Energy, Inflation and Speeding Tickets

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Includes: DBO, OIL, USO, XLE
by: Ken Bell, CFA

By now, it's probably safe to assume that everyone knows that oil and gasoline prices have been rising sharply and are near record levels. Even the recently discovered uncontacted tribe in Peru can be seen in this photo (courtesy of Reuters) trying to shoot down a plane for its fuel.

One of the surprises in the current cycle has been that rising energy prices haven't yet shown up in broader measures of inflation. The most recent Consumer Price Index [CPI] figure registered a year-over-year increase of 4.2%, but core CPI (excluding food and energy) came in at a relatively modest 2.3% increase. The bulls highlight this discrepancy and claim that it points to an overblown fear of inflation. They also point to the lack of flow through from the rising Producer Price Index [PPI] to the CPI as evidence that rising energy prices, in particular, are not impacting the price of goods and services more broadly.

According to the Bureau of Labor Statistics website, food makes up about 13.8% of the CPI, and energy accounts for 9.7%, for a total of 23.5%. In making the case for core inflation, economists point to the volatility of food and energy prices. Everyone can agree that food and energy prices are more volatile than many other goods and services, but I'm rather sympathetic to those who claim that we shouldn't ignore them. First off, they account for nearly one quarter of overall CPI. Second, we're talking about food and energy! Along with housing, these things are not exactly discretionary.

Now, let's look at the 9.7% weighting of energy in the CPI. We're definitely not as energy dependent as we were during the last energy crisis, which is certainly a positive. However, oil is used in a huge variety of ways and can be found in everything from plastic, lipstick, and disposable diapers to Captain Kirk's hair, tires, panty hose, lotion, Vaseline, and artificial limbs. And, of course, the manufacture of most products requires the use of energy, most of which is derived by the burning of fossil fuels. So although energy itself may only account for 9.7% of the goods and services measured by the CPI, the importance and impact of energy is certainly greater.

So, will we ultimately see these higher prices flow through to other goods and services? It seems likely. Plenty of transportation business are levying fuel surcharges, which is the obvious place to expect it first. Other service providers who rely on transportation seem to be jumping on board. Anecdotally, my wife just raised her rates for her interior design business in part due to higher gasoline costs. Her handyman just did the same. And, according to yesterday's USA Today:

The surging price of gasoline has come to this: a "fuel surcharge" on your next speeding ticket.

Drivers caught speeding in this north Atlanta suburb soon will have to pay an extra $12 — to cover $4-a-gallon gas costs for the police officers who stop them.

The City Council passed the fee hike, effective July 1, to offset fuel prices that have eaten up nearly 60% of the police department's 2008 fuel budget, Police Chief Ken Ball says.

He expects the fee increase, which applies to all moving violations and can be rescinded if gas prices fall below $3 a gallon, to generate $19,500 to $26,000 a year for the town of 7,700.

Ball says he was seeking ways to maintain patrols despite record high gas prices. "I was hearing that Delta (Air Lines), pizza deliverers, florists were adding fuel charges to their services, and I thought, why not police departments?" he says.

By my math, a $12 surcharge on $4/gallon gasoline works out to 3 gallons of gas per speeder. If we assume 20 mpg (highway), it seems each speeder should be entitled to a 60 mile chase.

Whether higher energy prices flow through may not even matter as far as equity returns are concerned. To the degree that sellers don't pass along their higher costs, their margins, earnings, and valuation will suffer. If they do pass them along in this current environment, we run the risk of seeing a sharper decline in consumption as an over-stretched consumer is forced to retrench even further. Neither case bodes particularly well for equities.

As for strategy, I still believe that we are in the middle innings of this commodity bull market and plan to continue holding a core position while exploiting significant short-term moves. I remain overweight commodities and energy, but I wouldn't be at all surprised to see a pullback near-term given the rhetoric over new Saudi production, "crack downs" on oil speculators, and near-term reduced oil demand -- at least from the industrialized world. (For the record, I do not believe that this new oil from the Saudis or restrictions on speculators will solve the problem of high oil prices.) Retrenchments are part of a healthy bull market. Should such a pullback occur, I will be a buyer yet again.

Disclosure: The author is long artificial limbs and uncontacted Peruvian tribes and short Pollyannas.