A Salvador Dali Market

Even the gold plated bears are turning bullish on the industrial equity markets.

Why?

The short answer: "Inflation"

Yesterday, in Sydney, a TV show was aired where a man was interviewed regarding his monthly grocery bill. He is a pensioner who happens to record every purchase he makes at the supermarket and has done so since 2003. He analysed his monthly grocery bills over the four year period to discover that he is paying in 2007, 67% more than he paid in 2003. As a pensioner, his buying habits have not changed significantly.

The 67% is accurate. That translates to a compound growth rate of 13.7%.

Official Australian CPI inflation numbers are nowhere near than percentage. Not to put too fine a point on it: Our government lies to us, as do other governments in other countries. In days gone by we would have drawn and quartered our political leaders. Now we just sigh, and move on.

With the breakout of the Dow Jones Industrials to a new high, the world is in danger of entering a surreal era.

What is "driving" this price inflation?

The short answer: "The Oil Price". (Of course there are other factors, like drought, but oil is the primary driver)

In 2003, the price per barrel of Brent Crude was around $30 a barrel. As at April 2007 it was $67 a barrel.

There are those who would argue that this conclusion is facile and simplistic. Maybe, but when one peels away the layers of the economic onion, one discovers that energy in general and oil in particular does indeed drive the world economy. Let's put another way: Without energy there could be no economy. Without anything else, we could make a plan. We could eat rice or corn instead of bread. We could build with bricks or stone instead of concrete. Energy is essential. The rest is optional.

In 2004, when the oil price was $45 a barrel, total output of oil accounted for 3% of total world GDP.

At $67 a barrel, and at a similar daily production of barrel numbers, two outcomes (at the extreme) are possible. Either:

1. Prices of everything else must rise to keep oil at 3% of total, or
2. Volumes of everything else that contributes to world GDP must fall to keep oil at 3%

Of course, if dollar contribution of oil to world GDP rises in percentage terms, and the volume of oil production remains relatively constant, then volumes of everything else must fall even further for the 3% to remain constant.

But volumes of everything else have not been falling. They have been rising. This implies that the world economy is becoming increasingly sensitive to oil price movements. Through a process called "leverage", the potential impact of a $1 change in oil price is becoming magnified. (Assuming oil drives the economy)

The "key" factor on which to focus is that oil refinery output is relatively inelastic. In fact, volume of oil output grows very slowly, at around 2% p.a., and Peak Oil is forecast to arrive between 2008 and 2037 depending on underlying assumptions. The longer oil availability takes to peak the more savage will be the fall-off of availability following the peak - as can be seen from the following: (Source:www.mnforsustain.org/oil_peaking_of_world_oil_production_appendix.htm#Appendix%20I).

This is because no new oil fields of consequence are coming on stream.

It needs to be recognised that world population grows at 1.14% p.a. (source: http://en.wikipedia.org/wiki/World_population#_note-5) and, therefore, oil output per capita is the key issue here. Per capita output started to flatten some years ago. i.e. Oil output has not been rising at 2% p.a. This has sinister implications if oil does indeed drive the world economy.

Importantly, the US consumes far more oil per capita than any other nation on earth - as can be seen from the following chart: (Source:www.mnforsustain.org/oil_peaking_of_world_oil_production_appendix.htm#Appendix%20I)

In 1960, the US consumed 46% of world oil output. By 2025 this number is forecast to fall to 23%

What is the mechanism by which this rise in oil price is translated to price inflation, world-wide?

The short answer: The US Federal Reserve inflates world money supply by printing dollars to pay for US oil imports.

These same dollars (from previous years) are recycled by other countries to pay for their oil imports. Right now, 70% of world reserves are paper dollars - which are used to pay for the oil and coal, which drive the world economy. It was in no-one's interests for Saddam to price his oil in Euros.

Through the multiplier effect, assuming 5% savings rate, every dollar that the Fed prints grows to become $9 after 12 cycles of spending. (It doesn't all land up as dollars, but it does all land up as fiat currency in other countries).

Of course, the rate at which money supply grows is a function of its velocity. How long does it take one cycle of spending to filter through?

In simplistic terms, (assuming the Fed prints the cash):

• If velocity of money slows and oil output remains constant, purchases of everything else slow and annual volumes of non-oil output fall
• If velocity of money remains constant, purchases of everything else remains constant, and prices rise across the board by the amount of dollars printed to pay for the oil (as a percentage of world money supply). This is called "monetary inflation".
• If velocity of money rises (because people save less and consume more) and money supply rises then the economy booms for a short period whilst production capacity can still cope. With the advent of China's manufacturing capacity, world capacity has been growing faster than has been required. This is why inflation in past few years has been confined to assets.

US savings is now zero, and the US consumer is tapped out. Savings will need to turn negative for this state of affairs to continue. The genuine "boom" is over. We are back to constant or falling velocity of money, but rising money supply.

If the genuine boom is over because savings in the USA cannot fall further, can the Rest of the World drive the consumption of China's output?

Short answer: Probably not, given that the US accounts for 25% of the world's GDP, and the fast growing economies contribute far less than this.

Conclusion

It follows from the above that rising stock markets are reflecting the anticipation of price inflation. This is not a cause for celebration

The "problem" is caused by a confluence of four factors:

• Oil is irreplaceable. At present 67% of all transport within the USA is dependent on oil. (Oil, literally, "drives" the economy).
• The USA cannot afford to pay for its oil (or its wars for that matter)
• The Fed has a license to print money
• The oil industry does not raise its prices to compensate for dollar price rises. It raises prices to compensate for percentage price rises. (This is causing the Public to be "shafted" because wages are not rising commensurately)

Here's the proof of oil industry behaviour:

Exxon's numbers below show that its Mark-Up in percentage terms is roughly constant at around 75% - 80% (Dollar numbers are in billions)

Source: http://au.finance.yahoo.com/q/is?s=XOM&annual

Assuming a mark-up of 75%, what this implies on a per barrel basis is:

To maintain its dollar profits, it should have raised prices from $52.50 by $20 to $72.50

Under the above scenario, Exxon would pocket an "unearned premium" of $15 a barrel (which is why it could afford to pay its CEO such a large bonus)

It seems safe to assume that the industry leader is reflective of industry standards.

Turning now to the retail end of the market, we see that it behaves in the identical manner. The following article appeared in today's news:

http://news.yahoo.com/s/ap/20070509/ap_on_fe_st/odd_cheap_gas_7

Gas station owner told to raise prices

Wed May 9, 6:05 AM ET

MERRILL, Wis. - A service station that offered discounted gas to senior citizens and people supporting youth sports has been ordered by the state to raise its prices. Center City BP owner Raj Bhandari has been offering senior citizens a 2 cent per gallon price break and discount cards that let sports boosters pay 3 cents less per gallon. But the state Department of Agriculture, Trade and Consumer Protection says those deals violate Wisconsin's Unfair Sales Act, which requires stations to sell gas for about 9.2 percent more than the wholesale price. Bhandari said he received a letter from the state auditor last month saying the state would sue him if he did not raise his prices. The state could penalize him for each discounted gallon he sold, with the fine determined by a judge. Bhandari, who bought the station a year ago, said he worries customers will think he stopped the discounts because he wants to make more money. About 10 percent of his customers had used the discount cards. Dale Van Camp said he bought a $50 card to support the local youth hockey program. It would have saved him about $100 per year on gas, he said.

Where will all this end?

The rising stock markets are evidencing that most of thinking society is in denial.

• Whilst there is no serious (visible) activity that will give rise to a move away from a dependence on fossil fuels
• Whilst the Fed has the power to print the paper dollars to pay for the oil that the US cannot afford to buy
• Whilst the dollars that are flooding off the printing press to pay for the wars in Afghanistan and Iraq continue to flood

Business in the US will continue to boom - for the time being - but it will be largely dollar availability driven, which is inflationary.

Overall Conclusion

Yes, the Dow Jones Industrials may be entering a new "Primary" up-leg.

How does it help us to know this, if the reason it is happening is a consequence of manic behaviour of political and financial leaders who are in denial?

Unless something structural changes, we are almost certainly heading for a train smash!

But the irony is, there are solutions. It is possible (and practical) to make these structural changes.