Relevant and even prescient commentary on news, politics and the economy.

Oil Prices

The last few weeks oil prices have been moving higher and few analysts seem to understand the full story.

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If there is any commodity that trades at a one world price it is oil.  So the recent weakness in West Texas Intermediate ( WTI)  is very unusual and stems from temporary bottlenecks.  Over the last few years a new major source of oil has emerged from fracking in North Dakota and other interior locations. The problem was that over the years pipelines and other supply chains for oil had been built to move crude from  coastal ports to interior locations  and refiners like Cushing, Oklahoma, not from the interior to ports. A s a consequence, when mid-western oil supplies expanded it created local surpluses and price weakness.  But now these bottlenecks are being eliminated.  In particular, two pipelines from Cushing to the Gulf Coast have been reversed and large quantities of oil are now flowing from Cushing to the Gulf ports and refiners.  As a consequence the spread between  WTI and Brent crude is  collapsing.

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Since the June low, Brent crude has risen some 6.5% while WTI has jumped some 15.7%.  This has caused the spread to collapse back to near its old pre-2011 values.  Butt in evaluating the impact of the Egyptian unrest on world oil prices the number to watch is the 6.5% increase in Brent crude, not the 15.7% increase in WTI.  But the impact on domestic gas prices is more complex.  On  the coast gas prices are experiencing small price increase in line with the move in Brent while in the interior gas prices are moving up some 10% to 20% in line with the jump in WTI.

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The Stock Market and Interest Rates

The quick and dirty rule of thumb is that the relationship between bond yields and the S&P 500 PE is one-to-one.

That is, 100 basis point change in bond yields should cause about a 100 basis point change in the PE.

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Since WWII, the long term trend for earnings growth has been some 7%, or about the same as nominal GDP growth. I’ve long thought that the PE is an expression of the present value of a perpetual stream of 7% earnings growth

In the 1990s bubble , investors came to believe that long term earnings growth had moved to a permanently higher level and that justified the higher valuation.

Now, I wonder if the market, in its wisdom is already discounting a lower level of earnings growth, maybe about 4%.  That could explain why the market looks cheap.  Interestingly, in this recovery nominal GDP growth has been very stable around 4%.

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Fed Policy and Bond Yields

Update:  Charts and data after the read more.

With the Fed completing a two day meeting and Bernanke holding a press conference today  it may be a good time to make a few comments about bond yields.

In an open economy with a current account deficit the equilibrium interest rate is the one that attracts sufficient foreign capital to finance the current account deficit with a stable exchange rate.  If the currency is rising it indicates that yields may be too high, while a falling currency implies that yields are too low.  This is important to understand because the US 10 year T-bond yields rose 46 basis points in May and the bulk of the increase stemmed from a rise in Japanese yields.  They surged because investors decided that Abenomics was working.  This, in turn, pulled bond yields up some 25 to 35 basis points in Britain, Germany, the US and many other countries.  All of this preceded the release of the Fed minutes and Bernanke’s  Congressional testimony.  Yet Wall Street and many bloggers  seem to ignore the point that two-thirds of the May bond yield rise was due to foreign factors, not the possibility of Fed tapering.

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Stock Market Valuation

Mark Thoma had a tweet asking if the stock market is  in a bubble.

I do not think so.

The market PE  on trailing operating earnings is 15.5 and my model says that based on the historic relationship to interest rates and inflation the market PE should be 21.5%.

Obviously, either the market does not believe rates will stay this low and are using a higher interest rate or they expect  long-run trend earnings to slip far below the long run trend of  7%   The market PE is an expression of the present value of expected long-run earnings growth.  The long term historic average for the market PE is 15, almost exactly where it is now.  Of course there is no central tendency for the market to converge on a PE of 15.  If you do a histogram of the market PE you will find that the probability of the PE being on any number between 10 and 20 is about the same.


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Maybe we just need to look at the market from a simpler perspective.

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Solar Power

Last year I had solar panels installed on my roof under a deal where I pay nothing up front for the installation and pay the solar company for the power I produce at a rate about 75%   of  what I pay the electric utility.

I just got my April bill from the electric company.

It was a credit for $15.54, so I actually produced more electricity than I consumed in April.

Over the winter months I met about half of my electric needs from solar.

I thought that was pretty good for the Boston area.

So it will be interesting to see what happen this summer when solar production should be maximized.

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World Industrial Production

I see some evidence that higher domestic energy production and improved competitiveness of US manufacturing is having a positive impact on the US trade balance and US industrial production. But I still expects the impact to be limited. In particular, the real non-petroleum trade balance continues to deteriorate. Increased supplies of cheap natural gas helps the petrol-chemical industry, but  its impact on other industries appear limited. If their is any segment of the economy where the rule of one world price holds, it is energy. Cheap energy prices in the US will only last until the industry can remove the bottle-necks and open those markets to competition. Firms do not build new plants to exploit temporary advantages.  Work is already underway to reverse a pipeline from the Gulf Coast to Cushing, Oklahoma so the surplus oil in the Midwest can be exported.  The Boston  Globe reported that an application was just filed to reverse the oil pipeline from the Maine Coast to Montreal to facilitate exports of Canadian tar sands oil.

If you compare US industrial production to the rest of the world there does not seem to be much of a change that can not be traced to recent world economic growth rather than structural changes in US production.


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In real terms the total trade balance is improving because of reduced oil imports and expanded oil exports.

But, excluding oil, the real trade balance is still growing.  The rate of growth may be slowing, but that seems to stem more from weak  world growth  rather than structural changes in the US.


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Moreover, real non-petroleum exports are clearly peaking and may be rolling over.


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Employment Situation

The headline numbers in the employment report were very weak as  payroll employment rose by only 88,000  and the household survey reported a -206,000 drop in employment while the labor force fell by -496,000.  The futures markets are reacting very badly.  But the workweek expanded and aggregrate hours worked increased 0.3% as compared to 0.5% last month.

Private payrolls grew  96,000  and government employment fell 7,000 implying that the sequester is not yet having a significant impact.

After falling to  below trend last year hours worked is now back on the 0.2% trend displayed earlier in the cycle.   So basically it looks like the headline numbers are overstating the weakness.

Interestingly, my bond valuation model still says that the 10 year T Bond yield should be about 1.5%.
 The model still has fed funds in it, but  nothing else to capture other measure of fed policy..

Average hourly earnings were essentially unchanged last month, but the smoothed data still implies that wage gains have bottomed.

Average weekly earnings also still looks like it has  bottomed.

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