THIS WEEK: OIL AND GAS TAX ECONOMICS
The Well-Timed Strategy for Week Ending May 9, 2008
by Peter Navarro, Ph.D.
May 5, 2008

The Markets 

Is the U. S. stock market a leading indicator of the U.S. economy? That’s the presumption I have historically followed as a self-professed “macro trader” – see, for example, my trading book “If It Rains in Brazil, Buy Starbucks.” 

The “markets as leading indicator” view, however, is a presumption that has been increasingly subject to slippage. One major “problem” is that U.S. markets are increasingly driven by international currency issues. For example, the domestic economy might be in trouble but with a weak dollar, a lot of big, U.S.-listed multinationals might do well because of foreign earnings – and make U.S. markets look bullish. A second reason U.S. markets might not properly signal economic strength or weakness is because of the powerful effects of particular sectors like energy and commodities. 

That said, my claim for the past several weeks that the strength of U.S. markets has been merely reflective of a “technical bounce” must be reevaluated in light of recent economic data showing at least a slowing rate of job losses. If it turns out that we are headed more for a “shallow V” recession than the “deep U” many are worried about, that would certainly be bullish. Stay tuned. 

Presidential Politics and Oil Economics 

Based on John McCain’s self-professed ignorance of economics coupled with his ties to a gaggle of “tax cut advisors” like Jack Kemp, I was not particularly surprised that McCain is calling for a moratorium on the gas tax. I was, however, absolutely floored when the Clinton campaign, which has a much more sophisticated economics team, jumped on the gas tax bandwagon. 

Let’s be really clear about this: A short run cut in the gas tax is sheer economic, fiscal, and environmental lunacy. Such a tax cut would do little or nothing to cut gas prices in the short run, provide the absolutely wrong incentives for energy conservation over the long run, and contribute to a burgeoning budget deficit – while denying necessary funds for public infrastructure.

The “journalist’s view” of gas tax economics, as mouthed by pundits all last week, is that a gas tax cut would increase gas demand and thereby push the price back up to previous levels. This is an easy idea for John Q. Public to understand, but it is likely (almost) totally wrong. Prices won’t rise so much because of increased demand but rather something far more troubling. To understand the issue requires just a little bit of heavy economic principles lifting. 

To wit, with any tax cut or tax increase, who bears the benefit or burden of the cut or increase depends on both the elasticity of supply and the elasticity of demand in the market. In the case of gasoline, short run demand is very inelastic – that is, it is very unresponsive to price. However, in the short run envisioned for the gas tax holiday – the summer driving season – the elasticity of gas supply is close to perfectly inelastic. This is because of severe refinery constraints in many parts of the country. 

Conclusion: If the elasticity of gas supply is perfectly inelastic, any cut in the gas tax would simply result in an almost one-for-one increase in the pump price. In other words, the gas tax “holiday” for consumers would be no holiday at all but merely another windfall for gasoline refiners. 

And speaking of windfalls, I found it amusing that the weekend WSJ took Barack Obama to task for advocating a windfall profit tax – while giving him only the very faintest of praise for not falling in with McCain and Clinton on the gas tax holiday. 

In fact, the economics of a windfall profits tax are far more compelling than the WSJ lets on. Economists view a true windfall tax as a one time event administered retroactively to a period of profit activity over and above those profits which might be earned in a competitive market. Such a one-time windfall profits tax is the ”best of taxes” in that it has absolutely no impact on resource allocation, e.g., it wouldn’t depress oil production. Such a point got lost, however, in the WSJ translation.

QUICK TAKES

1. One of the reasons I like reading the Financial Times is that it runs front page stories about things like the price of camels tripling. The reason: with fuel expensive, more and more farmers are turning in their tractors for camels. Now somebody tell me how I can go long the camel market. 

2. My concern that Obama will be torn apart in the general election seems hardly misplaced as the gutting has already begun. Reverend Wright and elitist criticisms have brought him right back to the pack in a rough enough way to get even the super delegates thinking. What’s most disturbing about the gutting is the racist tones the McCain surrogates have already begun to strike – a case in point is the North Carolina ads against Obama. 

“Any trader or investor who ignores the power of macroeconomics over the world’s
financial markets will, sooner or later, lose more than they should—and if they are
trading on margin, perhaps more than they have.”
 -- If It's Raining in Brazil, Buy Starbucks

The Market Edge Market Summary from www.marketedge.com 

CONTACT INFORMATION
Peter Navarro
Irvine, California USA
Email  |  Website

DISCLAIMER: This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling, or holding of any financial instrument whatsoever. Trading and investing involves high levels of risk. The authors express personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The authors may or may not have positions in the financial instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future performance.