September 29, 2004
Transitory Times
By Brady Willett

Many economists and policy makers blame the current economic ‘soft patch’ solely on rising energy/oil prices. Many economists and policy makers also like point out that the U.S. economy is less reliant on oil than it used to be. To the average onlooker a potential contradiction emerges: if the U.S. economy is really less reliant on oil why is the price of oil the only thing said to be holding back growth today?

The U.S. Federal Reserve Board suggests that rising oil/energy prices are ‘transitory’; that softness in consumer spending [because of rising energy prices] “should prove short-lived” (Greenspan Testimony, July 20, 2004).  Similarly, Treasury Secretary Snow has called record oil a “short-term phenomenon” being driven by the “geopolitics of oil” (Sept 28).  Chiming in with variants of ‘oil price spikes no longer foreshadow recessions!’, Wall Street is basically in agreement with the policy makers. 

While it is true that the U.S. economy does not rely on oil as much as it used to (oil makes up a smaller % of GDP today than during the 1970s), this statement, when combined with rising oil is ‘transitory’, forms a myopic viewpoint.  To be sure, from a fundamental perspective the price of oil can only be said to be ‘temporarily high’ if 1) the supply of oil is about to increase or 2) total demand for oil is about to decrease (i.e. a recession is around the corner). Any discussion on the price of oil beyond these points of interest of view is meaningless. As for the U.S. economy being less ‘reliant’ on oil, a more rounded observation is made when discussing ‘dependency’.  Rather than nitpick about the subtle differences between the words ‘reliant’ and ‘dependent’, one chart will suffice. 


The two trends in the above chart are partially the result of policies – the 1970s/80s push in America away from oil production – but primarily because of geography. In other words, since America is not oil rich it needs to satisfy its oil needs by importing oil from countries that are.  It goes without saying that America’s need foreign oil is greater than it has ever been before. You could say that the American Economy has increasingly come to rely on foreign oil to function…

The Fundamental Picture

Per capita use by American’s is 23.4 barrels of oil a year, and the per capita use by someone from China and India are 1.5 and 0.8 barrels of oil a year respectively. With growth trends in places like China in mind and OPEC threatening to reach full capacity, is oil being undervalued? Simmons

Sometimes war/terrorism ‘premium’ speculations prove prophetic while other times they do not.  A ready example of when ‘war’ premium speculations have proven inaccurate is before Iraq was attacked -- $28 a barrel did not include an $8 ‘war premium’.  By contrast, during the 1990s – or when OPEC [in hindsight] always had spare capacity – most ‘premium’ speculations proved accurate. 

What is important to remember is that ‘premium’ speculations are usually proven right or wrong based upon the fundamentals. For an example of this phenomenon using equities, in the late 1990s Henry Blodget always seemed to be ‘right’ about the near term direction of internet stocks, but he was ultimately dead wrong when it came to the fundamentals of these stocks. The price of oil, like the price of stocks, can trade outside of its fundamentals for a period of time, but not forever.

In short, and using the chart below a guidepost, if US crude stocks continue to decline oil prices may continue to rise, and if stocks rise the price of oil may fall.


Fed Speculations About ‘Transitory’ Elements Are Always Optimistic

While Greenspan is quick to point out that record oil is ‘transitory’, he and other Fed members go silent when it comes to record capital inflows from foreign central banks into U.S. Markets.  To be sure, that Japan has doubled its stake in U.S. Treasury Securities since June 2002 doesn’t seem to bother the Fed.  Moreover, that there is talk of China – the second largest foreign holder of Treasuries – losing its appetite for American debt doesn’t merit any mention by the Fed.

Think about this way: Greenspan and company have repeatedly warned (usually during Q&A sessions) that the U.S. current account deficit is unsustainable, yet the Fed has never began an FOMC Statement with the phrase “high demand for U.S. debt is transitory and the dollar will inevitably decline.” Why does the Fed suggest that the price of oil will inevitably decline (which is pure speculation) and ignore what some members believe to be an inevitable decline in the U.S. dollar?  Always look on the bright side of...

Conclusions

With the Dow reaching lower lows and higher highs all year long. Whether or not this year’s bearish trend can be broken depends largely on the price of crude and the perceived value of the U.S. dollar (by foreign capital).


It is worth remembering that when foreign capital inflows into the U.S. hesitate this not only has the potential to impact interest rates, but also equity prices (i.e. foreign equity investors have been just as exuberant as ‘mania’ stock investors).  



With crude reaching new record highs this week opinions concerning the impact of rising energy prices may change in the weeks ahead.  However, don’t look to the Fed and/or policy makers to ever concede that oil is at records for fundamental reasons. Why? Because – eventually – if the supply of oil does not increase demand will decline (i.e. a recession will arrive).  In the end policy makers will right…

In sum, the bull is threatening to become a bear, the U.S. dollar’s strength is slowing turning to weakness, and the price of oil is either about to collapse or spark a crisis…transitory times indeed.