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

The oil industry is undergoing a major structural change.

Lifted from comments from this post US to be leading producer of oil is Spencer England’s comment about structural change in the oil markets. Obvious to some but bears repeating for a lot of us, as we discuss environmental issues or gasoline prices in the media more than structural economic impacts:

Spencer says:

The development of fracking and the tar sands means that the oil industry is undergoing a major structural change.

Use to be that one of the thing that made the oil industry very unique was that virtually all their costs were sunk or fixed costs and variable costs were relatively insignificant. Under this cost structure if prices fall it still pays to produce oil when prices fell as long as revenues covered the variable costs. So falling prices did not lead to falling output.

But now the marginal supply of oil is from tar sands or fracking where variable costs are very high. Moreover, the marginal costs of bringing in new oil from these sources is now in the $80 to $100 range.

So now, when prices fall, at the margin some producers will withdraw from the market and output will fall.

This is creating a fairly solid floor, the price for oil at about $80 — where oil bottomed last year and again this year.

Very few people are incorporating this structural change in the oil market into their analysis.


Who Cares About Nominal Rigidities?

Tyler Cowen doesn’t much.

I tend to agree with Cowen. Nominal rigidities were quite the thing just before I arrived, so I think they are over rated. However, there are two points one of which is totally twitty and the other of which is a dead horse still being beaten by Paul Krugman.

OK twitty: By definition for there to be unemployment there must be three agents, an employer, an employee and an unemployed person. The unemployed person must be eager to work as the employee does at the employee’s wage. The employer must consider the unemployed person qualified. This means that unemployment can certainly be eliminated if wages fall. At some point, either the employee decides to quit and just live off savings till social security kicks in or the unemployed person decides he or she doesn’t want the job. By definition, wage rigidity is needed to explain unemployment. This is true even if lower wages do not at all cause higher employment. If nothing else super low wages can convince people to leave the labor force eliminating unemployment that way. In this case wage flexibility doesn’t help the unemployed — it makes the alternative of working worse so they consider their horrible predicment the best they can hope for. I said it was twitty.

Second, things are unusual because we are in a liquidity trap. The reason nominal rigidities usually matter is that the real money supply could increase if the nominal money stock staid the same and wages and prices fell. From 1940 through 2008 this meant that wage and price flexibility should have prevented output from fallin. N ow, however, the money supply doesn’t matter since we are in a liquidity trap. In the IS-LM model (M/P) (money divided by the price level) appears. If P is free to adjust, then there can be no problem with insufficient aggregate demand. Therefore in all of the macro literature from 1940 through 2008, nominal rigidities were considered important. The idea here is wages go down so the firms cut prices (to maximize profits they would) so real balances (M/P) goes up so aggregate demand goes up so GDP goes up. There is no need for real wages to fall.

Right now this doesn’t matter as M/P doesn’t matter. But for decades and decades it mattered a lot, so nominal rigidities mattered. In practice, wages and prices are sticky so all reality based macroeconmists (“that’s not enough I need a majority” — Adlai Stevenson) agreed that nominal rigidities mattered. Now not so much. M/P doesn’t matter so P only matters because of debt deflation (lower P makes nominal mortgage debt an ever worse problem) so wage and price flexibility won’t save us so Keynesians don’t talk about it.

As always, don’t confuse “Keynesians” with Keynes. Keynes was not interested in nominal rigidities The General Theory through “The General Theory Restated” included nothing on nominal anything.

Oil prices and consumer spending.

With the recent surge in oil prices I thought it would be useful to look at the potential impact with one set of data I watch. It is energy as a share of personal consumption expenditures or consumer spending. In the 1970s energy consumption rose from about 6% to 9% of spending, or about 50%. In the early 2000s energy rose from about 4% to 7% of consumer spending before it collapsed. As of December energy’s share of consumer spending was already back to 6% of spending, about the level it peaked at in the last cycle before the financial panic generated a drop in other consumer spending. If you look at energy consumption this way it appears that oil consumption was already at the point where futher oil price increases would rapidly impact consumer spending on other items.

One area where higher oil prices clearly impacts consumer spending is autos, as consumer spending on new and used autos and energy have a very strong negative correlation. If rising oil prices generate a drop in real income or standard of living one of the easiest way to compensate is to delay buying a new,or used car. What would have been new monthly auto payments can be used to sustain consumption of other items. In this chart you can clearly see that this happened in both the 1970s and the 2000s. You can also see that spending on energy and autos accounted for about 10% of consumer spending in the 1990s and 2000s.

But the chart also shows that auto consumption was only about 3.5% of consumer spending at the end of 2010 as compared to a 5% to 5.5% norm in the 1990s and 2000s economic expansions. So the consumer does not really have the option to cut back on auto consumption like they did in the previous examples of oil price spikes. These charts suggest that if oil prices remain high or expand well past $100 we are quite likely to see consumer spending suffer across the board. Note that this chart of spending is based on nominal dollars.

Also note that Brent crude is already about $120 while West Texas Intermediate — the US base price — has only increased to about $100. This apparently is due to excess supplies in the Midwest because of a new oil pipeline from Canada. Such a divergence can only last so long, so that if oil supplies are interrupted for very long you can expect West Texas Intermediate to close on the Brent price fairly rapidly.

The ECB would quash a discrete shift in German nominal GDP rather than accommodate it

David Beckworth points to Scott Sumner, who points to Kantoos on the effectiveness of nominal income targeting in Germany. Kantoos’ illustration certainly suggests that the ECB has been successful in getting the dynamics of output and prices (nominal GDP) right over the last decade.

I have no contention with the historical evidence. Whether or not the historical data supports an effective nominal GDP target is trivial compared to the suggestion that the ECB will tolerate a pickup in German nominal GDP going forward. Wage pressures and lower unemployment will lead higher nominal GDP, but will likely increase German inflation as well; this will set the stage for tighter, rather than accommodative, ECB policy.

Although Kantoos did acquiesce that the ECB doesn’t officially target nominal GDP, he didn’t, in my view, give this simple fact enough face time. The ECB is the most hawkish of the G4 central banks. As you can see from the histogram of inflation over the last decade, the central tendency is very strong at 2-2.5%.

As the histogram shows, the ECB rarely institutes a policy rule that drives inflation above its stated objective: “the ECB aims at inflation rates of below, but close to, 2% over the medium term.” The ECB’s reaction-function to German price pressures will be of utmost importance, given Germany’s 26% weight in Eurozone inflation.

Kantoos and David Beckworth posit that the 2% wage growth achieved due to highly competitive German industry (see reference at end of post) is evidence that the ECB targeted nominal GDP and nominal per-capita GDP effectively. In contrast, I would argue that the ECB’s had it pretty easy, where the recession simply delayed the inevitable tightening that would have occurred in favor of the 2% inflation target.

(Read more after the jump)
Measured on a quarterly basis, annual per-capita nominal income growth in Germany averaged just 2.1% since Jan. 1999 (when the ECB took over monetary policy across the Eurozone). Germany represents 26% of the HICP (harmonized price index used by the ECB, and the weighting data is available at Eurostat table prc_hicp_inw), so upward economic pressure on German prices and output (nominal GDP), would manifest into, all else equal (i.e., not offset by deflation in other big countries), average inflation above the ECB’s comfort zone – I use the word ‘zone’ loosely; it’s 2%. The ECB is unlikely to tolerate this.

Currently, tax hikes and a rebound of economic activity and commodity prices are pressuring prices in even the ‘fiscally austere’ European economies (Spain at 2.9% annual inflation in December). So the offset to German inflation pressures on the average inflation rate are not existent at this time.

My sense is that the ECB is biding its time until German price pressures emerge before they have to tighten monetary policy across the Eurozone. For example, the ECB must have been happy that some German unions are negotiating wage hikes that are lower than the current rate of annual per capita nominal GDP growth, 4% Y/Y in Q2 and Q3 2010. (see chart above).

So how much time does the ECB have? At this time, excessive inflation is not ubiquitous in the German HICP, the ECB’s preferred measure of inflation. Currently it really is mostly a food and energy story.

I computed a diffusion index across all of the subcomponents of the HICP index for some Eurozone economies. The index is pretty simple: above 50, there are more components of the HICP that are growing at a greater than 2% annual pace, while below 50, there are more components growth below the 2% pace.

The December diffusion in Germany, 28, is lower than its average since 2004, 33. Not only has Germany historically seen prices growing broadly lower than 2%, but they still are. However, despite the low the level of diffusion, the trend is upward.

As wage contracts reset, I expect that the breadth of price increases will increase and drive overall inflation above the historical German comfort zone, 1.5% average 1995-2007 (before the recession). In the weaker economies, Portugal (not shown), Italy, and Spain, there has been a pickup in subcomponent-level 2% inflation as well – eventually pressures in these economies should fade with fiscal austerity.

However, pressures are in the pipeline. Tight capacity utilization and labor markets will inevitably drive inflation on the cost side.

According to the European Commission, the survey of German Q1 2011 capacity utilization, 84.9%, is above its decade average, 83.1%. Eventually, German firms will have to pay higher wages on the margin in order to satisfy strong(er) demand.

And German labor markets are tight. Schroeder’s labor reform has dropped the unemployment rate, 6.6% in December 2010 on a seasonally-adjusted and harmonised basis, to well below its 15-year average, 8.5%. Inflation from the cost side is certainly in the works, barring a surge in productivity, that is.

In my view, German prices should be allowed to trend upward – the German real exchange rate is too low. If Spain, Italy, Portugal, or Ireland are to have any chance at all for fiscal austerity to actually drop the fiscal deficit, German prices must rise (I’ve written about this before). In my view, though, it’s more likely that the ECB attempts to quash a discrete shift in German nominal income growth via tighter policy than accommodate it.

Rebecca Wilder

Reference: The European Commission publishes a quarterly report on Price and Cost Competitiveness, a fantastic resource. Regarding German trends in competitiveness and the real exchange rate, please see the charts for Tables 3, 4, and 5 on page 2-12 (.pdf page 16) in the latest quarterly report on price and cost competitiveness.

Price elasticity, taxes and wages: Or, why I don’t take wingnut economics seriously

by Bruce Webb

It is I think a truism that in any economic enterprise all costs ultimately have to come out of price, that in the end ‘the customer pays’. But what is not true is that price is infinitely elastic, at some point price in and of itself will restrain demand, and while you can prop up demand through some things like advertising and marketing (the ‘gotta have it factor’), at some point the ancient principle ‘what the market can bear’ will kick in. This principle is so obvious as to hardly be worth stating yet many on the Right simply turn it off and on as needed.

This was highlighted in what Kevin Drum aptly called a checkbo9ok tax:

The Democrats supporting the current legislation have assured an anxious electorate that whatever funds are used to create whatever regulatory scheme created will come from the banks, not the taxpayers. Let me emphasize that so that even casual readers will catch it: the Democrats promise that you won’t pay for their legislation, banks will.


Since when have corporations ever paid taxes, fees or penalties? Employees end up paying in the form of lower salaries and benefits. Customers end up paying in the form of higher costs.

And in this case, every account holder will be forced to pay higher fees on their checking account and savings account. That’s you, my friendly reader. Can you say “checkbook tax”? I can, and I think lots of candidates will be saying it come November.

Yes, just as the entire Republican membership of the Senate is repeating Luntz’s last gem: “Taxpayer funded bailout”. But it is crap economics.

In wingnuttia, prices are entirely elastic in regards to taxes, they just flow through to customers. Yet they are sticky in regards to anything else, for example increases in minimum wage just cost jobs. Nowhere in the argument is the real claim revealed, that taxes squeeze profits, and that managers and owners are simply looking out for their own interests.

The argument that corporate taxes somehow are just double taxation because ultimately all cost has to come out of price is just bullshit, it is the internal division of the proceeds from that sale that make all the difference, and ultimately the sales price is disconnected from simple cost. Yet the Frank Luntz’s of this world trot this same ‘elastic for thee but not for me’ argument time and time again. And it WORKS! They can always sell just about anything by pretending that the main concern of the commercial operation is jobs on the one hand and low prices on the other when the reality is that the suits could give a crap about either, if they can boost profits by closing a plant here and boosting a price there they will. Everyone knows this yet somehow the Frank Luntz’s of this world can still sell this message with a straight face.

I just don’t get it.

Oil prices VS Storms

By: Divorced one like Bush

Being that there is a lot of “authoritative” talking going on about the cause of the up’s and down’s of oil and one cause being suggested is the anticipation of storms, I thought looking at the history of storms and oil price would help toward answering the hypothesis of oil prices rising in anticipation of storm damage.

Using the daily price of WTI Cushing/Oklahoma oil I charted the relationship of price to the storm dates. I use 6 price points. A. 2 Monday’s before, B. Friday before, C. Monday before, D. Day of Storm, E. Friday after, F. 1 week after day of storm. Any number in parenthesize is the price for the next open trading day. When the storm fell on a week end, I counted 1 week after and used the next Monday.

Chart after the fold.

I do not do correlation calculations. But, I think this chart shows that there is no significant speculation in pricing based on Gulf storms. There are 4 times that the price 1 wk post storm is lower than 2 Monday’s prior to the storm. They are in order: Dolly 7/23/08 down $22.95, Dennis 7/10/05 down $2.66, Rita down 2.58 9/24/05 and Opal 10/4/95 down $0.10. Of these 4, Rita has the highest pre-storm climb of $3.92 or 6%. Dolly only showed a 2% climb pre-storm but there has been a 16% drop since her high 2 weeks before she hit.

The interesting string is the 4 storms of 2005. Katrina and Rita are the only storms that show some possibility of a storm pricing effect within this series. Katrina with an almost $2.00 (3%) rise in 2 wks and then a decline of $4.50 until the price jumped $4.30 in 1 week before Rita. However, the next trading day after Rita, the price was down $1.23 and 1 week later it was within $0.93 of the 2 weeks prior to tropical storm Cindy of 7/5/05 ( 2.5 months time between the two). As to this year, the price is just plain going down since the peak 2 weeks before hurricane Dolly which is 1 month of downward trend before the republicans started filling hot air balloons.

It appears that if there is a storm pricing effect, it is a recent phenomenon and of a rather small and short lived event. Being a new event in oil pricing, I would suggest that what effect there is, is purely emotional and related to the emotional climate we are living in. Gun shy? We only have fear to fear? Or, maybe it is an herd mentality learned that a storm is a good excuse to make a quick dollar. That would be herd mentality market manipulation. Oh no, did I just ruin it for everyone?

Guess we are going to have to find someone talking with more authority than what we have had so far regarding the cause oil pricing.