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Oil's Inflation Bubble

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Oil prices continued to fall on Wednesday to a low of  $121.60 but the reasons were not obvious. Several analysts claimed it was due to the Bernanke speech on Tuesday where he warned that inflation had become a more prominent concern. Others believe the drop is from fears of demand destruction with U.S. gasoline at $4 per gallon. Still others believe the cost of fuel worldwide and the strikes, protests and mob scenes are a picture of a sharp slowdown in consumption worldwide. All of those factors are definitely in play but the real problem is the calendar and the CFTC.

Bernanke's inflation fears are being fueled by the high price of oil filtering through the economy in everything from straight gasoline for consumers, diesel for truckers carrying products to stores and for the rising price of thousands of products made with oil. Crude oil is the most common ingredient in nearly everything we use in our daily life. You can't have oil double in price over the last 18 months and not have inflation. The Fed tries to ignore this problem by looking at the Consumer Price Index core rate for their inflation numbers. The core rate excludes food and energy from the calculation. In my opinion this is absurd since everyone with a heartbeat uses both fuel and food on a daily basis. Actually according to the government statistics the price of food has risen even more than oil in percentage terms over the last year. Analysts are afraid the Fed has suddenly switched into inflation mode and interest rates could begin rising as soon as the FOMC meeting on June 24th. Rising rates slow the economy and depress oil consumption. I realize this is a flimsy excuse for crude to decline given the growth in the BRIC nations but it is definitely one being tossed about in the news.

Inflation in China is also being blamed for the decline in prices. China is currently undergoing its worst bout of inflation since the 1997 disaster. Fuel prices are soaring even though China sets the official price. Fuel in the black market is selling for nearly double the stated price. With oil at $125 and price controls on gasoline and diesel the Chinese oil companies are refining only the bare minimum in an attempt to cut their losses. You can't buy oil at $125 and sell the refined products for $60 and survive.

The problem of gasoline subsidies is not just in China. India hike is prices by 10% on Wednesday and Malaysia raised their prices by 40%. That was the second increase of the year for India. Indonesia and Taiwan have also announced they were cutting back on subsidies to save money. Some countries subsidize fuel to encourage growth in the economy. Cheap fuel allows fledgling startup businesses to make a profit and grow. The problem is what happens when the government takes away the cheap fuel. Consumers think they should always have it and don't understand the economics behind the move. Over a dozen countries are literally losing billions every month because they can't raise the prices for fear of riots. We are already seeing that all over the world. Truckers, retailers, fishermen, workers are all rioting and protesting over rising fuel prices. Over a dozen cities reported riots already this week. Those who were scratching out a living on 25-cent gasoline can't make ends meet on double or triple that amount even though that would still be a huge subsidy.

The impact to the airline business is being felt every day. United announced today they were grounding an additional 70 planes, cutting 1,100 more jobs and slashing capacity and routes to cope with prices. China's booming airline business is crumbling as well. Both the major Chinese carriers announced sharp cutbacks in service this week. United said it was going to ground its entire fleet of Boeing 737s, a total of 94 planes. They are also going to ground six of their 747s the least fuel efficient plane they fly. United said it was going to scrap its coach-only "Ted" service and reconfigure the planes for regular routes. By rough count over the last 60 days there have been more than 500 U.S. planes taken out of service or announced they were going to be removed from service.

I still believe the decline in crude prices is related to the CFTC and their potential changes in crude futures trading. Institutional investors are afraid the CFTC will announce some sweeping change and everyone will be forced to run for the exits to avoid the new rules. They are simply taking profits ahead of the changes. Secondly this is the time of year where oil prices tend to decline. They ramp up into the Memorial Day weekend in anticipation of the summer driving season. Once past Memorial Day prices tend to decline as traders take profits and wait for hurricane season to heat up later in the summer.

Crude prices are suffering for all the reasons listed above and not any single one. I expect prices to cool assuming we don't have a gulf hurricane and decline in October. There is a lot of new production coming online in 2009 and that could cause a temporary oversupply if demand continues to slow due to price. By the late second half of 2009 we will be staring at a production dry spell for several years and 2010 is my target for peak oil to finally arrive. When it arrives we will look back at $120 oil and say remember when?

Jim Brown

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