Are Oil Price Hikes About to Set Off an Inflationary Spiral?

by | published July 16th, 2013

There is a long-held belief that significant increases in oil prices are harbingers of building inflationary pressures.

It follows from the observation that a market able to absorb more expensive oil is also one where prices are rising elsewhere.

And for those who remember their “Intro to Economics,” there is an additional element.

Recall that the two primary factors that cause inflation are the amount of currency in circulation and the velocity with which that currency is changing hands.

In the case of the former, the relationship between oil prices and inflation obliges us to apply a somewhat broader view of what makes an underlying “marker asset.”

After all, the actual price of wet barrels (traded consignments of actual crude or the products made from it) is driven by the price of paper barrels these days (the futures contracts on those deliveries).

Since there are many more paper barrels than wet barrels, it is the perception of traders on the future price of oil that drives this market not what a delivery costs this morning.

Which leads us to inflation’s other component: the velocity of money…

Oil Prices and the Velocity of Money

Let’s make this one simple. The velocity of money increases in an environment where participants believe prices will be rising. In this environment, money tends to change hands more quickly causing prices to go higher.

In short, there is less reason to save money if it is perceived that prices will rise faster than any proceeds that could be had from the use of the withdrawn currency. Read here: “The rise in staple product prices will exceed the savings rate.”

When it comes to a commodity as energy, so fundamental to economic activity, an increase in velocity will translate into a classic inflationary spiral.

Or at least this is the traditional argument.

Of course, it goes without saying that a pronounced and prolonged price explosion such as the one we experienced five years ago certainly would carry significant inflationary consequences.

At the peak in 2008, price levels did climb as oil rose to an intraday high of $147.92 a barrel and natural gas was pushed $13 per 1,000 cubic feet or million BTUs (the NYMEX futures contract for gas).

Yet the situation we have this time around carries very different dynamics indeed.

First off, while current indicators do point toward higher crude oil prices, they are not to the extent we witnessed in 2008. We are seeing pricing increases – West Texas Intermediate (WTI), the benchmark crude rate on the NYMEX, is up almost 23% in less than three months.

But on the other hand, natural gas is trading at less than $3.70. And despite it being almost a 100% improvement from the lows of early 2012, is not going to be exacting the same upward pressure on the energy sector as a whole.

Second, the bond market is not contributing to an inflationary impulse the same way it did five years ago.

And last, while the American economy is improving, it has been a very sluggish recovery so far with unemployment remaining higher than in a normal upturn, industrial productivity still showing signs of weakness, and a weaker dollar than in years past.

True, the U.S. situation is still preferable to the contraction underway in Western Europe. Then again, the primary global energy demand is still seen as coming primarily from China. It’s actually in China where the inflationary impact is most likely to initially emerge.

Oil Prices as the New “Gold Standard”

With the rise in crude oil as a parallel for gold in registering the storing of market value, and that crude still denominated in dollars, the opportunity for asset valuations moving into oil as a surrogate is intensifying.

In fact, until the plunge in gold is over, this movement is not going to reverse.

Even then, the more fundamental importance of oil as a barometer of genuine market activity will likely restrain a quick return to gold as a primary offset for either economic downturns or inflation.

In my judgment, all of this means the following…

At some point, given the reluctance of the Fed to abandon Quantitative Easing (QE) and the concern expressed by the investment markets that such an end is coming anytime soon, inflation will emerge.

Yet the end of QE is likely to be later rather than sooner.

In the interim, oil has the leverage to expand in price without providing the usually associated open door to inflationary pressures.

That is good for us. After all, we are investing in energy and oil remains the primary driver of that sector.

Any prospect for increased raw material prices that are not inflationary means the rising tide will lift more boats – producers, processors, transporters, service providers, distributors – before the increase in prices begins to serve as a break on profitability.

And that translates into better returns on our energy investments.

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  1. Marius
    July 18th, 2013 at 00:24 | #1

    Hard to argue with your analyssis, but somehow, some things don’t match.Seems in June, by official data, personal consumption grew less than half of estimates; and actually, if you take off car sales and gasoline consumption,it shrinked! That means velocity of money is going down.
    The suply side of shale oil and nat gas inched upside. Still the price of WTI went from around 90$ to over 100$. A 15% increase, despite oversuply.So did the gasoline prices, with a move upwards of 12% only in the last week.
    As long as you think the can of beans you find on the grocery store shelf, appears there by magic and doesn’t need anny transportation,your analysis stands up! Otherwise, try to cope with real world and real inflation!

  2. Dale
    July 23rd, 2013 at 13:21 | #2

    It is the kind of inflation that Marius speaks of that will once again break the camels back. Most everyone capable of investing is able to withstand a few extra bucks for the drive to the office and that smaller and smaller $12 container of coffee, but more than 80% of Americans have to start making significant choices when gasoline hits just $3.75 a gallon. At $4.50 a gallon the choices are critical and it won’t take as much to break the camels back this time around.

  3. george pappa
    August 1st, 2013 at 09:56 | #3

    As the original grass-roots speaker of what became part of the “closing the enron loophole” bill back in 2005, part of what I said, is once oil gets into a high trading range, it will be the norm. With the ease of trading paper contracts for oil, it makes it easy for all other commodities to follow suit, spirlling inflation, and the cost of living. Every year in early spring, we have a promise of an economic recovery, but when oil hits $100.00 a barrel, and gasoline goes to $4.00 plus a gallon, it pulls the rug out from under that hope. Inflation has hit the drillers, refiners, and even the Sauidis. No matter what the supply of oil we have, traders will manipulate it on paper. It seems to me, that evey year, another mid east country has an out break of unrest, and it gets into the news, and the price of oil goes up more than normal. This year it was Egypt, now Egypt does not produce any oil at all. It’s simply a game that their government plays with people’s lives, to get the price of oil up. On another front, what does Gina McCarthy, the head of the federal EPA know about the economy. The reason why I’m saying that is, because she is trying to block the XL pipeline project, with air quality jargon. Our economy will never grow without affordable oil. This whole alternitive energy thing, with wind, and solar is only twenty percent efficient at best. What has killed people in this country primarily is the food we ate, and smoking cirgaretes. Yes, the U.S. has made great strides in cleaning up the air quality, and with cars, and trucks getting better mileage, that in itself will help get even cleaner air quality. Do you feel that we’re being played by a “stacked deck”.

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