1950s. And the more FED lowers interest rates,the less confident will Chinese and Indian and OEC investors be with the dollar. Stop consuming and start producing should be the mantra. Incidentally, this is why growth manufacturers will be awarded higher valuations, while the bankers, insurers, value-adds get bonked.

[dsrtwriter]

I think that what we are experiencing is oil and commodity price increases relative to the dollar,and the rate of those increases is essenetially a world market "vote" on the efficacy,or lack thereof, of Fed rescue attempts.

Smoke and mirrors does not work in this situation. If the Fed had permitted homeowners to lose their homes, leading to a wholesaling of the overpriced housing stock, the rest of us who own homes would at worst, likely just find that our home value "clock" is reset back about five years. Not really a problem unless you have to sell a home you bought within the past five years, or if you were foolish enough to succumb to the banks' hype of home equity loans to buy that new boat or vacation a couple of years ago.

Secondly, if the Fed had just permitted Bear Stearns to go under, and the other "investment bankers" (talk about a new oxymoron) to simply see their share prices drop to reflect their real worth,again this would in the long run temper the rise in commodity prices.

You can get technical all you want about what is truly "inflation". Most of us know it when we see it.The smoke and mirrors tricks indicate to the world that there is no fixed (ie.gold) backing of the currency. Credit lines, swaps, etc. are created out of thin air, when all of us can see plainly that the excessive value of homes has evaporated, and any attempts to mask the pain must by definition cheapen the dollar.

Unlike a dollar, it actually takes resources and human capital to find, extract, and purify oil, gold, copper,grow wheat, etc..That is reality.
And so when we see these fancy attempts to stop a market reaction to the home credit mess, the market is not fooled.

We do have inflation. Real assets are going up in nominal dollar price, yet relative to gold not so much. Oh, houses, you say that there is deflation?

Not really, it is a matter of semantics. Housing prices were massively inflationary the past few years due to the liberal credit.
The fact that their prices are ratcheting back in the face of higher commodity prices does not reflect a deflationary situation for the economy,because the government is interfering with allowing them to fall to where they should be.

So the result is that the consequences are seen more in commodities instead of the houses.

Instead of the banks and the homeowners paying the price, we all end up paying in our purchase of eggs, bread, oil, etc..

There is no free lunch.

[AmesTiedeman]

Demand is higher than steady supplies of 85 mm a day allow.

[BrucePile]

Inflation debates always just make my head spin. You should keep in mind that there are two types - monetary inflation and price inflation.

Monetary is increasing the money supply, which doesn't have to cause any particular price to go up. Price inflation is when there's a shortage of something that people are willing to pay up for, which doesn't have to come out of any increase in money supply. You can have one without the other in any particular area of the markets.

So, with commodities, with or without practical use shortages, there is price deflation in homes, price inflation in soybeans, price deflation in hedge funds, price inflation in rice, price deflation in anything that smacks of packaged debt, and price inflation in anything that smacks of practical use. The markets are a zero sum game - every dollar you gain over and above the index's performance comes from an underperformer's pocket. So deflation/inflation is always going on no matter the supply of money it's being done with.

There is always a wandering herd of investment money out there (made bigger and more energetic by increasing money supply) moving in and out of various areas. So instead of trying to figure out inflation or deflation per se, I just try to see where the wandering herd is leaving and where it is going. We have a major cycle now of the herd wandering away from financial assets and into hard assets. You can plainly see this on a historical chart, a cycle that runs every 15 years or so.

[Rusty Crazy]

I have a background in Economics.. which i must admit is very rusty.. however I have got interested in this debate, as, working in sustainable fuels, I am looking for some counter-arguments to the "biofuels are evil" lobby. That there may actually be other causes to the current rises in commodity prices, hard though it may be to believe.

Two things particularly hit home for me:

"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?"

1st in the article itself mentioning the ECB´s reaction to the hike in prices, using the bluntest tool in the box (although the only one they really have). The same mistake was made by the British Conservative government in the 80´s and early 90´s to control spending, when fiscal policy would have had a much quicker, more direct impact. Having devasting recessionary impacts.

I am currently in southern Spain, there is 20% unemployment rate due to structural barriers to employment. The economy needs labour market reform and stimulation, not stalling! The high interest rates are maintaining a high euro, damaging exports, devastating the housing market, and to what benefit?

The other thing is:

Those who seem to think that Climate Change isnt a problem. Err maybe the 6 years Australian drought (amongst others), causing rice crop failures, and, price rises in commodities might just be caused by a changing climate?? As was predicted by a Malthusian friend of mine about 10 years ago, and according to him, it's going to get worse..

any real economic support/criticism would be appreciated on these two points

Yours

A Climate Change "crazy"