Consumer Prices Ride the Energy Elevator—High and Going Higher
Markets delivered another active and impactful week on Wall Street. While the Dow Jones Industrial Average led the declines with a 1.9% drop, all major indexes finished the week firmly in the red. Gold prices broke above $1,900 intraweek as the entire precious metals complex rallied. For crude oil and 2-year Treasury yields, the blistering pace of their rallies finally stalled. In fact, both crude and 2-yr yields closed lower for the first week out of the last nine. Commodities were mostly higher, and materials were the best performing sector. While geopolitical tensions between Russia and the Ukraine dominated headlines throughout the week, markets appeared to be focused elsewhere—digesting instead the magnitude of recent developments regarding inflation and central bank policy initiatives.
Two weeks ago, the market news was dominated by the Consumer Price Index (CPI) after it unleashed its 7.5% headline stunner. This week the January Producer Price Index (PPI) testified to the extent of surging prices in our early 2022 economy. While the PPI frequently receives much less media fanfare than CPI, the truth is that PPI may be even more significant. Where producer prices go, consumer prices follow. In the sequence of business, it is the company that initially bears the brunt of price inflation. Later, the consumer kindly reimburses the company.
On Tuesday, the US Bureau of Labor Statistics released January PPI results. Headline PPI increased at double the rate analysts expected as prices gained 1% in January. The 1% monthly increase was tied for the second highest monthly price spike in PPI history, and marks a re-acceleration of prices increases from December’s 0.4% gain. Service sector prices increased by 0.7%, while prices in the goods sector gained by 1.3%. For the year, headline PPI is now running at a scorching 9.7%.
On a year-over-year basis, headline PPI is now just a tick shy of all-time highs. It’s the latest signal that price inflation is likely to persist at higher levels than hoped, and that serious price pressures will remain entrenched for longer than many expected.
Energy prices can be an explosive contributor to an inflationary environment. Virtually every producer, every consumer, and every sector is impacted by high energy prices. What we are witnessing since the world emerged from Covid lockdowns is a brewing global energy crisis, complete with a crushing surge in prices. In 2021, the price of traditional sources of energy across the board, from the uranium used in nuclear power to natural gas, gasoline, heating oil, ethanol, crude oil, and coal all surged by anywhere from over 40% to well over 100%. To provide some perspective on surging prices, consider that West Texas Intermediate Crude Oil (WTI) is up well over 1,350% from the April 2020 Covid lows to recent highs. The Covid shock distorted all markets, and none more so than the oil market. That said, however, measuring WTI price increases from the average levels seen in 2019 still underscores the extent of energy price increases. From 2019’s average pre-pandemic era prices, WTI has since surged by over 70%.
At the height of the global pandemic, oil demand virtually evaporated overnight. In response, oil producers aggressively pulled the emergency brake on production to dramatically reduce supply. Subsequently, domestic and global monetary and fiscal policy over-stimulated the restart of the world economy. The coordinated global liquidity injection was the equivalent of giving a pint-sized adrenaline shot to a baby. As a result, since 2021, oil demand has come surging back at levels outstripping the pace of production increases.
With these dynamics in place for over a year, inventories have been drawn tight globally. Just this week, the US Department of Energy reported a significantly larger than expected 12.6 million barrel (mb) drawdown in oil and oil products. At the same time, US EIA inventories reported another in a string of drawdowns, and at Cushing, Oklahoma, a draw of 1.9mb brings their inventory down to critically low levels. US production was flat on the week, maintaining a rate of 11.6mb per day versus the pre-pandemic level of 13mb per day in February 2020.
Globally, the Energy Information Administration (EIA) has raised their demand estimates and now expects global oil demand to exceed pre-pandemic levels ahead of their previous schedule by reaching 99.7mb per day this year. In recent comments made in January, Saudi Aramco CEO Amin Al Nasser agreed with the accelerated IAE demand assessment and said he thinks we are nearly already there on demand. During the fourth quarter of 2021, the IEA said global demand “defied expectations” rising by 1.1mb per day. The increase was an upward revision of 345,000 barrels per day compared to its previous forecast.
The IAE has said that the data suggests “2022 is starting off with global oil inventories well below pre-pandemic levels.” At the same time, the IAE and Bloomberg both lowered OPEC capacity estimates for 2022 by 0.8mb per day and 1.2mb per day respectively. The IAE went on to say that “If demand continues to grow strongly or supply disappoints, the low level of stocks and shrinking spare capacity mean that oil markets could be in for another volatile year in 2022.”
To translate, their supply and demand model forecasts are all built tenuously on assumptions. Their assumptions for relatively subdued demand, higher production, adequate inventories, and plenty of spare capacity haven’t been panning out. In fact, these assumptions haven’t been panning out for over a year, and now that trend is continuing and in some cases accelerating. The IAE has been as wrong on oil as the Fed has been on inflation. When the IAE warns of the possibility of “another volatile” year in oil prices in 2022, that’s not downside volatility they’re talking about. Meanwhile, Wall Street banks have been well ahead of the curve over the various “energy agencies” as better than $100 per barrel oil has steadily become “Street” consensus since the second half of 2021.
So, why all the fuss over oil and energy prices? The major concern is that we already have exceptionally high levels of inflation. Without a dramatic assist from significantly lower energy prices, inflation is extremely unlikely to break.
Expensive energy, in large part, translates directly to expensive prices for just about everything else. The higher prices individuals pay at the pump are just the tip of the iceberg when considering the broad and unavoidable economy-wide impact of high energy prices. To start, energy is a vital primary input cost for the production of consumer products. In a very significant second-round effect, energy is also a crucial cost component for the transportation of those products from the factory to the store shelf, whether the route be by land, sea, or air.
Items on grocery store shelves are also similarly affected. In the nitrogen fertilizer industry, energy feedstock accounts for 70-80% of ammonia production costs. In the phosphate fertilizer sector, production costs are also heavily influenced by ammonia, as well as sulfur—which is a byproduct of oil and gas production. Like other consumer products in our age of industrial scale and global supply chains, food prices also take a double hit. After the agricultural product prices reflect the high cost of fertilizers, food products must also be transported to their final destination. Finally, many energy-intensive products (especially lower-margin goods), can become unprofitable at higher energy prices. In many instances this initially results in production cuts. Declining production then leads to tighter supply and shortages. These have the initial impact of further escalating prices for the increasingly scarce product.
All in all, high energy prices are a tremendous strain that ripples throughout the entire economy. High energy prices affect the prices paid to stay warm in winter, cool in summer, the prices for all the products you need, for all the food you eat, and the price to travel beyond walking distances.
The struggle over high energy prices and inflation is currently on display in China. In the face of a problematic surge in coal prices, the Chinese government seems to have settled upon a questionable solution certain to dramatically exacerbate the problem over time. The policy path China seems to be taking is in response to a very similar dynamic to that facing the US Federal Reserve presently—namely, an attempt to pull off the ultimate needle thread by killing off inflation without landing a mortal blow to the economy. Faced with the crisis of surging energy prices, China’s top “planning” agency, the National Development and Reform Commission, two weeks ago asked the nation’s major coal miners, presumably nicely, to reduce prices. Beijing then offered suggested price caps, and, not so nicely, threatened to punish “hoarders and price manipulators.” While I don’t speak the official state language, “hoarders and price manipulators” almost certainly means anyone freely trading above the cap.
This week, several major Chinese providers of coal market data halted their price indexes in response to increasing pressure from Beijing. According to Bloomberg, independent data provider Fenwei Energy Information Services suspended indexes for multiple thermal coal grade prices, as well as the most widely tracked coal benchmark. According to a company statement, the company plans to resume reporting when prices “return to normal.” Yimei, another independent data provider, also halted price reporting “until further notice.” Yimei said they were having trouble establishing reliable trading data and tracking spot transactions. They said the suspension is therefore intended to “avoid misleading market players.”
The entire globe is dealing with the strain of inflation and the force multiplier that is surging energy prices. The story out of China, however, is timely and disturbingly relevant here in the US. Just this week, there was chatter within US “free-market” political circles about the possibility of easing consumer price pressures by implementing price controls and even temporarily suspending the gas tax. Just as in China, these types of proposed “remedies” won’t work in the long run, and would only make matters worse. They would not harness the free price system to incentivize increased production and supply. As a result, they would not let the free market process operate sufficiently to naturally reduce price. In response to talk of a gas tax holiday, former Treasury Secretary Larry Summers told Bloomberg, “I think we are plumbing the depths of new bad ideas with that one.” Furthermore Summers went on to call price controls a “grave error” that would be a “disaster” and prescription for shortages.
So, with a full-fledged wage-price spiral already initiated and energy prices acting as the ultimate inflation force multiplier, aside from a Chinese style “solution,” what is the Federal Reserve to do? This week, respected Credit Suisse analyst and former New York Federal Reserve market liquidity specialist Zoltan Poszar tried to offer answers to that crucial question. Poszar’s view shares the same basic premise as several other notable analysts, including Bank of America’s Michael Hartnett.
What Poszar, Hartnett, and others agree on is that the Fed can’t slay inflation on Main Street without inducing deflation on Wall Street. In a note released late Thursday that unnerved markets, Poszar suggested that the Fed needs to do what is necessary to knock down the price of risk assets. Specifically, he focused in on the idea that the Fed harness volatility as a weapon. He said, “Volatility is the best policeman of risk appetite and risk assets.” He suggested the Fed “put volatility in its service to engineer a correction in house prices and risk assets—equities, credit, and Bitcoin too.” Poszar’s theory is essentially that if the Fed deflates the bubble in these risk asset categories, it will send people back into the labor force and introduce enough new labor supply to ease the historically tight labor market and subdue the wage-price spiral. Mr. Poszar’s efforts to tackle inflation without mortally wounding the economy are extremely appreciated. However, it seems very likely that his plan would unleash a downdraft into the economy, ultimately culminating in recession.
Poszar, in his curious note, goes on to say that “Maybe the Fed should hike 50 bps in March, put an end to press conferences, and sell $50 billion of 10-year notes the next day… Maybe FOMC members talk too much. They don’t keep the market guessing. They suppress volatility.” Now here, Poszar appears to be elaborating on the sentiments expressed last week from Fed governor Bullard when the latter very unexpectedly floated the idea of a surprise intra-meeting rate hike.
For over a decade the Fed has gone to great lengths to telegraph its intentions and meticulously craft deliberate messaging to the market. If at this point, however, market “shock therapy” is the best capable minds can come up with for how the Fed can save the day, that’s a problem. This kind of problem solving appears to have a bit more than just a hint of desperation.
While they share the same premise, BofA’s Michael Hartnett sees a far different progression of events. Hartnett sees the Fed tightening policy into a late cycle slowdown. In his view, events in motion quickly culminate in a second half of 2022 recession. While Hartnett’s thesis is far from Wall Street consensus, and his timetable may be aggressive, his ultimate conclusion is entirely reasonable.
Additionally, the strong breakout rally recently in the gold market that sent the yellow metal above $1,900 this week may corroborate Michael Hartnett’s position. Typically, gold prices have a strong negative correlation with rising real interest rates. It is this typically strong negative correlation that is primarily responsible for the widely held view that a hawkish Federal Reserve raising interest rates is negative for gold prices. In fact, as Goldman Sachs pointed out just a week ago when they raised their 12-month gold price forecast to $2,150, gold’s negative correlation with rising real interest rates breaks down during a Fed tightening cycle. As Goldman argues, this is because as the Fed hikes interest rates, market fears over slowing economic growth and imminent recession significantly increase and take precedence over any concerns over real rates. Currently, gold may be among the loudest canaries in the coal mine.
Weekly performance: The S&P 500 was down this week by 1.58%. Gold was up 3.13%, silver gained 2.65%, platinum was up 5.70%, and palladium jumped 6.58% on the week. The HUI gold miners index was up by 6.51%. The IFRA iShares US Infrastructure ETF gained 0.36% for the week. Energy commodities were mixed. WTI crude oil was off 3.10% and continues to chop about in the low $90s price range, while natural gas surged 11.14% on the week. The CRB Commodity Index was nearly unchanged, up 0.80%, while copper gained 0.31%. The Dow Jones US Specialty Real Estate Investment Trust Index was down 2.10% on the week, while the Vanguard Utilities ETF (VPU) was lower by 1.14%. The dollar was down slightly by 0.05% to close the week at 96.02. Despite another week of significant volatility, the yield on the 10-year Treasury ended the week unchanged at 1.92%.
Have a great long weekend!
Chief Executive Officer