Breaking Point

It's nice to see that Stephen Roach is back from his summer vacation. In the first paragraph of his first missive since returning to his duties at Morgan Stanley, he reminds us once again, why he is our favorite economist:

"On the surface, the global economy seems to be doing just fine. Yet just beneath that seemingly tranquil surface, the imbalances and tensions are only getting worse."

Yes, the recurring worry of all but the true believers and the supply-siders - what lies beneath the surface. What exactly is it that could be festering beneath the smooth outer layer of oft-repeated government statistics? That is, government statistics for the world's economic locomotive which paint a pretty macroeconomic picture of a healthy non-inflationary economy - 3.4% GDP, 5.0% unemployment, and 2.5% inflation.

"At first blush, there seems to be little reason to worry -- according to our US team, personal consumption growth is tracking a 5.5% gain in the current quarter. But consider the costs of that stellar accomplishment -- a personal saving rate that has finally hit the “zero” threshold, debt ratios that continue to move into the stratosphere, and asset-led underpinnings of residential property markets that are now firmly in bubble territory. Courtesy of surging oil prices, these costs are now at the breaking point, in my view."

So, zero savings, stratospheric debt, and a housing bubble when combined with higher gasoline prices and some big heating oil bills this winter could be a problem?

An interesting theory, but we're talking about the American consumer here. Surely the indefatigable American consumer can handle an extra 50 cents a gallon at the gas station.

Just the Beginning

Well, 50 cents may just be the beginning. Let's look again at the Matt Simmons interview with Jim Puplava over at Financial Sense Online:

MATT: ... we’re going to be lucky to get through the Summer without some periodic shortages. We probably will, but the odds are probably as high we will have some shortages, and then if we get through the Summer we have a fabulous respite from Labor Day to Thanksgiving, until we hunker down to try to figure out how the world gets through the Winter of 2005 and 2006 because oil demand globally could easily go to 86-88 million bpd during the Winter, and that could easily exceed supply by 2-5 million bpd.[38:53]

JIM: If that was to happen we would almost be looking at $75-80 oil, I suspect.

MATT: No, no, no. Oil prices could easily go up 5-10 times.

Hmmm... Five to ten times. That would make for some interesting gas price signs out at the curb, and some fascinating news stories.

We read the other day that the cost of oil represents 44% of the cost of gasoline. That would mean that today, all other things being equal, if gas is priced at $2.70 per gallon here in California, and oil were to double in cost, then the price of gas would rise 44% to $3.89. In a more severe case, but still not at Mr. Simmons' worst case scenario of a ten-fold increase in oil prices, if oil were to quintuple in cost, then the price of gas would rise 176% to $7.46.

Hmmm... $7.46 a gallon.

How Indefatigable?

This could really put a crimp in the lifestyle of a new homeowner. Consider the example of a couple who recently bought a home having stretched their purchasing power to limits that were unheard of just five years ago, with total allowable debt service of over 50% of gross income.

There's not too much left over at the end of the month, but that hasn't been a problem yet.

Now, let's factor in rising gas prices. Say the couple normally drives 12,000 miles each with an average fuel economy of 20 miles per gallon. This works out to be a total of 2000 miles or 100 gallons of gas per month. So, all other things being equal, if oil doubles in cost, the monthly gasoline bill goes up by $119, and if oil quintuples in cost, the monthly gasoline bill goes up by $476.

Ouch!

Of course the couple will probably drive less and maybe start carpooling, so the actual cost increase will not be as large as the calculations above, but at the same time, prices of all other goods and services that are dependent upon fuel costs will rise.

Combine these increased fuel costs with the effect of rising short term interest rates on adjustable rate mortgages or other debt service such as ever increasing home equity lines of credit (used more and more to purchase expensive gasoline) and it's easy to see how making ends meet could get increasingly difficult.

It's easy to see how this could be a breaking point.