From the tech bubble to subprime to Goldman Sachs — how producers are facing tough times ahead.
Last week, Hamza Khan, analyst at The Schork Report, examined the Consumer Price Index (CPI), which measures the price paid by urban consumers. We considered the figures positive for consumers as prices grew by just 0.06%, well below the 0.18% increase seen during last year.
On the breakdown, the gasoline index fell by 0.82% despite stronger prices on the Nymex futures market. This is good news for the consumer, but potentially bad news for the upcoming earnings season for the refiners.
To demonstrate why, Khan looked at the Producer Price Index (PPI), which measures the revenue received by an item’s producer, whereas the CPI measures the price paid by consumers. The CPI includes taxes while the PPI does not. Details of other small differences can be found on the Bureau of Labor Statistics Web site.
Ostensibly, the CPI/PPI ratio measures the premium received by producers for providing goods to consumers. There are two major implications of the ratio: firstly, it measures the incentive for producers to produce, and secondly it measures whether producers will absorb higher wholesale costs or pass them on to consumers. For total goods, the U.S. economy saw several decades of growth as cheap imports fuelled domestic production, as demonstrated in the chart in today’s issue of The Schork Report.
Following the tech collapse of 2000-01, investors began to look for alternative investments and found them in emerging markets and commodities. As the prices of commodities — from rice to iron — soared, producers were forced to pay more for raw materials.
The CPI/PPI ratio peaked in December 2002, as wholesale prices increased out of step with prices charged to consumers. To make matters worse, summer 2008 saw consumers cutting back on spending as the subprime crisis spread to the rest of the economy. At this point, the CPI/PPI ratio was already falling, which meant producers were not receiving a large enough premium to produce. This led to large lay-offs and scale-backs in production, making the recession worse. The ratio recovered after the commodities bubble burst, but has been falling again, from a local peak of 1.252 in July to 1.210 in March — i.e., producers are facing tougher times again.
Nowhere is this effect more acute than in the gasoline sector, as demonstrated in the Chart of the Day in today’s issue of The Schork Report. At the end of 2007, producers attempted to increase prices in line with rising futures costs. This helped boost the CPI/PPI ratio from 0.967 in November ’07 to 1.065 in December. But crude kept climbing past 100 and the ratio fell back to 1.007 by June ’08, the peak of the bubble.
Refiners knew demand destruction would take place if prices at the pump rose too quickly. Fortunately for them, the bubble popped and their premium rose back to 1.249.
In January of this year, as crude oil prices ran up to $86, the producers premium dropped back to pre-bubble lows of 1.010. Prices at the pump were soon jacked up and the ratio as of March stands at 1.045. With prices at the pump already approaching $3.00 we appear to be stuck in a catch 22.
If producers do not increase prices, they will face heavy losses à la 2008, leading to layoffs and cutbacks in the long term. If they do increase prices, consumers will have less money to spend on other parts of the economy — potentially strangling the nebulous recovery.
The compromise is that prices for Nymex WTI remain around 85.00, prices at the pump remain north of $2.80 and the CPI/PPI ratio remains around the 2006-07 average of 1.098. This will lead to more pain at the pump in the short term, and refiners will not see early ’09 level profits, but once the shock wears off it bodes well for the economy as a whole.
Unless, of course, the SEC’s case against Goldman Sachs falls apart. Traders will return to the market with a writ of carte blanche, and with the star player leading the team again, prices will rally to 95.00 and above. Good news for Wall Street, bad news for Main Street...so what’s new?
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Stephen Schork is the Editor of The Schork Reportand has more than 17 years experience in physical commodity and derivatives trading, risk systems modeling and structured commodity finance.