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NEW YORK (
TheStreet ) -- Oil prices have generally been rising since the lows in the economy and markets of early 2009. But, in recent weeks, the two most watched benchmarks for crude oil have decoupled. The price for Brent crude oil has moved sharply higher to over $100 per barrel, while the price of West Texas Intermediate (WTI) crude oil has dropped back to around $85 (Chart 1). This unprecedented decoupling of oil prices leaves many to ponder which benchmark will prove to be right and what it means for consumers, the economy and the markets.
WTI crude prices, used primarily in the United States, are falling due to:
Inventories of crude oil are at record levels in the United States. Well above the five-year average and at the top end of the five-year range of inventories for this time of year (Chart 2).
Demand growth has been modest. For example, a gauge of gasoline demand, miles traveled by vehicles in the United States, is rising only slowly on a year-over-year basis, according to the U.S. Department of Transportation (Chart 3).
Supply has been strong with oil imports from Canada having been up along with higher U.S. oil production (despite the decline in Gulf of Mexico production).
The price of Brent crude, used primarily in Europe and Asia, is rising due to:
High demand from Asian emerging markets.
Declining production in the North Sea.
The geopolitical risk of disruption of transportation through the Suez Canal.
We believe the prices will re-converge with Brent falling and WTI rising in price over the coming months. A rise in WTI back above $90 per barrel is not necessarily a negative for economic growth in the United States. Historically, the threshold where crude oil prices limit demand --and, therefore, economic growth--is above $110 (Chart 4).
However, an accompanying rise in gasoline prices has been shown to lift expectations of future inflation in consumer surveys -- something we know the Fed watches closely in formulating monetary policy. In fact, the minutes to the Jan. 26, 2011
policymaking meeting (released last week) noted that "households' long-term inflation expectations stayed in the range that has prevailed for some time." An uptick in gasoline prices could boost these expectations and bias the Fed toward starting a series of rate hikes that may slow U.S. economic growth.
Rate hikes are now fully priced in to the Fed funds futures market for as soon as November of 2011. But even before the Fed takes any action to tighten monetary policy, higher inflation expectations would likely boost bond yields and continue the rise in rates that drove the 10-year Treasury note up to about 3.75% in early February 2011 from 3.4% in January 2011.
We believe focusing on the theme of reflation is important to investment success in 2011. Portfolio exposure to commodities asset classes and effectively reducing bond duration, or interest rate sensitivity, are two ways to potentially profit and protect from the return of inflation.
Jeffrey is Chief Market Strategist and Executive Vice President at LPL Financial.