Thursday, February 19, 2009

Energy Prices, And The Fight Against Deflation

All the talk about deflation has falling off considerably, and a lot of that has to do with energy prices. Will energy prices continue to go up? How will they continue to impact consumer prices? Do we still need to worry about deflation? James Picerno from the Capital Spectator attempts to answer these questions and more in his blog post below:

Producer prices rose last month. That's good news in the war on deflation.

The news wasn't totally unexpected, as we discussed on Tuesday. The partial rebound in energy last month—heating oil and gasoline—is a key reason for the return of inflation to wholesale prices in January. The same forces suggest that tomorrow's update on consumer prices will also post a mild gain for last month.

Producer prices rose 0.8% in January on a seasonally adjusted basis, the Labor Department reported this morning. That's the biggest gain since July—in fact, it's the only gain since July. From August to December, wholesale prices fell in each and every month. That makes today's news of higher prices welcome since it suggests that price stability may be near. It's too soon to be sure, but for today, at least, there's fresh reason for hope.

The source of the last month's rise was the 3.7% pop in the energy component of the producer price index (PPI). It's not clear that energy prices won't resume their decline. Crude oil, as we write, is trading at around $35 a barrel in New York, well below its January average of roughly $40. Heating oil, natural gas and gasoline are also losing ground so far this month.

To the extent that the January's rebound in prices depends on energy, there's probably further deflationary worries ahead. In fact, you can just about count on it. Heating oil and natural gas prices no longer have seasonal support of winter and so as the warmer weather approaches, lower prices are likely. Meanwhile, the economic weakness that's still pulsing through the American economy is likely to bring another leg down in the demand for crude oil and gasoline.

Nonetheless, the heavy losses in energy are likely behind us. That doesn't mean that prices won't go lower. But expecting another 50% in crude oil, for instance, requires an exceptionally bearish outlook that looks excessive from your editor's vantage at the moment.

Maybe, just maybe, there's a bottom lurking in energy prices in the near future. That's the view of the energy team at Bernstein Research in London. In a research note sent to clients today, Bernstein opines with contrarian flair: "The outlook for the energy space now seeming as grim as it can be in 2009 and increasingly in 2010, we believe there is limited downside to the beta energy names and therefore it is the right time to make a relative valuation call for the North American energy stocks." Bernstein recommends that investment portfolios should be "increasingly overweight energy as the year progresses…"

We're not particularly fond of dramatic changes to portfolios based on industry trends and so we remain agnostic on such recommendations. Rather, we're intrigued by the fact that some energy strategists are starting to think that the great decline in energy prices, if not over, may be close to ending.

Although Bernstein's not predicting a new bull market in oil, the shop observes that spare production capacity is still "relatively tight." Meanwhile, Bernstein estimates that oil and gas are close to their "cash cost." The firm advises that "over time [oil and gas] prices cycle around the marginal cost of supply dependent on near term supply/demand dynamics." If we're at or near cash cost, that implies that a bottom is, if not imminent, close, as suggested by the chart below, which comes via today's Bernstein report.

Even if energy prices begin treading water, that would go a long way in helping keep deflation at bay. Meanwhile, the aggressively loose monetary policy is only starting to seep into the economy. As the year goes on, the substantial reflation efforts engineered by the Fed should start to show results. The big question is whether the broad economic environment continues to deteriorate and overwhelm the reflationary trend.

Yes, 2009 is the great year of transition, with negative and positive forces battling one another in an epic struggle to claim the future. Today's price report is but a small skirmish in a larger war. Then again, victory in war comes one battle at a time. Score one for the anti-deflation army. Just don't celebrate for too long. There's still plenty of fighting ahead.

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