PlexNex

COMBUSTION: Fuel Perspectives

What does it take to understand that prices -- that is, the cost of living -- are certain to rise broadly & durably due to the follow-on effects of the high price of fuel?

Delta

Delta Airlines (AP newswire) is trimming jobs, reducing planes and cutting flights while stating they expect their jet fuel bill next year to be $2 billion higher than they had previously anticipated. Fuel was already, at 29 percent, the largest cost component of Delta's operating budget.

FedEx Bellwether

Recent quarterly earnings at FedEx are down 6 percent, versus the year-ago period (AP), and executives echoed the note from UPS that shipments are down since late January.

Clue-Stick

During our President's Pentagon speech this week on the fifth anniversary of the invasion of Iraq he appeared to be under heavy sedation. It seems to be dawning on him not only that Iraq didn't work out, but also that his adventure has killed a hundred thousand people and is helping to wreck the economy.

FT's Andrew Ward reported this week on President Bush's earlier oil price epiphany ...

During a White House press conference last month, George W. Bush was startled when a reporter asked what advice he had for Americans facing the prospect of $4 a gallon gasoline.

“Wait, what did you just say? You’re predicting $4 [That quote in Euro and GBP -- €2.55, £2.02 -- probably doesn't startle Europeans. -ed] a gallon gasoline?” the president replied, prompting the reporter to assure him prices were indeed closing in on that figure. “Oh, yeah? That’s interesting. I hadn’t heard that.”

Presidents and other heads of state in white stucco houses do not drive themselves, so you can imagine why the synapses are slow. But this is proof that the President doesn't read or speak with his advisers -- and has probably been sedated for more than a few weeks.

Understanding $100 Oil

Here in the US it costs three times what it did only a few years ago to fill the Land Rover. Up against encroaching thoughts of dusting down one's old bicycle, one wonders why?

The triple-digit oil price has four clear influences: a surging global economy; tight capacity; good but uncertain supply; and financial forces only loosely coupled to oil.

People are doing well, starting businesses, borrowing money and spending it on productive enterprise; all this activity requires transportation, heat and electricity, a great portion of it provided by oil. China, the world's most populous country ( 1.3 billion, GDP per capita of $2,460) is developing an urban middle class. India too, the world's second largest country (1.1 billion, GDP per capita $965), is gaining similarly. Off low bases, such vitality increases worldwide competition for energy resources with direct effect. Oil demand is thus firm, growing and seems unlikely to relax.

Capacity is not too abundant. As of April 2006, spare oil refining capacity had narrowed to a bit less than 3 percent of demand, said oil expert Leo Drollas of London's Center for Global Energy Studies. Low oil prices in the 1980s and 1990's had quelled investment in facilities and people; but higher prices now are driving expansion again.

Current oil stocks are low. According to The Economist:

"Every time a tempest brews in the Gulf of Mexico or dark clouds appear on the political horizon in the Middle East, jittery markets have pushed prices higher. This week, it was a cold snap in America and turmoil in Nigeria that helped the price reach three figures."

Supply seems precarious. Nigeria is torn by bitter local rights disputes. State-run oil regimes like in Russia and Venezuela are withholding supply from open market trading. Iraq is an unknown. Tensions with Iran make Persian sources unlikely. Worries about the future stretch the risk-premium of the barrel price.

Reserves (in the ground) are ample but not certain. The Oil Sands in Fort McMurray, Alberta, Canada, hold more oil than the Arabian Peninsula by some measures, for example, yet environmental concerns and the high costs of extraction mean this abundant potential may not count.

Shifts of capital are in play, too. Leo Drollas notes that the amount of money tracking commodity indices increased almost ten fold between 2001 and 2006 to about $70 billion. Oil, a good portion of the commodities index basket, is bid up merely due to mechanical index-matching flows into futures contracts. Arbitrage then pulls up the current spot price of a "wet" barrel to meet the technically driven futures price, unrelated to fundamentals.

Currency weaknesses punish oil-importing nations and we feel this acutely at the pump. A falling dollar makes the imported barrel more expensive at home. Americans consume 20.6 million barrels per day, of which only 6.9 million barrels originate domestically. Americans are therefore vulnerable to currency effects on more oil than the number two consumer, China, uses overall.

Oil the bicycle, Darling! But sparingly.