This morning’s update on producer prices couldn’t be any clearer: disinflation (deflation?) is alive and well in the wholesale marketplace.
Producer prices fell 1.6% last month, the largest monthly decline in five years, and the second in a row, coming on the heels of September’s 1.3% stumble. As a result, wholesale prices for the past 12 months through October are off 1.5%–the first year-over-year decline in four years.
Once again, the descent of energy prices is the major catalyst for a lower producer price index. Energy-related goods tumbled 5.0% in October, following an 8.4% decline in September.
Alas, energy prices can’t fall indefinitely. In fact, there are signs that prices of crude oil and gasoline are stabilizing. For oil, the $60-a-barrel level appears to be a floor, at least for the moment. The December ’06 crude contract on the NYMEX was changing hands at around $59 this morning. That’s down from around $80 in July. Gasoline, meanwhile, seems intent on hovering in the $1.50-$1.60 range (as per the December ’06 contract), which is also down sharply from around $2 a gallon back in July.
But lest we think that price stability seems the path of least resistance for energy at the moment, one analyst crunches the numbers and contemplates an alternative future. “The distortion of the commodity futures curve by financial investment is the greatest challenge to the stability of the crude and natural gas markets in the last 10 years,” wrote Ben Dell, a member of the energy research team in the London office of Sanford Bernstein, in a research note to clients today.

Indeed, from ETFs to hedge funds, financial players have piled into oil futures in a big, big way. Passive investment in the Goldman Sachs Commodity Index and the Dow Jones-AIG index (both heavily weighted in oil) have grown to nearly $120 billion this year from under $20 billion in 2003, according to Dell’s report. Is this passive investment impacting the futures market for crude? Absolutely, says our man in London.
Dell noted that the oil futures curve currently exhibits a record-high level of contango. Contango means that futures prices are higher than spot, or cash prices. Although contango does happen from time to time, the current episode is “decoupled” from economic fundamentals, he opined. In sum, there’s too much oil supply to warrant oil futures prices rising the further out in time one goes. “On a weighted average basis, commercial independent storage is now 97% full, or effectively full compared to storage contracted capacity 18 months ago at 85% full and around 70% full in 2003,” Dell wrote.
He found it odd that the premium in future oil prices over spot have continued to widen recently even as the outlook for OPEC’s spare capacity in oil production has increased in 2006 and is expected to continue improving next year and again in 2008. In particular, this year’s spare OPEC capacity is predicted to be slightly above 2 million barrels a day, up slightly from less than 2 million b/d in 2005. Next year, OPEC spare capacity is forecast to be close to 4 million b/d, and above that level in 2008.
Running an historical correlation analysis of oil prices relative to spare capacity data shows that $60-plus-a-barrel oil reflects jibes with the current estimate of spare capacity, according to Dell’s numbers. But if next year’s higher estimate of spare capacity is assumed, the relevant oil price is around $30 a barrel.
Does that mean that oil prices are set to fall by 50% soon? Probably not. Oil is a commodity, but one that comes with more than its fair share of geopolitical baggage that distorts and manipulates free-market pricing. Nonetheless, Dell’s analysis suggests that pressure for further price declines in oil are growing. If so, the news on inflation may be due for more good news going forward which, in turn, may give a boost to bonds and stocks. Yes, there are any number of scenarios that could render that outlook moot. But for the moment, Dell’s analysis isn’t easily dismissed.


  1. zinc

    “The distortion of the commodity futures curve by financial investment”
    The distortion of the commodity prices by financial investment is a fact of life over the past two-three years. I think the CRB index is the best inflation gauge I have seen. I wonder why the Fed ignores it.
    When does “distortion” of the market become manipulation or cornering of the market. OPEC has a distorting effect but the cartel structure is illegal in the US and the countries in question are producers. Financial speculators are non-producing middlemen who have no inherent right to drive prices up.
    Each tick in the market price above the lowest possible price, is a tax on consumers imposed by the investment players. The futures market is promoted as efficient because it provides a common ground and liquidity for consumers and producers to establish a fair, market clearing price. When financial speculators add 20 – 50 pct on to the price through futures contracts, the market is not efficient and has lost it’s usefullness. Spillover effects are significant and include creating general inflation, which is certainly the case this time.
    Part of the voters discomfort with the republicans is the ease with which financial interests have gamed the system and the look the other way regulation.

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