Higher Inflation Is On The Way
Current monetary policy is setting the U.S. up for a period of high inflation and asset bubbles in 2021 that will inevitably be followed by a deflationary bust. The current policy of zero rates and unbounded growth in the money supply widens inequality and does not support the Fed’s mandate of long term price stability and full employment.
Let’s dissect some of the likely things to happen in the next six months and see what the world might look like come June. First, with oil. Oil prices have been steadily climbing over the past couple months, despite the increases in Covid cases and associated lockdowns. Yesterday, the EIA put out a report showing crude oil inventories increased by 15M barrels, and where did prices go in response to this bearish new? Up. The oil markets are trying to tell us something. Oil prices go up when the market is worried about the potential for supply to not meet future demand. Based on my view of 2021, this worry is justified.
This shortfall of supply is driven by a lack of investment in the oil sector. Much is being said about the transition away from oil, but this will likely happen much slower than people expect. In 2025, gasoline powered cars are still likely to make up ~90% of new car sales. Once sold, these cars stay on the road for years and years, consuming gasoline. The ~10% of projected 2025 new car sales coming from electric vehicles still represents significant growth for the EV industry, which is expected to make up only 2.5% of new car sales in 2020.
This transition away from oil is likely to happen even slower for other petroleum products where there is less investment in oil alternatives (ex. Jet Fuel, Red Solo Cups, N95 Masks, etc.).
Despite the obvious demand for oil in the years to come, the recent shortfall of investment is understandable. Investors in oil companies have been burned, with 100's of North American Oil Exploration & Production companies going bankrupt in the past five years. The one’s that survived rewarded investors with consistent negative returns on capital due to oil prices falling by ~50% over this period.
Companies have responded to this trend, and the recent pandemic-induced oil price crash, by slashing Capex budgets in a bid to survive. In 2020, Global Exploration & Production Capex will be about 50% lower than what it was in 2014, and this is expected to continue to fall in 2021.
This wouldn’t be an issue if we could just use existing oil wells to maintain the current level of supply, but unfortunately that’s not how the oil industry works. New drilling has to happen to make up for declining output from older rigs. This is especially true for shale, which is responsible for essentially all of the growth in production over the past decade (and the decrease in prices). Shale technology allows for a greater percentage of a well’s production potential to be captured in the first couple years compared to traditional oil wells. This is good for shale investors, as it reduces the amount of time it takes to have sales exceed the initial cost of drilling. However, this also means that shale rigs have to be replaced at a quicker rate compared to traditional oil wells. This is not happening as seen by the sustained reduction in global rig count:
This drop is more concerning than what happened in 2016 for a few reasons. First and most obvious, the lack of a rebound: producers are uncomfortable investing until the pandemic is under control. But also, a greater percentage of our oil production comes from shale now, and these wells need high rates of replenishment, which isn’t happening. Also, 2017 demand didn’t experience close to the same level of demand growth that 2021 is likely to experience. The EIA expects 2021 demand to increase by 6M barrels per day compared to 2020, an estimate I view as conservative based on my view of pent up demand and the impact of the vaccine roll out. The EIA also expects supply to increase by 3M barrels per day in 2021 compared to 2020. I view this supply growth as next to impossible given current rig count levels and the 6–12 month lag between a contract for new drilling and getting actual output from a well.
This is the foundation for my view that oil prices will continue to rise. I believe we won’t see the necessary increases in Capex to meet demand until oil reaches the $60–70 range. Budget constrained E&P companies need to have strong margins before weary oil investors & executives feel comfortable with increasing investment again. It’s also important to note this range, which I expect to happen sometime in Q2 of 2021, would represent a more than doubling of oil prices from Q2 2020 levels.
This price range for oil likely means higher inflation than we’ve seen at any point in the past 20 years. A recent Federal Reserve study found that for every 10% increase in oil prices, the U.S. experiences a .7% increase in overall prices (CPI). Let’s be conservative and say the link is .5% for every 10% increase in oil; that would mean a 100%+ increase in oil prices would result in a 5%+ increase in overall prices. That doesn’t begin to account for all the other supply chain disruptions from the pandemic and the likely demand pull inflation coming from them next year.
Current monetary policy is doing nothing to address this coming inflation, but it is doing a lot to fuel asset bubbles. Take housing as an example. Mortgage rates continue to hit new lows as a result of current Fed policy. This is already acting as a catalyst for home price appreciation with housing prices going up at the fastest levels since the early 2000’s. Mortgage rates are also a leading indicator, meaning it’s likely that prices rise at an even faster rate over the next few months, as a result of where rates are today:
Rapidly rising home prices over a time period when millions have been put out of work is indicative of a bubble, one that is unlikely to deflate until rates increase. Valuation metrics for the stock market show similarly concerning trends: stocks have become too expensive. My view is these bubbles are likely to continue to inflate as long as rates stay this low.
Based on Fed communications to date, it seems highly unlikely the Fed will raise rates in the next six months. The market is currently pricing in a 0% chance that rates will rise through the June Fed meeting. I believe this is a mistake.
If we look six months into the future, my view is consumer price inflation will be well above Fed targets. However, the real issue is housing and stock market bubbles inflating to a point of no return. Here, point of no return means a situation where any small increase in rates becomes enough to pop these bubbles and create another bear market. This will result in additional Fed intervention, ever widening inequality, rinse and repeat. This can be avoided. Employment will likely continue to recover, even with the Fed taking a proactive approach to preventing excess inflation and asset bubbles. The Fed should raise rates, as the vaccine gets rolled out, to achieve this objective.
That being said, what I think the Fed should do and what I think the Fed will do are two different things. I think the Fed will continue to keep rates unnecessarily low, and as such, I will be staying long stocks, oil & other commodities, and short Treasuries.