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Category Archives: Oil Prices / OPEC / Oil Industry

Here are responses to some comments.

Bernard commented that there are other factors that need to be taken into account. Correct.

I was looking for a short cut to get a sense of how things will unfold in the next 2 year, because nobody did predict this housing bust or its magnitude, the recession or for that matter that the banks would get into this supersized mess.

Some times when modeling I divide factors into fast and slow variables, (its an art) compared to oil price swings almost everything looks like slow variables, and are in an approximate steady state, then oil becomes the major drive in the short term.

Zachary was curious how much reliance you can put on using average numbers, in particular with respect to arriving at gas costs as a % of discretionary income.

I usually don’t like using average numbers (because I’d rather build fairly detailed models) but in the absence of good publically available data, averages will do. We’ll know by 1Q 2010 how this gas price hypothesis works out.

My bet is that gas cost as a % of discretionary income is a pretty good indicator of consumer spending but needs testing. To get some idea of its potential effectiveness, look at what happened by 2Q 2008. In Denver many people stopped driving cars and switched to Light Rail and buses. The Light Rail, usually not crowded, was packed. Jammed packed.

Another way to look at things is that any policy that increases discretionary income will help restore the consumer spending (and therefore this economy), while that which reduces discretionary income will retard the consumer spending.

To this we can add, an oil price hike just transfers the funds from US government policies to oil producing nations because the effects of the enlargened discretionary income is negated by the increased energy costs.

If you keep enlargening the ‘pie’ you get inflation, if you don’t, you lock down consumer spending. Not easy.

So the ‘answer’ to this recession severity question seems to be not to stimulate consumer spending, but to stimulate industrial growth and job creation.

Any ideas?

Benjamin T Solomon
Managing Principal
QuantumRisk LLC

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Disclosure: I’m a capitalist too, and my musings & opinions on this blog are part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. These musing are not to be taken as an endorsement or disapproval of any persons, entity, goods or services.
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My apologies for this late response to my earlier post on the severity of this recession. I was preparing a paper for a conference. The thesis of my paper is that the experimental data shows that a photon’s probability distribution is not a Gaussian distribution. But this blog is not the right place for it here. You can tell that my focus is in building models that can be experimentally or historically verified by real world data.

OK coming back to this recession. I really hope that the policies that are being placed into effect will turn the economy around, and for this discussion ‘but may be not’. The Dow is at 8440.36 at this minute, and has come up 2,000 from its 6,440.08 low on March 09, 2009. If this upward trend in the Dow holds, this suggests that the economy should turn around 6 to 9 months from March or September to December 2009.

But this 6-9 month lag between the market and the economy is generally true when gas pump prices are below $2.00/gallon (or equivalent).

I view the economy as tessellations of the consumers’ gross incomes, disposable incomes or discretionary incomes. Then one in theory could build a probability distribution of these incomes. Unlike loss modeling where we are looking to the behavior of the tail, in the tessellate model we would cut-off or ignore the 5% or 1% tails, and model how incomes would behave under economic stress.

For example, the gross income tessellate could be used to model tax revenues, the disposable income tessellate to model consumer housing demand and ‘capex’ expenditures, while the discretionary income tessellate would be used to model retail purchases.

Using only averages we can estimate some effects of this tessellate model.

In 2006, the estimated average annual salary of a US small business employee (they account for 50% of the US workforce) was $31,049, and Conference Board tells us that the average per capita discretionary income in 2006 was $9,148. For households with incomes of $50,000 or less, i.e. small business employees, the 2006 discretionary income was $1,900 for the whole family of 2.7 people. This tells us that it is vital to know how to partition the data correctly to get good results.

The average American drives about 12,000 miles per year. At approximately 20 miles to the gallon, this translates to an annualized $1,050 when gas prices were $1.75/gallon in 1Q 2005, and $2,460 in 2Q 2008 when gas prices peaked at $4.25/gallon. (Source: American Petroleum Institute).

Or gasoline cost was up from 11.5% (2005) of discretionary income to 26.9% ( 2008 ) (using 2006 discretionary data for all years).  A sizeable increase. 

But this does not tell the whole story. From a small business employee perspective (50% of US workforce), gasoline costs went from 55% (early 2005) to 90% (mid 2006) to 130% (mid 2008). Definitely not sustainable.

Today (May 19 2009) gas prices are around $2.20/gallon (my guess is that this is on the low side).  This converts to 14.43% & 69.47% of average and small business employee discretionary incomes, respectively.  Or to put it succinctly, 50% of US employees have the discretionary budgets less gas costs reduced to $580 PER YEAR. That is definitely going to ripple through the economy as this is a reduction of consumer spending on other goods & services.

That means the small business employee is already feeling the pinch, and consumer spending of this 50% of the economy has already slowed down again.  We should see this coming through the economy in the next few months.  Also these numbers have not factored the 11 million newly unemployed. My guess is that a second slow down is in the works and should be visible by mid-summer.

Benjamin T Solomon
Managing Principal
QuantumRisk LLC

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Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational/educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position.
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Most forecasters try to be middle of the road, but try to cushion the downside, and ‘enhance’ the upside. The scenario below could become a reality and could lead to an extended recession well into 2011.

1. The raw data suggests that pump prices triggered the house price collapse. The logical cause and effect would be spiking gas prices eliminated many peoples’ discretionary incomes.

2. This reduction in discretionary income rippled throughout the economy as a reduction in consumer spending, a finite budget showing up as reduced demand for goods and services.

3. Therefore, the housing collapse, the mortgage mess, and the banking crisis. But would not have been as severe as it is now if the sub-prime mess was not waiting in the wings.

4. If the Fed/FDIC has underestimated the severity of the banking crisis as Nouriel Roubini  has suggested, we are going to see more bank failures, and further tightening of credit. This may be the case if their methodology addressed mean loss rather than percentile loss (eg CVaR). I’ll research the methodology and will let you know what I think. But don’t get me wrong, I have great respect of Bernake, Bair and Geithner.

5. My crude estimate is that $2.00/gallon is the threshold price for point of inflexion between +ve and –ve economic growth. Gas prices at the pump have exceeded $2.00/gallon. If I am correct we are going to see further slowdown and more job losses.

Therefore, this crude analysis suggests that the Fed/FDIC/forecasters have underestimated this recession severity in the presence of oil price increases, and just may be our recession will last well into 2011.

Benjamin T Solomon
Managing Principal
QuantumRisk LLC

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Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational/educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position.
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Steven Chu, Nobel Laureate, has expressed similar concerns about the effect of oil prices on the economy as I have in Watch the Pump Prices. That is really great.

I believe if we hasten the development and commercialization of non-fossil fuel energy sources, we can create a tremendous number of new skilled and white collar jobs while solving the fossil fuel addiction problem.

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Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational/educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position.
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Paul Krugman’s blog post Bailout for Bunglers was instructive. I particularly liked the end:

“There’s more at stake here than fairness, although that matters too. Saving the economy is going to be very expensive: that $800 billion stimulus plan is probably just a down payment, and rescuing the financial system, even if it’s done right, is going to cost hundreds of billions more. We can’t afford to squander money giving huge windfalls to banks and their executives, merely to preserve the illusion of private ownership.”

Though I agree with Paul Krugman, I think somethink is missing. We need to identify the cause of the recession before we can put forward a recovery package.

From the perspective of business and economic processes, two processes collided in 2005-2008 time frame that resulted in our current recession. The first was the bursting of the house price bubble, and the second was the oil price spike.

The figure below depicts US Home prices up to 2005. House prices peaked in 2006 and started to decline.

shiller_ie2_fig_2-1

Source: Robert Schiller’s United States Housing Bubble (Wikipedia)

The two figures below show average monthly oil prices (Dec 07 to Jan 09) and average yearly oil prices (1967 to 2009).

yearlyavgoilprice

monthlyavgoilprice

Source: OPEC


Conference Board tells us that the average per capita discretionary income in 2006 was $9,148 or gasoline cost was went up from 11.5% (2005) of discretionary income to 26.9% ( 2008 ) (using 2006 discretionary data for all years). A sizeable increase. But this does not tell the whole story.

For households with incomes of $50,000 or less, i.e. small business employees, the 2006 discretionary income was $1,900 for the whole family of 2.7 people. That is, gasoline costs went from 55% (early 2005) to 90% (mid 2006) to 130% (mid 2008). Definitely not sustainable.

Given that the initial toxic mortgages were Alt-A/Subprime loans, and my guess, is that most of these borrowers were small business employees, the gasoline price spike would have killed off these borrowers’ ability to service the loans. No payments resulted in deliquencies, defaults, suffocated demand and finally home price depreciation, and further time-lagged domino effects that scuttled the banks and the rest of the economy.

House prices only started to fall in 2006 when gasoline prices had become unsustainable.

Looking at the graphical data, we can now infer that gas prices at the pump must remain below $2.00/gallon, if the US economy is to come out of this recession any time soon. This is a very important lesson, gasoline prices wiped out a substantial portion of the discretionary income of about half of the US working population.

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Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational/educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position.
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