Volatile Fuel Prices Killing the Economy | The Canadian Encyclopedia


Volatile Fuel Prices Killing the Economy

When gasoline prices in Central Canada hit record highs in early May, Industry Minister Tony Clement did what he always does when consumer rage boils over: he donned his populist cape and channelled citizens' fury against a shadowy adversary--in this case, Big Oil.

This article was originally published in Maclean's Magazine on May 30, 2011

Volatile Fuel Prices Killing the Economy

When gasoline prices in Central Canada hit record highs in early May, Industry Minister Tony Clement did what he always does when consumer rage boils over: he donned his populist cape and channelled citizens' fury against a shadowy adversary--in this case, Big Oil. Standing in the driveway of a Toronto home, flanked by black and white Volkswagens and facing a wall of TV cameras, Clement bemoaned the lack of transparency in how PUMP prices are set. He then vowed to summon executives from the refining, distribution and retail industries to Ottawa for hearings. "All I know is that prices are going up and down and sideways and no one really knows why," he said.

He was partly right, in that prices are zig-zagging wildly. At the start of May, oil and gasoline prices reached punishingly high levels, rekindling dark memories of the spike in energy costs that tipped the global economy into recession in 2008. Then, in the span of just a few days, oil prices, along with most other commodities, went into free fall. Gas prices have begun to drift down too, though not nearly as fast. But by the time MPs actually get around to holding hearings several months from now, the price of crude may well have fallen to the point that this most recent bout of pain at the pumps will have been forgotten--or it may have soared so high that the only affordable way anybody will be getting to Parliament Hill is by bicycle.

But where Clement was wrong was in his contention that nobody can explain what's behind the extreme price movements. On the contrary, a growing number of experts in the INDUSTRY as well as academia have come to the conclusion that excessive speculation by traders and investors, aided by ultra-low interest rates and easy money, is severely distorting the market. "You simply can't explain these levels of volatility by supply and demand because market fundamentals don't shift that quickly over such a short period of time," says Michael Greenberger, a law professor at the University of Maryland who, in the 1990s, was in charge of the trading and markets division at the Commodity Futures Trading Commission, the U.S. government agency that regulates commodity futures. "Most observers now believe speculators are actively manipulating oil prices."

Consumers are no doubt happy that oil prices are heading south for the time being. And while there's understandable anger that gasoline prices haven't come down as quickly, there's typically a lag effect, so analysts expect pump prices to drop further. But here's the thing. High oil and fuel prices aren't necessarily what we should be most worried about. The real threat to the economy--to households and businesses alike--is the sheer unpredictability of energy costs. Over the past five years the price of west Texas crude, the primary American benchmark for oil, has yo-yoed from US$60 a barrel to US$145 in 2008, all the way back down to US$30 during the recession, then up again to US$114, before settling this year around US$100. That last drop, of nearly 13 per cent, occurred over four days, a shift that a decade ago might have occurred over the span of months.

Such extreme swings in energy prices are leaving companies and consumers paralyzed. If you're a business manager, how do you decide whether to invest or hire when you have no idea how much one of your largest expenses will cost even a month from now? For prospective home or car buyers, it's a similar story. Do you buy a big home in the suburbs and risk high gas prices for your daily commute, or pay more to live in the city and skip the car altogether? "The volatility can actually slow investment behaviour, and when you do that, you begin to slow the pace at which the economy can potentially grow," says Kenneth Medlock, a fellow in energy studies at the James A. Baker III Institute for Public Policy at Rice University. "It's putting a chokehold on investment."

In other words, wild swings in oil prices threaten to cripple the economy. And experts say it could get much worse.

For an economy like the U.S., which is overwhelmingly reliant on consumer spending, any sharp increase in oil prices wreaks havoc. According to James Hamilton, a professor of economics at the University of California, San Diego, 10 out of 11 recessions since the Second World War were preceded by a spike in energy prices. The reason is simple. When U.S. gasoline prices reach levels like US$3.50 a gallon--they're currently at US$3.92 a gallon--discretionary spending comes to a halt. People stop buying gadgets, they eat out less, and they put less mileage on their vehicles. In fact, Hamilton argues that the slowdown in 2007 and 2008 might not have developed into a full-blown recession at all, were it not for a severe decline in U.S. domestic auto production, itself the result of high fuel prices. Absent the collapse of the auto sector, Hamilton argues the economy would have eked out 1.2 per cent of growth between the fourth quarter of 2007 and the third quarter of 2008. Instead, by then it was already in recession.

There's plenty of evidence that the return to high oil prices is already hurting the U.S. economy. A poll conducted by Associated Press-GfK in late March--when oil prices had already risen 26 per cent since the start of the year to US$108 a barrel--revealed that two-thirds of Americans expected rising gasoline prices to cause hardship for them or their families in the coming months. Seventy-one per cent said they'd been forced to cut back on other expenses, while 64 per cent were driving less and just over half cancelled their vacation plans to stay closer to home. At the time, Mark Zandi, chief economist at Moody's Analytics, estimated higher oil prices had chopped 0.5 percentage points from growth in the first quarter. "The surge in oil prices since the end of last year is already doing significant damage," he said.

The situation is Canada is more complex, given our large resource sector, which benefits when commodity prices are strong. But still, Canada continues to rely heavily on the American economic engine for growth; another slump there would hit us hard.

The good news, Hamilton told Maclean's, is that this most recent spike in energy prices shouldn't result in another outright recession. That's because U.S. consumers never fully went back to their SUV-driving ways, and so they are not as badly exposed to pump pains this time around. The U.S. is also enjoying income and job gains, which are helping to offset higher fuel costs. But the extreme volatility in the price of oil, not to mention other commodities, is doing serious long-term damage to the economy and goes a long way to explain the halting pace of the recovery, say economists. In the U.S. there are fears that the violent swings in oil prices are causing companies to delay hiring.

At the very least, the ups and downs in oil prices are putting serious strains on companies. Not surprisingly, one of the most hard-hit sectors is transportation. As with all airlines, fuel is the single largest expense for WestJet, accounting for 30 per cent of its costs. Every penny increase in the price of fuel costs the company an extra $10 million. Since January alone, the rise in the price of jet fuel from 70 cents a litre to 90 cents has taken $200 million off the company's bottom line on an annual basis, according to Robert Palmer, a spokesman for WestJet. "The volatility makes the situation that much worse, because at least if you knew oil prices would rise and remain there, you could adjust your budget," he says. "But because you don't know whether oil is going to go up or down one week to the next, or how high it might go, it's very difficult to run your business when your biggest input cost is fluctuating so wildly."

To protect itself from price swings, WestJet has hedged roughly 20 per cent of its planned jet fuel needs for the year through futures contracts, which allow it to buy fuel at set prices down the road. Still, that only does so much. Higher fuel prices have forced all airlines to pass on part of the costs to passengers. Since January, WestJet has instituted five fare increases of between $5 and $15 each time. "On the one hand we're forced to pass on some of these costs, but the last thing we want to do is de-stimulate demand for air travel," says Palmer. "So far we've been very fortunate that hasn't happened."

For small- and medium-sized businesses though, hedging against rising fuel costs isn't even an option, says Jayson Myers, CEO of the Canadian Manufacturers and Exporters trade group. Hedging strategies are complex and costly, and in a market where commodity prices are see-sawing wildly, the potential for companies to bet wrong on the future price of fuel is high. Besides, having to manage a hedging strategy in volatile markets means companies are less focused on their actual lines of business.

For Canadian companies, the chaos in commodity markets is made worse by whipsaw movements of the loonie, says Myers. Commodities are priced in U.S. dollars, yet since 2007 the exchange rate has swung from $1.07, down to 78 cents and back to $1.03.

Volatility in oil prices is taking its toll on households, too. The two biggest purchases any family typically makes are a house and car, and swings in gasoline prices make those decisions extremely difficult.

We've already seen this play out in the types of vehicles consumers have opted for over the past few years. As oil prices crossed the US$100 mark earlier this year, Canadian and American households began shifting to smaller, more fuel-efficient vehicles. In the U.S., sales of compact cars and small crossovers jumped 40 per cent in March and April from the year before, and now account for nearly one-quarter of all sales, up from less than than 20 per cent last year, according to a report from Scotia Economics. It's a similar story in Canada, where small cars and crossovers are the fastest growing segment, replacing pickups and minivans. In fact, in the U.S., truck sales are at their lowest level in three decades, even though just last fall those gas guzzlers were staging a major comeback. What that means is there are a lot of people who bought larger vehicles when oil prices were dramatically cheaper last year, and are paying the price when it comes time to fill up.

A similar phenomenon is playing out in the real estate sector. In recent years, the city of Barrie, Ont., has emerged as a far-flung bedroom community of Toronto, which is located about 90 km to the south. Homebuyers are drawn to Barrie's affordable house prices and proximity to Ontario's cottage country, with the trade-off being a rather lengthy commute of between one hour to 1½ hours to the city each morning, and then back again after work.

But rising gas prices--or, more accurately, wildly fluctuating gas prices--have thrown a wrench into the calculations of Barrie homebuyers, who are finding it difficult to determine whether it still makes financial sense to live so far away from their jobs. "It's really hard to budget when gas prices have gone up by 40 per cent in a year," says Terry LeClair, a Barrie real estate broker. "We've definitely got some sticker shock going on right now." He calculates a typical Barrie commuter, who was spending $350 to $400 a month on fill-ups, now spends an extra $140 a month on gas--roughly what it costs to carry an additional $40,000 with a 30-year variable-rate mortgage at current rates. The result? "You're looking at a more stagnant market because people are trying to get accustomed to this higher amount," LeClair says. "They're asking themselves whether they want to spend three hours on the highway every day and still put $500 in the tank every month."

On the surface, there are lots of reasons why pump prices have fluctuated so much lately. When explaining the surge in energy costs earlier this year, analysts pointed to unrest in Libya, strong growth in China and wild storms and floods in the southern U.S. that curtailed supply. Then, when prices fell, it was attributed to the death of Osama bin Laden, a potential slowdown in the U.S. economy and the debt crisis in Europe. In short, these are complex and uncertain times, so expect oil prices to gyrate wildly.

But it's folly to believe that in the past, when volatility was tamer, the world was any simpler. And for all the talk of "peak oil"--the theory that world oil production has reached its capacity--the actual balance between supply and demand has remained relatively constant, says the former commodities market official Greenberger.

What has changed is that in the mid-2000s investment firms started to offer investors new ways to bet on the continued rise of raw material prices with a variety of investment vehicles tied to commodity indexes. These products, which Greenberger calls "betting parties for wealthy investors and financial institutions," started out with US$13 billion in assets in 2004. But within four years that figure had jumped to more than US$300 billion. Then when the financial crisis hit, investors yanked US$75 billion out of such funds, which Greenberger argues was the driving force behind the collapse in commodity prices in 2008. As investor confidence returned after the Great Recession, the amount of money flowing back into these commodity investments skyrocketed. According to a recent report by Barclays Capital, commodity assets under management climbed above US$400 billion for the first time ever in March.

At the same time, commodity futures markets have undergone a seismic shift. In simple terms, futures allow producers and consumers to hedge their risks by locking in prices for raw materials. Non-commercial traders, or speculators, have always played a crucial role by providing liquidity, but only ever made up less than 30 per cent of the market. In 2000, the U.S. government deregulated commodity markets. As a result, financial traders, who have no intention of ever actually buying or selling any barrels of oil, now account for 70 per cent of the market.

As if adding fuel to the fire, central banks have kept interest rates near historical lows, and pumped trillions of dollars worth of new money into the global economy to reignite growth. As a result, money has never been cheaper and easier for investors to borrow--a speculator's dream.

Can the crazed ups and downs of oil prices be tamed? It's often said that the best cure for high prices is high prices. When fuel is expensive, consumers cut back, and eventually prices fall back in line. But experts say the massive swings we've witnessed in oil prices prove that the dynamic between supply and demand is badly broken. The Dodd-Frank financial reform law, passed by Washington in the wake of the financial crisis, does call on the Commodity Futures Trading Commission to clamp down on excessive speculation in futures markets. But so far the new rules face fierce opposition from the industry and Republican lawmakers.

Whatever happens, don't expect the volatility to end soon, says Greenberger. While oil, and hence gasoline prices, may be falling right now, there's simply so much speculative money chasing commodities that the market is just as likely to reverse gear again. In other words, this wild and destructive roller coaster ride could have a long way to go.


Maclean's May 30, 2011