Andreoli on Oil and Fuel: Why are oil and fuel prices still high?

Many believe that high or rapidly rising oil prices cause recessions; but in turn, during a recession, industrial production and demand for transportation decline. Consequently, the price for oil and fuel falls, and as it declines, the economy is stimulated.

Derik Andreoli, Ph.D.c. is the Senior Analyst at Mercator International, LLC.

By Derik Andreoli
October 01, 2011 - LM Editorial

There is an enticing line of argument employed by some economists and analysts that is loosely based on the predator-prey model, one of the earliest models in mathematical ecology.
From an ecological perspective, the populations of predators and prey affect one another.

For instance, as a population of lynx expands, the population of hares upon which they feast, contracts. But as the population of hares recedes, the carrying capacity for lynx is reduced, and the population of lynx falls into decline. Of course as the population of their primary predator declines, the number of hares rapidly expands, and so on. Visually, we might imagine a graph of the two populations as two sine waves, one lagging the other.

Similarly, many believe that high or rapidly rising oil prices cause recessions; but in turn, during a recession, industrial production and demand for transportation decline. Consequently, the price for oil and fuel falls, and as it declines, the economy is stimulated.

This makes sense because to a large degree dollars not poured into our gas tanks are used to make other purchases or investments that have a greater stimulatory effect on the economy. In this adapted model, rising oil prices are the lynx that menace the helpless economy.

The fact that oil price spikes preceded all but one of the seven post-1970 U.S. recessions certainly lends prima facie support for the predator-prey model, but correlation does not prove causation and the economy is clearly affected by more than just the price of oil.

According to the research of a pair of university economists and a member of the Federal Reserve Board, however, the rate of unemployment can be accurately predicted using just two inputs: oil prices and real interest rates. To be clear, their model passes the Granger causality test, hence the researchers can state beyond a statistical shadow of doubt that an oil price or interest rate movement in period one causes a movement in the unemployment rate in period two.

This discussion of the predator-prey model begs important questions, not the least of which include: “Are we headed back into recession?” “And, with the economy sputtering, why are oil and fuel prices so high?”

Regarding the former, evidence is certainly mounting that the U.S. is on the cusp of a double dip, if not already sliding into recession. The unemployment rate remains over 9 percent, with 14.8 million unemployed and another 11.6 million discouraged or underemployed. The four-week average for unemployment benefit requests was up for the fourth straight week (as of September 15), and the poverty rate has ascended to a level not reached in more than 50 years. 

On the housing front, foreclosures jumped 33 percent between July and August—the biggest single month jump in four years.

Given the state of the job and housing markets, it should come as no surprise that in August consumer confidence dropped a staggering 14.7 points and CEO confidence retreated 12 points.

Then there is my favorite leading indicator, the Ceridian-UCLA Pulse of Commerce Index (PCI), which is a measure of fuel consumed by truckers purchasing diesel from cardlock facilities. The seasonally and workday adjusted PCI fell 1.4 points in August after declining 0.2 points in July, indicating that fewer goods were in transit for two consecutive months. Needless to say, this decline does not inspire warm and fuzzy feelings about U.S. economic prospects.

That’s a lot of bad news, but to prove that I’m not a pessimist, I’ll share the Ceridian interpretation, which urges caution to those who might interpret the decline in the PCI as a harbinger of recession. In the September report, the Ceridian folks said that “we experienced similarly sluggish PCI and GDP growth in the aftermath of the 2001 recession.  During that time, the economy didn’t really get moving until a wave of new home ownership rose. Best therefore to consider a slow-growth alternative to a recession—stumbling forward, waiting to get the energy to run again, but not falling down.”

I find this quote particularly compelling because it points out that the economy did not recover from the last oil-price-spike-led recession until the housing bubble had grown well beyond the “froth” stage. Hopefully, this time around we can build a recovery on a more solid foundation; however, without a dramatic improvement in consumer confidence it is hard to imagine where the demand for goods and services is going to come from.

In the past, the government could goose the economy by “spending against the wind” (and building reserves through taxation during periods of expansion). Unfortunately, the government is now hamstrung by concerns over federal debt.

Going back to the Ceridian quote, I appreciate the insight contained in what must be an accidental choice of words. If there really is something to the predator-prey model, and there clearly is, we are quite literally “waiting to get the energy” for a full recovery. Unfortunately, on the supply side of the energy equation, tensions in the Middle East/North Africa (MENA) region remain extremely high, and the resumption of the flow of light sweet crude from Libya and the U.S. Gulf of Mexico remains a long way off.

From the demand side, China’s growth rate remains near double digits (though it is showing signs of weakness), and India’s growth rate hovers around 8 percent. Ergo, any marginal declines in consumption here won’t have much of an impact on prices given growing demand in emerging markets.

In short, it’s difficult to imagine where the energy for a full recovery is going to come from.

Light sweet crude from the Bakken formation in North Dakota is certainly growing robustly, but U.S. exports of gasoline and distillate have surged.

On the natural gas front, while the shale gas revolution is still going strong, there’s reason to question the sustainability of low prices. Along these lines, the U.S. Geological Survey (USGS) recently revised their estimate of the total shale gas resource, cutting the initial estimate by 80 percent—a fact that won’t come as a surprise to those shippers who read my shale gas column.

Of course, this downward revision is not the first of its kind. In October 2010, the USGS reduced its estimate of undiscovered crude in the National Petroleum Reserve-Alaska (the NPR-A, not to be confused with ANWR) by a whopping 9.7 billion barrels, a 90 percent downgrade. To put this downgrade into perspective, 9.7 billion barrels is the equivalent of 70 years of production from the Bakken at current rates.

Resource downgrades and credit downgrades certainly don’t instill confidence in those of us who understand that a healthy economy requires the efficient movement of goods, people, and capital.

Looking forward, the U.S. economy is clearly not out of the weeds, a fact that makes it difficult for supply chain managers to keep their eyes on the road. We know there’s a turn up ahead, but it’s still difficult to see whether the road is going to take us to recovery and even higher fuel prices, or stagnation/recession with high fuel prices.

The wise logistics and supply chain manager will have thought these options through and developed strategies for both.

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 .(JavaScript must be enabled to view this email address).

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