Don't Blame Big Oil
Gasoline prices are going up and will reach new records by summer. This time it won’t be due to hurricanes, the war in Iraq, or greedy oil companies. The blame for higher gasoline prices rests with government policy. Let’s begin with the root cause of the current crisis. It began last summer with an energy bill that included a new ethanol mandate that will raise ethanol use to 7.5 billion gallons by 2012 beginning this year. In addition to requiring the use of ethanol in gasoline, Congress also refused to include liability protection for producers of MTBE. MTBE mandated by government has now become a target for trial lawyers. The result is that MTBE makers are pulling out of the market at a time ethanol production can’t meet the new demand mandated by Congress. So we are seeing gasoline inventories drawn down and gas supplies getting squeezed.
Trial lawyers are getting ready for their next tort bonanza. Because refiners have been given no legal protection, producers and refiners are exiting the market. Valero, one of the nation's largest refiners has announced plans to phase out production. While refiners and producers are phasing out MTBE production, its replacement ethanol can’t be produced fast enough. Even the ethanol industry has acknowledged it can’t make up the shortfall. Refiners have been warning for years of the shortage problem and if they were given no legal protection from trial lawyers, they would exit the MTBE market. That is exactly what happened.
The changeover from MTBE to ethanol, even if we could produce all that was demanded, still presents a major problem. Ethanol can’t be shipped through our pipeline system. Instead, it needs to be trucked or shipped by rail to terminals near its processing point. It costs more to ship and requires more energy use to get it to its ultimate destination.
Our energy follies don’t end with ethanol. Beginning in January of this year and in June American refiners will have to reduce the amount of sulfur in diesel from 500 parts per million (ppm) to 15 ppm. In January the sulfur content of gasoline was reduced from 90 ppm to 30 ppm. The new reductions mandated by the EPA represent the biggest changes to the gasoline market since leaded gas was phased out three decades ago. These new regulations add more complexity to our supply chain of gasoline. American refiners are required to blend 45 different blends of gasoline. Our gasoline mix can be appropriately labeled as a "Heinz 57" plan. Each state or government entity throughout this country has its own blend of environmental fuel mix instead of one variety that meets most standards. Each one of these blends requires special segregation while it is shipped, stored or sold. This is stupidly at best and insanity at worst.
These mandates couldn’t come at a worse time. We still have a good portion of our energy production off line in the Gulf of Mexico. Damaged refineries from last year’s hurricane season are barely back on line and a new hurricane season will soon be upon us. On Tuesday of this week the Energy Department issued a forecast for the price of gasoline this summer. Surprise, surprise! Prices are headed higher by as much as 25 cents to an average of $2.62 a gallon.
|
NATIONAL AVERAGES FOR | |||
| Regular | Mid | Premium | |
| Current Avg. | $2.686 | $2,853 | $2.955 |
| Month Ago Avg. | 2.360 | 2.506 | 2.597 |
| Year Ago Avg. | 2.276 | 2.416 | 2.504 |
|
Note: prices per gallon Source: AAA Fuel Gauge & WSJ, April 11, 2006 | |||
I believe this number is way too conservative. In San Diego we are already experiencing prices that are higher than the aftershocks of Katrina and Rita. The EIA said that it expects oil prices to remain high -- averaging $65 a barrel for the year. The Energy Department also said that more ethanol will be needed to meet demand. The EIA also pointed out those new regulations will cause additional costs to be incurred by refiners because of the new sulfur requirements and the phase-out of MTBE.
There you have it. Gasoline prices are headed much higher not because of supply and demand issues, but because of government policy. Higher gasoline prices will act as one more tax on the American consumer. High energy prices and rising interest rates are one reason that a recession seems inevitable at this point.
Money Creation Alive and Well
There is a lot of talk these days about central banks drying up liquidity around the globe. This talk is nonsense. Yes, central banks are raising interest rates. There is no denying that. However, at the same time they are raising interest rates, they are making sure the banking and financial system is kept well supplied with plenty of money to lend. The global money supply is expanding at unprecedented levels either in the high single digits or in some cases double-digits. This is reported each week in the back pages of the Economist. The latest money supply growth rates are listed below.
| Australia | + 9.1% |
| Britain | +11.7% |
| Canada | +7.7% |
| Denmark | +14.7% |
| US | +8.1% |
| Euroland | +7.3% |
Money supply growth rates of 7-14% don’t strike me as tight liquidity. In fact it points to just the opposite. Money supply growth rates of this magnitude are one reason why inflation is on the rise. It can be seen in asset bubbles around the globe in equities, bonds, mortgages, and in real estate. It is also one reason why commodity prices are on the rise, especially precious metals. The rise in gold, silver, platinum and palladium are all signaling the coming age of inflation. This inflation will not be held back by interest rate hikes. Any setback in precious metals through policy intervention will only be a temporary setback, nothing more.
The next “Great Inflation” is baked in the cake. The US current account and budget deficits are out of control. With defense spending and entitlement spending now consuming almost 75% of the government’s budget, deficit spending is on automatic pilot. No amount of tax hikes could arrest the problem. In fact any tax hikes would only aggravate the problem in the same way that Hoover’s and Roosevelt’s tax increases turned a recession into a depression.
Source: The Grandfather Economic Report
To get a grasp of the magnitude of the problem, last year total credit in the US expanded by $3.340 trillion, up over $500 billion from 2004. Total outstanding debt now stands at $40.230 trillion as of the end of last year. Last year nominal GDP grew by $751.4 billion against credit expansion of $3.340 trillion. It is now taking $4.45 of new debt to produce $1 of GDP. Since the year 2000, overall credit in the US has been growing at an annual rate of $2.4 trillion. Since 2004 that rate of growth is accelerating. In 2004 it grew by $2.818 trillion and in 2005 total credit expanded by $3.340 trillion. Given the rate of growth in money and credit, last year's record could be surpassed again this year.
With an annual current account deficit of $805 billion and a budget deficit expected to exceed $400 billion, the U.S. government is going to need another source of financing.
I suspect that a U.S. version of quantitative easing is in the works with the Fed now suspending the reporting of M3. The only reason to drop reporting of M3 is that it doesn’t want the markets to know what it is doing. Please review the chart of M3 as last reported. Notice the parabolic rise beginning in 1994. In the final three months that we have figures for M3 it grew from $10.119 trillion on November 28th to $10.340 trillion on February 27th, an increase of $221 billion or an annual increase of 8.7%. I can only imagine what it is today. Forget all talk about deflation. The “Great Inflation” has now entered its second phase in what will be a gradual road to hyperinflation. Its time to build an ark in preparation for the great money flood that is on its way.
Standing on the Precipice
The Fed has raised interest rates 15 times and it looks by reading the financial markets that it will raise rates once again when it meets on May 10th. At that point the fed funds rate will have risen to 5.0%. After 5% any rate hikes above that level will put the economy and the financial markets at great risk. As the graph below taken from the Fed’s own web site indicates, the growth of debt in the U.S. has gone parabolic. Foreclosure and delinquency trends are on the rise. Nearly $1 trillion in adjustable rate mortgages are due to reset over the next year. The real estate boom in the U.S. was fueled by a tempting array of low mortgages. These low rates helped millions of Americans qualify for home or refinance loans. According to the Mortgage Bankers Association nearly 25% of mortgages or 10 million carry adjustable interest rates. Most of these mortgages are owed by people with sub-par credit ratings, who took out the loans as the only way to qualify for a home. Now many of these mortgages are due to reset.
This trend is ominous for borrowers who were seduced by low monthly rates. Now that rates are rising and their ARMs are set to rise many homeowners are finding themselves in over their heads and unable to handle higher interest rates. Those who could afford higher payments and have equity in their homes are refinancing, locking in a fixed rate. For many others there are no options. They simply can’t handle the higher payment burden. It is why delinquencies and foreclosures are on the rise. Delinquencies and foreclosures are set to rise this year and reach a peak by 2008. The pain is beginning to show in states such as Colorado where foreclosures have jumped by 31.5% in the Denver area. Other states from West Virginia, Alabama, Michigan, and Missouri to Tennessee are reporting similar problems.
As the spread between ARMs and fixed rates narrow with a flattening yield curve, the troubled homeowner has very few options to contend with other than to sell or risk foreclosure. With very little equity tied up in the property, many are choosing to hand over the keys to the bank.
Bad Debt Rising
The strain on household debt burdens is carried over into the credit card sector where credit card charge offs are now approaching 5%. The increase in charge-offs runs parallel to rising debt burdens as shown in the graph below.
In a recent Fed paper Fed officials concluded that since 1983 rising wealth and the preponderance of heavy borrowers in the population have increased together. Using regression analysis the Fed concluded that the combined force of wealth and heavy borrowers correlate closely in explaining the rise in debt burdens and the increase in bad debts. Left out of their analysis was the impact of inflation in creating this wealth.
Which brings me back to the Fed’s predicament. In an effort to stave off the effects of its inflation policies in creating rising prices and asset bubbles the Fed has attempted to apply the brakes through rate hikes. At the same time it has kept the wheels of credit creation greased through inflating the money supply. By raising interest rates the Fed was targeting the latest bubble of its own creation in real estate. Using a gradual rate increase, the Fed hopes to avoid financial mishaps which usually accompany every Fed rate hike cycle.
At the same time that it is attempting to avoid a financial conflagration, the Fed is also attempting to remove some of the froth and deflate some of the hot air in the real estate market. So far it has succeeded in avoiding any serious financial accidents and it appears that the froth and hot air has been let out of the real estate market. As shown in the graphs left from The Bank Credit Analyst's April 2006 issue, mortgage applications have plunged in recent weeks and are now back to levels not seen since 2003. New home sales have been in a downward trend and as a result the inventory to sales ratio is rising.
Other signs of a slowdown are evident in falling prices. In San Diego homes prices have been falling about 1.5% a month. New home builders are giving incentives from option packages and cars to covering closing costs. More new home buyers are walking away from their home purchases before close of escrow. Many builders are reporting a significant drop in buyer traffic while homebuilder sales expectations have dropped considerably. This is also reflected in a number of homebuilders issuing profit warnings.
The Fed has succeeded in taking some of the froth out of the real estate market. However, if it continues with its rate hikes as it now appears, it risks imploding the real estate market which has consequences for the financial system. Even if it stops at 5%, the effects of the rate tightening will linger on for years due to a marked increase in the number of adjustable rate mortgages.
It has been my contention that in order for the Fed to stop raising interest rates it will need commodity prices to stabilize as well as take some of the froth out of the financial markets. With oil prices at close to $70 a barrel, gold at over $600 an ounce, copper at $2.76 a pound, it will be difficult for the Fed to maintain that it has gotten inflation under control. Publicly, officials point to a low “core” CPI as evidence that inflationary pressures have been contained. If you take official inflationary data at face value, there isn’t a problem. It’s the unofficial data (the cost of living) that is going up for most Americans. And with the rise in commodity prices this becomes the problem. This is an issue that is not going away. More than likely what will happen is that the Fed will keep raising rates until something breaks in the economy or the financial markets and maybe both.
Fed rate hike cycles are great destroyers of wealth. Remember the last one which began in 1999? The financial markets talked about a soft landing. Instead we experienced a major bear market in stocks with the Nasdaq losing 75% of its value and the US economy went into a recession. As the graph below indicates, 90% of the time the Fed ends up throwing the economy into recession followed by an accompanying bear market in stocks. The only soft landing I’ve seen in my 30-year career in the business was in 1994. The rate hike cycle that year didn’t create a recession, but it caused an incredible amount of damage to the bond and derivative markets. Does anyone remember Orange County’s bankruptcy?
So what are the chances the “Gang that can’t shoot straight” will get it right this time? The probable course of action is that the Fed will raise rates and it will end up being a quarter point too far. The economy could very well go into a recession although distorted economic statistics will hide that fact. We could very well get a 10-15% correction in the stock and commodity markets, and even worse, a major financial accident in the form of a major player (hedge fund or bank) going bankrupt. This looks more likely if the Fed moves beyond 5%.
What will follow in the aftermath? Probably quantitative easing in the form of helicopter money and an ocean of money. Instead of the usual disinflation that usually flows at the end of most rate cycles, this time we’ll experience rising interest rates and inflation. The inflation issue is not going away for one simple reason; the Fed is printing too much money. Another is that there is too much debt in the economy and the government's own budget is now beyond control. The US must inflate or die. There is no other choice nor do we have politicians who are capable of making painful choices.
To get a glimpse of what lies ahead, please review the charts of interest rates and money supply from the 1970s. The Fed continued to raise interest rates throughout the entire decade while at the same time flooding the financial system with money. The Fed also monetized a considerable amount of the government’s deficit -- something I think it will be forced to do again. The inflation problem is not going away. There is simply too much debt in the system.
Government is going to get bigger and its growth is beyond financing through taxes. Money creation is going to be the order of the day, which is why M3 is no longer being reported. Buy gold, buy silver, buy oil, and buy things. They are going to be worth more in terms of depreciated dollars.
Until the next time... fair winds and clear skies!
© 2006 James J. Puplava
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