Stagflation and Peak Oil: How Related Are They? (Part I)

Includes: UDN, USO, UUP
by: Larry Bellehumeur

Two terms that definitely scare investors (at least those who don't know what implications both have on their portfolio) are Stagflation and Peak Oil. One (Stagflation) might be happening soon but could be avoided, while the other (Peak Oil) might not happen soon, but cannot be avoided.

I'll leave the exact definition up to someone smarter than I, but Stagflation basically means a sustained period of slower than normal growth, combined with a period of higher than normal inflation. While there are a few ways that it could be caused (I'm sure that a war would do it), an extreme spike in the price of a vital commodity would be the most likely reason. The disruption of oil in 1973 (causing an extreme spike in the price of crude) caused Stagflation for much of the decade, resulting in an extreme hike in the price of almost everything, while salaries weren't going up to match. This was repeated in the early part of the 1980s. Since then, inflation has been very much in check.

Peak Oil is a term which has caused much confusion. If you simply based our consumption rate of oil on what is in the ground, we'd have enough oil for the next 500 years. However, not all of the oil is in fact recoverable (although the percentage is going up with improved drilling techniques, such as horizontal drilling). There is a limitation on how fast we can get oil out of the ground for two reasons. One, if you were to pump out oil too fast early on in a well's life, it will reduce the pressure that forced the oil to come out of the ground in the first place. While such techniques as pumping in large volumes of water (aquifiers) has worked to sustain the pressure on many of the Saudi's fields, engineers are cautious to keep the flow at a sustainable rate. The second part is that many of Todays largest fields have been producing for decades. Hubbert's Peak refers to the fact that most wells begin to reduce the amount of oil that can be produced (daily) from a well once the field reaches 50% of its recoverable oil. Many of the superfields that provide much of today's oil (Ghawar in Saudi, Cattarell in Mexico) are either at this stage or are close to it.

So, are the two items linked? Undoubtedly!

The world's oil consumption has increased dramatically in the past few years, driven by not only Emerging markets, but by the increasing consumption of many products that use a large amount of oil to produce (computers are a big user of oil, which most people are not aware of, as there is a lot of components which use a lot of oil in their manufacturing process).

Are we in Peak Oil today? Not sure that anyone knows for sure, but it seems obvious that we are getting close. Techniques to increase the volume of liquids in the refining process have helped to cover up the fact that the world's oil production is near the top, if not already there.

The price of oil seems to have reflected this. Despite the recent demand reduction in the past few weeks, oil consumption has continued to rise faster than production for years, despite prices rising many times over.

It is now becoming apparent that the high price of crude has creeped its way into many aspects of life. Transportation companies have started to charge large fuel surcharges on their deliveries. The costs of many goods that are imported from overseas is starting to rise. And, for anyone that has taken a flight recently, the fuel surcharge seems to be more than the cost of the flight. This is starting to make its way into everyday life, with companies no longer being able to absorb the extra costs and being forced to raise prices.

Can the situation get any better?

Logic says...not anytime soon. Despite recent oil finds in Brazil, and the recent confirmation of massive deposits of crude in the Arctic, none of these recent discoveries will be online this decade. Even when they do come online, the cost per barrel will be extraordinary, compared to the easy flowing crude from the Middle East. And, if many of the large oil field go into decline, we'll need this new oil just to keep up with current production.

How will this play out?

Ben Bernanke and other heads of the Central Banks will definitely earn this keep in the next few years. Bernanke, in particular, might have to choose completely between propping up a failing economy with more cheap money (lowering interest rates) or facing inflation head on (raising rates) sooner than later.

Lowering interest rates will certainly spur economic activity, at least at first. However, if you thought that the US dollar was low now, imagine if he cuts rates by 50-100 basis points. It would make the greenback one of the worst currencies on the planet. This may also spur some further talk of pricing crude in a currency other than the US dollar. It would also cause a lot less investment in the US Treasuries by foreign entities. Finally, inflation would absolutely go ballistic, pushing well over 10% in no time...

Raising interest rates will certainly kill some economic activity, at least at first. However, it would help to stabilize inflation, at least slow it down. The problem is going to be...housing. Many Americans (and their homes) are highly leveraged. I'm not sure how much Bernanke could raise rates before the rate of people walking away from their home sky-rocketed. The amount of debt is much greater than at any time in history in the US, and even 2-3% rate hikes would be devastating (imagine if we had 15-18+% rates like in the late 70s / early 80s!)

When you balance out the two, it appears that Bernanke may try to walk the line (keep rates a bit higher, to ward off inflation, but not too high as to cause a further credit crisis). Will he succeed? I'm not sure, but I would plan on making your portfolio more adaptable to this environment (see my next article for more ideas).

Remember another important factor. If we are really at Peak Oil, this is going to make the problems much, much worse. Oil may have no choice but to hit $200 a barrel just to crimp demand. Combining this with escalating food costs, it will definitely put us in a prolonged recession...