Bianco Research L.L.C. An A R T A C

Volume 19, No. 81

Bianco Research L.L.C.

An Arbor Research & Trading Affiliated Company

Independent ? Objective ? Original

1731 North Marcey, Chicago IL 60614



Commentary

Market Opinions and Topics of Interest

By Howard L. Simons (847) 304-1511 October 31, 2008

Gasoline, Productivity And Inflation After The Downturn

Much has changed since our May Commentary on gasoline expenditures, inflation and productivity. That document was written when crude oil was at $125, roughly twice the recent price level, and one week before global equities reached their post-Bear Stearns high. Global growth was still strong, investment banks were still walking the earth and Benjamin Bernanke was three weeks away from threatening to raise interest rates to combat stillrising inflation.

While vehicle-miles declined 5.6% in August from year-ago levels, a significant level to be sure and one consistent with declines in the 1974-1975 and 1980 recessions, it is important to remember prices are affected not by vehicle-miles but rather by total volumetric demand. We repeat from May (original boldface):

If we index constant-dollar gasoline prices to July 1984 levels and map the logarithm

Where Is The Lead/Lag Relationship?

0.875 0.750 0.625 0.500 0.375 0.250 0.125 0.000 -0.125 -0.250 -0.375 -0.500 -0.625 -0.750 -0.875 -1.000 -1.125 -1.250 -1.375 -1.500

Constant-Dollar Gasoline (Left Scale)

9.25

9.20

9.15

9.10

9.05

9.00

8.95

8.90

8.85

Gasoline Demand

8.80

(Right Scale)

8.75

8.70

Productivity

Implied gasoline demand (thin red line, following page) fell 3.0% from year-ago levels in the third quarter; on a seasonally adjusted basis (light red line), it fell 2.2%. Constant-dollar GDP per barrel of gasoline consumed (thick blue line) has declined

thereof (thin red line, left-hand chart) against the logarithm of implied gasoline demand (thick blue line), we see total gasoline demand has risen higher in an erratic fashion for almost a quarter-century independent of price.

If price elasticity of demand was operating as designed, we would see a negative trend in the scatter diagram (right-hand chart). The trend is erratically positive. The partial contribution of price to total demand may be negative, but it is being overwhelmed by income- and engineeringrelated factors. Both continue to support our original thesis that gasoline demand can rise independently of price so long as the economic value added by its consumption exceeds the total cost paid.

Where Is The Negative Price Elasticity Of Demand?

9.25 9.20 9.15 9.10 9.05 9.00 8.95 8.90 8.85 8.80 8.75 8.70

Logarithm Of Gasoline Re-Indexed To July 1984 = 100%

0.64% before seasonal adjustment and is at a record high after seasonal adjustment (light blue line).

Logarithm Of Gasoline Re-Indexed To July 1984 = 100% (Thin Red Line)

1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Logarithm Of U.S. Implied Gasoline Demand, MMB/D (Thick Blue Line)

Logarithm Of U.S. Implied Gasoline Demand, MMB/D -1.500 -1.375 -1.250 -1.125 -1.000 -0.875 -0.750 -0.625 -0.500 -0.375 -0.250 -0.125 0.000 0.125 0.250 0.375 0.500 0.625 0.750 0.875

U.S. Gasoline Demand, Thousand Barrels Per Day (Thin Red Line)

1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Real GDP Per Barrel (Thick Blue Line)

Bianco Research, L.L.C.

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October 31, 2008

This much seems clear: The U.S. and indeed the global economy were able to absorb higher petroleum prices without crisis; they have been unable to absorb the credit crunch with similar

equanimity. Any decline in petroleum demand produced by the credit crunch and its income effects will exceed that of higher prices.

Rising Productivity of U.S. Gasoline Consumption

9,750 9,500 9,250 9,000 8,750 8,500 8,250 8,000 7,750 7,500 7,250 7,000 6,750 6,500 6,250 6,000

Implied Gasoline Demand (Left Scale)

Constant $ GDP/B (Right Scale)

$3,500 $3,300 $3,100 $2,900 $2,700 $2,500 $2,300 $2,100 $1,900

Gasoline And Inflation

We note, as before, how a simple timeline is more than twice as robust as an explanatory variable for the Consumer Price index (thick blue line) as are wholesale gasoline prices (thin red line); the comparative r2 values are .995 and .489. As

gasoline prices have been rising for nine years and the CPI only recently has moved over trend, we still find gasoline prices a poor metric for the CPI. Of course, this may say more about the CPI's construction than about the impact of gasoline prices on household budgets.

Gasoline Does Not Drive Inflation

Consumer Price Index (Thick Blue Line)

87 Octane Gasoline, USGC, Cents Per Gallon (Thin Red Line)

350

325

Gasoline

(Left Scale)

300

275

250

225

200

175

150

r2 = .995

125

100

75

50

25

CPI (Right Scale)

220

210

200

190

180

170

160

150

140

r2 = .489

130

120

110

100

1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

The Consumption Link

If we blend the rising consumption noted above with the rising price, we must get rising total consumer expenditures for gasoline. We can proxy this effect by taking retail sales at service stations as a

percentage of total personal consumption (thick blue line, following page). It leads year-over-year changes in the CPI (red columns) by six months on average.

Bianco Research, L.L.C.

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October 31, 2008

The last datum is for September. We noted in May that if gasoline continued to claim a larger share of consumer budgets in April and May, which occurred, upward pressure on the CPI would result, which also occurred.

The recent drop in gasoline prices is still too shortlived to have produced any material changes in

consumer budgets yet; once again, consumer spending is going to be affected much more by the incipient recession and destruction of household wealth than it is by gasoline prices. If all trends currently observed persist, we should see downward pressure on the CPI through the first quarter of 2009.

Gasoline Expenditures And Consumer Inflation

Gasoline / Personal Expenditures (Blue Line)

CPI PCYA Led 6 Months (Red Columns)

5.8% 5.5% 5.2% 4.9% 4.6% 4.3% 4.0% 3.7% 3.4% 3.1% 2.8% 2.5% 2.2% 1.9% 1.6% 1.3% 1.0%

CPI Y-o-Y Led 6 Months

(Left Scale)

Gasoline Expenditures / Personal Consumption (Right Scale)

6.10% 5.90% 5.70% 5.50% 5.30% 5.10% 4.90% 4.70% 4.50% 4.30% 4.10% 3.90% 3.70% 3.50% 3.30% 3.10% 2.90% 2.70%

Jan-92 Jul-92 Jan-93 Jul-93 Jan-94 Jul-94 Jan-95 Jul-95 Jan-96 Jul-96 Jan-97 Jul-97 Jan-98 Jul-98 Jan-99 Jul-99 Jan-00 Jul-00 Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08

Conclusion

One of the precepts of behavioral finance is pain and pleasure produce highly asymmetric effects; the pain of loss is roughly three times as great as the pleasure of gain. Investors also have a hypertrophic sense of entitlement; gains are supposed to happen while losses are not. Journalists, we can attest, are far less curious about 900-point gains in the Dow Jones Industrial Average than they are about 500point losses.

The treatment of petroleum prices in general and gasoline prices in particular is consistent with these observations. We have written a series of Market Facts noting the positive partial contribution of crude oil prices to the S&P 500, and others noting the weak and unstable contribution of energy prices to

inflation expectations, and it is safe to say neither statistical demonstration has been embraced wholeheartedly.

We were asked many times during the September 2007 ? July 2008 doubling of crude oil prices what it would take to bring them back down and we answered consistently, "A global recession." Lower gasoline prices are of small solace in this context, ranking just above a 2% dividend yield on a stock whose price has fallen by 50%.

When the economy recovers, the long-term bull market in energy prices will return and will not derail that recovery so long as the economic value added by energy purchases exceed their total cost.

Bianco Research, L.L.C.

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October 31, 2008

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