U.S. bailout package will spark inflation and shift the burden to foreign investors: CIBC World Markets

Inflation will be further stoked by growing oil supply crunch

TORONTO, Jan. 23 /PRNewswire-FirstCall/ - CIBC (CM: TSX; NYSE) - To pay for its multi-trillion dollar bailout and stimulus packages, the Obama administration will print money at an unprecedented rate, a course that will drive up inflation and drive down the greenback while shifting a large part of the financial burden onto foreign investors, finds a new report from CIBC World Markets.

The report predicts that like Argentina in the late 1980s and Zimbabwe today, the U.S. government will simply create more money to fund its plans. "If the central bank prints it, someone will spend it," says Jeff Rubin, chief economist and chief strategist at CIBC World Markets. "Already U.S. money supply is growing at a nearly 20 per cent rate in the last three months and the printing presses are just warming up. And there's no shortage of more troubled assets to monetize along with $1.5 trillion-plus federal deficits to keep money supply growth chugging along in the future.

"As it buys up spread product, the Fed will leave Treasuries to be mopped up by foreigners. Since outsiders, like the People's Bank of China, now own over 50 per cent of America's debt, there has never been a better time to reflate. Why default on your taxpayers when you can default on someone else's? A 10-year Treasury bond will, of course, mature at par, but who's to say the greenback won't sink 40 per cent against the Yuan over its term like it did against the Yen between 1971 and 1981?"

Mr. Rubin notes that while the prospect of reflation may seem incredulous on the cusp of negative U.S. CPI numbers, past deficits that were a mere fraction of what they are today in relation to the size of the American economy, were readily monetized. And without fail, that monetization led to an explosive bout of subsequent inflation.

"The huge World War II deficits saw inflation peak at almost 20 per cent in 1947," adds Mr. Rubin. "When the printing presses were turned up to pay for the Korean War, inflation moved from negative territory to over nine per cent within the space of nine months in the early 1950s. And when Arthur Burns greased the Fed's presses after the Vietnam War, inflation soon made a triumphant return back to double-digit territory.

"Headline U.S. CPI inflation will grab a negative handle in the next few months but it will be running north of four per cent in less than a year."

Adding to these inflationary forces in the next year will be increased pressure on oil prices. While global demand is expected to be down about one per cent in 2009, oil supply is also declining. The plunge in oil prices caused by the recession has put the brakes on a number of new supply projects that were expected to address the depletion loss of nearly four million barrels a day this year alone.

"The IEA (International Energy Agency) recently estimated that the industry will have to spend well over half a trillion dollars annually to meet future demand and counter depletion," says Mr. Rubin. "No one is going to finance those money-losing mega-investments at oil prices anywhere near $40 per barrel. If yesterday's record high prices haven't spurred supply growth, what chances do oil prices a third or a quarter of those record levels have?"

A year ago, Mr. Rubin estimated that production would grow from about 86 million barrels per day in 2008 to around 88 million by decade's end, based on data for 200 pending new projects. However, recent announcements of project cancellations and postponements not only cancel out the expected two million barrel per day increase in global production by 2010, but they are likely to actually drive production down a million barrels per day below last year's levels.

In Canada, a region the IEA expects will be the single largest source of new crude supply, almost three times as important as Saudi Arabia over the next 20 years, cancellations or delays in recent months have already affected about one million barrels per day of planned oil sands capacity. Now, rather than grow by close to 400,000 barrels per day by 2010, total Canadian production is likely to rise by only a third of that.

"That's only the tip of the iceberg since the vast majority of cancellations have been on projects whose first flow dates are well after 2010," adds Mr. Rubin. "If oil prices were to stay at current levels, production, instead of plateauing around 88 million barrels per day by 2012 as we had previously forecast, would decline at an accelerating pace between now and 2015. By 2015, production would decline to around 76 million barrels per day, a level of roughly 10 per cent lower than last year's level. Unlike past oil shocks, there is no longer any newly discovered $10 per barrel North Sea oil to meet a rebound in demand."

He notes that higher prices will ultimately change that supply outlook by reversing some of the cancellations announced in the wake of oil's price plunge. Global demand snapped back at around a three per cent pace after the two declines in oil consumption seen in the early 1980s. Even a 2-2 1/2 per cent bounce back would leave the world facing even tighter supply conditions than it did in 2007 when oil prices moved from $60 to $100 per barrel.

"Back then, demand was about 1.5 million barrels per day more than supply. This imbalance, not only led to a very rapid inventory drawdown, but also attracted speculative activity in oil markets. By our estimates, we expect to see an even larger imbalance, almost two million barrels per day, between recovering demand and shrinking supply as early as 2010.

"When that happens, global oil inventories will plunge, and global oil prices will once again spike. That may well reverse some of the supply destruction that is currently taking place, but not before world oil prices print triple-digit levels again."

The complete CIBC World Markets report is available at:

http://research.cibcwm.com/economic_public/download/sjan09.pdf

CIBC World Markets is the corporate and investment banking arm of CIBC. To deliver on its mandate as a premier client-focused and Canadian-based investment bank, World Markets provides a wide range of credit, capital markets, investment banking, merchant banking and research products and services to government, institutional, corporate and retail clients in Canada and in key markets around the world.

SOURCE CIBC World Markets