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to save money if it is perceived that prices will rise faster than any proceeds that could be had from the use of the withdrawn currency.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, just take a look:
- First off, while current indicators do point toward higher crude oil prices in 2013, 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 U.S. 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.
This oil prices analysis was originally delivered to subscribers of Dr. Kent Moors' Oil & Energy Investor. For Moors' take on the energy sector's biggest price and investment moves, and his free bi-weekly energy investment analysis, just go here.
About the Author
Dr. Kent Moors is an internationally recognized expert in oil and natural gas policy, risk assessment, and emerging market economic development. He serves as an advisor to many U.S. governors and foreign governments. Kent details his latest global travels in his free Oil & Energy Investor e-letter. He makes specific investment recommendations in his newsletter, the Energy Advantage. For more active investors, he issues shorter-term trades in his Energy Inner Circle.