The Economist's Buttonwood Tree worries about oil prices. It misses one macroeconomic angle: a rise in oil prices functions (macroeconomically) like a demand-reducing tax increase in the short run, but it also raises the inflation rate. You cannot rely on a Federal Reserve with any worries about its credibility to lower interest rates to cushion the impact.
Economist.com: ...the more nervous, Buttonwood among them, worry about the situation in America. An increase in gasoline prices acts as a tax. And this sharply higher tax is being forced through just as interest rates are rising and fiscal policy is being tightened.
American households are already stretched, with debt-service costs at record levels. It should therefore come as little surprise that the economy is showing signs of weakness. The message from the Treasury-bond market, which tends to thrive on slow growth and low interest rates, is not a heartening one: yields are little higher than they were at the beginning of last year. Weaker growth might, of course, translate into weaker demand and thus lower oil prices, at least briefly. But clearly that point has not yet arrived. And governments and companies will probably take advantage of any drop in the oil price to build up stocks, thereby putting upward pressure on the price.
The big question for financial markets is: who will pay the tax that a higher oil price represents? Clearly, America as a whole will fork out in some way because it is a net importer of oil, and the effects of the rise in the oil price are greater there because gasoline is taxed so lightly and oil is denominated in dollars, a currency that shows every sign of weakening further. It is, of course, a moot point whether it will be mainly consumers or companies who pick up the tab. In the 1970s the tax was paid for largely by consumers in the form of inflation, which ate away at the worth of any investment with fixed returns. But this time inflation is muted, for now at least: consumer prices actually fell in July. This may be because, with the world economy now so interconnected, companies find it hard to push up prices.
If consumers do not pick up the full tab, companies will have to pick up some of it through lower margins. There is plenty of room for them to do so because profits are at record highs. Falling profits are unlikely to be anything but baleful for a stockmarket that is generously valued and under pressure from rising interest rates. Any industry heavily exposed to a high oil price and falling consumption would not seem the most toothsome of investments. Possibly, then, car companies and (especially) airlines might best be taken off the menu. Shares in both have already lost around 20% of their value this year, compared with a fall of some 4% in the S&P 500....
The last two sentences are strange. Taken together, don't they say that car companies and airlines should stay on the menu? That the market has already priced its estimate of the effect of higher oil prices? The question for investors, after all, is not, "What will the future be like?" The question is, "What will the future be like relative to the future that the market already expects?"
Posted by DeLong at August 18, 2004 11:18 AM | TrackBack | | Other weblogs commenting on this postThis may be stating the obvious but, isn't the problem one of risk premium? And that those industries most directly dependent on oil are at higher risk, thus making any market estimates less reliable?
Posted by: peBird on August 18, 2004 12:18 PMThe warning is not just that these stocks are overvalued like AAPL with its PE ratio of 50+. AAPL is solvent for a while and continës to reinvent itself.
Especially the airlines but less so autos might go belly up as in LTV. High gas prices are bad for auto company profits. So don't worry about short term collapse in value that may make a comeback over 3-5 years. Worry about collapse, Enron style, stick a fork in it.
Posted by: bakho on August 18, 2004 01:19 PM>>The question for investors, after all, is not, "What will the future be like?" The question is, "What will the future be like relative to the future that the market already expects?" <<
Good point, thanks for pointing out the column!
Posted by: Mats Lind on August 18, 2004 01:26 PMIn addition to the recent hit from high gas prices, auto mfg are experiencing high health care costs:
"The Big Three’s health care bills are staggering.
GM alone spends $4.8 billion — $1.3 billion just on prescription drugs — for 1.1 million workers, retirees and their dependents. The world’s largest automaker estimates health care costs amount to $1,400 for each vehicle it sells in the United States, and that number is rising.
Toyota Motor Co.p.’s health care costs per vehicle average about $300, GM estimates.
“It puts us at a severe disadvantage when we’re struggling to remain competitive,” GM spokeswoman Kimberly Hippler said.
Ford spends $3.2 billion a year for 560,000 workers, retirees and dependents, or about $1,000 per vehicle. The company spends more on health care than it does on steel.
DaimlerChrysler AG’s Chrysler Group spent $1.9 billion in 2003 on health care and prescription drugs for 390,000 employees, retirees and their dependents. That works out to $1,300 per vehicle."
http://www.detnews.com/2004/autosinsider/0408/18/a01-246154.htm
Posted by: bakho on August 18, 2004 02:11 PMButtonwood is right to short car and airline stocks if he thinks that the market hasn't fully accepted that oil is staying up at 50 d/b indefinitely AND if oil really IS staying at 50 d/b.
Mind you, a lot of investment in these stocks is now hedged. Longs in one auto company are sure to be hedged with shorts in another, or something related like parts manufacturers. This provides a fairly strong floor for the moment.
The Economist is in the business of selling economic analysis to market participants among others, it is has any self-respect, it is not writing things that market marticipants already fully understand... :-) And wether that's actually the case or not is another issue. The $100 bill will not lie on the sidewalk indifinetely, but it will take somebody at some point to notice it, for it to find a comfortable purse. I find us economists a little too ready to assume time (and friction) out as a dimesion of our analysis, convenient assumption for sure, but a risky one also I think in terms of the realism of our predictions.
Posted by: Jean-Philippe Stijns on August 18, 2004 08:02 PMNo-one is pointing out the obvious fact: what sort of insane lunatics
(a) bet on the price of oil TEN YEARS from now. My god, how is this different from rolling dice?
(b) bet that that ten year price will be lower than what we have today
(cf http://www2.barchart.com/dfutpage.asp?sym=CL&code=BSTK) which if I understand it correctly is charging $35 for a barrel of oil delivered 6 yrs from now.
Doesn't the gap between this and the real world of god-knows-what about to happen in Iraq, and substantially larger oil usage by China (and probably India) seem rather worrying?
Posted by: Maynard Handley on August 18, 2004 11:07 PMMaynard; the answer to your 1) is that there is actually very little trade in ten-year contracts, and what there is is usually between industrial parties on both sides.
The answer to 2) is that a barrel of oil in ten years is worth less than a barrel of oil now, because you have to "tail" the price for the interest you could have earned on the money by not buying the oil. My back of an envelope calculation is that $35 ten year forward would be equivalent to about $50 spot.
dsquared: Really, only about 3.63% for ten years? Ten year T is around 4.25% right now...
My quick instinct is that if the airlines haven't been hedging their fuel costs, they're a massive short on the general principle that they don't understand their business.
The auto industry is another issue. In the US, they adapted in the late 1970s, and then again when Japan started eating their lunch (exception noted for AMC which either adapted too soon or defined itself too poorly).
If you're shorting the auto industry, it shouldn't be because of oil price fluctuations, which can be adapted and innovated around (e.g., sell some of the cars popular in Europe, Israel, etc. around especially urban areas, where people are NOT driving 60 miles/day to work). The short in the auto industry should be because it has become a collection of finance companies, meaning that the P/E too high for the group and the cash flows are too subject to rate shock and inflation, of which oil is only one aspect.
Posted by: Ken Houghton on August 19, 2004 06:58 AMFor auto stocks, don't go by P/E which is very low at the moment. People buy auto stocks for the dividends, not growth potential. Auto is a mature industry, not a growth industry.
Posted by: bakho on August 19, 2004 07:51 AMDaniel I realize the point about the carry involved in ten year oil, but that's not my point. My point is that surely $50/b is not a sensible expected price for oil ten years from now? That just seems awfully optimistic.
I mean, my understanding is correct, is it not? I give you $35 today, and you give me a barrel of oil ten years from now. This seems like a great deal for me (buying the oil) and a loser deal for you (selling the oil).
Is this a reflection that the industrial/financial establishment really really really doesn't believe in increased demand and essentially static supply (some geologists say the peak production is due in about 5 yrs, but let's leave that aside and go with static)? Is is a reflection that certain sellers are so desperate for dollars today that they'll sell future oil at silly prices?
Posted by: Maynard Handley on August 19, 2004 11:54 AM