FT Energy Source Comment: Orange crush

Gregor Macdonald writes:

The present reflation will do very little for individual Americans. If 11.6 per cent  unemployment in California during a time of $72 oil doesn’t make the point, then perhaps 15 per cent  unemployment and $100 oil will.

Higher equity prices alone, unless accompanied by organic growth that is both broad-based and real, will not be enough to offset the effects of higher interest rates, higher energy costs, stagnant job growth, falling wages in real terms, and a ravaged housing market. While these competing forces are at play in nearly all places in the United States, they are particularly acute in the golden state of California.

California has over 35m residents, and 22m of them live in the big, populated counties of the south. Known as “SoCal”, this is the part of the state where the single family, detached home is common and where most residents have to commute long distances by car. The five big counties of the south – Los Angeles, Riverside, San Bernardino, Orange, and San Diego – were not built to handle $100 oil (the average price in 2008), let alone $150 oil. They were not even built to handle $75 oil.

At the end of the second world war, San Bernardino for example had only 200,000 residents living beneath its eponymous dry mountain range. Now, that one county holds 2m people. The conversion of dry lands, such as citrus groves, to housing was all made possible by the construction of freeways into a ganglion of networked but endless suburbs. And the freeways worked, after they were built, because oil remained cheap for 50 years. Until this decade, of course. And that’s when the problems started, for California.

The growth the US experienced after the year 2000 was phantom, and appropriately has now been entirely given back. All those jobs, which were really just debt-based reflationary jobs in housing and finance, have vanished as the US workforce in 2009 returns to the same levels as 1999. And what’s the plan, for the country now? Reflate, reflate, reflate. But as Elizabeth Warren, the chair of the Congressional Oversight Panel, put it last week, this is not likely to work “if the idea is to use the practices of the last five years, and see if we can get a little bubble going.” In other words, we have already seen that the US economy cannot sustainably live on reflation alone. So why are we trying to do so again?

In a piece I wrote in June called “Overhead Crush” I explained that a downward slope had now formed via the twin pressures of interest rates and oil prices. Every time the economy would attempt to recover during reflation, energy and credit costs were now fated to move too far ahead of real growth. The result would be an oscillation in the economy, with successively lower highs. This is precisely what’s happening now. The economy has recovered from a deep, spike trough. But, at the cost of a doubling of oil prices and a nearly 80% rise in the yield on the 10 year US Treasury. In the midst of what is regarded as recovery, the risk of another downturn is growing.

It’s astonishing that oil can be at $72 during the midst of what is frankly a soft depression in the US. It was just five years ago this spring that oil at $40 was thought unsustainably high. Additionally, there is no need to grapple with a binary choice between inflation and deflation. Here in the States, with California as our pole star, we are getting both at the same time. Constrained by this new ceiling, it is nearly impossible to imagine how the US can achieve a sustainable recovery without California. And California itself cannot recover without SoCal. The plowing under of acres of oranges to build miles of freeways over 50 years made so much sense at the time. Now, the region is saddled with a transport system that starts to buckle when petrol reaches $5 a gallon. What’s really crushing however is that the US is left to pine, rather hopelessly, for the return of two price structures unlikely to be seen again: seriously expensive homes, and very cheap gasoline.

Gregor Macdonald is an oil analyst and energy sector investor. He blogs at gregor.us