The Current Oil Price Picture

There must have been a sigh of relief from inflation watchers as oil prices fell to $63/barrel on September 7. Prices have been declining steadily for a month despite continued tension in the Middle East and the steady “fear factor” drum beat of last few weeks.

The recent drop in oil price by as much as $10/barrel is a result of classic short term supply-demand interplay—swelling stockpile of crude oil relative to softening demand resulting from the end of the summer driving season in the U.S. and major industrial economies. The supply picture was further improved by resumption of loading of oil tankers in Nigeria as the dock strike was settled. The cessation of hostilities in Lebanon certainly had a positive effect on oil prices in the last two weeks.

According to the U.S. Energy Information Administration (EIA), the current drop in crude oil prices is unlikely to be sustained into the next year and crude oil price will average $70/barrel in 2007. The underlying assumption for this likely scenario is: supply will not keeping up with rising demand. On the supply side, the expectation is that there will not be much increase in oil production capacity next year. Most of that increase will come from Saudi Arabia.

The oil price situation is unlikely to change in 2007 unless Middle East tensions are significantly reduced and OPEC turns on the oil spigot further. Oil prices will continue to fluctuate in the range $65-$75 range for the next 12 months with the ebb and flow of problems in the Middle East and supply uncertainties related to it.

Longer Term Oil Picture

There is some good news on the energy front—-the recent discovery of a huge oil field (deposit of ~15 billion barrels) very, very deep (7,000 feet underwater and an additional 20,000 feet below the sea floor) in the Gulf of Mexico by Chevron and its partners. This is an extraordinary technological achievement by one of the leading oil companies of the world. The newly discovered Mexican oilfields will undoubtedly increase U.S. oil reserves.

The challenge, however, is that it will be years before oil production will materialize from this field. Furthermore, it will only make a relatively small impact on the U.S. energy picture with its daily production of 800,000 barrels a day—a small fraction of the U.S. daily oil consumption. (Cambridge Energy Research, Cambridge, Mass.)

With the U.S. as the world’s largest consumer and importer of oil (60 % of U.S. consumption is met by imports that come mostly from highly unstable and dangerous places), this technologically impressive oil strike in the Gulf of Mexico should not lull us into complacency.

I agree with President Bush when he says that we are addicted to foreign and we should lessen our dependency on it. The question is how should we do this? To be serious about this goal we need to do more than just prospect for oil. We as a nation should increase our efforts toward more intensive development of renewable energy sources, continue to enhance energy conservation, and work on greater fuel efficiency in our transportation sector.

Housing in California – July/August 2006

According the California Association of Realtors, the median price of an existing home in California increased by 6.2% in June ($578,000) and sales declined by 26.3% compared to the same period a year ago. This is the first time since November 2001 the back-to-back (May and June ’06) monthly median price of California homes have not increased by double-digit percentages. Obviously the market is slowing down in terms of sales but prices continue to rise; however the rate of price increase is declining.

Although mortgage rates softened a bit in July, they had inched up for five consecutive months between February ’06 and June ’06. Thirty year fixed mortgage rates averaged 6.68% during June ’06 compared to 5.58% in June ’05. Rising rates have been one of the factors underlying recent sales slowdown of existing homes.

The ten California cities with the highest median home prices in June 2006 were:
Beverly Hills: $1,877,500
Burlingame: $1,725,000
Manhattan Beach: $1,575,000
Los Altos: $1,543,500
Newport Beach: $1,347,250
Saratoga: $1,309,000
Mill Valley: $1,294,500
Palos Verde Estates: $1,225,000
Orinda: $1,207,500
La Canada Flintridge: $1.150,000

It is not surprising to note that five of these cities are part of Southern California Riviera and the remaining five are in the San Francisco Bay Area.

The ten California communities that experienced the highest existing home appreciation in June 2006 include: Delano (94%), Beverly Hills (45%), Barstow (37%), Culver City 935.5%), Porterville (45%), Paramount (31.7%), Inglewood (31.3%), Laguna Hills (30.6%), Arroyo Grande (30.5%), and California City (28.3%). None of these cities are in the San Francisco Bay Area; they are mostly in Southern California and Southern Central Valley.

From an existing home annual sales growth (% change –May ’05-May’06)) and price change (same period % change) perspective following is the pattern on a region-by-region basis:
Region                           Change Sales (%)  Change Price (%)
California                          -26.3                          6.2
Central Valley                    -34.5                          2.6
Los Angeles                      -17.0                         11.9
Sacramento                      -38.7                          0.6
San Francisco Ba               -21.0                          3.6
Riverside/San. Bernardino  -33.5                          7.4

All of the above regions show a price increase and a sales decline. The only regions that show price declines (not shown above) between June ’05 and June ’06 are: Santa Cruz County, Palm Springs/Lower desert, and Northern Santa Barbara County. There are no California regions that show increasing sales of existing homes for the period.

Undoubtedly residential real estate is slowing down in all regions of the state but price are still holding firm.

The Fed and the Economy – July/August 2006

On June 29 the Fed in order to ward off inflation raised the Fed Funds rate to 5.25% bringing up the overnight lending rate to its highest level since June 2004.and this was the 17th straight increase in the Fed Funds rate since that time.

In response to the softening in the inflation fighting language used by the Fed chair Mr.Bernanke in his July 19 testimony in the Senate banking Committee hearings the stock market celebrated the possible end in interest rate hikes via a 212-point rise in the Dow on July 20, 2006. The market enthusiasm was not sustainable and did not last more than a day in light of the fact that significant inflation risks remain because of high-energy prices. The onset of serious geopolitical events in Middle East in the last few weeks exacerbates the energy price risk further.

The minutes of the Federal Open Market Committee (the committee that decides on interest rate policy) meetings of June 19-20 reveals significant concerns about the recent rise in the core inflations rate (the CPI minus energy and food prices) which suggests that high energy prices are now getting broadly transmitted into the economy.

According to the U.S. Department of Labor the economy added 113,000 jobs in July 2006 down from the June increase of 124,000 jobs. The U.S. unemployment rate also increased in July to 4.8% from 4.6% in June. This is the highest-level of national unemployment we have had since February 2006 (July unemployment in California stood at 4.9%).

Another clear indication of a slowdown in the economy is that the second quarter 2006 real GDP growth was only 2.6% compared to the blistering pace of 5.6% in the first quarter.

The Department of Labor also reported that average hourly earnings rose for the month by 0.4% to $16.75 in July. This was comparable to the 0.5% wage increase in the month of June. Higher wages mean higher inflation unless the effect is offset by higher productivity.

In light of the June and July data we would say that the next move of the Fed is a toss up. The Fed will be tracking the core rate of inflation, job and wage growth, and productivity growth, as it makes a decision about the next move relating to the Fed Funds Rate in the August ‘06 meeting.

My hope, given the mixed messages from the recent data, is that the Fed will take a pause before it raises rates for the 18th time as current policy will have an impact on the economy for the next six and months and beyond.

Commercial Real Estate – July 2006

For nearly two years U.S. commercial vacancy rates have declined. Average vacancy rate in 72 major office markets across the country in the second quarter stood at 13.8% compared to 14.2% in the first quarter of 2006.Declining vacancy rate has triggered rent increases of 2% for each of the two quarters of this year—another clear sign of a recovery in the commercial real estate market.

The national aggregate vacancy rate data does not give us an accurate picture of office market recovery, as there are large differences among the different U.S. regions. The differences among the various markets reflect the uneven nature of job growth across the country. (Job growth is the prime driver of commercial space use) Another factor in the current resurgence is that smaller companies have created most of the new job growth and this has been a problem for cities that are dominated by major corporations and not hosts to small and medium sized businesses. Other factors that have influenced commercial development in various regions include business friendly local governments and local or regional limitations on office space construction

A key question about the sustainability of commercial real estate in the U.S is what impact will rising interest rates have on the industry? After all interest rates affect commercial mortgage rates just as they affect home mortgage rates.

The major difference between residential and commercial mortgages is that in the former case buyers are mostly private individuals who are sensitive to rate changes compared to the latter where investors are a diverse group that include institutions such as pension funds that can pay cash and not borrow money.

There is another factor underlying the surge in commercial real estate—- strong international demand for U.S. commercial properties. Australia and Germany are the leaders in the foreign stampede to acquire American properties. Why? There are four cogent reasons: a) declining value of the U.S. dollar relative to Australian dollar and the Euro (Germany) that makes U.S. properties more affordable, b) the pull of the number one economy in the world—the U.S., c) flight to safety- (lower political and economic risks in the U.S. than in Europe and Asia), and d) fair laws and highly developed U.S. financial markets attract institutional investors such as pension funds from Australia and Europe.

Bernanke Moves Markets, but Caution is Still Prudent

The power of Federal Reserve Board (“Fed”) pronouncements on financial markets was evident again. Mr.Bernanke’s apparently soothing words about the future course of interest rates in his latest testimony before the Senate banking Committee (July 18th) triggered an immediate rally in the stock market. The Dow Jones Index rose by nearly 180 points in morning trading on July 19th and Treasury Bonds recovered from earlier losses.

What did he actually say? This is the gist: although he was still concerned about inflation (higher energy and commodity prices), slowdown in economic growth would reduce price pressures in the
U.S. economy in the coming months. He also suggested that recent hikes in the Federal Funds Rate are beginning to reduce inflation risk down the road.

The financial markets interpreted Mr. Bernanke’s statements as a hint that the Fed may be coming close to ending its series of interest rate hikes. This interpretation may be a bit premature and Mr. Bernanke confirmed that by saying inflation risks are still very much present and the future course of interest rates depend on actual data on inflation and economic growth over the coming weeks.

Here are some recent economic data that, in my opinion, suggests that the evidence is mixed, we need more data, and the situation needs careful watching:

1. According to the U.S. Labor Department, the CPI in June increased by only 0.2%, the smallest increase since last February. However, the core rate of inflation (CPI minus energy and food prices) increased by 0.3% in June – higher than the CPI.

2. My concern is that core inflation is rising at an annual rate of 3.6%–significantly higher than the “comfort level” core rate of 2.0% annually.

3. The housing industry continues to slow down. The latest Commerce Department data on new home construction declined by 5.3% in June—we need to look at July and August construction before we can suggest a significant trend.

Undoubtedly Mr. Bernanke’s recent testimony to the Senate Banking Committee was encouraging, but the spasmodic one-day response of the stock market to the Fed Chair’s statement does not suggest that the economy is out of the woods. In light of the serious current geopolitical concerns in the
Middle East and the possibility of continued price volatility in the energy markets, jumping to conclusions about the future course of the economy from a “one day wonder” in our stock market is foolhardy at best.

 

Don’t Celebrate Yet: Comments on the Fed’s Latest Interest Rate Hike

The Fed just raised the Fed Funds rate by 0.25% on last Thursday (June 29, 2006) for the 17^th time in the hopes of containing the upward march of inflation. The Fed Funds rate (short term rate that the Fed sets) is now stands at 5.25%–the highest in five years.

The financial markets welcomed the news via a jump in the Dow by 217 points (and the NASDAQ by 63 points) on Friday. Why should the financial markets celebrate rising interest rates? The response normally would have been a drop in the market. It had to do with the softer tone of the Fed statement relating to the announcement – the Fed Open Market Committee was hopeful that a slowing economy might cool down inflationary pressures, and may not need to raise rates further.

My feeling –hold the champagne, the celebration may be premature. The Fed did not shut the door on at least another increase in the Fed Funds rate in August or later. The timing of the next rate increase will depend on how inflation and the strength of the economy fare in the coming weeks. In the next several weeks we need to keep our eyes on the Consumer Price Index (CPI), the Core Rate of inflation (the CPI minus energy and food prices), and job growth data.

Change, Challenge and the Economy

I've just returned from attending an international conference in Barcelona, Spain, on the state of the Internet (you can read a commentary on my trip in my June 18th "Global Village" column in the Contra Costa Times or check my website for archived articles). It continues to amaze me how dramatically the Internet has changed our lives and will continue to do so. As we've seen over the last couple of years, just one aspect of the Internet – blogging – has proven to be a new force that is influencing all of our lives in many unexpected ways - from feeding us news on a moment-by-moment basis to empowering each of us to express ourselves to a truly global audience.

With the news filled with stories about the ups and downs of the Dow, the Nasdaq, changes in employment, trade deficits, global competition, new technology, etc., how can anyone keep up with today's blindingly fast pace of change? As an economist, I'm very much involved in tracking how these changes affect business and the economy, today and into the future. This is quite a challenge. I'm planning on using this blog to share my thoughts and perspectives with you as we all try to make sense of today's economy and tomorrow's business environment.