In February, the Producer Price Index (PPI) fell by 0.6%, a far bigger decline than the 0.2% drop expected by the consensus of forecasts. However, all of the decline came from a bigger-than-expected fall in Energy prices. The core index, which strips out the volatile food and energy components rose by 0.1%, which was in line with forecasts.

The decline in the headline number only partially reversed the big 1.4% increase in January, which came on top of a 0.4% rise in December. Core prices have been much more stable (as is normally the case) with this month’s 0.1% rise coming on top of a 0.3% increase in January and an unchanged reading in December.  Unfortunately, energy prices, especially crude oil, have rallied so far in March, so the headline number for March is likely to be back in the plus column.

If we look farther up the production chain, price pressures also cooled significantly in February. At the intermediate stage of processing (think Bread, Flour, Wheat to keep Finished, Intermediate and Crude goods separate in your mind) prices rose only 0.1% if February, a sharp deceleration from the 1.7% rise in January and the 0.6% increase in December.

A 2nd Look at Intermediates

On the other hand, at the core level for intermediate goods, prices did accelerate to a 0.9% increases after back-to-back rises of 0.5% in the previous two months. Intermediate food prices fell 0.4% on top of a 0.3% decline in January, but those back-to-back declines did not erase the 1.8% increase in December.

Intermediate energy prices fell 2.7% after increases of 6.9% in January and 0.5% in December. Prices at the crude level, which are essentially commodities, can be very volatile.

Volatility in Crude Prices

On a headline basis, crude prices fell by 3.5% after a 9.6% spike in January and a 0.8% rise in December. Even stripping out food and energy, crude level prices can really jump around, with a 0.6% decline in February not even coming close to erasing the 6.6% rise in January and the 4.5% increase in December. Crude energy prices fell by 6.4% after a 16.4% increase in January and a 2.8% decline in December.

Year over year, prices for all finished goods have risen 4.4%, which is a bit on the scary-sounding side. However, that mostly reflects the rebound in the price of energy from extremely depressed levels a year ago. Core prices, which are what the Federal Reserve tends to keep a closer eye on, are up just 1.0%.

While rising energy prices do have the potential to feed into the price of everything else, so far it does not seem to be doing so. Year over year, intermediate stage goods are actually up just 3.0%, which is below the increase at the finished level.

Not only that, but the rate of change is slowing  In January at the intermediate level prices were up 4.6% year over year and in December they were up 5.6%. The same cannot be said at the crude level here the year-over-year price changes are high and accelerating.

Crude goods prices in February were 28.6% higher than a year ago, while in January they were up 25.2% year over year and in December they were up “just” 12.2% year over year.

Results Match Capacity Utilization Report

It is worth noting that this fits with what we saw in the Capacity Utilization report that came out on Monday (see here). In February, crude good production facilities were operating at 86.2% of capacity, which is roughly in line with the long term historic average of 86.5% of capacity.

Plants that produce intermediate goods were running at just 69.6% of capacity, far below the long-term average rates of 81.6%. Factories that produce finished goods were more or less in the same boat as the intermediate facilities, operating at just 70.8% of capacity, which is well below the long-term average rate of 77.5%.

With operating rates so low, the producers of those goods do not have the leverage to be able to pass through the higher crude goods prices. This would seem to indicate that producers of crude goods, like copper miner Freeport McMoRan (FCX) and oil and gas E&P firms, should be better positioned than firms closer to making the final consumer products.

When looking for E&P companies, look for those that are well positioned to increase their production over the next few years. Some of those that look interesting to me include Petrobras (PBR) with its giant offshore fields, EnCana (ECA), which is ramping up natural gas production from the shale plays, and for those of you looking for a smaller cap name that will really be increasing production this year, ATP Oil and Gas (ATPG) is where a new project in the Gulf of Mexico is coming on line and should more than double production this year.

The low year-over-year increase in the core prices confirms that the Fed is doing the right thing in keeping the Fed funds rate at “exceptionally low levels for an extended period of time.” Unemployment and idle capacity are the bigger threat to the economy than inflation right now. We will see if this is true at the consumer level (which is much more important) tomorrow morning.

Dirk van Dijk, CFA is the Chief Equity Strategist for With more than 25 years investment experience he has become a popular commentator appearing in the Wall Street Journal and on CNBC. Dirk is also the Editor in charge of the market beating Zacks Strategic Investor service.

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