Inflation Alert

Inflation is an insidious economic cancer. It diminishes asset values, erodes wages and forces people to assume higher risks in managing their financial lives.

It impacts the value of the U.S. dollar, the world’s reserve currency. It can mean higher commodity prices, higher financing costs and fewer government revenues for social welfare support. A higher-valued U.S. dollar saps the strength of foreign economies, exacerbating hunger and wellness and leaving more people in poverty. 

For the last 18 months, the world’s central bankers have struggled to control rampant inflation.  Some inflation was caused by Russia’s invasion of Ukraine. Global energy markets were also disrupted, sending prices sky-high. Soaring European natural gas prices and global crude oil prices boosted the cost of living and operating businesses. Companies could raise prices, but workers could only strike for more pay. 

Consumers responded by buying less. 

Bankers’ inflation playbooks call for reducing liquidity and raising interest rates. Businesses and consumers suffer, reducing economic activity. As painful as this exercise is, it’s the only way to restore price stability. The game plan caused people to lose their jobs as companies needed fewer workers to meet reduced consumer demand. The plan works, but it’s been less effective in the current environment.  Why? The pandemic. 

COVID Drove Inflation Higher

In 2020, when COVID burst on the scene, governments felt the only way to stop the deadly virus was to lock down economies. This meant governments had to provide financial support to people who lost their incomes. Issuing checks to families to replace their lost income due to lockdowns kept economies afloat but added to inflationary pressures. 

People confined to their homes, students attending school via Zoom and workers operating remotely via the Internet all needed additional stuff. Demand for electronics – computers, iPhones, monitors and servers – soared. People needed new furniture to work from home. These goods had to be shipped, which led to congestion at our ports as transportation and distribution networks were stressed unloading and delivering goods to consumers. 

Costs soared. 

Transportation costs continue to be high as diesel fuel prices remain elevated. Higher diesel prices came with the upturn in crude oil demand following the end of the pandemic. Oil prices were propelled higher by the Ukrainian war. Last December, G7 member countries banned Russian crude oil purchases and now its refined products. The restriction and a price cap on what buyers can pay cut Russia’s petroleum income, undercutting the country’s ability to fund its war with Ukraine. 

However, with access to Russian diesel lost, new trade routes were needed. To overcome the disruption ? primarily in unfinished oil – the U.S. turned to other OPEC suppliers and especially to India, where Russian oil is being refined. 

While struggling to keep the economy functioning during and following the pandemic, the Biden Administration embarked on an aggressive effort to transition the country to a net-zero carbon emissions power system. The American Rescue Plan Act and the Inflation Reduction Act assured clean energy developers substantial tax credits to encourage new renewable energy projects. 

One outcome of these laws has been an uptick in plans for increasing renewable fuel output targeting the air and truck transport sectors that cannot easily be electrified. Biodiesel and renewable diesel for truckers and sustainable aviation fuel (SAF) for planes are mandated by California clean energy rules being adopted by other states. 

Government subsidies of $1.00 a gallon for biodiesel and renewable diesel and $1.50 a gallon for SAF are driving the conversion of refineries and the construction of new ones. Importantly, these new fuels require different raw material inputs than a typical oil refinery although their fuel outputs are interchangeable and mixable. These new, clean fuel refineries utilize soybean oil and agricultural wastes, including used cooking oil, as feedstocks to produce their products. 

Getting these new feedstocks to the refineries has created new transportation routes, primarily satisfied by inland marine vessels. This has added new demand for the inland marine transportation and Jones Act tanker markets, ensuring a healthy outlook for their businesses.  

Jones Act Fleet Struggles to Meet Demand

A recent webinar had three U.S. shipping company CEOs discussing the changing nature and challenges facing the domestic marine industry that will lead to higher transportation costs in the future, embedding higher prices in the economy. The Jones Act was enacted in 1920 to support the domestic shipping industry following World War I and requires any cargo traveling by sea between two U.S. ports to sail on an American-owned ship, built in the U.S. and with a majority of its crew being U.S. citizens.

This legislation is controversial as it’s perceived to be a protectionist trade practice outlawed by international trade rules. It’s also accused of being inflationary since international vessels are cheaper to build and operate. But the Jones Act is the law of the land, and its benefits – in terms of national security and supporting the domestic maritime industry – far outweigh its costs. 

Meanwhile, the domestic petroleum industry has been shrinking refining capacity, necessitating increasing volumes of finished products being shipped around the country. Additionally, the U.S. has shifted from being primarily an oil-importing to an oil-exporting country, and that has created new shipping routes. 

Journeys have lengthened as a result. For example, more Gulf Coast refined products are being delivered to California, necessitating the dedication of three to four tankers as roundtrips last for 30 to 40 days. This ties up capacity and crews, boosting fleet utilization but adding to costs. 

Another factor has been the growth of the domestic petrochemical industry. While much of this expansion has been along the Gulf Coast, more petrochemical plants are now scattered around the country, primarily situated on rivers that facilitate the delivery of raw materials and the shipping of final products. That has further added to the demand for Jones Act vessels.

Rate Hikes Needed to Support Fleet Expansion

With new fuel markets, increased refined volumes being shipped to markets lacking sufficient refining capacity, and a growing domestic petrochemical industry, Jones Act fleets are highly utilized. Given projections for these trends to continue, one expects shipping companies to be building new vessels.  However, none are being built according to the CEOs. Why? Because vessel charter rates aren’t high enough to generate acceptable financial returns for building 30- and 40-year life assets. 

When asked why no one was building new barges, tankers and ATBs, Kirby Marine CEO Christian O’Neil rattled off the cost of components needed and how much they have increased in price in the past couple of years. To build a 30,000-barrel tank barge, the 200 percent increase in the price of plate steel has nearly doubled the barge’s cost from a few years ago. O’Neil pointed out that paint costs have increased by 25 percent, oil filters are up 125 percent, wire for electronics is 30-40 percent higher and communication radios cost 130 percent more. 

Moreover, if Kirby were to build a new inland towboat, it would need to install Tier 4 engines that are more fuel and emissions-friendly but would add $1 million more to the unit’s cost than by using Tier 3 engines. O’Neil suggested that inland barge rates must increase by 30-40 percent to trigger the ordering of new marine equipment. 

Even so, new units wouldn’t arrive for 9-12 months. Given the construction time and inflation’s uncertainty, would barge owners demand even higher rates as a hedge against future cost increases or would they demand longer contract times for financial protection? 

Coastal tankers face other cost pressures. New tankers will be subject to International Maritime Organization rules on carbon intensity in fuels. There are no propulsion systems currently available that meet these new IMO rules. With tankers having 40-year lives, building one with an engine that may be ruled out for failing to meet the new fuel rules means risking rapid obsolescence with serious financial risks. 

That risk is in addition to the uncertainty about their demand. These tankers haul gasoline, diesel and aviation fuel supplies that have an uncertain demand outlook given the net-zero emissions mantra –  another potential obsolescence risk. Both conditions will add to inflationary pressures. 

Operators are also concerned about inflation’s impact on operating costs. Future changes in regulations for equipment and the operation of vessels could lift costs. What new rules will govern regulatory-mandated drydockings, further adding to operating expenses? 

Shrinking Supply of Mariners

And what about the need to attract American mariners to crew the new vessels and replace retiring crew members? This has become a significant challenge. One CEO suggested the maritime industry needs to reach down to sixth graders with an educational program about careers in the industry. No one has started such an effort, but if the Jones Act fleet grows it will need more crew and maritime officers. A primary inducement would be higher wages.

High inflation rates will eventually abate as central bank policies take effect. But until something changes, the U.S. is looking at higher energy and transportation costs boosting future inflation.