Oil and the Macro-economy 2010 Macroeconomic Cause and Effect, and the Impact of Financial Flows

Daniel P. Ahn, Ph.D. January 2010

1

Oil and the Macro-economy •

Demand:

Impact of downturn on US demand

•

Financial flows:

Growth of passive index investors and retail ETFs

•

QE and deficits:

Setting the macro stage for inflation expectations, dollar depreciation

•

Disentanglement: Disentangling demand vs. supply oil shocks to determine macro impact

2

Oil prices peaked in July 2008, plunged, then bounced back WTI reached an all-time high of $147.27/bbl, but the price in real terms (2000$) topped out at $96.84. The 36% slide in October was the largest monthly drop ever, but prompt prices rebounded sharply to half the 2008 peak. Real and nominal WTI (2000-09 monthly average)

Jan-00=100 160 140

Nominal WTI Prices Dollar-adjusted WTI Prices Inflation-Adjusted WTI Prices

120 100 80 60 40 20 0 2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

3

Economic downturn and demand outlook Recovery sees permanent demand destruction in gasoline but potential bounce back in distillate

4

Through the Looking-Glass Domestic petroleum demand has continued to lag despite headline V mb/d 2005

2010

18

Dec

Nov

Oct

Sep

Aug

Jul

Jun

May

Apr

17

Y-o-y demand changes by product

10%

1.0

5%

0.5

0%

0.0

Distillate

Gasoline

Residual

Jet Fuel

LPG

Propane

-0.5

GDP vs. 2005-07 average Total Products vs. 2005-07 average Gasoline vs. 2005-07 average Distillate vs. 2005-07 average

-1.0 -1.5 -2.0

-25% 2005

2009

19

mb/d 1.5

-20%

2008

20

%chng 15%

-15%

2007

21

GDP and petroleum demand vs. 2005-07 avg

-10%

2006

22

The main sources of this destruction has been in gasoline and distillate demand.

-5%

US Total Products Supplied

23

Mar




The roughly 2mb/d of demand destruction seen in the fall of 2008 has not been reversed, and current demand levels trail the 20+ mb/d of demand seen pre-crisis.

US total petroleum products supplied

Feb




Despite the headline V seen in broad macroeconomic indicators such as GDP and industrial production, petroleum products has not recovered apace.

Jan




2007

2009

-2.5 Jan-07

Jul-07

Jan-08

Jul-08

Jan-09

Jul-09

Source: Bloomberg, LCM Research. 5

Distilled Bounce The laggard distillate may recover strongly due to returning industrial activity








Historically, there has been a reasonably steady relationship between industrial activity and distillate demand (adjusted for seasonality), where a 10% increase in industrial production is reflected in a 8.5% increase in distillate demand. This relationship has largely remained stable despite the crisis and the out-of-trend fall in industrial production relative to overall GDP. With industrial production typically “overshooting” both to the downside and to the upside during a business cycle, the signs point to a continued surge in industrial activity for inventory restocking, etc. as the recovery takes root. This suggests that distillate demand, hitherto the laggard in the petroleum complex, may see something of a bounce back. A modest +2.5% growth in GDP for 2010 may see as high as 5-6% bounce in IP, suggesting a 4-5% (160-200kb/d) recovery in distillate demand.

Industrial production to distillate demand log dmd 8.45

Log Distillate Demand to IP 1995-2007 Linear (1995-2007)

8.40 8.35

2008-2009 Linear (2008-2009)

8.30 y = 0.8431x + 4.3569 R2 = 0.7813

8.25 8.20 8.15

y = 0.827x + 4.4007 R2 = 0.7163

8.10 8.05 8.00 7.95 4.35

4.40

4.45

4.50

4.55

4.60

4.65

4.70

4.75

Historical GDP to IP relationship log IP 4.8 4.7 4.6 4.5 4.4

Industrial lag

Industrial surge

4.3 4.2

IP vs. GDP 2Q80 to 2Q08 IP vs. GDP 3Q08 to present Linear (IP vs. GDP 2Q80 to 2Q08) Linear (IP vs. GDP 3Q08 to present)

4.1 4 3.9 8.6

8.8

9

9.2

9.4

9.6

Source: US EIA, BEA. 6

Distilled Bounce, Cont’d Continued industrial inventory restocking activity and seasonal factors

Seasonal movements in distillate demand

Quadrant1

55 50 45 Dec-09

40 35 30

Quadrant3

Quadrant4

25

new orders

20 20

30

40

50

60

70

80

4-week average distillate inventory movements kb/d

Seasonal Distillate Factors

log dmd

inventories Quadrant2 60

4-w k changes in US Distillate Stocks

600

12% 10% 8% 6% 4% 2% 0% -2% -4% -6% -8%

400 200 0 -200 -400

Dec

Nov

Oct

Sep

Aug

2008 2006 2010 Jul

May

-800

Jun

2009 2007 2005

-600

Apr

2009

2005

2003

2001

1999

1997

1995

+9%/-6%

2007

+5%/-4%

Mar




ISM Inventory/Order Cycle

Feb




Data from the ISM show a surge of new orders, but still below-average inventory levels, leaving room for more stock-building activity. On top of the secular increases from continued industrial activity, there are seasonal factors, which though recently diminishing in magnitude, still may account for another +150kb/d of demand. Altogether, the 300-350kb/d of demand promises to make a noticeable dent in the massive distillate inventory overhang.

Jan




Source: Bloomberg, EIA, LCM Research. 7

The “New Normal” for Gasoline Driving habit shifts and vehicle efficiency have permanently destroyed demand








In contrast to distillate’s stable relationship with industrial activity, gasoline demand has broken the historic relationship it had sustained with personal expenditure. Unlike distillate, gasoline demand features a larger discretionary component subject to the whims of the consumer decision-making and the health of their wallets. And consumers have decided, in light of a weak labor market and continued credit constraints, to cut back on their driving. Vehicle miles-travelled, typically around or above 250bn miles-travelled, has dropped by an average 6bn miles-travelled in 2008-09. And these shifts in driving habits will likely be a permanent feature of the broader shifts in personal expenditure away from durable and non-durable spending, and remain resilient to a headline economic recovery.

Industrial production to distillate demand log dmd 9.20

Log Gasoline Demand to PCE 1995-2007 Linear (1995-2007)

9.15

2008-2009 Linear (2008-2009)

9.10 9.05 "New normal" -350 to -400kb/d of permanent demand destruction

9.00 8.95 8.90 8.60

8.70

8.80

8.90

9.00

9.10

9.20

US motor vehicle miles traveled, 2005-2009 bn miles 260 255 250 245 240 2009 235 Jan

Feb

2008 Mar

Apr

2007 May

2006 Jun

Jul

2005 Aug

Sep

Oct

Nov

Dec

Source: US EIA, BEA. 8

“New Normal,” Cont’d The gasoline downshift is part of a broader consumer spending reorientation








On top of behavioral shifts, the US government has moved ahead with vehicle efficiency standards and bio-fuel mandates. The Energy Independence and Security Act of 2007 imposes new CAFÉ standards, rising annually from 2011 to 2020, imposing 35 mpg limits for both cars and SUVs. While initiatives for improved efficiency standards dated to before the onset of the recession, the crisis and cash-for-clunkers programs have accelerated fleet efficiency gains as consumers switched from thirsty SUVs and light trucks to more efficient compact cars. This suggests that gasoline demand may have peaked , and would operate under a “new normal” -350 to -400kb/d lower than past levels, added to another -250kb/d in seasonal demand weakness for Q1 2010.

Seasonal movements in gasoline demand

log PCE 9.2

PCE vs. GDP 3Q08 to present

9.1

Personal expenditures have held up w ell w ith GDP

9 8.9 8.8 8.7 8.6 9

9.1

4%

60

2%

40

0%

20

-2%

0

-4%

-20 +4%/-3% +5%/-7% 2009

2007

2005

2003

2001

1999

1997

9.4

9.5

9.6

Services

Non-Durables

Durables

-40 -60 -80

-10% 1995

9.3

100 80

-8%

9.2

M-o-m changes in Personal Spending Components

6%

-6%

PCE vs. GDP 2Q80 to 2Q08

$bn

Seasonal Gasoline Factors

log dmd

GDP and Personal Expenditure

-100 2005

2006

2007

2008

2009

Source: Bloomberg, EIA, LCM Research. 9

Return of oil.com Returning risk appetite, inflation fears, and FX weakness drive financial investment into oil

10

Oil matures from a peripheral to an integrated asset Macro themes of a global risk recovery, dollar weakness, and inflation risk





Historically, oil and other commodities have reflected local and global demand/supply balances, but had little systematic relationships with other macro asset classes such as the US dollar exchange rate or equities. But recently, oil and other commodities have recently been unusually sensitive to movements in dollar, equity, and inflation movements, even more so than gold, the traditional commodity asset class of choice.

Historical Gold/DXY Correlations %correlation 20%

0

0% -10%

-0.5

-20% -30%

-1

-40%

-1.5

-50%

DXY-Gold correlations

-60% -80% 1988

1990

30% 20% 10% 0% -10% -20% Since 2004, the dollaroil relationship has turned sharply negative

DXY-WTI correlations

-50% -60% 1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

1992

1994 1996

1998

2000

2002

2004

2006

2008

-2.5 2010

Historical WTI/S&P Correlations

%correlation

-40%

-2

Relationship Slope

-70%

Historical WTI/DXY Correlations

-30%

0.5

10%

2008

2010

%correlation 60% 50% 40% 30% 20% 10% 0% -10% -20% -30% -40% -50% -60% 1988 1990

S&P-WTI correlations

Since late 2008, the equityoil relationship has also turned positive 1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

Source: Bloomberg, LCM Research. 11

The elephants of the pits: passive index investors Index investment, at its peak, accounted for 25% of all long interest in WTI paper Rise of passive commodity indices





Passive commodity indices, providing beta exposure to large institutional investors such as university endowments and pension funds, grew rapidly since 2006. From around $75bn in Jan-06, they peaked near $300bn in Jul-08, before plummeting. Recently, they have grown again to approach $200bn. After large liquidations from July 2008 to January 2009, we are seeing financial investment flow in oil and other commodities return with a vengeance, which 2010 rebalancing only paused. History of AUM and cumulative inflows into passive commodity indices $bn 300 250

AUM minus Inflow

Cumulative Inflow

200 150 100 50 Jan-06

Jul-06

Jan-07

Jul-07

Jan-08

Jul-08

Jan-09

Jul-09

Jan-10

________________ Source: Bloomberg, CFTC, GSCI, DJ-AIG, LCM Research. 12

Return of both general indices and oil-specific ETFs Data on the cost of production see the strongest rate of deflation in decades





For WTI crude oil, we estimate cumulative index inflow of $33bn into a total WTI AUM of about $93bn in Jun-08. To put in perspective, the entire market capitalization of all WTI open interest on the NYMEX exchange is about $380bn. Hence, index investment accounted for about a quarter of all long interest in paper oil. Recently, index investment into the crudes are returning, but 2009 also saw the emergence of oil and gas-related ETFs, such as USO and UNG, which grew even as index AUM fell.

Index AUM in WTI and Brent $bn 125 100

AUM minus Inflow

75 50 25 0 Jan-06

Jul-06

Net Index Inflows into WTI and Brent

5

Jul-07

Jan-08

Jul-08

Jan-09

Jul-09

Jan-10

% of Prompt Open Interest (rhs)

$bn 4.5

Total AUM (lhs)

%OI 30%

4

Significant Inflow s

25%

3.5

0

3

20%

2.5

-5

15%

2

-10

1.5

Massive outflows

10%

1

-15 -20 Jan-06

Jan-07

The Rise and Fall of Oil ETFs

Some inflow but shift tow ard alternate investment vehicles

$bn 10

Cumulative Inflow

5%

0.5 Jun-06

Dec-06

May-07

Nov-07

Apr-08

Oct-08

Mar-09

Sep-09

0 Jan-07

0% May-07

Sep-07

Jan-08

May-08

Sep-08

Jan-09

May-09

Source: BLS, LCMC Research. 13

Commodities seem to be pricing in high levels of inflation Financial investment into commodities have returned in force


Oil markets have shown surprising price resilience despite weak fundamental data. – The response in oil markets to the FOMC QE announcement in March 17, 2009 was all out-of-proportion to responses in other assets such as US 10-year Treasuries, Gold, the US Dollar




Fears of inflation can drive financial diversification into real assets such as gold, oil, and other commodities, potentially stimulating headline inflation and self-fulfilling the prophecy. – Annualized outlays on crude oil have already reached roughly $500bn for the US, and $2tn for world.




Nominal inflation-driven instead of fundamental-driven commodity price spikes raise the specter of 1970s-style stagflation, prolonging economic pain. Breakeven rates and crude oil prices

%inflation 5

5-yr Breakeven Rates

WTI Crude Oil

4 3 2

Market reactions to 3/17 announcement $/bbl 160

3/17=100 114

140

112

120

110

100 80

1 0 -1 -2 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09

60

108

1/DXY

Gold

WTI 60m

US 10-yr Treasuries, the USD, and Gold stabilized, but longdated WTI continued to rally

Rally from Fed QE

106 104 102

40

100

20

98

0 Jan-10

10-yr Treasury

96 3/17

3/18

3/19

3/20

3/21

3/22

3/23

3/24

3/25

Source: Bloomberg, LCMC. 14

QE QED Heavy QE programs, fiscal balance deterioration set stage for inflation/currency fears

15

The March of the Plumbers: the Fed Commercial banks have increased excess reserves comparable to QE injections








Facing a frozen credit market and the threat of a deflationary spiral, central banks have drastically loosened monetary policy. The Fed has been notable in pushing interest rates to effectively zero and pursuing asset purchases in a dramatic “quantitative easing” experiment. The Fed’s purchases of mortgage-backed securities and institutional debt has seen the “unconventional” portion of its balance sheet rise to over $1.2tn, pushing their total balance sheet from pre-crisis levels around 8.4% of GDP to over 22% of GDP. However, the systemic hoarding by commercial banks of the liquidity injections in the form of reserves have raised fears of an inflationary surge once credit conditions ease sufficiently to drive the excess money supply into the system. Fed QE asset purchases, Jan-08 to present

$bn 1400

Term Auction Facility AIG Credit Mortgage-Backed Securities

Term Security Lending Federal Agency Debt

Depository Holdings at Fed, Jan-08 to present Depository Institution Excess Reserves Depository Institution Required Reserves

$bn 1200

1200

1000

1000

800

800 600 600 400

400

200

200 0 Jan-08

Apr-08

Jul-08

Oct-08

Jan-09

Apr-09

Jul-09

Oct-09

0 Jan-08

Apr-08

Jul-08

Oct-08

Jan-09

Apr-09

Jul-09

Oct-09

Source: Bloomberg, LCM Research. 16

Debt Troubles Medium-term projections show grim US public finance picture








On top of the pressures from QE, the US legislature has largely failed to present a credible plan to bring medium-term deficits under control. The CBO forecasts that unless dramatic cost savings are achieved in the fast-growing Medicare/Medicaid and Social Security liabilities, public debt could soar to nearly 200% by 2035 and 300% by 2050. The pressures of servicing these deficits have grown as foreigners, notably the Chinese, have grown increasingly reluctant to fund them through US Treasury purchases at remarkably low rates of interest. This has raised market fears of a potential “monetization” of public liabilities through irresponsible use of the printing press, sparking a ruinous inflation or stagflation last seen in the 1970s. CBO alternative scenario for US federal budgets %GDP 70 60

%GDP Spending (lhs) Revenues (lhs) Public Debt as % of GDP (rhs)

800

%GDP 70

700

60

600

50

500

40

400

30

300

20

200

10

100

0

0 2009

2020

2035

2050

2080

Components of CBO fiscal spending projections Interest Medicaid Medicare Social Security Other noninterest spending

50 40 30 20 10 0 2009

2020

2035

2050

2080

Source: Bloomberg, LCM Research. 17

Whither inflation? Combination of QE and fiscal deficits has stirred fears of high inflation
One

side consequence of the US “kitchen sink” approach to monetary QE and fiscal stimuli has been to stir fears of high medium-term inflation.
The combination of massive US government borrowing to pay for the fiscal stimulus package and the concurrent large expansion of money supply raised dark whispers of “printing money,” akin to the hyperinflationary episodes in Germany and Austria during the interwar period.
But the experience of the Japanese “lost decade” shows how massive QE can coexist with a continued deflation without an effective turnaround. US Government Deficit as % of GDP %GDP 4

US Fiscal Deficit % of GDP

2 0 -2 -4 -6 -8 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009

Central Bank Balance Sheets as % of GDP %GDP

EU

Japan

UK

US

2008

2009

80% 70% 60% 50% 40% 30% 20% 10% 0% 2001

2002

2003

2004

2005

2006

2007

Source: Bloomberg, LCM Research. 18

Phillips in Peril?








Ironically, the “green shoots” of optimism that the Federal Reserve and other policymakers have strived so hard to reinforce to prevent a deflationary spiral may potentially backfired. The dislocation between the real slack in the economy and optimism over a sharp V-shaped recovery and accompanying expectations of higher nominal inflation has opened up the possibility of a shift outward in the Phillips Curve. Maintaining central bank independence and maneuvering room against any inflationary unhinging will be critical to preventing another 1970s-style stagflationary episode. Phillips Curve in the 1970s and 2000s %inflation 14

1970-1980

2000-2009

1979

12 1970s stagflation

10

1973

8 2000s moderation

6

?

4

2009

2 %unemp

0 3

4

5

6

7

8

9

10

Source: St. Louis Fed, LCM Research. 19

For a Rainy Day The dollar had been artificially pushed through flight-to-quality and its reversal











Despite concerns over the sustainability of US fiscal and current account deficits, the verdict of international investors has thus far been a ringing confirmation of the superiority of dollar-denominated assets, particularly US Treasuries, as a safe haven when the world turns ugly. Net purchases by foreigners of US long-term securities surged amid the credit crisis, peaking at $36.5bn in October of last year. However, the capital flows have begun a reversal that may accelerate as the global economy mends and return-starved investors start seeking performance, particularly in stronger emerging economies. Already, China has reduced its net Treasury purchases to virtually nothing by November. Nevertheless, the even economic poorer outlook and budgetary troubles from the other mature economies such as the EU and Japan, has led to a recent stabilization of the dollar against a trade-weighted basket US Trade-weighted dollar

Net foreign purchases of US Treasuries $bn 200

US Trade-Weighted Dollar

Jan-08=100 120 115

Other

China

Japan

Carribean Banking Centers

Russia

OPEC

150

-10% decline

100

110

-5.5% decline 50

105 0 100

flight-to-quality

retrenchment

95 90 Jan-08

-50

stabilization

-100 -150

May-08

Sep-08

Jan-09

May-09

Sep-09

Jan-10

Feb-08

May-08

Aug-08

Nov-08

Feb-09

May-09

Aug-09

Source: Bloomberg, US Treasury, LCM Research. 20

Reservations over the reserve currency The US is substituting private borrowing with public borrowing







Even as US personal savings rose to historic highs as consumers cut back on spending, the US government has expanded its spending, thus substituting private for public borrowing. To pay for this fiscal spending despite falling tax revenues, the US Treasury must massively expand their liabilities through borrowing. Purchases from China, the GCC, and other investors, despite artificially unattractive yields, will be critical to maintain the fiscal soundness of the US economy. US foreign liabilities have increased to 127% of GDP as of 2007 and will likely accelerate higher. Meanwhile, US assets abroad have also reached about 100% of GDP. Typically, these liabilities should be reduced through a succession of current account surpluses, with the value of net exports reducing the outstanding net liabilities. US Private and Public Savings Rates

%

US fiscal deficit as % of GDP

6

US personal savings as % of disposable income

Private and Official Foreign Liabilities as % of GDP %GDP 0%

4

-20%

2

-40%

0

-60%

-2 -80%

-4

-100%

-6 -8 -10 Jan-07

Official Foreign Liabilities

Private Foreiign Liabilities

-120%

Apr-07

Jul-07

Oct-07

Jan-08

Apr-08

Jul-08

Oct-08

Jan-09

-140% 1976

1979

1982

1985

1988

1991

1994

1997

2000

2003

2006

Source: Bloomberg, BEA, LCM Research. 21

Exorbitant privileges of currency adjustment Weakness in the USD may deflate away external liabilities


The US also benefits from “exorbitant privilege” in subtler ways than d’Estaing noted – Nearly all US foreign liabilities are USD denominated, while perhaps 70% of US assets abroad are in local currency. – A rough rule of thumb would suggest a 10% depreciation in the dollar would, ceteris paribus, transfer about 7% of GDP (in US $) onto the US international balance sheet. By comparison, the US current account deficit was “only” 4.7% of GDP in 4Q08.







Gourinchas and Rey (2007) estimate that nearly 27% of the US external adjustment was absorbed by the excess returns US investors gained relative to foreign investors, much due to dollar depreciation. We believe this international portfolio adjustment mechanism, rather than pure nominal inflation, may be the key mechanism to release pressures of US fiscal and monetary expansion PBC US Treasury and Non-Treasury Reserves

$tn 2.2

1978=100 180

PBC US Treasury Holdings Non-US Treasury Foreign Reserves

2

US Net External Liabilities y-o-y Changes and Dollar US Net External Liability Changes

$bn

US Dollar

400

160

1.8 1.6

200

140

0

1.4 1.2

120

1

100

-200

0.8 0.4

-600

60

0.2 0 Mar-00

-400

80

0.6

Mar-01

Mar-02

Mar-03

Mar-04

Mar-05

Mar-06

Mar-07

Mar-08

40 1977

1980

1983

1986

1989

1992

1995

1998

2001

2004

-800 2007

Source: People’s Bank of China, State Administration of Foreign Exchange, US Treasury, LCM Research. 22

Daniel P. Ahn Director of Macroeconomic Research Head of Quantitative Portfolio Strategies [email protected] 212.651.3198

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•Certification The views expressed in this report accurately reflect the personal views of Daniel P. Ahn, the primary individual responsible for this report, about the subject referred to herein, and no part of such compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed herein. •Disclaimer The material herein has been prepared and/ or issued by LCM, member SIPC, and/or of its affiliates. LCM accepts responsibility for the content of this material in connection with its distribution in the United States. This report is based on current public information that LCM considers reliable, but we do not represent that this information, including any third party information, is accurate or complete and it should not be relied upon as such. Opinions expressed herein reflect the opinion the primary individual responsible for this report and are subject to change without notice. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy the instruments mentioned in it. No part of the document may be reproduced without full attribution.

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