Rising energy prices pace CPI surge
Supply and demand in the oil market contributing to inflation.
Nominal retail inflation in May soared by a faster-than-expected annual pace of 5%, the consumer price index’s (CPI) largest year-over-year (y/y) gain since August 2008. Energy costs were the single largest contributor, with a sharp 28.5% increase over the past year. Moreover, core CPI, which strips out food and energy costs, rose by a faster-than-expected 3.8% y/y in May, which is the most rapid increase in 29 years.
The S&P 500 climbed to a new record high of 4,250 yesterday—rising inflation provides companies with more pricing power in the recovering economy. Stocks have rallied by 13% this year and by 94% from the market’s pandemic bottom in March 2020. The S&P is now less than 6% away from our full-year target price of 4,500.
But despite the surge in inflation, benchmark 10-year Treasury yields continue to grind lower, hitting an overbought, 3-month low of 1.43% earlier today. This makes very little sense to us, as we’re still expecting that yields will rise to 2% or higher by year-end. The bond vigilantes, in our view, must believe the Federal Reserve’s explanation that the current inflation spike is transitory. As the procedural base effects completely roll off in coming months, they reason, then inflationary pressures should ease.
We’re not sold on that thesis, however. Crude oil (West Texas Intermediate, or WTI) and gasoline prices have soared by 112% and 45%, respectively, over the past seven months, with higher prices likely over the balance of this year. We believe inflation will be stickier and more sustainable than the Fed expects, in part because it appears energy prices have further upside room to run.
Oil prices rebounding As the global economy began to reopen in the second half of last year, crude oil prices (WTI) rebounded from a negative $40 per barrel in April 2020 to a positive $40 per barrel over the summer. Sitting at an oversold $34 per barrel in early November 2020, WTI has more than doubled to $71 today, a 3-year high. What fueled such a strong recovery? Operation Warp Speed was a success and nearly two-thirds of the U.S. adult population has been vaccinated, so the economy is rapidly reopening, creating a surge in both travel demand and energy usage. As a result, we are sticking to our long-standing and very out-of-consensus forecast for a $90 target price for crude oil over the next year.
Pain at the pump Over this same period, the daily national average for lagging gas prices is at $3.08 per gallon today, which is a 7-year high, up 46% from $2.10 last November. Prices are much higher, of course, in states like New York and California. The American Automobile Association (AAA) projects that gas could hit $4 a gallon in some states later this year, as drivers hit the road again in earnest when their states re-open. So if oil and gas prices continue to rise over the balance of 2021, there’s also a good chance that nominal inflation will continue to grind higher.
It’s all about supply and demand At a meeting earlier this month, the Organization of the Petroleum Exporting Countries (OPEC+) affirmed its plan to increase overall production by 350,000 barrels per day (BPD) in June and by another 441,000 BPD in July. Meanwhile, Saudi Arabia plans to continue gradually reversing its own one million BPD production cut (implemented last January) by adding 250,000 BDP in June and another 400,000 BPD in July. OPEC believes that demand growth will continue to outstrip additional supply, which should keep prices firm and moving higher.
Biden’s policies contribute to rising energy prices In his first five months in office, several of President Biden’s energy policies have contributed to the tighter global supply/demand balance and rising prices. Due to environmental concerns, the Biden administration has canceled the Keystone XL Pipeline project, banned fracking on federal lands and suspended oil leases in Alaska’s Arctic National Wildlife Refuge, which have helped to reduce the global supply of oil and boost prices over the past several months.
In addition, Biden’s administration has accelerated the longer-term shift to electric vehicles. Although we are still a decade or more away from a critical mass of electric autos, Biden’s executive orders raise questions about whether we have already achieved peak oil demand for transportation, which is resulting in less exploration and production (E&P) activity among the major oil drillers. Consequently, major oil companies are reducing their E&P budgets and diversifying into renewables.
Iranian wild card The Biden administration’s efforts to re-engage nuclear disarmament talks with Iran could lift its U.S.-imposed oil production sanctions. Because OPEC’s third-largest producer is not currently subject to any OPEC quotas, Iran potentially could add one million BDP or more onto the market over the next year or so, which could eventually take significant market share from the U.S.
Gas lines revisited? A half-century ago, OPEC owned the global oil market, and its Arab-oil embargo against the U.S. sharply reduced supply, spiked prices, pushed our economy into a deep recession, and forced Americans to wait in hours-long gas lines on odd-even days to fill up their tanks. Never again, we said, and through the technological innovation of fracking, the U.S. became the largest oil producer in the world at 13 million BPD, ahead of both Russia and Saudi Arabia.
But our recent policy decisions put us in a potentially disadvantageous position, as we voluntarily relinquish our market leadership while prices soar yet achieve nothing on our goal of improving the environment. The reality is that OPEC, Russia, China and Iran, among others, will gratefully fill the oil-market void that we’ve created by shooting ourselves in the foot, with no concerns about the resultant environmental impact. And as energy prices continue to rise, nominal inflation in the U.S. may become less transitory and more sustainable.