by Edward Harrison
Brent Crude is still trading above $98 a barrel. And agricultural commodities remain at extremely elevated levels. World food prices are at all-time highs. The worry is inflation in consumer prices that is not matched by increases in wages. Everywhere you turn, you read about food price inflation: in Brazil, China, Tunisia, Algeria, you name it.
This morning, Andy Lees of UBS wrote:
Today’s WSJ says there is a growing fear that the rioting in Tunisia over food prices along with high unemployment could spread across the Arab world where unemployment is extremely high. Reuters reports today that Sudan (produce 490,000bpd) is having rioting over price rises and proposed cuts in petrol and sugar subsidies. Iran (special case) has seen gasoline go up from 1000 rials a litre to 4000 for 50 litres a month and 7000 for larger volumes. Iranian flour prices went up on December 19th 40 fold (slightly less for some people). Rapidly rising food and energy prices are starting to affect the energy producers themselves, potentially removing further supply from the export market.
I’m not sure exactly what Andy means here but he could be saying one of two things. Either you’re not going to export beef when you can make money domestically due to the soaring price, or government is going to step in and restrict exports because they want to feed their people first before exporting abroad. Given the experience with food price inflation in 2008, I pick the latter interpretation.
But then what about so-called peak resources i.e. the idea that demand growth in emerging markets is straining resource production? Oil goes into everything, not just gasoline or distillate consumption but for the production of Christmas trees, plastic baby bottles, and, most importantly, food. Since oil demand is inelastic, peak resources would put us into the parabolic part of the supply-demand curve. And production is simply not increasing. In many parts of the world, it is declining. And that invariably means export hoarding by resource producers when domestic consumers are hit by these rising prices.
Andy writes:
Yesterday Reuters ran an article highlighting that Russian oil output growth would slow this year to 1.1% down from 2.2% last year and 4.5% pa over the last 10 years – (Russia had accounted for nearly 60% of world growth in oil production since 1999). 44% of government revenues come from the oil industry and it is strangling it. Even the Energy Minister Sergei Shmatko said that unless Russia changes its tax policy, production could fall by 20% to 8mbpd (he didn’t give a time scale). He said tax policy has to change from tax breaks for Greenfield sites to supporting the older fields in West Siberia which are already in decline but where the fall will accelerate without greater investment – (Remember in Soviet times oil production halved in the late 1980’s due effectively to underinvestment, which was only brought back after the Russian debt default resulted in domestic wages falling about 90% and therefore making it competitive once again). He said the government needs to cut tax revenues from 73% of revenues to 65% to encourage investment. Putin said Russia will have to gradually shift to taxing super profits rather than revenue.
In Saudi Arabia the 5 year USD400bn plan announced in 2008 raised the breakeven level from USD40bbl to USD74bbl according to the Centre for Global Energy Studies. In 2009 Saudi Arabia overspent posting a budget deficit of 6.2% GDP. In October last year Saudi’s finance minister said public expenditure would be higher than had been budgeted for although he said it was too early to say whether there would be another deficit. "The higher spending does not seem to be moderating and 2011 will be characterised by another expansionary budget" according to Banque Saudi Fransi. Despite its wealth Saudi Arabia is facing rising unemployment of its citizens and is spending on projects to create jobs. Last year The Oil Drum reported that the Haradh III project which came on stream in 2006 producing 300,000bpd had already seem well productivity fall by 60%.
Overall OPEC’s production rose by 2.5m bpd since 2000 but domestic consumption meant exports were flat. The cost of production is clearly soaring , but what also appears to be happening is that the social transfer cost is also rising rapidly as the government uses the revenues to maintain public order. Unfortunately, judging by what Russia is saying there isn’t enough left over to invest in maintaining or growing production. Like the West these energy producing countries are faced with the question of allocating capital productively so as to maximise oil output or socially to avoid political turmoil. Perhaps the best example is Venezuela where production has fallen 25% since 2000, with exports down 34%.
Oil price is being squeezed by declining economics of production (declining EROIE) and rising demand in the developing economies which itself is really driven by the declining eroie (energy extraction is becoming more resource intensive to extract etc and so more demand from other resource producers) and now social pressures in the oil producers themselves. Certain food producers are also starting to take supply off the international market to meet domestic needs. Oil prices are clearly going higher. The only question is just how quickly the marginal buyer is priced out; whether it is priced out smoothly with the rising oil, or whether the demand destruction cumulates into one big hit as it did in 2008.
What does that mean for investors? In my 2011 forecast, I said that rising commodity prices are capped because of demand destruction. But, experience in every single global slowdown in the last 40 years shows that the demand destruction causes GDP growth to slow. Andy thinks the Fed is aware of this potential hiccup and poised to react accordingly. He writes:
I still think that with Bernanke’s QE programme it is too soon too be shorting the banks or airlines – (he will accelerate his asset purchase programme if there is any demand destruction), but I think we have to have some exposure to this so would just stick to the long oil calls we talked about a few days ago; Dec 2012 100 calls last traded at 10.71 and the Dec 2012 110 calls 6.93.
I think we are mid-cycle right now frankly. So, it doesn’t seem like an opportune time to get massively short, if you asked me. Look at what’s happening in the tech space. Yesterday, Fred Wilson wrote to his venture-capital blog readers:
If you need the money, then raise it now. I have not seen a better time to raise money for web startups since the late 90s.
That’s not the kind of environment that characterizes early cycle environments, more mid or late cycle economic environments (late enough to short?). We’re talking the beginning of irrational exuberance here – not just in tech, but in commodities and emerging markets too.
Bottom line: the inflation everyone has been talking about is coming. Will it feed through into other consumer prices given the high margins businesses in the US now enjoy? Hopefully not for consumers. But if not, that will have a negative effect on earnings growth but not negative enough to stop the rally in shares if job growth/demand picks up fast enough. Nevertheless, with unemployment still high in the developed economies, I doubt any of this will be offset by concomitant increases in income.