Can’t Live With Them, Can’t Live Without Them

The topic here is hydrocarbons. Oil prices are creating the latest market conundrum. West Texas Intermediate is approaching the $90 level and is up double digits over the last couple of weeks. One might think that is bullish for the economy (better economy = more demand = higher price), but this might also be a case of crimped supply. The Saudis and the Russians are continuing production limitations, while U.S. oil production is only creeping back toward all-time highs. But U.S. crude inventories (including the SPR) are at lows last seen in 2004.

Whatever the cause of higher oil prices, we can be sure that those increases will flow through into inflation data over the coming months. The next CPI print (for August) is next week, but we may not see much evidence of oil’s recent run as much of the move higher has occurred over the last 2 weeks. Unless this rise is somehow reversed, September and October headline inflation data could break the recent downward trend and head higher.

We know the Fed is focused on core inflation (ex-food and energy), but consumers feel ALL inflation and the ultimate inflation barometer for consumers is the price of gasoline. If the price of cornflakes gets too high, you can always switch to store brand cereal. That’s not the case with gasoline. Gasoline crowds out other expenditures. Whatever I must spend on gasoline, I am unable to spend on anything else.

Inflation fears clearly subsided this summer and has led to optimism that the Fed will stop raising interest rates. However, from a purely mathematical view, the decline in inflation is losing steam because comparisons get more difficult. Another concern is that core inflation has been very slow to decline. This has placed great focus on what, if anything, the Fed will do next, but we think that focus is misplaced. The odds are very strong that we are at or near the end of this rate hike cycle. Whether the Fed hikes another 0.25% matters very little.

What matters is how the consumer, the driver of the economy, responds to stronger inflation headwinds over the next few months. The timing of the higher energy prices is particularly bad because these increases are occurring just as

1) student loan interest is kicking back in;

2) excess savings from the pandemic appears to be dwindling; and

3) default rates on consumer loans (credit cards, autos, homes) are all rising (although not yet at a concerning level).

How the consumer responds will tell the tale of the economic tape. As for the stock market, this is seasonally a tough time of year and that trend seems primed to repeat this year.

Markets vs. Regulation

The problem with regulation is that it is often crafted without regard to economics. When crafted properly, regulation can be a key driver for desired economic changes, however, when economics is ignored, it is more than likely to cause inefficiencies and economic problems.

Case in point, despite generous subsidies, wind energy projects in the U.S. are in some trouble.  The cost of wind power had been steadily declining over many years, but now that trend has reversed. What happened? First of all, interest rates rose. It seems the economics of these projects had been based on rates staying near zero. That clearly has not happened. Another problem is the rising cost of materials for clean energy. The sudden, massive increase in funding for clean energy has stretched supply to the limit, and possibly beyond. Economics 101 states that shortage leads to higher prices and that means the well intentioned, positive result we are looking for is getting further out of reach. Once again, it is the law of unintended consequences rearing its ugly head.

Case in point, despite massive subsidies available for offshore wind projects, this week, the CEO of Denmark’s Orsted, the world’s largest offshore wind farm developer, stated that the company is willing to walk away from projects in the U.S. without more support. Last week the company said it could see impairments in the U.S. of roughly $2.3 billion due to supply chain problems, higher interest rates and a lack of additional tax credits.

Also in the local news this week (reported in Newsday), New York wind energy projects are already proposing rate increases. According to the New York State Energy Research and Development Authority, Sunrise Wind has proposed a 27% price increased from $110.37 a megawatt hour to $139.99.

Equinor, a Norwegian wind energy developer, is also requesting increases. It’s Empire 1 project is requesting a 35% price increase. The Empire 2 project is seeking a 65% increase and the company’s Beacon Wind project is requesting 62% increase.

Our own poorly constructed policies are driving up the cost of clean energy. These increases may not be huge to the typical utility customer, but these projects are far from complete and if history is any guide, we can expect even higher costs to result if nothing changes. Economics is about crafting the proper incentives to move the economy in a desired direction, not regulation that forces it in a particular direction.

It appears that we have a real problem with hydrocarbons. We can’t live with them, and we can’t live without them.

The Economy is Headed Up/Down (pick one)

The economic data continues to be muddled. No matter where you stand, you can pick from headlines to back your position. Bullish? You can point to ISM (Institute for Supply Management) Services PMI (Purchasing Managers Index) defying expectation by rising 52.7 to 54.5, well above the 52.5 expected.

Bearish? Take a look at the S&P Global US Services PMI which declined from 52.3 in July to 50.5 in August.

But wait, aren’t those essentially measuring the same thing? You bet they are. Somebody got it wrong and somebody got it right. The problem is figuring out which is which. If you are confused by the current state of the economy, you have plenty of company, professional and amateur.

We will make one observation. Economic data only appears conflicting at inflection points. When economic activity is steady state, the preponderance of evidence points in a single direction, but just as a changing tide creates rough waters, changing economic conditions create conflicting data. The odds suggest that the next leg of economic activity will be down. How far down is still to be determined.

What We’re Reading

Hurricane Lee strengthens to Category 5 storm in Atlantic

Shrink and theft losses near $1 billion at Lowe’s — here’s how much they’re costing other retailers

China’s Country Garden Makes Overdue Dollar-Bond Payments, Avoiding Default

Companies Pay More to Borrow in Record Bond Rush

Apple Becomes the Biggest U.S.-China Pawn Yet

Soaring Costs Stress US Offshore Wind Companies

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By: thinkhouse