There’s been a lot of excitement in the past year over the rise of North American oil production and the promise of increased oil production across the whole of the Americas in the years to come. National security experts and other geo-political observers have waxed poetic at the thought of this emerging, hemispheric strength in energy supply.

What’s less discussed, however, is the negligible effect this supply swing is having on lowering the price of oil, due to the fact that, combined with OPEC production, aggregate global production remains mostly flat.

But there’s another component to this new belief in the changing global landscape for oil: the dawning awareness that OPEC’s power has finally gone into decline. You can read the celebration of OPEC’s waning in power in practically every publication from Foreign Policy to various political blogs and op-eds. David Ignatius of the Washington Post wrapped up nearly all of the recent claims in a nice bundle in his May 4, 2012 piece, An Economic Boom Ahead?, when he quoted PFC Energy’s David West:

“This is the energy equivalent of the Berlin Wall coming down,” contends West. “Just as the trauma of the Cold War ended in Berlin, so the trauma of the 1973 oil embargo is ending now.” The geopolitical implications of this change are striking: “We will no longer rely on the Middle East, or compete with such nations as China or India for resources.”

(Source)

While it’s true that the Americas hold great promise to convert natural gas resources to higher production levels, that is not the case with oil. The celebration of a geo-political swing in energy power therefore misses a crucial point: No region — from OPEC to Non-OPEC, from Africa to Russia — has the single-handed ability to lower the price of oil now, because none can bring on new supply quickly enough for a long-enough sustained period of time.

And there is more to this story than meets the eye.

History of OPEC

For over 30 years, OPEC has produced less than half of the world’s oil. Indeed, as of today, OPEC produces only a little more than 40% of the world’s oil. But most of the world’s spare capacity has been held by Gulf State producers. Thus OPEC, primarily Saudi Arabia, has long been able to control the price of oil in not one, but two, directions. Historically this has meant that the concentration of oil pricing power resided with OPEC and its largest producer, Saudi Arabia.

But starting in 2005, global oil markets sensed that OPEC was only able to influence the price of oil in one direction: higher, by lowering output. OPEC’s ability to lower prices started to crack, break up, and generally fail as the first phase of oil’s repricing headed into 2008. Indeed, OPEC raised production several times in the 2004-2008 period, attempting to restrain oil prices as it moved to protect the global economy from an oil shock. However, the oil market, which was going through a fundamental transition at the time, as it reoriented itself towards insatiable, price-insensitive demand from Asia — paid little attention.

Instead, supply disruptions at small producers and in small regions had a greater influence on oil price (pushing it higher) than OPEC’s influence on attempting to push the price lower.

It’s actually not clear that OPEC has had any measurable influence on restraining oil prices for years. Summer hurricanes in the Gulf of Mexico, unrest and outages in the Niger Delta, and various strikes presented greater upward pressure on oil prices than upward OPEC supply changes.

The Mythology of OPEC

There is a trailing cultural myth, therefore, (which is nothing more than a hangover from 30 years ago), that OPEC can mount swift, price-killing upsurges of production. But as the below chart shows, OPEC production has made no progress in at all in the seven years since 2005, as oil began its price transition.

As oil rose above $50 in 2005, eventually reaching $90 in 2007, and then on to levels above $140 in 2008, OPEC production both rose and fell, but without any reliable correlation to price. In the aftermath of 2008, OPEC production has correlated better with the recovery in oil prices. But again, the rise in OPEC production has only come back towards the previous highs from last decade. Here is a recent news story rather breathlessly discussing the most recent OPEC production levels this year:

Acting to mitigate market nervousness amid Iran supply fears, OPEC on Thursday said it was pumping more oil than the market needs—at levels not seen since summer 2008—and expressed a cautiously optimistic note on demand. The cautious optimism, combined with a production boost sufficient to cover all of Iran’s oil exports, is likely to further stabilize oil markets, where volatility by some measures has already smoothed in recent weeks. In its latest monthly market report, the Organization of Petroleum Exporting Countries said its crude production was 32.42 million barrels a day in March, up 317,000 barrels a day from the previous month.

Yes, but there’s a neglected point to make: these production levels are not special. Not meaningful. And are not newsworthy in any sense. Production at/above 32 million barrels a day? That level has been reached at least 4-5 times since 2005, with at best weak correlation to price changes.

Let’s take a closer look at the global share of oil supply, divided in two between non-OPEC and OPEC production.

Non-OPEC vs. OPEC Oil Production

There are several possible conclusions to draw from the above chart, which shows that non-OPEC provided nearly 58% of global crude oil supply in 2011, and OPEC provided 42%.

1. Non-OPEC is the domain of private oil companies, and has managed to increase its market share over the past 30 years through competition and through the use of technology.
2. OPEC’s market share has stagnated, possibly due to the predominance of state-run oil companies and the interference of political structures.
3. Non-OPEC has the pricing power, due to its larger market share.
4. Or perhaps OPEC still retains the pricing power, due to its greater quantity of spare capacity.

There’s an element of truth in each of these observations.

Many also believe that both OPEC and non-OPEC could be producing a lot more oil. In the case of OPEC, many harbor the view that state-run producers and governments are sitting on massive, hidden spare capacity and retaining it as a cartel to manipulate oil prices higher. In the case of non-OPEC, many believe that environmentalists, regulations, and other limits placed by democratically-elected governments are suppressing a wall of supply that could come to market easily if only the oil is ‘set free.’

These views, however, are not only extreme but shaky. They are typical of the kind of grand claims that fit people’s worries and suspicions, rather than fitting any empirical data. The fact is that OPEC spare capacity has been under pressure for some time despite persistent belief to the contrary, with estimates running below 3 mbpd, or even below 2 mbpd. (For recent commentary on OPEC spare capacity, see A Model of Oil Prices by Chris Nelder). The case for hidden, held-back oil capacity in OPEC is weak, especially as domestic populations in the Gulf have dramatically increased the consumption of their own oil.

Meanwhile, non-OPEC large producers like Russia have significantly increased production this past decade. And regions like North America have been able to slow declines. Western oil companies — which dominate non-OPEC production — have scoured the globe looking to replace their reserves, but largely to no avail. This is why ExxonMobil and ConocoPhilips eventually gave up, capitulated, and bought natural gas assets instead. By doing so, they followed in the steps of Royal Dutch Shell, which had taken the natural gas pathway years earlier.

Therefore, a fact about non-OPEC production that was unknown even to the industry ten years ago is now very plain: There just isn’t a vast quantity of new oil that can come online easily and inexpensively outside of OPEC-controlled regions. Only Russia, the largest non-OPEC producer and now the largest single country producer in the world — eclipsing even Saudi Arabia — was able to significantly increase production.

A Window into Non-OPEC Supply: Russia

Two charts will tell us all we need to know about the limits facing non-OPEC crude oil production. First, let’s take a look at total non-OPEC production on an annual basis:

Just as with OPEC production, little if any progress has been made in the past seven years. This has been a complete surprise to most analysts, especially within the industry itself. Who would have thought that with a regime change in oil prices, non-OPEC could not sustainably increase production to much higher levels? Instead, non-OPEC production remains stuck around a ceiling, just like OPEC.

The Big Reveal comes, however, when we take a look at non-OPEC supply without Russia.

Without Russia, non-OPEC supply has actually lost about a million barrels a day of production in the last ten years. This speaks volumes to the quickly-rising costs of bringing on a new barrel of oil in non-OPEC regions, which we will discuss further in Part II of this report.

The Price of Oil When OPEC Is Powerless

Let’s imagine for a moment that OPEC could, if it chose to, pour an extra 3 mbpd of oil on the world market. And that by doing so, it could lower the price of WTIC oil to $90 or less. What would that accomplish? And for how long would such “lower” prices last?

In Part II: The Cruel Math of the Marginal Barrel, we explain that while fluctuations in economic activity can certainly raise and lower the price of oil, there are deeper structural reasons why OPEC — even with its spare capacity — can no longer sustainably “lower” the price of oil. Moreover, we will discuss how, paradoxically, any surge of supply from OPEC which did persuasively lower the price of oil could wind up having the opposite effect on price eventually thereafter.

Surprising? Yes, but not strange or unlikely, for reasons we will explain. Finally, we conclude that oil’s floor price – outside of volatile 30-90 day periods — is higher than ever before. This will make for a large surprise, should another acute phase of the financial crisis rock oil prices lower over a 2-3 month period.

Click here to access Part II of this report (free executive summary; paid enrollment required for full access).

As always, included in the chart is the monthly price of oil for the obvious reason: car dependent Southern California remains uniquely and painfully exposed to oil prices. This cost of living input is a feature, and is embedded, in all aspects of the food stamp program. Mainly, because the household balance sheet of SNAP participants is splayed between food and energy costs. Food stamps partially offset the rising cost of gasoline.

–Gregor

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Once a year the very chic and exclusive TED conference takes place in Southern California, bringing together entrepreneurs, inventors, and thought leaders from every corner of the world.

There, gathered around a stage, a kind of hivemind begins to unfold in which the most cutting edge ideas in healthcare, energy, social development, and behavioral psychology are shared from a very plugged-in, big screen podium. It’s extremely well done.

And despite the reflexive criticism from outside the conference — that the gathering is inward looking and elitist — TED usually does manage to disturb the zeitgeist, a little, with its unveilings in technology and innovation. It is good, plainly so, that next step advances in solar technology, data collection, and developing world health initiatives are explained and broadcasted from TED. Especially given that policy makers, or those who have the ear of policy makers, are also often in attendance.

A better charge to level against the TED conference, however, is that it’s routinely if not unfailingly optimistic.

The 2009 conference, held in the aftermath of the global financial crisis, did not address the unpleasantness of that historic event in any meaningful way. Moreover, very few talks in recent years have addressed energy costs, and especially the price revolution in oil.

In some sense, TED is the techno-innovators’ version of the faith expressed by neo-liberal economics, in which the market solves nearly all of its own problems. The enduring posture at TED, therefore, is one that acknowledges serious world problems, ranging from war to famine, water and food availability, but which nearly always concludes that amazing and ingenious people – geniuses – are working to solve the problem. The Great Man theory of history would find each TED conference a comfortable place to be.

So it was perhaps surprising but also encouraging that the January 2012 TED conference finally addressed the subject of Collapse, by inviting Paul Gilding to give his talk The Earth is Full (opens to video).

I’d actually seen a version of Gilding’s talk at the Ilhahee Lecture Series here in Portland last fall. Gilding’s view is that we’ve reached a relationship between global population and available natural resources, that makes it inevitable that the economy—a converter of natural resources into goods—will sharply slow down, if it has not started to slow down already. Gilding can be thought of not as a neo-Malthusian, or a doomer, but rather as an ecological economist. (As most readers know, I share this same view.) Gilding looks at trailing historical growth rates — again, the rate at which natural resources are converted to industrial and population growth — and concludes that the future size of the economy at these growth rates would create a machine that the earth simply cannot sustain. Again, I agree.

But Gilding’s TED talk was countered, if you will, with a more typical and rousing plea from Peter Diamandis of the X Prize Foundation.

Diamandis, grounded heavily by a personal background in science and medicine, is not naive. His talk, Abundance is Our Future, was a laundry list of fast-moving technological innovations that have transformed poverty rates historically, and which promise to transform quality of life in the years ahead.

One of the most laudable, and humanistic beliefs, advanced by Diamandis is that the 3 billion people remaining to come online to the Internet and telecom networks represents a vast and underutilized supply of human thinking. As a previous educator myself, I find this argument to be powerful.

My quibble with Diamandis and his talk is that the magnitude of the world’s present challenges cannot wait for the array of potential solutions that may start to work at the margins of humanity, even despite his core belief that innovation and its impacts will actually start to speed up. After all, Diamandis is an adherent to technological singularity, the notion that exponential growth in technology will eventually reach a crescendo, thus offering humankind super-solutions at a kind of hyperspeed rate of change. (By the way, I don’t agree with this view.)

Diamandis would go on to further test my ability to follow his arguments, however, when he recently announced a team that will explore the possibility of mineral mining on moving asteroids. I’ve no doubt the public has reacted to this prospect as either impossible, or as another silly story about the grandiose dreams of tech millionaires.

I had a different reaction: why is Diamandis thinking about mineral mining in space, when resources here on Earth — in his view — are so abundant?

Blue Sky (Asteroid) Mining

Although here in America we tend to dumb down complex subjects into simple ‘Either-Or’ arguments, it was useful to hear the Gilding vs Diamandis debate at TED. In addition to their respective presentations, they had an onstage exchange which you can see here, hosted by Chris Anderson.

One of the major default lines between cornucopian technologists like Diamandis, and thinkers like Gilding, is the role that technology plays in the creation and extraction of resources. In ecological-economics, technology helps us extract resources. But, for folks like Diamandis, technology creates resources. It is both a distinction without a difference and also a distinction with a huge difference, depending on your perspective.

And the implications, depending on that difference, for the future price path of commodities, for inflation, for industrial growth are enormous.

Ask yourself the following. For the technologies which allowed for the increased rate of extraction of coal in the 19th century, or,  which now allow for the increased rate of extraction of natural gas from shale in the 21st century: did those technologies create the resources or merely extract them as they already existed? The answer seems rather obvious, doesn’t it? I mean, I want to be sympathetic to the view that technology creates resources, in the sense that technology makes previous unrecognized or unrecoverable resources available. But a threshold I cannot cross, however, is that idea that there are always a new resources waiting to be discovered, if we can only create a technology to obtain them.

Which brings us back to mining for minerals. On asteroids.

Why is Diamandis not pursuing technologies for material upgrading, for example? In material upgrading, the task is to substitute materials once thought inapplicable, for example, to the task of solar manufacturing or electricity transmission. If copper gets too expensive to use for electrical transmission, then some other metal, or combination of metals, or even liquids or gases are used. That’s the theory, anyway.

Why mount energy-intensive missions into space, and run heavy payloads back to earth? Surely the ROI (return on investment) to such efforts would be low, even if the minerals involved commanded a very high price….back on earth.

I think I have one answer to this question, but first, let’s review the business plan, the mission, of Planetary Resources, Inc. From the Los Angeles Times:

A group of 21st-century private space entrepreneurs is expected to unveil an ambitious new venture to mine the surface of near-Earth asteroids in search of precious metals and rare metallic elements. The plan may seem like it was torn from a science fiction novel, and critics say the idea may be far-fetched and difficult for a small company to accomplish. But the company, Planetary Resources Inc., has already drawn an A-list of investors and advisors. The backers include Google Inc. Chief Executive Larry Page and Chairman Eric Schmidt, “Avatar” director James Cameron and Microsoft Corp.’s former chief software architect Charles Simonyi….”Humanity has been driven for thousands of years to explore the Earth for resources,” said Peter H. Diamandis, the company’s co-founder and co-chairman. “The next step is to expand the economic sphere of humanity beyond Earth’s confines.”

You have to wonder: is it possible that the team behind Planetary Resources accepts that many crucial natural resources, necessary for mobile, greentech, and telecom development are–in truth neither replicable, nor substitutable, nor sufficiently recoverable here on our fair and blue planet?

The Abundance Movement

A flowering of new books, heralding a new age of abundance, have recently appeared, including one from Mr Diamandis.

However, it is worth noting this cultural theme comes after a decade in which the production rate of many natural resources, from oil to gold, to more recently copper, did not speed up but instead either slowed or stagnated in the face of quickly rising prices. Crude oil production has been trapped below a ceiling since 2005. Global production of gold actually fell every year of the past decade until the last two years, but is once again stagnating. Copper production managed to rise the past decade. However, ore grades of copper have been declining for a century, and this is why copper has now repriced at much higher levels, closer to $4.00 per pound. Recent data shows also that the rate of growth of global copper production in the last decade slowed significantly, and stagnated also in the past 24 months.

There’s an important distinction to make, therefore, between an Abundance movement that simply posits we’ll have more of everything, at cheaper prices, in the same style as the past, as opposed to an Abundance movement that is tethered to reality, and realizes that large changes in consumption, values, and lifestyle will be needed to create the next phase of “wealth.”

Authors such as Juliet Schor, who wrote Plentitude, are much more reflective of and respectful of limits, and therefore does not dream of the next phase of mineral mining in outer space. Rather, many “new wealth” thinkers have gravitated instead to a less is more pathway, in which a lot of our previous consumption and time-bankruptcy is finally recognized as waste.

Three Crucial Problems with the “More is More” Abundance Movement

Peter Thiel recently debated George Gilder at ISI (you can open the video at YouTube, here). Thiel made a familiar point, which is that the impact of technological progress has become more narrow. I have treated this issue in previous reports, and pointed to some of the data on which this thesis relies, including the stagnation of Total Factor Productivity, for example.

But Thiel goes on to make a second point which is that belief in rapid, even accelerating technological progress is surely going to cause tremendous mis-allocation of capital. And that’s the first crucial problem I see with the cornucopian abundance movement.

Like a financial system that refuses to accept that tightly coupled structures are risky, and that risk itself grows with in tandem with complexity, the cornucopian abundance approach simply won’t take no for an answer. That means instead of focusing on smaller solutions with more immediate effects, grandiose solutions with long timelines are pursued instead.

The second crucial problem is a failure to consider the limit outlined by Paul Gilding, which is that present growth rates of energy consumption, for example, imply an economy that just about everyone can agree is simply too large for the planet to handle. You simply cannot keep growing the size of the human-created heat engine up to the level of a star. This was articulated beautifully by physicist Tom Murphy in his recent and very wide read post Exponential Economist Meets Finite Physicist. When problem solvers entirely avoid the subject of limits it is both appealing, and exciting, but eventually it becomes vaguely pathological.

Finally, there are a number of pressing issues already on the planet, which range from the risk created when food production is outsourced by water-starved populations to other continents, to large regions of the world such as Asia attempting to provide increased electrified transport for billions of people. Leapfrog adoption of mobile telecom, and the rise of social networks will no doubt serve to get these emerging voices out to a world eager to learn, and to help with solutions. But celebrating the success of solutions before they’ve actually arrived, indeed well before they’ve arrived, is no solution at all.

Repricing the Planet: Real World Copper as Opposed to Metals in Space

In Part II: The Looming Dislocation Risks Posed By Resource Scarcity, we dive further into the challenges that accompany the acceleration of technology, which relate to de-industrialization and the displacement of human labor with automation.

Previously in the past century this dynamic gave rise to increased productivity, and wealth. But that may no longer be the case. We are not living in a world where any of our critical natural resources are forecasting a radical upswing in supply. Oil and copper, for example, remain decidedly unconcerned about substitution or miracles from space.

Importantly, we will take a closer look at the red metal (no, not the red planet!), also known as Dr. Copper. What happened to global copper production this past decade as the price rose? And how crucial will copper become, as the world tries to transition away from transport based on liquid BTU?

Click here to access Part II of this report (free executive summary; enrollment required for full access) 

I’ve drawn a red, vertical line in the USDA chart at the year 2003. As you can see, that is the year that the unemployment rate started to fall again after the previous recession, but, that the poverty rate and participation rate in food stamp programs went higher. Why the divergence? The explanation is rather obvious to me. This is the period when energy, especially oil, entered a phase transition to structurally higher prices. It’s also the period that food price inflation, and food price volatility, entered the system. Eventually all series would correlate once again, after the 2008 financial crisis.

There’s certainly no need to post a chart of energy prices here. However, I did find a fresh and up to date chart of food price inflation from a Congressional Budget Service report, Consumers and Food Price Inflation, April 2011. (opens to PDF)

What’s happened in the United States the past decade is that purchasing power for food and energy has declined. While government data shows overall inflation as tepid, the effects of this decline can be observed in real terms in the advance of poverty. This is why I began my research into city level SNAP data years ago, in the automobile and gasoline sensitive economies of southern California. Since that time a number of reports and data have recorded the strong advance of food poverty and energy poverty in the United States. If you are looking for inflation you won’t find it in the aggregate. The inflation’s in the poverty.

–Gregor

When the 2011 data is released sometime in the next 8 weeks, I expect to see the following changes. First, global production of crude oil was flat in 2011 compared to 2010. While it’s possible that BP could record an increase nevertheless in global oil consumption–implying that oil came out of inventories to meet demand—I am going to drop oil’s share of global consumption as other sources rise. Therefore, I tip oil’s share to fall to 32.50%.  As for natural gas, I call global NG’s share to rise to 24.36%. Nuclear meanwhile stagnated as usual, thus losing more share, and falls to the 5% share mark. Hydro held its share mostly steady at 6.37%. Renewables rose fast again, to attain a 1.47% share. Finally, coal had another strong year of share gains, and finally crossed the 30% level, to reach 30.31% of global consumption.

Overall, global consumption of energy from all sources in 2011, I predict, rose by a bit more than 4.00%. This was slightly lower than the strong rebound year of 2010, owing to the European crisis in the second half and flat global oil consumption. The world continues to turn to other sources of energy now that peak oil has been reached, with the fastest growth rates in renewables, and continued strong gains in natural gas and coal.

–Gregor

Because global oil production has been trapped below a ceiling since 2005, at 74 mbpd, nearly all of the world’s growth in energy demand is coming through the powergrid. This means increased demand for hydro, wind, solar, natural gas and coal. Indeed, coal, which preceded oil and carried onward in a reduced role during the oil age, has been making a comeback over the past decade. On the level of power, oil held a unique supremacy for over 50 years. But the king of fossil fuels was, is, and will remain coal. And oil? Oil’s role in human history will turn out to be very brief. On a longer timeline: oil was nothing but a bright, momentary flash.

–Gregor

To illustrate how I see the future price path of homes in non-walkable cities, I made up the following graphic:

Walkable cities are very nice indeed, and I’ve been fortunate to live in several of them: Boston, New York, San Francisco and now my present city, Portland. But the majority of American homes, in order to capture any future increase in value, will need to benefit again from rising wages and flat to falling energy costs. At the current juncture, those are two trends unlikely to appear any time soon. Advantages will accrue, therefore, to US residential real estate near rail lines. Cities that wish to thrive will need to face up to these realities soon by halting all investment in roads and highways, diverting transport funding to rail and BRT (Bus Rapid Transit), and by extending these transport networks further into residential communities through walking and bike paths.

–Gregor

Less discussed is the emergence of new oil demand from the Middle East and especially Africa. While oil demand from younger populations in the Middle East is subsidized, and offers the prospect that future subsidy removals could slow demand, Africa’s capability to hit the world with new demand looks particularly intriguing. With roughly 1 billion people on the continent, the trajectory of future African demand could follow the same path of other emerging Asia with a ferocious insensitivity to price rises as new users come onstream, consuming only a little oil individually. Moreover, as you can see in the chart, African demand accounts for less than 4% of world demand, even though it contains over 14% of world population. In other words, in a world of flat supply, in which crude oil production has been trapped below 74 mbpd of production since 2005, Africa could easily add 2-3 mbpd of new demand over the next several years. If not more.

A small amount of petrol is a life-changer to a new user, adopting short-trip motorized transport for the first time. There are myriad reasons to watch Africa, and many who are involved in everything from agricultural development to mobile communications already do. But Africa as an emerging source of oil demand, the kind that could rapidly escalate and catch the world by surprise, is another reason to study this emerging continent closely.

–Gregor

Ideological deflationists and inflationists alike find themselves both facing the same problem. The former still carry the torch for a vicious deflationary juggernaut sure to overpower the actions of the mightiest central banks on the planet. The latter keep expecting not merely a strong inflation but a breakout of hyperinflation.

Neither has occurred, and the question is, why not?

The answer is a ‘cold’ inflation, marked by a steady loss of purchasing power that has progressed through Western economies, not merely over the past few years but over the past decade. Moreover, perhaps it’s also the case that complacency in the face of empirical data (heavily-manipulated, many would argue), support has grown up around ongoing “benign” inflation.

If so, Western economies face an unpriced risk now, not from spiraling deflation, nor hyperinflation, but rather from the breakout of a (merely) strong inflation.

Surely, this is an outcome that sovereign bond markets and stock markets are completely unprepared for. Indeed, by continually framing the inflation vs. deflation debate in extreme terms, market participants have created a blind spot: the risk of a conventional, but ‘hot,’ inflation.

The Fears of 2008

In the spring of 2008, on the back of the Fed’s easing program that began the previous summer, many global commodities were running to all-time highs. Agricultural commodities were in the headlines, and the high price of corn had caused riots in Mexico the year before. In many respects, the 2007-2008 period prefigured some of the food price pressures that would help drive the Arab Spring three years later, in 2011. Of course, the bulk of the headlines went to the master commodity, oil, which flirted with $90 twice before breaking above the $100 barrier.

Market sentiment understandably turned to inflation. Indeed, during a few Fed meetings, Jeffrey Lacker of the Richmond Fed actually called for rate hikes. And the yield on the 10-year Treasury, which declined into a low of 3.88% towards the end of March 2008, actually rose again to 4.32% over three months into the end of Q2, 2008. The Economist magazine, always ready to provide the cover story, produced a rather memorable offering to the inflation angst that spring.

From its May 2008 story, Inflation’s Back:

“Ronald Reagan once described inflation as being “as violent as a mugger, as frightening as an armed robber and as deadly as a hit-man.” Until recently, central bankers thought that this thug had been locked up for life. Thanks to sound monetary policies, inflation worldwide had stayed low in recent years. But the mugger is back on the prowl.”

Here is the cover graphic:

Of course, we know how this particular story ended in 2008: badly. But not in the cloud of inflationary dust that the Economist magazine and hawkish members of the Fed envisioned. No, it ended “badly” with the most severe unleashing of asset deflation the United States had seen since the Great Depression, along with trillions of fresh credit dollars provided by the Federal Reserve needed just to stabilize the system during the long aftershock.

And the Deflationists Still Hold Some Cards

Four years later, the deflationists are still holding a few cards. True, actual recorded deflation was very brief and lasted only 6-9 months immediately after the crisis. And the deflationary spiral many predicted never did occur. Meanwhile, since 2008/2009, poor wage growth in the OECD and the continued supply of cheap labor from the developing world have ensured that one of the classic starter formulas for ‘traditional’ inflation — tight labor markets and rising wages — has failed to ignite.

Probably no market better expresses the ongoing, structural headwind to developed market inflation than the busted housing market. US households have indeed been working off their debt levels the past few years, but have only reduced those levels by a little more than 3%, from the 2007 highs. With so many Americans still unemployed or underemployed, and with debt levels that constrain purchasing power and also constrain mobility (i.e., the ability to move across country for a new job), it’s no surprise the US housing market remains trapped at levels far below its highs.

Of course, we know how this part goes.

The above chart comes from the February 2012 Economic Report of the President. The above chart (from Chapter 4 of the report) shows that the current bust, in real terms, has seen the worst price decline of all, compared to other historic declines over the past century. Indeed, that there is now little prospect that US residential real estate will ever recapture the old highs says a lot about structural shifts in everything from energy prices to our workforce, that the US faces at least until the end of the decade.

Stealthier Versions of Inflation

But wait a moment. Even if US residential real estate is fated never to be a recipient of inflation, owing to its dependence on oil prices and the automobile-highway complex, is it not the case that Americans have had to endure already a great loss of purchasing power for some time already? The US story of poor wage growth is now marked by some as far back as the 1970s. That is the longer timeline that is often used to explain the transformation from single-earning to double-wage-earning households. Moreover, health care, food, energy, and education costs have seen outsized gains the past 10-15 years.

Considering that most US pension funds, whether by plan or through individual retirement accounts, rely on the stock market, it seems fitting to mark the performance of the SP500 against a basket of commodities. After all, every retiree (and many an institution) eventually converts their financial capital into resources for living. One chart that I like shows the 15-year performance of the SP500 against the most preferred liquid energy in America: gasoline. (chart courtesy of FRED)

While tediously repetitive, the term Middle Class Squeeze still carries weight, as all of the previous components of the problem have only been exacerbated more recently by high energy prices. The purchasing power of the SP500 has literally crashed against oil. What’s particularly handy about the above chart is that when the SP500 was roughly at 1400 near the turn of the millennium, gasoline was indeed (briefly) around $1.00 per gallon. Now, over 12 years later, the SP500 once again trades near 1400, only this time, gasoline sells for 4 times as much, around $4.00 per gallon. But is this inflation?

The loss of purchasing power is certainly a form of inflation. However, what we’ve seen in the past decade is that many of the price changes affecting Western economies have not been driven by tight labor markets, wage inflation, or even reflationary policy — which the US has engaged for much of the past ten years. Instead, price level changes have emanated most strongly from the universe of natural resources, including everything from copper to oil, and, of course, agriculture. There is no question that cheap money policies from both the US and Japan have been driving speculative bubbles for some time. But housing and stock market inflation, as we have seen, have been transitory.

Structural Changes in Global Price Levels

Inflation has been running fairly hot in developing markets for some time. In regions like Asia, pressured to source food as growing populations bump up against limits to available arable land, the amount of capital devoted to food, shelter, and transportation remains high. However, if we think of lower-earning populations across the globe as a single class, there has been no protection from higher prices offered by developed economies to their poorer populations. The bottom two quintiles of US wage earners struggle with food and energy costs just as much as their counterparts across the globe.

These structural changes in price levels, along with the increasing inability of every population to endure them, have fallen into a statistical gray area. Headline measures of inflation in OECD countries churn out benign readings, while at the same time, poverty grows. But this is a particular kind of poverty, a food and energy poverty, which saps the power of consumers to spend disposable income on an array of other items.

This emerging resource poverty is going to drive further changes in price levels, and in particular it will restrain many forms of consumption, including real estate prices. Cities will find, for example, that with the price level of food rising and real estate prices stagnant with rising transportation costs, urban farming is going to advance very strongly. Note, for example, the resurgence in urban farming in places like Brooklyn, NY, where large tracts of industrial land have lain fallow for decades. Indeed, a classic pattern of ‘hot’ inflation is that it quickly begins to drive out spending for discretionary goods in favor of true basics, like food.

The Risk We Face

The United States currently enjoys reserve currency status, which enables it to borrow cheaply, and which keeps capital circulating through our government bond markets, which are the largest in the world. Given the backdrop to our post-credit-bubble environment, it is now the consensus view that we will cut a path similar to Japan’s as we oscillate from weak growth back to the stimulative rescue policies of the Federal Reserve.

There is therefore a sense of complacency about an escalation in prices.

In Part II: The Triggers That Will Spark ‘Hot’ Inflation, we explain how many of the factors which have restrained prices globally at colder levels will start to run hotter soon.

First, there are structural changes taking place in the developing world with regards to urbanization and the trajectory of labor markets. Can the supply of cheap labor in the non-OECD continue indefinitely?

Second, populations in the OECD are increasingly trapped in “safe” investments, such as government bonds, which currently restrain interest rates from moving higher. But this also creates a latent vulnerability for if perceptions of safety and loss of purchasing power were to shift hard. This shift in perceptions is ultimately more critical in any step-change to higher inflation than the supposed quantity of “money-printing” that’s been undertaken by global central banks.

Finally, we look at the assets that will benefit, as well as those that will suffer most, should a stronger inflation develop.

Click here to read Part II of this report (free executive summary; enrollment required to access).

While it may seem obvious that US and Canadian natural gas producers, and the laws of the free market, yearn to capture the yawning spread to much higher prices in Europe and Asia, it’s not clear yet where global prices will converge, exactly, when North America sends its first LNG “trains” out to the world. I have taken a middle road on North American NG supply (in contrast to my views on global oil) and have been adamant for years that supply optimists and supply pessimists will both eventually be disappointed. Mainly, I think that once the resource is hit hard, pulled along by the next leg of demand from exports, that all the latent problems associated with fracking–the energy and water intensiveness of drilling, and the damage to the environment in populated areas—will reveal themselves. My colleague Chris Nelder has suggested, accordingly, that the dream of booming LNG exports is ultimately a siren song that policy makers might want to consider. Or, reconsider, if you will. Indeed, capturing some portion of the higher world price will absolutely mark the bottom for North American NG, and thus the end of the price level which Americans currently enjoy. Perhaps this is why investors from Jeffrey Gundlach and Wilbur Ross are buying natural gas assets right now, according to The Business Insider.

–Gregor

Graphic: FERC.