Fiat Economics

Oil prices are likely to continue facing downward pressure as the year progresses, stemming from an oversupply amid weak demand.  The downward pressure placed on oil prices will probably be exacerbated later this year due to seasonal factors, which include the end of the summer driving season.

First off, I would like to point out that despite a significant decrease in demand for oil products US crude oil production has actually continued to rise (see chart).

Source: EIA

This probably implies that the excess supply is being stored in inventories, which in fact have been rising quite substantially (see chart).

Source: EIA

Now here is what’s interesting, despite falling energy demand and growing supply, WTI prices have begun to experience a resurgence over the past several months (see chart).

Source: EIA

What does this mean?  It is my belief that oil prices are being bolstered partially by speculators, refiners’ overly optimistic purchases of crude oil stemming from what is typically higher seasonal demand associated with the summer driving season, and a weaker dollar.  But, a weakened labor market has subdued consumers’ willingness to spend, forcing consumers to rethink travel plans, and reduce gas expenditures. Thereby, putting us in the awkward position where we have a growing oil supply, without any offsetting increments in demand. Yet, oil prices have begun to rise.

It is hard for me to make a bullish case for oil in the near-term given the current environment, so I won’t.  Today’s crude inventory levels helped to support this view, it showed a significant and unexpected rise in US crude oil inventory levels and a decline in demand for gas. As the summer driving season winds down, bringing with it even further pullbacks in gasoline purchases,  refiners will likely trim down crude oil procurement.  This should effectively remove an important pillar of support for WTI prices at their current levels.  At the same time, this will likely chase a number of speculators away from the market.

Upside risks to this forecast would include a strong and sudden demand increment by US consumers, or a sudden drop in relatively sticky supply.  Of course capacity and other global factors could come into play for this analysis, but we will save that for another article.

Consumers around the world are being indirectly taxed through record high gas prices. This of course hurts consumers’ pockets and can raise inflation fears. We wanted to take a look at the crack spread between WTI crude prices and US petroleum prices as measured by the Energy Information Agency. We outline the results below.

The February reading of the U.S. all grades all formulations retail gasoline prices per gallon was $3.078 verses a WTI price of $95.35/barrel for the month. Why is this important? First off, gasoline is produced by applying a refining process to crude oil, so factoring out crude previously purchased at a lower price and hedging activities, gasoline has to be more expensive than crude. For comparative reasons we broke the WTI/barrel price into a WTI/gallon price, so we could compared it to gas prices. The results were not surprising, that is until recently. The average spread over the last 15 years of WTI to gasoline prices per gallon has been $0.53; never going below $0.25, that is until October of 2007. As you can see from the chart below the Gas/WTI spread has remained fairly constant over the years until the recent convergence. We currently estimate the spread for March 2008 stands around -$0.15 after a reading of 0 in February. What does this mean? Well it means eventually, and likely sooner rather than later, the US will experience a sharp rise in gasoline prices, at least without an offsetting drop in WTI prices. If you were to apply the historical spread to current WTI/gallon prices US gasoline prices would total $3.96/gallon. This number seems quite realistic to me.

This chart shows the spread between WTI and gas prices has collapsed, meaning WTI prices will need to experience a sharp decline or gas prices need to catch up…

Source: Energy Information Agency & my calculations

Investment Relevance: Crack spreads are used as a measurement of the profit margins for oil companies, such as XOM. In fact, recently, we have seen a drop in both the spread and XOM’s share price. If this spread reverts to its historical level, then we would expect to see higher margins, which should be reflected in share prices. However, the current zero to negative spread does not bode well for the industry, but as we mentioned above we do not imagine that will last for long. One concern however, is that there tends to be a lagging relationship between the two variables. As you can see from the chart below there does in fact appear to be a correlation between the 4 month lagged XOM price and the Gas/WTI spread. This implies that the recent drop-off in the Gas/WTI spread could place some downward pressure on XOM. However, this is a very simplistic model, and I would strongly discourage anyone from trading on it without significant refinements. There is a lot more than one variable that will affect price; this is simply meant to be a demonstration.

4-Month lagged XOM price vs, Gas/WTI spread shows that XOM stock price could face some downward pressure in the coming months

US Ethanol Production has been increasing drastically

So what does this mean for food?

We are all aware that global food prices are rising sharply for a variety of reasons including weather and demand and supply shocks, but have energy prices had any affect?. Below we outline our view that the increasing in oil prices, have led to a substantial rise in ethanol production, and will have significant effect on food prices and eventually overall CPI. In order to have a consistent time series of agricultural prices we used the USDA prices received by farmers’ data. First off, let’s look at the relationship between WTI prices and ethanol production (chart below). As you can see below the two variables are highly correlated, this makes sense since the price of producing ethanol relative gas drops as oil prices move higher. However, the important question is what effect (if any) does the increased production of ethanol have on the food supply and prices?

High energy prices have been the driver behind the increased production

To answer this question we first analyzed corn price verse ethanol production (chart below). Again we see a strong correlation between the two, with the only anomaly being in 2005. This was caused by a good harvest and the effects of Hurricane Katrina. As we stated early the price of corn is influenced by a number of variables. Given the minimal use of ethanol prior to the beginning of this decade we do not believe ethanol production has had much, if any, affect on corn prices before now. In 1999 only 1.5bn gallons of ethanol were produced a year verse over 5bn today. That’s a lot more corn! Now that we now the production of ethanol can influence corn prices, what is the relationship of corn prices to the food and beverage CPI component and overall CPI?

Corn Prices have been influenced by ethanol production

Before we start this analysis lets mention some important direct uses of corn; food, corn syrup, animal feed, ethanol, etc… Meaning corn prices can influence everything from candy to milk. Now with this in mind, we would expect a significant rise in corn prices to eventually pass-through the food chain into every product that utilizes corn. In the chart below we compared corn prices to the food and beverage component of the US CPI on a y/y basis. Again the result was not surprising; the food and beverage component of the CPI has been increasing with corn prices. Given the wide spectrum of uses for corn it is hard to judge the total effective corn would have in the index (at least for this brief analysis), but we imagine it is significant.

Corn prices have helped to drive up the overall food and beverage CPI component

Conclusion:

The massive increase in ethanol production brought on by elevated energy prices has had a significant effect on corn prices. This means that as long as energy prices remain elevated, and corn is used as the primary crop to produce ethanol, we can expect to see the prices continue on this path. Given corns multiple uses within the food industry, we can also expect to see the food and beverage component of the CPI increase as a result. Also as lower value crops are switched over to corn we may also see a rise in the price of other crops as supply comes down. One alternative on the horizon is using switchgrass instead of corn to produce ethanol. It is believed that switchgrass will be a more efficient producer of ethanol and also will not directly impact the food supple, since you can’t eat it. However, this is still in an experimental stage and will take time. The bottom line is, so long as energy prices continue to rise and ethanol production along with it, we can expect to continue seeing the food and beverage component of the CPI trending up.

Investment Idea:

If you believe that the price and value of agricultural goods will continue to rise from cross-over to energy products and higher world demand, we recommend purchasing agriculture based ETFs such as ‘MOO’ or ‘DBA’ as a good play on the sector. However, it is important to keep in mind that speculators may have artificially driven up prices in agro indexes, so it is possible that we could see the indices catch a bid in the short-term.

Price of DBA vs wheat, corn, & soybean (rebased to 100)