With the value proposition of sell-side research now completely gone, as most of it has become merely a conduit for shot gun propaganda (is there even one sell on Goldman's most recent conviction list?), third party research shops such as Credit Sights are promptly becoming the only objective and impartial sources of analytical insight. In its January 3 market commentary Credit Sights shares the first semi-official view of the adverse consequences to the economy should the current liquidity surge from the Fed not be moderated (and with such pundits as Fred "Dynamite" Mishkin telling Bloomberg earlier today that QE3 will not come, it is guaranteed that QE3 is imminent). In a nutshell: "a rising oil price creates economic headwinds via numerous channels particularly if the increase is sudden. A decline in disposable incomes, reduced consumer confidence, lower levels of travel, a decline in demand for gas-guzzling larger autos and an upward bias to inflationary expectations are all spin off effects on the consumer of a rapid ascent in the price of oil." Which is why as liquidity continues looking for paths of least resistance, and finds them in such places as commodities (especially now that China has all but shut down the door to importing US liquidity) it is precisely the risk of a price spike in crude that is rapidly becoming the biggest risk to the "wealth effect" derived from the continued lunacy out of the Fed.
That said, the crude market has long been one in which analysts realize that there is a massive disconnet between fundamentals and reality: if based on actual draw downs, the price of oil would have to be far, far lower. But when is that last time fundamentals mattered in anything. Here is where Credit Sights sees oil going in the next year:
With inventories, according to the US Department of Energy, sitting 4% above the comparable period last year and 8% above the five-year seasonal average, the CreditSights Oil & Gas team considers there to be little in the supply/demand balance that suggest prices will spike and stay at significantly higher levels in 2011. We expect prices to trend higher than in 2010 however, on the back of the more robust demand conditions currently being factored into forecasts. We expect that in 2011 oil prices will trade a $75/bbl-$110/bbl range with increased volatility but think it unlikely that the year-end average 2011 price will be in the triple digits. We note the conservative bias in our forecasts relative to mainstream market commentators given the follow on effect that the oil price has on our expectations for the cash flow and credit metrics of companies in the oil and gas sector.
So with fundamentals irrelevant, what is? Well, the value of the dollar for one. And as QE3 is rolled out the impact on the dollar will be anything but favorable.
Typically, those forecasters that are painting a picture of much higher prices throughout 2011 are not doing it on the back of divergent expectations about the supply/demand fundamentals. The effect of speculative trading and the impact of currency movements, most notably US dollar weakness, are prominent. In 2007, 2008 and 2009, the trade weighted value of the US dollar had a statistically significant inverse correlation with crude oil prices – a marked change from the 2000-2006 period. But in 2010 that correlation has fallen in an environment of greater currency volatility. That makes the impact of the dollar on oil prices in 2011 more difficult to ascertain as the outlook for the US currency is clouded. While the path of least resistance may be for a lower dollar given the Fed's monetary policy stance, the role of the dollar as the world's reserve currency - and hence a store of value that benefits from the flight to quality trade in times of heightened risk - cannot be ignored given the ongoing sovereign debt crisis in Europe. In 2011 we expect significant currency volatility and therefore believe the oil/dollar correlation over the course of the year will once again be relatively low. Nevertheless, the representation of short-term dollar weakness as a factor driving oil prices higher is likely to continue, particularly given comments by producers that differentiate trends in nominal dollar prices from the more subdued rise in "real" prices. Oil prices north of $100/bl are already being justified by producers on the back of the dollar's decline in 2010.
So if Bernanke were to succeed in further destroying the dollar, which is now collateralized by a whole lot of empty houses and taxpayer funded mortgages, the first thing that will be impact is the possibility of actual organic economic growth.
If our forecasts of even modest increases in the oil price are realized then the US consumer will be paying considerably more at the gas pump in the coming year than was the case in early 2010 and that will necessarily have an impact on their hip pocket. Although the impact of higher oil prices on the US consumer – and by default the US economy – is often mentioned, it is rarely quantified. This is partly because it is a somewhat amorphous relationship with far more nuances than can be addressed in a catchy headline. What is often reported is that the US uses approximately 20 million barrels of oil a day, with about 45% of that being used as gasoline for motor vehicles. If you assume that each barrel of oil produces 20 gallons, then the amount of oil consumed for driving in the US is 180 million gallons per day – or 65.7 billion per year.
This generates an impressive annualized number when talking in terms of the price impact for each $1 increase in the price of a barrel of oil and there is no denying that rapid increases in the "gas tax" do have an impact on consumer spending behavior. Few would argue that such a direct translation is accurate however, given the elasticity of gasoline demand and the significant potential for consumers to modify their behavior. Nor are empirical studies of the consumer effect of changing oil prices definitive given changes in the US economy's fuel efficiency, the overall impact of the most recent decade of low inflation and ongoing societal shifts on the back of technological developments. Nuances aside, a rising oil price creates economic headwinds via numerous channels particularly if the increase is sudden. A decline in disposable incomes, reduced consumer confidence, lower levels of travel, a decline in demand for gas-guzzling larger autos and an upward bias to inflationary expectations are all spin off effects on the consumer of a rapid ascent in the price of oil. These are among the impacts to search for should oil move outside of our forecast range early in 2011 and remain at elevated levels.
Bottom line: tax cut extension, meet gas tax. But at least everyone believes they are getting a little richer (on a nominal basis) even if all the real money is going straight into Wall Street's 2011 bonus accrual. Same as it always has.