Andreoli on Oil and Fuel: Beware the “scorpion’s tail”

Are oil prices about to send the U.S. back into recession?

By ·

For logistics managers, it’s important to understand what surplus oil production capacity means to oil and fuel prices—and, therefore, your bottom line.

Surplus oil production capacity refers to the amount of oil that can be brought online to meet a surge in demand or to make up for a sudden decline in production. Prices rise sharply when surplus capacity dips below 1.5 percent of total consumption, or when surplus production capacity is declining rapidly toward that level.

In the January Logistics Management Annual Rate Outlook webcast, I warned that surplus oil production capacity is likely to fall into the danger zone before the end of the year. The International Energy Agency’s (IEA) most recent Oil Market Report (March) supports this conclusion, warning that surplus production capacity has been eroded since the beginning of the year, and that “the market’s relatively slim ‘buffer’ suggests a bumpy ride in the months ahead.”

image

In April 2010, surplus capacity exceeded 4 million barrels per day (mbd), or 4.7 percent of global consumption, and U.S. refineries were paying roughly $75 per barrel. By December 2011, surplus capacity had fallen to 2.24 mbd, consumption increased, and surplus capacity fell to just 2.5 percent. Refiners found themselves paying $106 for that same barrel of oil.

The IEA now estimates that surplus production capacity has fallen to 2 mbd. In Euro terms, the price for a barrel of Brent crude is higher than it has ever been, and West Texas Intermediate (WTI), the benchmark crude quoted by U.S. media outlets, is higher today than it was in March 2008—the year oil prices hit $147 per barrel and the national price for diesel rose to $4.72 per gallon.

A plot of oil prices over time resembles the curve of a scorpion’s tail. Are oil prices now approaching the stinger? Are oil prices about to send the U.S. back into recession?

Such a prediction is difficult because rising oil prices threaten the economy in different ways at different times. It’s hard to foresee precisely how rising oil prices will impact the global economy this time around.

In the run-up to the 2008 oil price spike, rising energy prices drove up inflation, causing the Federal Reserve to increase the lending rate from 1 percent in 2003 to 5.25 percent by 2006. The jump in interest rates proved to be the stinger at the end of the scorpion’s tail.

Rising interest rates caused adjustable rate subprime mortgages to surge, and many borrowers who were already punch-drunk from rising energy costs found themselves on the ropes paying for their mortgages. Defaults began to mount.

Looking back, we now know that the risk of mortgage default is correlated—that having a neighbor default greatly increases the probability that another neighbor will follow suit. Yet, the statistical models employed by investment banks that were packaging mortgages together into collateralized debt obligations were blind to this fact. Consequently, when foreclosures began to rise, banks suddenly found themselves undercapitalized.

In September 2008 Lehman Brothers collapsed, and investment banks essentially stopped lending to one another. The chill that blew through the banking system caused credit to freeze.

As rising energy expenditures continued to eat into disposable income, the foreclosure crisis mounted, and consumer confidence plummeted. Americans tightened their belts. But as spending declined, the economy threatened to enter a deflationary death spiral where declining demand for goods leads to declining output and employment, which causes confidence to further erode and belts to tighten further.

While the Fed’s easy money policy has its downside, the alternative was deflation and depression.

What’s different this time around?
For the time being, the rising cost of oil has not had the same impact on energy inflation as it did during the last oil price run. This is in large part attributable to the shale gas boom that has driven natural gas prices down to $3 per thousand cubic feet (Mcf). By contrast, in 2008 prices were nearly $12 per Mcf.

The rising cost of oil has also had a muted impact on the general rate of inflation. To a large degree this is due to the lingering high unemployment rate, which today sits at 8.3 percent. By contrast, the unemployment rate steadily declined between 2003 and late 2007. If the rate of unemployment was 4.5 percent, as it was in 2006, inflation would be high and the Fed would feel significant pressure to raise rates.

The elevated unemployment rate continues to suppress inflationary pressures thus allowing the Federal Reserve to stay true to their January statement that interest rates will not be lifted until 2014. Some believe that the Fed’s easy money policy is why oil prices are so high. But last I checked, easy money doesn’t search out a single commodity, and oil inflation has far outpaced other commodities like precious metals and agriculture.

Though unemployment is high, the employment situation continues to improve and elevate consumer confidence.

Thus, aggregate demand is being maintained despite the increasing portion of disposable income being spent on gasoline.

Aggregate demand is also being buoyed by new vehicle sales, which have risen sharply on both pent up demand and the fact that today’s vehicles are far more fuel efficient than those being replaced. By contrast, rising fuel prices contributed to declining sales of inefficient SUVs and other trucks as early as 2006.

There is no hard-and-fast rule governing oil and fuel prices as they pertain to consumer confidence. Regressions run on historical data fail to take into account the myriad and important distinctions between today’s economy and the economy that existed during the previous oil price run.

If consumer confidence continues to be firm and interest rates remain low, there is reason to be cautiously optimistic that the U.S. can avoid falling into another oil price induced recession, which is good news. The bad news is that as prices continue to rise, we inch ever closer to the venomous stinger.

The question is, will your supply chain gain or lose competitive advantage as prices inch up? And will you be nimble enough to dodge the scorpion’s tail when she strikes?


About the Author

Derik Andreoli
Derik Andreoli, Ph.D.c. is the Senior Analyst at Mercator International, LLC. He welcomes any comments or questions, and can be contacted at [email protected]

Subscribe to Logistics Management Magazine!

Subscribe today. It's FREE!
Get timely insider information that you can use to better manage your entire logistics operation.
Start your FREE subscription today!

Latest Whitepaper
Finding Agility in your Workforce: Are you prepared to meet the next market shift?
Logistics companies need every advantage available to them to be a vendor of choice and remain competitive
Download Today!
From the April 2017 Issue
Our “33rd Annual Salary Survey” reflects more diversity entering the logistics management market, and in marked contrast to 2016, paints a rosier outlook for career placement and advancement.
Is Your Tractor Trailer Yard a Black Hole?
Information Management: Wearables come in for a refit
View More From this Issue
Subscribe to Our Email Newsletter
Sign up today to receive our FREE, weekly email newsletter!
Latest Webcast
Maximize Your LTL Driver Adherence with Real-time Feedback
This webinar shows how companies are using real-time performance data to optimize the scheduling of their city fleets, as well as the routing of their standard, accelerated and time-critical shipments.
Register Today!
EDITORS' PICKS
2017 Salary Survey: Fresh Voices Express Optimism
Our “33rd Annual Salary Survey” reflects more diversity entering the logistics management...
LM Exclusive: Major Modes Join E-commerce Mix
While last mile carriers receive much of the attention, the traditional modal heavyweights are in...

ASEAN Logistics: Building Collectively
While most of the world withdraws inward, Southeast Asia is practicing effective cooperation between...
2017 Rate Outlook: Will the pieces fall into place?
Trade and transport analysts see a turnaround in last year’s negative market outlook, but as...