Oil vs QE3

So, last night, the US October CPI deflated. Yes, month on month it fell 0.1%. Year on year was less salutary, up 3.5%. Here is the breakup:

The big fall year on year was in the energy index, down from 19.3 this time last year to 14.2 this year. So, with the CPI disinflating some is there hope (despair) for further monetary stimulus, that is QE?

I think not! For one simple reason: oil is back at $100 (WTI that is, neither Brent no TAPIS got anywhere near it on the downside). Here are the charts. First, the oil price:

And second, the US gasoline price:

Note the similarity of charts and consistent falls into October, as well as the absence of the current 20% surge. Stand by for a lousy CPI in the next few months.

So, why is oil up? Well, Middle East instability never helps. We’ve got revolution brewing in Syria. Unresolved revolutions in Egypt and Libya, as well as simmering Iran/Israel tensions. But none of that is why, in my view, oil just won’t go away. As I’ve argued before:

Commodity supply is inelastic. That is, it cannot respond quickly to a sudden surge in demand. The chart offered below (and mentioned above) shows the effects on any given market if supply cannot respond quickly. Don’t be scared of it, it is easier than it looks:

Q0 and P0 represent the initial equilibrium situation in any market. Initial demand is provided by D0, whereas supply is shown as either SR (restricted) or SU (unrestricted).

Following an increase in demand, such as a surge of emerging markets looking to engineer an historically swift catch-up in living standards through mass urbanisation, the demand curve shifts outwards from D0 to D1. When commodity supply is restricted, prices rise sharply from P0 to PR. By contrast, when supply is unrestricted, prices rise more gradually from P0 to PU.

The situation works the same way in reverse. For example, if there was a sharp fall in demand following a contraction like that of the GFC or an inflationary bust causing commodity demand to fall from D1 to D0, then prices fall much further when commodity supply is constrained.

The graph illustrates that demand shocks combined with inelastic supply do not result in a one way bet of upwards price movements. Rather, such economic settings produce volatility, with steeper price rises and spectacular collapses.

Why you might ask? It’s pretty simple. This is a mathematical representation of human panic. When a market is perceived to be unable to increase supply easily then speculators move in. In strategic markets like oil, governments begin to fret about security of supply. They stockpile. More speculators enter the market. So on, and so forth.

Obviously this is especially the case with oil, which labours under the perception/reality of peaked supply. In such markets, spare capacity plays a big role in determining price. I’ve updated my previous OPEC spare capacity versus the oil price chart:

As you can see, despite growing global weakness, spare capacity has been falling consistently over the past six months. The market panics that afflicted the oil market in August and September (as well as every other market) did not reflect this reality and hence, as some modicum of calm has returned, the oil price has risen on the growing perception of supply scarcity.

Roughly 1.5 million barrels of this supply capacity drought is locked out in Libya so getting oil flowing there will make a big difference. It is projecting a steady resumption, with 40% returned by year end and all of it by June 2012. But it shows as well that until global growth takes a real wallop, oil is going to be a serious pest.