The Oil Drum

With Consumer Prices Index (CPI) rising to 3.3% (year on year to May-08), the fastest rate of increase in over a decade, the Governor of the Bank of England has written to the Chancellor to explain.

Open letter from Mervyn King governor of the Bank of England to Alistair Darling, Chancellor of the Exchequer. Click for full letter.

Higher energy prices are feeding through to rampant consumer energy price inflation. And yet the authorities and many investment houses still see energy prices falling in the future. This naive view of global energy supplies is starving energy markets of the capital required to expand conventional and alternative energy supplies.

UK National Grid, with responsibility for the distribution of natural gas and electricity in the UK, see flat to falling natural gas prices to 2015 and beyond. Comments welcome!

Global annual average natural gas spot prices from the BP statistical review of world energy 2007. Click all charts to enlarge

[Editor's note: this story was first run on 4th February 2008]

Higher energy prices are feeding through to rampant consumer energy price inflation. And yet the authorities and many investment houses still see energy prices falling in the future. This naive view of global energy supplies is starving energy markets of the capital required to expand conventional and alternative energy supplies.

Global annual average natural gas spot prices from the BP statistical review of world energy 2007. Click all charts to enlarge

Year-on-year percentage change in monthly consumer food prices and prices paid to farmers (average across all farm products) Jan 1970 - October 2007. Source Bureau of Labor Statistics, and National Agricultural Statistics Service. Graph is not zero-scaled. Click to enlarge.

A curious custom in the UK is that we still get milk delivered to our door step by the milkman each day. Today we received a rather curious note from our milkman (Robert Wiseman Dairies) warning of higher prices, growing demand and extreme weather. What is the world coming to?

An inflationary future is becoming conventional wisdom, but, as consensus takes time to develop, the stronger the consensus, the later it is in the trend. A consensus is a backward-looking phenomenon of little use - except as a general contrarian indicator - in detecting the inevitable discontinuities that can abruptly and painfully invalidate all one's assumptions.

We have lived through a long period of inflationary credit expansion, and regard it as normal, but credit expansion is a self-limiting condition. Credit bubbles are merely the rediscovery by a new generation of the powers of leverage (see for instance A Short History of Financial Euphoria by Galbraith, Manias, Panics and Crashes by Kindleberger or Financial Armageddon by Michael Panzner). Every credit bubble that ever existed has eventually deflated, and this one will be no different.

We have essentially already reached the limit of debt serviceability that brings an expansion to an end. We are already seeing the tightening of credit standards, the refusal of banks to lend to one another, the frozen commercial paper, the bank runs, the redefinition of what constitutes a store of value, the rejection of financial alchemy, the debt defaults that reduce the money supply, the falling prices in the housing market, the lack of confidence - which together unmistakably herald deflation. Central banks can do nothing more than paper over the cracks for a short time, at the cost of aggravating the eventual impact of deflation.

Time to Aim High?

I salute Wasik for pointing out the sham that the CPI is. However, it is because of the debasement of the dollar and distortions in the CPI that the Fed has practically forced risk down everyone's throat. But one must be cognizant of herding behavior that has nearly everyone thinking exactly like he is and the Fed wants. Aim high. Shoot for the moon. Do or die. You are losing money by saving. Buy assets. Only fools save. In the long term, stocks always go up.

The problem is that aiming high is synonymous with increasing risk. Up till now, risk taking has been rewarded. But what happens when everyone does the same thing? More to the point, what happens when everyone does the same thing for 20 years or longer? Eventually, risk gets so unappreciated that various asset classes go to the moon....

....Essentially, the same advice given for real estate (you cannot buy too much home, home prices always go up) is now being touted for stocks. There is an amazing belief in the Fed's ability right now to control the business cycle, as well as price stability. It's not warranted. At this stage of the cycle in a slowing economy, with rampant overcapacity, a tenuous job climate, and no real reason for businesses to expand, the odds are that aiming high is precisely the wrong thing to do.

This is a guest post by Robert Smithson, a portfolio manager at a London based investment fund.

This is part one of a two part article on the economics of oil price demand. The second part looks at the economics of peak oil, and how the oil fits into an overall energy demand curve.

Introduction

“The world is consuming more oil than it is producing.” --The Economist, July 14-20 print edition.

Wow, that’s a shockingly foolish statement. Each day approximately 84 million barrels of oil are extracted from the earth, and approximately the same amount is consumed. It can be no other way: inventory space is limited, and could not be extended significantly by “excess production” or indeed drawn down for long by “excess demand”.

The problem is a basic lack of understanding of economics. And The Economist is hardly the only culprit.

(This is a post with the old comment thread for the post above...sorry to make you click back and forth...the new link is here.)

This is a guest post from Jeff Vail.

Will Peak Oil lead to inflation, deflation, or some variant thereof? I don’t claim to know the answer—in fact, I’d argue that anyone who "knows" the answer is discussing theology, not economics. My hope here is to present a case for Peak Oil resulting in inflation, and to spark a centralized debate on the topic. Allow me one courtesy: for the purposes of this discussion, assume that we are not able to sufficiently mitigate the effects of Peak Oil through conservation, efficiency, or alternative energy sources. Assume that Peak Oil will have significant, negative economic effects—the issue that we are discussing here is whether those negative effects will be inflationary or deflationary. I will focus my discussion on effects on the United States, but thoughts on the inflation/deflation debate outside the US are certainly welcome.

Annual income twenty pounds, annual expenditure nineteen six, result happiness. Annual income twenty pounds, annual expenditure twenty pound ought and six, result misery. --- Charles Dickens.

Monthly savings rate for January 2002-May 2006 (plum), together with a version that assumed prices of gasoline and natural gas had not changed (green). Click to enlarge. The fine lines are the monthly figures, and the heavy lines are a 13 month centered moving average. Graph is not zero scaled, and x-axis is not at zero. Source: BEA NIPA Table 2.6 for personal savings data, and EIA for gasoline consumption, gasoline prices, natural gas residential consumption, and prices.