Although deflationary trends are blazing across the economy, the media is fixated on inflation. All areas of the supply chain—commodities, manufacturing, transportation, and even retail—are now experiencing shortages and lowering prices. Price hikes caused by supply shock constraints are dissolving like a champagne wine cellar during a heat wave. (Now there’s a metaphor!) As the shortages started to ease in recent months, prices began to move downward.
Take the most spectacular example first: natural gas, Putin’s secret weapon that was meant to trap the EU in its grasp.
The Nat Gas Story
First of all, supplies of natural gas are suddenly abundant. Inventories are nearly full.
- “After having to give up its reliance on Russian gas and find alternative suppliers to help prepare for winter, Germany’s gas storage was 97.7 % full on Thursday. European stocks are at 93.8 %, well above the goal to reach 80 % capacity before November.”
More gas is on the way – LNG tankers are swarming Europe.
- “Companies that sell natural gas, driven by the high prices, flooded the European market. Special ships with huge amounts of liquefied natural gas raced to Europe from the United States, Qatar and other countries…” – NY Times, Oct 25, 2022
Which of course has crushed prices.
- “The flush storage facilities have caused short-term spot prices in Europe to plummet: Europe’s natural gas benchmark price fell to 93 euros per megawatt-hour on Tuesday, a drop of more than 70% from its peak.”
Back to normal, one might say – at least in the U.S.
European prices are still elevated above the pre-Ukraine norm, but the price is down 75% since August. The European gas market has even seen the sort of bizarre glitch that hit the American crude oil market in April 2020 — transactions executing (or at least quoting) at negative prices.
- “At one point, the hourly Dutch price slipped into the negative, meaning that, with so little space left to store purchased gas, traders were briefly willing to pay someone to take gas off their hands. It marked an extraordinary moment.”
The same happened here.
- “The prices of natural gas in the U.S. state of Texas fell into negative territory this week….Natural gas prices in the U.S. Permian Basin fell 85% to $0.41 per million British thermal units on Monday, and fell further to around -$2 on Tuesday.”
European forecasts are mixed. Recent headlines divide between those that scream (“Europe faces ‘unprecedented risk’ of a gas shortage” – AP, Oct 3) and those that express bewilderment (“Europe now has so much natural gas that prices just dipped below zero” – CNN, Oct 26). A few months ago the media was full of dire predictions based on the supposed shortage of Liquid Natural Gas unloading facilities in Europe. LNG terminals were said to be in the wrong places (e.g., Spain, poorly connected by pipelines to pass LNG gas to the rest of Europe), and it was reported that it would take years to fix this. Now, suddenly, it may take only a few months.
- “Germany is rushing to build five floating LNG terminals by the end of the year… Work has already started while permit applications are still being scrutinised. ‘Everything that’s usually done step by step, we are now doing in parallel’ – politicians are confident the [first] terminal and its connecting pipeline can be built in seven months.” (The Guardian, August 18 2022)
Full inventories mean demand will slack off significantly. (It was the aggressive program to fill these reserves that created the price spike earlier this year. That buying is over.)
Big-picture-wise, the natural gas market is beginning to worry more about gluts than shortages. The crowd of LNG tankers is leaning hard on the psychology of the energy markets, and that G-word is popping up in the headlines (“Is Another Gas Glut on the Horizon?” – WSJ, Oct 24, 2022) and it is even being cited as a positive factor for relieving pressure on non-European markets (“Europe Gas Glut to Help Ease Winter LNG Crunch in Asia” – Bloomberg, Oct 25, 2022)
Longer term, a substantial structural increase in natural gas production is beginning to show. Gas producers are responding to opportunity, and supply is expanding, globally –
- “The current buildup of LNG ships waiting in European waters to offload their cargo has started to push prices down, hinting at how quickly the market can shift….New LNG commitments have been stacking up after years of little investment. An additional 105 million metric tons are expected to come online by 2026, a significant increase [27%] given global LNG trade was 380 million tons in 2021.”
This is likely an underestimate. U.S. shale gas production grew 73% from 2015 to 2020, before leveling off in the stress of the pandemic shock. It is projected to grow by another 30% in this decade, and there are indications that investment is picking up. Shale gas from fracking operations is a significant under-developed source of future supply in many other countries, including China, Mexico, Argentina, Algeria and Indonesia.
In short, the market is working, balancing supply and demand through the pricing mechanism. This is what markets do. Supply shortages create price spikes. Producers ramp up to take advantage of the profit opportunity. Supply expands. Consumers economize. Prices drop. Demand slacks off even more as inventories fill. Fears of a glut depress prices further. After the overshoot and undershoot, “normalcy” returns.
Commodities in General (Beyond Nat Gas)
The same thing is happening in many sectors of the economy. At the front end of the supply chain, all major commodities have experienced large and rapid price declines in the last 8 months.
In the middle of the supply chain, the shipping bottlenecks are unblocking.
- “The backup of container ships off Southern California’s coast that was at the heart of U.S. supply chain congestion during the Covid-19 pandemic has effectively disappeared. The queue of ships waiting to unload at the ports of Los Angeles and Long Beach fell from a peak of 109 ships in January to four vessels this week.”
And of course, this means that international shipping costs have plummeted.
- “By September 2021, the average cost for shipping a container from Asia to the U.S. West Coast exceeded $20,000, a sixfold increase from a year earlier. Last week, the average cost to ship a container from Asia to the U.S. West Coast had declined 84% from a year earlier to $2,720.”
This trend applies not just to transoceanic shipments.. Domestic overland freight prices have been declining since the Spring.
Producer prices have peaked, and are forecasted to decline rapidly in the next several quarters.
Retail inventories for consumer goods are filling up.
- “U.S. retailers have been sitting on a record $732 billion of inventory as of July — a 21 % increase from a year ago.”
Suppliers of “general merchandise” (excl food, pharmaceuticals, gasoline) – department stores and outlets like Walmart, Target, and Home Depot, selling clothing, household goods, furniture, and appliances – are especially affected by the inventory bubble.
Many retailers are seeing this trend.
- “Shares of Target’s stock have fallen more than 34 % so far this year, largely related to inventory concerns. Nike shares, meanwhile, fell nearly 13 % in one day in late September after the retail giant said it would have to “aggressively” mark down products on its website and in its outlet stores….”
- “Department store chain Kohl’s has 48 % more inventory than it did a year ago… It plans to put those products out on shelves this fall.”
- “Not even the country’s largest online retailer has been immune from inventory woes. An Amazon warehouse near Nashville has been overwhelmed by excess inventory.”
Even automakers are impacted:
- “New vehicle inventory has increased another 12.19% in October, the second consecutive month it has risen over 10%….New vehicle inventory reached its highest level since June 2021.”
As day follows night, these gluts will drive prices lower. Firms are discounting aggressively to reduce inventory levels.
- “There are already signs that prices are easing in some parts of the economy. Appliances, bedroom furniture, jewellery, TVs and smartphones were all cheaper in August than they were in July.”
Retail prices for general merchandise averaged 1.2% per month from Sept 2021 through March 2022, but since then they have increased by an average of just 0.02% per month (essentially flat).
The Inflation “Bubble” Bursts
This is what the end of the inflationary bubble looks like. Deflationary trends are working their way through the supply chain. Commodity prices are falling. Transportation costs are down. The Producer Price Index is dropping. Retail inventories expanding, indicating that the trend should shortly reach the consumer.
But when the CPI starts to show this trend, it will already be late – because of the way the index is constructed and reported. That means the Federal Reserve, which has bolted monetary policy to the headline index, will also be late.
The implications are mixed. For investors, the prospect of an undershoot by the market is growing with every passing month. The eventual recognition of the reversal of the inflationary trends will be the signal for an explosive rally.
For the rest of us, however, the prospect is not so pleasant. The Fed’s policy moves (lots of tough talk, performative rate increases, aggressive quantitative tightening) will hurt the economy, and hurt workers and consumers, as they take effect in the form of increased unemployment and slowing growth (possible recession). It’s what comes from using the wrong tools for the job (interest rates won’t cure supply bottlenecks), and steering by means of the rear-view mirror (the backwards-looking CPI).
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