The Energy Blues

Energy...
Sometimes I think I'm runnin' out of energy
Seems like we use an awful lot for
Heatin' and lightin' and drivin'
Readin' and writin' and jivin'
Energy ... You'd think we'd be savin' it up.

- "The Energy Blues", Schoolhouse Rock

Did you ever think that your financial future would be dictated by something called a "crack spread"? The more that Macro Man thinks about this issue, the more he reckons that the single most important economic variable in the United States these days is the energy crack spread.

This, for the uninitiated, is a measure of refining margins: how much refiners earn for buying crude oil and turning it into gasoline and heating oil. The higher the spread, the bigger the margin; the lower the spread, the smaller the margin.

At the moment, crack spreads are well below the average of the past couple of years, and way, way below the highs of earlier this year. The upshot is that despite the record high and stunning rise in oil prices, the US consumer has not really felt the pinch in motoring or heating bills. Updating a chart posted a couple of weeks ago reveals the massive disparity between crude and product prices.
Why is this important? The lack of energy pass-through has provided a very significant buffer to consumers by maintaining or even raising growth of disposable income. At the same time, it has kept a lid on headline inflation and, by extension, inflation expectations, thus allowing the Fed to reflate by 0.75% over the past six weeks.

Imagine, however, what would happen if crack spreads, pictured above, were to normalize. Eyeballing the top chart, it would appear to imply gasoline prices in excess of $3.75: a full dollar higher than recent levels. How important would that be?

Let's put it this way. The phrase "US house price fall" yields 15.7 million search results on Google. The recent Case/Schiller 20-city house price index was down 4.4% year-on-year. According to recent research from Morgan Stanley, the consumption effects of a 10% decline in house prices is the same as that from a $0.70 rise is gasoline prices. So to put it another way, another dollar on the price of gas would have the same impact as a house price decline more than three times as severe as the current one.

The impact would leave the Fed perched on the horns of a dilemma. Should they ease to mitigate the potential recessionary impact of the negative income shock? Or should they raise to offset the clear threat of letting the inflationary genie out of the bottle? The 1970's Fed chose the former option with disastrous results.

As Macro Man wrote in the comment section of Cassandra's blog last night:

"If (and some would say 'when'), however, crack spreads widen out and gas prices go from $2.75 to $3.75 before you can say the phrase "Chevy Dreadnought", the moment will come when Ben must choose whether to deploy the full capacity of his Sikorsky, or whether to take the train instead (an infinitely less pleasant, yet socially responsible, option.)

Let's just say I'm not expecting to see him on the 6.33 to London Bridge any time soon."

Either way, a rise in crack spreads should be bearish for risky assets; indeed, Macro Man would now identify crack spreads as the single largest threat to his constructive worldview. Therefore, they merit close attention.

Elsewhere, three interesting energy-related observations:

* The major GCC countries all followed the Fed in cutting rates. The UAE must surely be approaching negative real interest rates in the double digits. No doubt the IMF analysts are high-fiving each other to see such prudent policy-making

* Chinese inflation won't just be about food anymore. The government sanctioned a 10% rise in energy prices, which should immediately add 0.3% - 0.4% to headline CPI, and serves as a reminder that one of the reason that non-food inflation has been so low is administered prices.

* The IEA has called on the world's governments to devise ways to reduce energy consumption. Arthur Pigou, please report to the United States. Paging Arthur Pigou.....

October, meanwhile, was a pleasant month for Macro Man, as he made just over 3%: his best month of the year. Virtually every return compartment performed, with equity alpha the sole losing segment courtesy of some of Macro Man's hedging activities.

Even the commodity trades performed, though in typical fashion Macro Man turned a potentially great month in the space into a merely good one by turning $750 gold calls into $740 gold puts with bullion at $760.

Crack spread commentary notwithstanding, Macro Man is not a commodity expert and knows it. The relatively small risk allocation appears justified given the poor intramonth trading.

A source of pride, however, was the performance of the beta plus strategies, which correctly stayed with FX carry during the mid-month hiccups. Macro Man's preferred indicator remains firmly planted in risk-seeking territory, unsurprisingly, so he remains positioned even at apparently nosebleed levels.

Perhaps a recvoery in crack spreads will be the very thing to push Macro Man and and others off of the FX carry bandwagon....